10. Fair Value

Fair value is the price that would be received upon sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The following fair value hierarchy is used in selecting inputs, with the highest priority given to Level 1, as these are the most transparent or reliable:

•

Level 1 — Quoted prices for identical instruments in active markets.

•

Level 2 — Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs are observable directly or indirectly.

•

Level 3 — Valuations derived from valuation techniques in which one or more significant inputs are unobservable.

Lorillard is responsible for the valuation process and as part of this process may use data from outside sources in establishing fair value. Lorillard performs due diligence to understand the inputs used or how the data was calculated or derived, and corroborates the reasonableness of external inputs in the valuation process.

Assets and liabilities measured at fair value on a recurring basis at December 31, 2013 were as follows:


(In millions)	Level 1		Level 2		Level 3		Total
Cash and Cash Equivalents:
Prime money market funds	$	1,454	$	—	$	—	$	1,454

Total cash and cash equivalents	$	1,454	$	—	$	—	$	1,454

Short-term investments:
Corporate debt securities	$	—	$	63	$	—	$	63
U.S. Government agency obligations		—		59		—		59
Commercial paper		—		22		—		22
International government obligations		—		13		—		13

Total short-term investments	$	—	$	157			$	157

Long-term investments:
Corporate debt securities	$	—	$	86	$	—	$	86
U.S. Government agency obligations		—		7		—		7

Total long-term investments	$	—	$	93	$	—	$	93

Derivative Asset:
Interest rate swaps — fixed to floating rate	$	—	$	60	$	—	$	60

Other liabilities:
SKYCIG earn out liability	$	—	$	—	$	25	$	25

Assets and liabilities measured at fair value on a recurring basis at December 31, 2012 were as follows:


(In millions)	Level 1		Level 2		Level 3		Total
Cash and Cash Equivalents:
Prime money market funds	$	1,720	$	—	$	—	$	1,720

Total cash and cash equivalents	$	1,720	$	—	$	—	$	1,720

Derivative Asset:
Interest rate swaps — fixed to floating rate	$	—	$	111	$	—	$	111

Total derivative asset	$	—	$	111	$	—	$	111

The fair value of the money market funds, classified as Level 1, utilized quoted prices in active markets.

The fair value of the interest rate swaps, classified as Level 2, utilized a market approach model using the notional amount of the interest rate swap and observable inputs of time to maturity and market interest rates. See Note 13, “Derivative Instruments,” for additional information on the interest rate swaps.

Short-term and long-term investments include corporate debt securities, U.S. Government agency obligations, commercial paper and international government obligations. The fair value of corporate debt securities, U.S. Government agency obligations, commercial paper and international government obligations, classified as Level 2, utilized quoted prices for identical assets in less active markets or quoted prices for similar assets in active markets.

There were no transfers between levels within the fair value hierarchy. There were no Level 3 purchases, sales, issuances or settlements of these assets and liabilities for the years ended 2013 and 2012, with the exception of the incurrence of the earn out liability associated with the acquisition of SKYCIG.

Proceeds from sales, maturities and calls of available for sale securities were $26 million for the twelve months ended December 31, 2013. There were no proceeds from sales, maturities and calls of available for sale securities for the twelve months ended December 31, 2012. For the twelve months ended December 31, 2013, realized gains and losses on sales, maturities and calls of available for sale securities were not material. There were no realized gains and losses on sales, maturities and calls of available for sale securities for the twelve months ended December 31, 2012.

The fair value of the SKYCIG earn out liability (the “Earn Out”), classified as Level 3 was determined utilizing a discounted cash flows approach using various probability-weighted SKYCIG 2015 financial performance scenarios, upon which the ultimate earn out liability to be paid in 2016 will be based. Significant unobservable inputs used in calculating the fair value of the Earn Out include various SKYCIG financial performance scenarios, the probability of achieving those scenarios, and the discount rate. Based upon this calculation, the fair value of the Earn Out was determined to be £15 million (approximately $25 million), as of the date of the acquisition (October 1, 2013) and December 31, 2013. The amount of the Earn Out that will be ultimately paid in 2016 could range from £0 to £30 million (approximately $0 to $49 million at December 31, 2013 exchange rates). Changes in the fair value of the Earn Out are recorded as a component of selling, general and administrative expenses of the Electronic Cigarettes segment. See Note 2, “Acquisitions” for additional information related to the acquisition of SKYCIG.