FAIR VALUE MEASUREMENTS

The Company uses forward foreign exchange contracts to manage its exposure to the variability of cash flows, primarily related to the foreign exchange rate changes of future intercompany product and third-party purchases of materials denominated in a foreign currency. The Company uses cross currency interest rate swaps to manage currency risk primarily related to borrowings.

The Company also uses equity collar contracts to manage exposure to market risk associated with certain equity investments.

All three types of derivatives are designated as cash flow hedges.

The Company uses interest rate swaps as an instrument to manage interest rate risk related to fixed rate borrowings. These derivatives are designated as fair value hedges. The Company uses cross currency interest rate swaps and forward foreign exchange contracts designated as net investment hedges. Additionally, the Company uses forward foreign exchange contracts to offset its exposure to certain foreign currency assets and liabilities. These forward foreign exchange contracts are not designated as hedges, and therefore, changes in the fair values of these derivatives are recognized in earnings, thereby offsetting the current earnings effect of the related foreign currency assets and liabilities.

The Company early adopted ASU 2017-12: Targeted Improvements to Accounting for Hedge Activities effective as of the beginning of fiscal second quarter of 2018.

The Company does not enter into derivative financial instruments for trading or speculative purposes, or that contain credit risk related contingent features. During the fiscal second quarter of 2017, the Company entered into credit support agreements (CSA) with certain derivative counterparties establishing collateral thresholds based on respective credit ratings and netting agreements. As of September 30, 2018, the total amount of collateral paid under the credit support agreements amounted to $153 million, net. For equity collar contracts, the Company pledged the underlying hedged marketable equity securities to the counter-party as collateral. On an ongoing basis, the Company monitors counter-party credit ratings. The Company considers credit non-performance risk to be low, because the Company primarily enters into agreements with commercial institutions that have at least an investment grade credit rating. Refer to the table on significant financial assets and liabilities measured at fair value contained in this footnote for receivables and payables with these commercial institutions. As of September 30, 2018, the Company had notional amounts outstanding for forward foreign exchange contracts, cross currency interest rate swaps and interest rate swaps of $38.8 billion, $7.3 billion and $1.1 billion, respectively. As of December 31, 2017, the Company had notional amounts outstanding for forward foreign exchange contracts, cross currency interest rate swaps and interest rate swaps of $34.5 billion, $2.3 billion and $1.1 billion, respectively.

All derivative instruments are recorded on the balance sheet at fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether the derivative is designated as part of a hedge transaction, and if so, the type of hedge transaction.

The designation as a cash flow hedge is made at the entrance date of the derivative contract. At inception, all derivatives are expected to be highly effective. Changes in the fair value of a derivative that is designated as a cash flow hedge and is highly effective are recorded in accumulated other comprehensive income until the underlying transaction affects earnings and are then reclassified to earnings in the same account as the hedged transaction. Gains and losses associated with interest rate swaps and changes in fair value of hedged debt attributable to changes in interest rates are recorded to interest expense in the period in which they occur. Gains and losses on net investment hedges are accounted for through the currency translation account. On an ongoing basis, the Company assesses whether each derivative continues to be highly effective in offsetting changes of hedged items. If a derivative is no longer expected to be highly effective, hedge accounting is discontinued.

During the fiscal second quarter of 2016, the Company designated its Euro denominated notes issued in May 2016 with due dates ranging from 2022 to 2035 as a net investment hedge of the Company's investments in certain of its international subsidiaries that use the Euro as their functional currency in order to reduce the volatility caused by changes in exchange rates.

As of September 30, 2018, the balance of deferred net gain on derivatives included in accumulated other comprehensive income was $16 million after-tax. For additional information, see the Consolidated Statements of Comprehensive Income and Note 7. The Company expects that substantially all of the amounts related to forward foreign exchange contracts will be reclassified into earnings over the next 12 months as a result of transactions that are expected to occur over that period. The maximum length of time over which the Company is hedging transaction exposure is 18 months, excluding interest rate contracts, net investment hedges and equity collar contracts. The amount ultimately realized in earnings may differ as foreign exchange rates change. Realized gains and losses are ultimately determined by actual exchange rates at maturity of the derivative.

The following table is a summary of the activity related to derivatives and hedges for the fiscal third quarters in 2018 and 2017:



	September 30, 2018									October 1, 2017
(Dollars in Millions)	Sales		Cost of Products Sold	R&D Expense		Interest (Income) Expense		Other (Income) Expense		Sales	Cost of Products Sold		R&D Expense		Interest (Income) Expense		Other (Income) Expense
The effects of fair value, net investment and cash flow hedging:
Gain (Loss) on fair value hedging relationship:
Interest rate swaps contracts:
Hedged items	$	—	—	—		(7	)	—		—	—		—		(4	)	—
Derivatives designated as hedging instruments	—		—	—		7		—		—	—		—		4		—

Gain (Loss) on net investment hedging relationship:
Cross currency interest rate swaps contracts:
Amount of gain or (loss) recognized in income on derivative amount excluded from effectiveness testing	—		—	—		25		—		—	—		—		—		—
Amount of gain or (loss) recognized in AOCI	—		—	—		25		—		—	—		—		—		—

Gain (Loss) on cash flow hedging relationship:
Forward foreign exchange contracts:
Amount of gain or (loss) reclassified from AOCI into income ⁽¹⁾	4		97	10		—		(3	)	5	(63	)	(30	)	—		(49	)

Amount of gain or (loss) recognized in AOCI ⁽¹⁾	15		192	(4	)	—		(1	)	18	(16	)	(39	)	—		(15	)

Cross currency interest rate swaps contracts:
Amount of gain or (loss) reclassified from AOCI into income	—		—	—		34		—		—			—		106		—
Amount of gain or (loss) recognized in AOCI	$	—	—	—		35		—		—	—		—		114		—

The following table is a summary of the activity related to derivatives and hedges for the fiscal nine months in 2018 and 2017:



	September 30, 2018										October 1, 2017
(Dollars in Millions)	Sales			Cost of Products Sold	R&D Expense		Interest (Income) Expense		Other (Income) Expense		Sales		Cost of Products Sold		R&D Expense		Interest (Income) Expense		Other (Income) Expense
The effects of fair value, net investment and cash flow hedging:
Gain (Loss) on fair value hedging relationship:
Interest rate swaps contracts:
Hedged items	$	—		—	—		3		—		—		—		—		(6	)	—
Derivatives designated as hedging instruments	—			—	—		(3	)	—		—		—		—		6		—

Gain (Loss) on net investment hedging relationship:
Cross currency interest rate swaps contracts:
Amount of gain or (loss) recognized in income on derivative amount excluded from effectiveness testing	—			—	—		27		—		—		—		—		—		—
Amount of gain or (loss) recognized in AOCI	—			—	—		27		—		—		—		—		—		—

Gain (Loss) on cash flow hedging relationship:
Forward foreign exchange contracts:
Amount of gain or (loss) reclassified from AOCI into income ⁽¹⁾	50			175	(242	)	—		(24	)	(34	)	(162	)	(131	)	—		(86	)

Amount of gain or (loss) recognized in AOCI ⁽¹⁾	(3		)	138	(220	)	—		(16	)	40		105		(167	)	—		(59	)

Cross currency interest rate swaps contracts:
Amount of gain or (loss) reclassified from AOCI into income	—			—	—		106		—		—		—		—		63		—
Amount of gain or (loss) recognized in AOCI	$	—		—	—		111		—		—		—		—		73		—

⁽¹⁾ Includes equity collar contracts. The equity collar contracts expired in December of 2017.

As of September 30, 2018 and December 31, 2017, the following amounts were recorded on the Consolidated Balance Sheet related to cumulative basis adjustment for fair value hedges:



Line item in the Consolidated Balance Sheet in which the hedged item is included	Carrying Amount of the Hedged Liability			Cumulative Amount of Fair Value Hedging Adjustment Included in the Carrying Amount of the Hedged Liability
(Dollars in Millions)	September 30, 2018		December 31, 2017	September 30, 2018		December 31, 2017
Current Portion of Long-term Debt	$	601	597	1		2
Long-term Debt	495		496	(4	)	3

The following table is the effect of derivatives not designated as hedging instrument for the fiscal third quarters and fiscal nine months in 2018 and 2017:

Gain/(Loss)

Recognized In

Income on Derivative

Gain/(Loss)

Recognized In

Income on Derivative

(Dollars in Millions)

Location of Gain /(Loss) Recognized in Income on Derivative

Fiscal Third Quarters Ended

Fiscal Nine Months Ended

Derivatives Not Designated as Hedging Instruments

September 30, 2018

October 1, 2017

September 30, 2018

October 1, 2017

Foreign Exchange Contracts

Other (income) expense

(12

)

(23

)



The following table is the effect of net investment hedges for the fiscal third quarters in 2018 and 2017:
	Gain/(Loss) Recognized In Accumulated OCI					Location of Gain or (Loss) Reclassified from Accumulated Other Comprehensive Income Into Income	Gain/(Loss) Reclassified From Accumulated OCI Into Income
(Dollars in Millions)	Fiscal Third Quarters Ended
	September 30, 2018			October 1, 2017			September 30, 2018	October 1, 2017
Debt	$	(50	)	(151	)	Other (income) expense	—	—
Cross Currency interest rate swaps	$	(75	)	—		Other (income) expense	—	—



The following table is the effect of net investment hedges for the fiscal nine months in 2018 and 2017:
	Gain/(Loss) Recognized In Accumulated OCI					Location of Gain or (Loss) Reclassified from Accumulated Other Comprehensive Income Into Income	Gain/(Loss) Reclassified From Accumulated OCI Into Income
(Dollars in Millions)	Fiscal Nine Months Ended
	September 30, 2018			October 1, 2017			September 30, 2018	October 1, 2017
Debt	$	106		(529	)	Other (income) expense	—	—
Cross Currency interest rate swaps	$	(37	)	—		Other (income) expense	—	—

The Company adopted ASU 2016-01: Financial Instruments: Recognition and Measurement of Financial Assets and Financial Liabilities as of the beginning of the fiscal year 2018. This ASU amends prior guidance to classify equity investments with readily determinable market values into different categories (that is, trading or available-for-sale) and require equity investments to be measured at fair value with changes in fair value recognized through net earnings. The Company made a cumulative effect adjustment to the opening balance of retained earnings upon adoption of ASU 2016-01 which increased retained earnings by $232 million, net of tax, and decreased accumulated other comprehensive income for previously net unrealized gains from equity investments.

The Company holds equity investments with readily determinable fair values and equity investments without readily determinable fair values. The Company has elected to measure equity investments that do not have readily determinable fair values at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer.

The following table is a summary of the activity related to equity investments as of September 30, 2018:



(Dollars in Millions)	December 31, 2017						September 30, 2018
	Carrying Value		Changes in Fair Value Reflected in Net Income ⁽¹⁾		Sales/ Purchases/Other ⁽²⁾		Carrying Value	Non Current Other Assets
Equity Investments with readily determinable value	$	751	(35	)	(19	)	697	697

Equity Investments without readily determinable value	$	510	7		122		639	639

⁽¹⁾ Recorded in Other Income/Expense

⁽²⁾ Other includes impact of currency

For equity investments without readily determinable market values, $31 million of the changes in fair value reflected in net income were the result of impairments. There were $38 million of changes in fair value reflected in net income due to changes in observable prices.

For the fiscal nine months ended October 1, 2017, changes in fair value reflected within other comprehensive income due to previously unrealized gains on equity investments with readily determinable fair values net of tax was a net gain of $269 million.

Fair value is the exit price that would be received to sell an asset or paid to transfer a liability. Fair value is a market-based measurement determined using assumptions that market participants would use in pricing an asset or liability. The authoritative literature establishes a three-level hierarchy to prioritize the inputs used in measuring fair value. The levels within the hierarchy are described below with Level 1 inputs having the highest priority and Level 3 inputs having the lowest.

The fair value of a derivative financial instrument (i.e., forward foreign exchange contracts, interest rate contracts) is the aggregation by currency of all future cash flows discounted to its present value at the prevailing market interest rates and subsequently converted to the U.S. Dollar at the current spot foreign exchange rate. The Company does not believe that fair values of these derivative instruments materially differ from the amounts that could be realized upon settlement or maturity, or that the changes in fair value will have a material effect on the Company’s results of operations, cash flows or financial position. The Company also holds equity investments which are classified as Level 1 and debt securities which are classified as Level 2. The Company did not have any other significant financial assets or liabilities which would require revised valuations under this standard that are recognized at fair value.

The following three levels of inputs are used to measure fair value:

Level 1 — Quoted prices in active markets for identical assets and liabilities.

Level 2 — Significant other observable inputs.

Level 3 — Significant unobservable inputs.

The Company’s significant financial assets and liabilities measured at fair value as of September 30, 2018 and December 31, 2017 were as follows:



	September 30, 2018					December 31, 2017
(Dollars in Millions)	Level 1		Level 2	Level 3	Total	Total⁽¹⁾
Derivatives designated as hedging instruments:
Assets:
Forward foreign exchange contracts	$	—	551	—	551	418
Interest rate contracts ⁽²⁾⁽⁴⁾	—		19	—	19	7
Total	—		570	—	570	425
Liabilities:
Forward foreign exchange contracts	—		401	—	401	402
Interest rate contracts ⁽³⁾⁽⁴⁾	—		269	—	269	165
Total	—		670	—	670	567
Derivatives not designated as hedging instruments:
Assets:
Forward foreign exchange contracts	—		28	—	28	38
Liabilities:
Forward foreign exchange contracts	—		45	—	45	38
Other Investments:
Equity investments ⁽⁵⁾	697		—	—	697	751
Debt securities⁽⁶⁾	$	—	11,155	—	11,155	5,310



Gross to Net Derivative Reconciliation	September 30, 2018			December 31, 2017
(Dollars in Millions)
Total Gross Assets	$	598		463
Credit Support Agreement (CSA)	(290		)	(76	)
Total Net Asset	308			387

Total Gross Liabilities	715			605
Credit Support Agreement (CSA)	(443		)	(238	)
Total Net Liabilities	$	272		367


⁽¹⁾	2017 assets and liabilities are all classified as Level 2 with the exception of equity investments of $751 million, which are classified as Level 1.


⁽²⁾	Includes $4 million and $7 million of non-current other assets for September 30, 2018 and December 31, 2017, respectively.


⁽³⁾	Includes $6 million and $9 million of non-current other liabilities for September 30, 2018 and December 31, 2017, respectively.


⁽⁴⁾	Includes cross currency interest rate swaps and interest rate swaps.


⁽⁵⁾	Classified as non-current other assets. The carrying amount of the equity investments were $697 million and $751 million as of September 30, 2018 and December 31, 2017, respectively.


⁽⁶⁾	Classified as cash equivalents and current marketable securities.

The Company's cash, cash equivalents and current marketable securities as of September 30, 2018 comprised:



	September 30, 2018
(Dollars in Millions)	Carrying Amount		Unrecognized Gain	Unrecognized Loss		Estimated Fair Value	Cash & Cash Equivalents	Current Marketable Securities
Cash	$	2,575	—	—		2,575	2,575
Other sovereign securities⁽¹⁾	—		—	—		—	—
U.S. reverse repurchase agreements	2,260		—	—		2,260	2,260
Other reverse repurchase agreements	479		—	—		479	479
Corporate debt securities⁽¹⁾	200		—	—		200	200	—
Money market funds	1,763		—	—		1,763	1,763
Time deposits⁽¹⁾	932		—	—		932	932
Subtotal	8,209		—	—		8,209	8,209	—

			Unrealized Gain	Unrealized Loss
Government securities	10,885		—	(1	)	10,884	7,835	3,049
Other sovereign securities	—		—	—		—	—	—
Corporate debt securities	271		—	—		271	12	259
Subtotal available for sale debt⁽²⁾	$	11,156	—	(1	)	11,155	7,847	3,308
Total cash, cash equivalents and current marketable securities							16,056	3,308

⁽¹⁾Held to maturity investments are reported at amortized cost and gains or losses are reported in earnings.

⁽²⁾Available for sale debt securities are reported at fair value with unrealized gains and losses reported net of taxes in other comprehensive income.

Fair value of government securities and obligations and corporate debt securities was estimated using quoted broker prices and significant other observable inputs.

The Company classifies all highly liquid investments with stated maturities of three months or less from date of purchase as cash equivalents and all highly liquid investments with stated maturities of greater than three months from the date of purchase as current marketable securities. Available for sale securities with stated maturities of greater than one year from the date of purchase are available for current operations and are classified as cash equivalents and current marketable securities.

The contractual maturities of the available for sale securities at September 30, 2018 are as follows:



(Dollars in Millions)	Cost Basis		Fair Value
Due within one year	$	11,079	11,078
Due after one year through five years	77		77
Due after five years through ten years	—		—
Total debt securities	$	11,156	11,155

Financial Instruments not measured at Fair Value:

The following financial liabilities are held at carrying amount on the consolidated balance sheet as of September 30, 2018:



(Dollars in Millions)	Carrying Amount		Estimated Fair Value

Financial Liabilities

Current Debt	$	1,773	1,773

Non-Current Debt
4.75% Notes due 2019 (1B Euro 1.1681)	1,166		1,231
1.875% Notes due 2019	495		490
3% Zero Coupon Convertible Subordinated Debentures due in 2020	52		100
1.950% Notes due 2020	499		490
2.95% Debentures due 2020	548		551
3.55% Notes due 2021	448		454
2.45% Notes due 2021	349		345
1.65% Notes due 2021	998		967
0.250% Notes due 2022 (1B Euro 1.1681)	1,165		1,172
2.25% Notes due 2022	996		973
6.73% Debentures due 2023	250		291
3.375% Notes due 2023	805		829
2.05% Notes due 2023	498		477
0.650% Notes due 2024 (750MM Euro 1.1681)	872		881
5.50% Notes due 2024 (500 MM GBP 1.3123)	651		793
2.625% Notes due 2025	748		719
2.45% Notes due 2026	1,991		1,884
2.95% Notes due 2027	996		956
2.90% Notes due 2028	1,493		1,420
1.150% Notes due 2028 (750MM Euro 1.1681)	868		874
6.95% Notes due 2029	296		385
4.95% Debentures due 2033	498		559
4.375% Notes due 2033	856		912
1.650% Notes due 2035 (1.5B Euro 1.1681)	1,735		1,774
3.55% Notes due 2036	988		945
5.95% Notes due 2037	991		1,252
3.625% Notes due 2037	1,486		1,433
3.40% Notes due 2038	990		926
5.85% Debentures due 2038	696		874
4.50% Debentures due 2040	538		573
4.85% Notes due 2041	297		330
4.50% Notes due 2043	495		532
3.70% Notes due 2046	1,971		1,884
3.75% Notes due 2047	991		951
3.50% Notes due 2048	742		689
Other	22		22
Total Non-Current Debt	$	29,480	29,938

The weighted average effective interest rate on non-current debt is 3.20%.

The excess of the estimated fair value over the carrying value of debt was $2.0 billion at December 31, 2017.

Fair value of the non-current debt was estimated using market prices, which were corroborated by quoted broker prices and significant other observable inputs.