Fair Value Measurements

9 Months Ended

Oct. 02, 2011

NOTE 4 — FAIR VALUE MEASUREMENTS

The Company uses forward 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 raw materials denominated in foreign currency. The Company also uses cross currency interest rate swaps to manage currency risk primarily related to borrowings. Both types of derivatives are designated as cash flow hedges. The Company also uses forward exchange contracts to manage its exposure to the variability of cash flows for repatriation of foreign dividends. These contracts are designated as net investment hedges. Additionally, the Company uses forward exchange contracts to offset its exposure to certain foreign currency assets and liabilities. These forward 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 does not enter into derivative financial instruments for trading or speculative purposes, or that contain credit risk related contingent features or requirements to post collateral. On an ongoing basis, the Company monitors counterparty credit ratings. The Company considers credit non-performance risk to be low, because the Company enters into agreements with commercial institutions that have at least an A (or equivalent) credit rating. As of October 2, 2011, the Company had notional amounts outstanding for forward foreign exchange contracts and cross currency interest rate swaps of $25 billion and $3 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/losses on net investment hedges are accounted for through the currency translation account and are insignificant. On an ongoing basis, the Company assesses whether each derivative continues to be highly effective in offsetting changes in the cash flows of hedged items. If and when a derivative is no longer expected to be highly effective, hedge accounting is discontinued. Hedge ineffectiveness, if any, is included in current period earnings in other (income)/expense, net, and was not material for the fiscal quarters ended October 2, 2011 and October 3, 2010. Refer to Note 7 for disclosures of movements in Accumulated Other Comprehensive Income.

As of October 2, 2011, the balance of deferred net gains on derivatives included in accumulated other comprehensive income was $180 million after-tax. For additional information, see Note 7. The Company expects that substantially all of the amounts related to 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 swaps. The amount ultimately realized in earnings will 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 designated as hedges for the fiscal third quarters in 2011 and 2010:


	Gain/ (Loss)						Gain/(Loss)						Gain/ (Loss)
	recognized in						reclassified from						recognized in
	Accumulated						Accumulated OCI						other
	OCI⁽¹⁾						into income⁽¹⁾						income/expense⁽²⁾
							Fiscal Third Quarters Ended
(Dollars in Millions)	2011			2010			2011			2010			2011			2010
Cash Flow Hedges
Foreign exchange contracts	$	(57	)		45			4			(12)	(A)		1			18
Foreign exchange contracts		(58	)		(7	)		(21	)		(106)	(B)		(1	)		121
Foreign exchange contracts		6			(46	)		(40	)		20	(C)		1			(11	)
Cross currency interest rate swaps		(67	)		(24	)		(6	)		(1)	(D)		—			—
Foreign exchange contracts		59			(63	)		(4	)		9	(E)		(1	)		(17	)
Total	$	(117	)		(95	)		(67	)		(90	)		—			111

All amounts shown in the table above are net of tax.

The following table is a summary of the activity related to derivatives designated as hedges for the fiscal nine months in 2011 and 2010:


	Gain/ (Loss)						Gain/ (Loss)						Gain/ (Loss)
	recognized in						reclassified from						recognized in
	Accumulated						Accumulated OCI						other
	OCI⁽¹⁾						into income⁽¹⁾						income/expense⁽²⁾
							Fiscal Nine Months Ended
(Dollars in Millions)	2011			2010			2011			2010			2011			2010
Cash Flow Hedges
Foreign exchange contracts	$	(30	)		(39	)		(6	)		(41)	(A)		(1	)		(3	)
Foreign exchange contracts		34			(213	)		(127	)		(204)	(B)		2			(33	)
Foreign exchange contracts		(2	)		27			(21	)		41	(C)		(1	)		5
Cross currency interest rate swaps		(107	)		(73	)		(24	)		10	(D)		—			—
Foreign exchange contracts		—			18			(7	)		8	(E)		1			3
Total	$	(105	)		(280	)		(185	)		(186	)		1			(28	)

All amounts shown in the table above are net of tax.


(1)		Effective portion

(2)		Ineffective portion

(A)		Included in Sales to customers

(B)		Included in Cost of products sold

(C)		Included in Research and development expense

(D)		Included in Interest (income)/Interest expense, net

(E)		Included in Other (income)/expense, net

For the fiscal third quarters ended October 2, 2011 and October 3, 2010, a loss of $10 million and a gain of $119 million, respectively, were recognized in Other (income)/expense, net, relating to foreign exchange contracts not designated as hedging instruments .

For the fiscal nine months ended October 2, 2011 and October 3, 2010, a loss of $2 million and a gain of $50 million, respectively, were recognized in Other (income)/expense, net, relating to foreign exchange contracts not designated as hedging instruments.

In addition, during the fiscal second quarter of 2011, the Company entered into an option to hedge the currency risk associated with the cash portion of the payment for the planned acquisition of Synthes, Inc. The option was not designated as a hedge, and therefore, changes in the fair value of the option are recognized as other (income)/expense, net. During the fiscal third quarter and the fiscal nine months ended October 2, 2011, the mark to market adjustment to reduce the value of the currency option was $304 million and $202 million, respectively.

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 that is 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 having the highest priority and Level 3 having the lowest.

The fair value of a derivative financial instrument (i.e., forward exchange contract or currency swap) 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 differs 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 because they are traded in an active exchange market. 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 October 2, 2011 and January 2, 2011 were as follows:


			October 2, 2011						January 2, 2011
(Dollars in Millions)	Level 1		Level 2		Level 3		Total		Total⁽¹⁾
Derivatives designated as hedging instruments:
Assets:
Foreign exchange contracts	$	—	$	604	$	—	$	604	$	321
Cross currency interest rate swaps⁽²⁾		—		7		—		7		17
Total		—		611		—		611		338
Liabilities:
Foreign exchange contracts		—		425		—		425		586
Cross currency interest rate swaps⁽³⁾		—		599		—		599		502
Total		—		1,024		—		1,024		1,088
Derivatives not designated as hedging instruments:
Assets:
Foreign exchange contracts		—		20		—		20		19
Swiss Franc Option*		—		265		—		265		—
Total		—		285		—		285		19
Liabilities:
Foreign exchange contracts		—		14		—		14		39
Other Investments⁽⁴⁾	$	1,211	$	—	$	—	$	1,211	$	1,165


*		Currency option related to the planned acquisition of Synthes, Inc.

(1)		As of January 2, 2011, these assets and liabilities are classified as Level 2 with the exception of Other Investments of $1,165 which are classified as Level 1.

(2)		Includes $7 million and $14 million of non-current assets for October 2, 2011 and January 2, 2011, respectively.

(3)		Includes $598 million and $502 million of non-current liabilities for October 2, 2011 and January 2, 2011, respectively.

(4)		Classified as non-current other assets.

Financial Instruments not measured at Fair Value:

The following financial assets and liabilities are held at carrying amount on the consolidated balance sheet as of October 2, 2011:


	Carrying		Estimated
(Dollars in Millions)	Amount		Fair Value
Financial Assets
Current Investments
Cash	$	2,314		2,314
Government securities and obligations		25,380		25,381
Corporate debt securities		612		612
Money market funds		1,550		1,550
Time deposits		1,071		1,071
Total cash, cash equivalents and current marketable securities	$	30,927		30,928
Fair value of government securities and obligations and corporate debt securities was estimated using quoted broker prices in active markets.
Financial Liabilities
Current Debt	$	5,326		5,326
Non-Current Debt
0.70% Notes due 2013		500		502
3.80% Debentures due 2013		500		526
3 month LIBOR+0% FRN due 2013		500		500
3 month LIBOR+0.09% FRN due 2014		750		750
1.20% Notes due 2014		999		1,015
2.15% Notes due 2016		898		933
5.55% Debentures due 2017		1,000		1,214
5.15% Debentures due 2018		898		1,081
4.75% Notes due 2019 (1B Euro 1.3634)		1,356		1,560
3% Zero Coupon Convertible Subordinated Debentures due in 2020		199		232
2.95% Debentures due 2020		541		567
3.55% Notes due 2021		446		496
6.73% Debentures due 2023		250		358
5.50% Notes due 2024 (500 GBP1.5672)		778		927
6.95% Notes due 2029		294		426
4.95% Debentures due 2033		500		582
5.95% Notes due 2037		995		1,318
5.86% Debentures due 2038		700		925
4.50% Debentures due 2040		539		601
4.85% Notes due 2041		298		351
Other		90		90
Total Non-Current Debt	$	13,031		14,954

The weighted average effective rate on non-current debt is 4.02%.

Fair value of the non-current debt was estimated using market prices, which were corroborated by quoted broker prices in active markets.

- Definition

The entire disclosure for the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments as well as disclosures related to the fair value of non-financial assets and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the entity is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risks are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information.

+ References

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