Fair Value Measurements and Financial Instruments

The Company is exposed to market risk from foreign currency exchange rates, interest rates and commodity price fluctuations. Volatility relating to these exposures is managed on a global basis by utilizing a number of techniques, including working capital management, sourcing strategies, selling price increases, selective borrowings in local currencies and entering into selective derivative instrument transactions, issued with standard features, in accordance with the Company’s treasury and risk management policies, which prohibit the use of derivatives for speculative purposes and leveraged derivatives for any purpose. It is the Company’s policy to enter into derivative instrument contracts with terms that match the underlying exposure being hedged. Hedge ineffectiveness, if any, is not material for any period presented. Provided below are details of the Company’s exposures by type of risk and derivative instruments by type of hedge designation.

Valuation Considerations

Assets and liabilities carried at fair value are classified as follows:

Level 1: Based upon quoted market prices in active markets for identical assets or liabilities.

Level 2: Based upon observable market-based inputs or unobservable inputs that are corroborated by market data.

Level 3: Based upon unobservable inputs reflecting the reporting entity’s own assumptions.

Foreign Exchange Risk

As the Company markets its products in over 200 countries and territories, it is exposed to currency fluctuations related to manufacturing and selling its products in currencies other than the U.S. dollar. The Company manages its foreign currency exposures through a combination of cost-containment measures, sourcing strategies, selling price increases and the hedging of certain costs in an effort to minimize the impact on earnings of foreign currency rate movements.

The Company utilizes foreign currency contracts, including forward and swap contracts, local currency deposits and local currency borrowings to hedge portions of its foreign currency purchases, assets and liabilities arising in the normal course of business and the net investment in certain foreign subsidiaries. The duration of foreign currency contracts generally does not exceed 12 months and the contracts are valued using observable market rates (Level 2 valuation).

Interest Rate Risk

The Company manages its targeted mix of fixed and floating rate debt with debt issuances and by entering into interest rate swaps in order to mitigate fluctuations in earnings and cash flows that may result from interest rate volatility. The notional amount, interest payment and maturity date of the swaps generally match the principal, interest payment and maturity date of the related debt, and the swaps are valued using observable benchmark rates (Level 2 valuation).

Commodity Price Risk

The Company is exposed to price volatility related to raw materials used in production, such as resins, pulp, essential oils, tropical oils, tallow, poultry, corn and soybeans. The Company manages its raw material exposures through a combination of cost containment measures, sourcing strategies, ongoing productivity initiatives and the limited use of commodity hedging contracts. Futures contracts are used on a limited basis, primarily in the Hill’s Pet Nutrition segment, to manage volatility related to raw material inventory purchases of certain traded commodities, and these contracts are measured using quoted commodity exchange prices (Level 1 valuation). The duration of the commodity contracts generally does not exceed 12 months.

Credit Risk

The Company is exposed to the risk of credit loss in the event of nonperformance by counterparties to financial instrument contracts; however, nonperformance is considered unlikely and any nonperformance is unlikely to be material as it is the Company’s policy to contract with diverse, credit-worthy counterparties based upon both strong credit ratings and other credit considerations.

The following summarizes the fair value of the Company’s derivative instruments and other financial instruments at December 31, 2014 and December 31, 2013:



	Assets					Liabilities
	Account	Fair Value				Account	Fair Value
Designated derivative instruments		12/31/14		12/31/13			12/31/14		12/31/13
Interest rate swap contracts	Other current assets	$	1	$	1	Other accruals	$	—	$	—
Interest rate swap contracts	Other assets	12		20		Other liabilities	2		1
Foreign currency contracts	Other current assets	21		14		Other accruals	4		8
Foreign currency contracts	Other assets	60		—		Other liabilities	—		10
Commodity contracts	Other current assets	—		—		Other accruals	1		—
Total designated		$	94	$	35		$	7	$	19

Derivatives not designated
Foreign currency contracts	Other current assets	$	—	$	—	Other accruals	$	—	$	3
Foreign currency contracts	Other assets	8		—		Other liabilities	—		—
Total not designated		$	8	$	—		$	—	$	3

Total derivative instruments		$	102	$	35		$	7	$	22

Other financial instruments
Marketable securities	Other current assets	$	200	$	173
Available-for-sale securities	Other assets	322		685
Note receivable	Other current assets	42		—
Total other financial instruments		$	564	$	858

The carrying amount of cash, cash equivalents, accounts receivable, a note receivable and short-term debt approximated fair value as of December 31, 2014 and 2013. The estimated fair value of the Company’s long-term debt, including the current portion, as of December 31, 2014 and 2013, was $6,346 and $5,690, respectively, and the related carrying value was $6,132 and $5,644, respectively. The estimated fair value of long-term debt was derived principally from quoted prices on the Company’s outstanding fixed-term notes (Level 2 valuation).

Fair Value Hedges

The Company has designated all interest rate swap contracts and certain foreign currency forward and option contracts as fair value hedges, for which the gain or loss on the derivative and the offsetting gain or loss on the hedged item are recognized in current earnings. The impact of foreign currency contracts is primarily recognized in Selling, general and administrative expenses and the impact of interest rate swap contracts is recognized in Interest (income) expense, net.

Activity related to fair value hedges recorded during each period presented was as follows:



	2014									2013
	Foreign Currency Contracts			Interest Rate Swaps			Total			Foreign Currency Contracts			Interest Rate Swaps			Total
Notional Value at December 31,	$	1,163		$	1,438		$	2,601		$	1,320		$	1,188		$	2,508
Gain (loss) on derivative	3			(8		)	(5		)	24			(22		)	2
Gain (loss) on hedged items	(3		)	8			5			(24		)	22			(2		)

Cash Flow Hedges

All of the Company’s commodity contracts and certain foreign currency forward contracts have been designated as cash flow hedges, for which the effective portion of the gain or loss is reported as a component of Other comprehensive income (“OCI”) and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings.

Activity related to cash flow hedges recorded during each period presented was as follows:



	2014						2013
	Foreign Currency Contracts		Commodity Contracts		Total		Foreign Currency Contracts		Commodity Contracts		Total
Notional Value at December 31,	$	511	$	14	$	525	$	386	$	14	$	400
Gain (loss) recognized in OCI	9		—		9		20		—		20
Gain (loss) reclassified into Cost of sales	5		—		5		16		1		17

The net gain (loss) recognized in OCI for both foreign currency contracts and commodity contracts is expected to be recognized in Cost of sales within the next twelve months.

Net Investment Hedges

The Company has designated certain foreign currency forward and option contracts and certain foreign currency-denominated debt as net investment hedges, for which the gain or loss on the instrument is reported as a component of Currency translation adjustments within OCI, along with the offsetting gain or loss on the hedged items.

Activity related to net investment hedges recorded during each period presented was as follows:



	2014									2013
	Foreign Currency Contracts			Foreign Currency Debt			Total			Foreign Currency Contracts			Foreign Currency Debt			Total
Notional Value at December 31,	$	567		$	297		$	864		$	529		$	256		$	785
Gain (loss) on instruments	73			11			84			(24		)	(4		)	(28		)
Gain (loss) on hedged items	(73		)	(11		)	(84		)	23			4			27

Derivatives Not Designated as Hedging Instruments

Derivatives not designated as hedging instruments for each period consist of a cross-currency swap that serves as an economic hedge of a foreign currency deposit, for which the gain or loss on the instrument and the offsetting gain or loss on the hedged item are recognized in Other (income) expense, net for each period.

Activity related to these contracts during each period presented was as follows:



	2014			2013
	Cross-currency Swap			Cross-currency Swap
Notional Value at December 31,	$	102		$	96
Gain (loss) on instrument	5			(2		)
Gain (loss) on hedged item	(5		)	2

Other Financial Instruments

Other financial instruments are classified as Other current assets or Other assets.

Other financial instruments classified as Other current assets include marketable securities and a fixed interest rate note receivable. Marketable securities consist of bank deposits of $123 with original maturities greater than 90 days (Level 1 valuation) and the current portion of bonds issued by the Venezuelan government (Level 2 valuation) in the amount of $77. The long-term portion of these bonds in the amount of $322 is included in Other assets.

Through its subsidiary in Venezuela, the Company is invested in U.S. dollar-linked devaluation-protected bonds and bolivar denominated fixed interest rate bonds, both of which are issued by the Venezuelan government. These bonds are actively traded and, therefore, are considered Level 2 investments as their values are determined based upon observable market-based inputs or unobservable inputs that are corroborated by market data. As of December 31, 2014, the fair market value of U.S. dollar-linked devaluation-protected bonds and bolivar denominated fixed interest rate bonds was $114 and $285, respectively. These bonds are considered available-for-sale securities and, as noted above, the long-term portion in the amount of $322 is included in Other assets.

The following table presents a reconciliation of the Venezuelan bonds at fair value for the twelve months ended December 31:



	2014			2013
Beginning balance as of January 1	$	685		$	642
Unrealized gain (loss) on investment	(341		)	(113		)
Purchases and sales during the period	55			156
Ending balance as of December 31	$	399		$	685

Unrealized loss on investment for the year ended December 31, 2014 included a net loss of $324 primarily related to the remeasurement of the bolivar denominated fixed interest rate bonds and the devaluation-protected bonds in Venezuela as a result of the effective devaluations in the first and third quarters of 2014.

Unrealized loss on investment for the year ended December 31, 2013 consisted primarily of a charge of $133 related only to the remeasurement of the bolivar denominated fixed interest rate bonds in Venezuela as a result of the devaluation in the first quarter of 2013. No remeasurement charge was required on the devaluation-protected bonds in the first quarter of 2013 since the official exchange rate changed from 4.30 to 6.30 bolivares per dollar and the devaluation-protected bonds revalued to the official exchange rate. For further information regarding Venezuela, refer to Note 14, Venezuela.