10-Q 1 mrk0630201810q.htm 2Q18 FORM 10-Q (MRK 06.30.2018) Document



 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
 
(Mark One)

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
 
For the quarterly period ended June 30, 2018
OR

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
 
For the transition period from ______ to ______
Commission File No. 1-6571
Merck & Co., Inc.
2000 Galloping Hill Road
Kenilworth, N.J. 07033
(908) 740-4000
Incorporated in New Jersey
 
I.R.S. Employer
 
 
Identification No. 22-1918501
The number of shares of common stock outstanding as of the close of business on July 31, 2018: 2,659,525,311
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes     No  
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes     No  
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
Accelerated filer
 
 
 
 
Non-accelerated filer
(Do not check if a smaller reporting company)
Smaller reporting company
 
 
 
 
 
 
Emerging growth company
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes   No 
 





Part I - Financial Information
Item 1. Financial Statements
MERCK & CO., INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF INCOME
(Unaudited, $ in millions except per share amounts)
 
 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
 
2018
 
2017
 
2018
 
2017
Sales
$
10,465

 
$
9,930

 
$
20,502

 
$
19,365

Costs, Expenses and Other
 
 
 
 
 
 
 
Materials and production
3,417

 
3,116

 
6,601

 
6,165

Marketing and administrative
2,508

 
2,500

 
5,016

 
4,972

Research and development
2,274

 
1,782

 
5,470

 
3,612

Restructuring costs
228

 
166

 
323

 
317

Other (income) expense, net
(48
)
 
(73
)
 
(340
)
 
(143
)
 
8,379

 
7,491

 
17,070

 
14,923

Income Before Taxes
2,086

 
2,439

 
3,432

 
4,442

Taxes on Income
370

 
488

 
975

 
935

Net Income
1,716

 
1,951

 
2,457

 
3,507

Less: Net Income Attributable to Noncontrolling Interests
9

 
5

 
14

 
11

Net Income Attributable to Merck & Co., Inc.
$
1,707

 
$
1,946

 
$
2,443

 
$
3,496

Basic Earnings per Common Share Attributable to Merck & Co., Inc. Common Shareholders
$
0.64

 
$
0.71

 
$
0.91

 
$
1.28

Earnings per Common Share Assuming Dilution Attributable to Merck & Co., Inc. Common Shareholders
$
0.63

 
$
0.71

 
$
0.90

 
$
1.27

Dividends Declared per Common Share
$
0.48

 
$
0.47

 
$
0.96

 
$
0.94

 
MERCK & CO., INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
(Unaudited, $ in millions)
 
 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
 
2018
 
2017
 
2018
 
2017
Net Income Attributable to Merck & Co., Inc.
$
1,707

 
$
1,946

 
$
2,443

 
$
3,496

Other Comprehensive Income (Loss) Net of Taxes:
 
 
 
 
 
 
 
Net unrealized gain (loss) on derivatives, net of reclassifications
266

 
(143
)
 
196

 
(375
)
Net unrealized gain (loss) on investments, net of reclassifications
3

 
35

 
(96
)
 
78

Benefit plan net gain and prior service credit, net of amortization
30

 
47

 
66

 
73

Cumulative translation adjustment
(361
)
 
47

 
(104
)
 
356

 
(62
)
 
(14
)
 
62

 
132

Comprehensive Income Attributable to Merck & Co., Inc.
$
1,645

 
$
1,932

 
$
2,505

 
$
3,628

 The accompanying notes are an integral part of these condensed consolidated financial statements.

- 2 -




MERCK & CO., INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEET
(Unaudited, $ in millions except per share amounts)
 
 
June 30, 2018
 
December 31, 2017
Assets
 
 
 
Current Assets
 
 
 
Cash and cash equivalents
$
5,310

 
$
6,092

Short-term investments
2,284

 
2,406

Accounts receivable (net of allowance for doubtful accounts of $210 in both 2018
and 2017)
7,287

 
6,873

Inventories (excludes inventories of $1,361 in 2018 and $1,187 in 2017
classified in Other assets - see Note 7)
5,178

 
5,096

Other current assets
4,005

 
4,299

Total current assets
24,064

 
24,766

Investments
10,033

 
12,125

Property, Plant and Equipment, at cost, net of accumulated depreciation of $16,567
in 2018 and $16,602 in 2017
12,626

 
12,439

Goodwill
18,274

 
18,284

Other Intangibles, Net
12,898

 
14,183

Other Assets
7,145

 
6,075

 
$
85,040

 
$
87,872

Liabilities and Equity
 
 
 
Current Liabilities
 
 
 
Loans payable and current portion of long-term debt
$
3,379

 
$
3,057

Trade accounts payable
3,024

 
3,102

Accrued and other current liabilities
9,755

 
10,427

Income taxes payable
661

 
708

Dividends payable
1,309

 
1,320

Total current liabilities
18,128

 
18,614

Long-Term Debt
19,959

 
21,353

Deferred Income Taxes
2,159

 
2,219

Other Noncurrent Liabilities
12,028

 
11,117

Merck & Co., Inc. Stockholders’ Equity
 
 
 
Common stock, $0.50 par value
Authorized - 6,500,000,000 shares
Issued - 3,577,103,522 shares in 2018 and 2017
1,788

 
1,788

Other paid-in capital
39,741

 
39,902

Retained earnings
41,523

 
41,350

Accumulated other comprehensive loss
(5,122
)
 
(4,910
)
 
77,930

 
78,130

Less treasury stock, at cost:
907,061,576 shares in 2018 and 880,491,914 shares in 2017
45,401

 
43,794

Total Merck & Co., Inc. stockholders’ equity
32,529

 
34,336

Noncontrolling Interests
237

 
233

Total equity
32,766

 
34,569

 
$
85,040

 
$
87,872

The accompanying notes are an integral part of this condensed consolidated financial statement.

- 3 -




MERCK & CO., INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
(Unaudited, $ in millions)
 
 
Six Months Ended 
 June 30,
 
2018
 
2017
Cash Flows from Operating Activities
 
 
 
Net income
$
2,457

 
$
3,507

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
2,363

 
2,355

Intangible asset impairment charges

 
131

Charge for future payments related to Eisai collaboration license options
650

 

Deferred income taxes
(258
)
 
(272
)
Share-based compensation
170

 
156

Other
429

 
63

Net changes in assets and liabilities
(1,274
)
 
(2,337
)
Net Cash Provided by Operating Activities
4,537

 
3,603

Cash Flows from Investing Activities
 
 
 
Capital expenditures
(1,033
)
 
(732
)
Purchases of securities and other investments
(5,248
)
 
(6,280
)
Proceeds from sales of securities and other investments
7,403

 
9,363

Other acquisitions, net of cash acquired
(372
)
 
(347
)
Other
(274
)
 
62

Net Cash Provided by Investing Activities
476

 
2,066

Cash Flows from Financing Activities
 
 
 
Net change in short-term borrowings
2,069

 
(24
)
Payments on debt
(3,008
)
 
(301
)
Purchases of treasury stock
(2,162
)
 
(2,153
)
Dividends paid to stockholders
(2,610
)
 
(2,601
)
Proceeds from exercise of stock options
299

 
408

Other
(277
)
 
(86
)
Net Cash Used in Financing Activities
(5,689
)
 
(4,757
)
Effect of Exchange Rate Changes on Cash, Cash Equivalents and Restricted Cash
(108
)
 
359

Net (Decrease) Increase in Cash, Cash Equivalents and Restricted Cash
(784
)
 
1,271

Cash, Cash Equivalents and Restricted Cash at Beginning of Year (includes restricted
cash of $4 million at January 1, 2018 included in Other Assets)
6,096

 
6,515

Cash, Cash Equivalents and Restricted Cash at End of Period (includes restricted cash
of $2 million at June 30, 2018 included in Other Assets)
$
5,312

 
$
7,786

The accompanying notes are an integral part of this condensed consolidated financial statement.

- 4 -

Notes to Condensed Consolidated Financial Statements (unaudited)

1.
Basis of Presentation
The accompanying unaudited condensed consolidated financial statements of Merck & Co., Inc. (Merck or the Company) have been prepared pursuant to the rules and regulations for reporting on Form 10-Q. Accordingly, certain information and disclosures required by accounting principles generally accepted in the United States for complete consolidated financial statements are not included herein. These interim statements should be read in conjunction with the audited financial statements and notes thereto included in Merck’s Form 10-K filed on February 27, 2018.
The results of operations of any interim period are not necessarily indicative of the results of operations for the full year. In the Company’s opinion, all adjustments necessary for a fair statement of these interim statements have been included and are of a normal and recurring nature. Certain reclassifications have been made to prior year amounts to conform to the current presentation.
Recently Adopted Accounting Standards
In May 2014, the Financial Accounting Standards Board (FASB) issued amended accounting guidance on revenue recognition (ASU 2014-09) that applies to all contracts with customers. The objective of the new guidance is to improve comparability of revenue recognition practices across entities and to provide more useful information to users of financial statements through improved disclosure requirements. The new standard permits two methods of adoption: retrospectively to each prior reporting period presented (full retrospective method), or retrospectively with the cumulative effect of adopting the guidance being recognized at the date of initial application (modified retrospective method). The new standard was effective as of January 1, 2018 and was adopted using the modified retrospective method. The Company recorded a cumulative-effect adjustment upon adoption increasing Retained earnings by $5 million. See Note 2 for additional information related to the adoption of this standard.
In January 2016, the FASB issued revised guidance for the accounting and reporting of financial instruments (ASU 2016-01) and in 2018 issued related technical corrections (ASU 2018-03). The new guidance requires that equity investments with readily determinable fair values currently classified as available for sale be measured at fair value with changes in fair value recognized in net income. The Company has elected to measure equity investments without readily determinable fair values at cost, less impairment, adjusted for subsequent observable price changes, which will be recognized in net income. The new guidance also changed certain disclosure requirements. ASU 2016-01 was effective as of January 1, 2018 and was adopted using a modified retrospective approach. The Company recorded a cumulative-effect adjustment upon adoption increasing Retained earnings by $8 million. ASU 2018-03 was also adopted as of January 1, 2018 on a prospective basis and did not result in any additional impacts upon adoption.
In October 2016, the FASB issued guidance on the accounting for the income tax consequences of intra-entity transfers of assets other than inventory (ASU 2016-16). The new guidance requires the recognition of the income tax consequences of an intra-entity transfer of an asset (with the exception of inventory) when the intra-entity transfer occurs, replacing the prohibition against doing so. The current exception to defer the recognition of any tax impact on the transfer of inventory within the consolidated entity until it is sold to a third party remains unaffected. The new standard was effective as of January 1, 2018 and was adopted using a modified retrospective approach. The Company recorded a cumulative-effect adjustment upon adoption increasing Retained earnings by $54 million with a corresponding decrease to Deferred Income Taxes.
In August 2017, the FASB issued new guidance on hedge accounting (ASU 2017-12) that is intended to more closely align hedge accounting with companies’ risk management strategies, simplify the application of hedge accounting, and increase transparency as to the scope and results of hedging programs. The new guidance makes more financial and nonfinancial hedging strategies eligible for hedge accounting, amends the presentation and disclosure requirements, and changes how companies assess effectiveness. The Company elected to early adopt this guidance as of January 1, 2018 on a modified retrospective basis. The new guidance was applied to all existing hedges as of the adoption date. For fair value hedges of interest rate risk outstanding as of the date of adoption, the Company recorded a cumulative-effect adjustment upon adoption to the basis adjustment on the hedged item resulting from applying the benchmark component of the coupon guidance. This adjustment decreased Retained earnings by $11 million. Also, in accordance with the transition provisions of ASU 2017-12, the Company was required to eliminate the separate measurement of ineffectiveness for its cash flow hedging instruments existing as of the adoption date through a cumulative-effect adjustment to retained earnings; however, all such amounts were de minimis.
In February 2018, the FASB issued new guidance to address a narrow-scope financial reporting issue that arose as a consequence of the Tax Cuts and Jobs Act (TCJA) (ASU 2018-02). Existing guidance requires that deferred tax liabilities and assets be adjusted for a change in tax laws or rates with the effect included in income from continuing operations in the reporting period that includes the enactment date. That guidance is applicable even in situations in which the related income tax effects of items in accumulated other comprehensive income were originally recognized in other comprehensive income (rather than in net income), such as amounts related to benefit plans and hedging activity. As a result, the tax effects of items within accumulated other comprehensive income do not reflect the appropriate tax rate (the difference is referred to as stranded tax effects). The new guidance allows for a reclassification of these amounts to retained earnings thereby eliminating these stranded tax effects. The Company elected to early adopt the new guidance in the first quarter of 2018 and reclassified the stranded income tax effects of

- 5 -

Notes to Condensed Consolidated Financial Statements (unaudited)

the TCJA increasing Accumulated other comprehensive loss in the provisional amount of $266 million with a corresponding increase to Retained earnings (see Note 15). The Company’s policy for releasing disproportionate income tax effects from Accumulated other comprehensive loss is to utilize the item-by-item approach.
The impact of adopting the above standards is as follows:
($ in millions)
ASU 2014-09 (Revenue)
 
ASU 2016-01 (Financial Instruments)
 
ASU 2016-16 (Intra-Entity Transfers of Assets Other than Inventory)
 
ASU 2017-12 (Derivatives and Hedging)
 
ASU 2018-02 (Reclassification of Certain Tax Effects)
 
Total
Assets - Increase (Decrease)
 
 
 
 
 
 
 
 
 
 
 
Accounts receivable
$
5

 
 
 
 
 
 
 
 
 
$
5

Liabilities - Increase (Decrease)
 
 
 
 
 
 
 
 
 
 


Income Taxes Payable
 
 
 
 
 
 
(3
)
 
 
 
(3
)
Debt
 
 
 
 
 
 
14

 
 
 
14

Deferred Income Taxes
 
 
 
 
(54
)
 
 
 
 
 
(54
)
Equity - Increase (Decrease)
 
 
 
 
 
 
 
 
 
 
 
Retained earnings
5

 
8

 
54

 
(11
)
 
266

 
322

Accumulated other comprehensive loss
 
 
(8
)
 
 
 
 
 
(266
)
 
(274
)
In March 2017, the FASB amended the guidance related to net periodic benefit cost for defined benefit plans that requires entities to (1) disaggregate the current service cost component from the other components of net benefit cost and present it with other employee compensation costs in the income statement within operations if such a subtotal is presented; (2) present the other components of net benefit cost separately in the income statement and outside of income from operations; and (3) only capitalize the service cost component when applicable. The Company adopted the new standard as of January 1, 2018 using a retrospective transition method as to the requirement for separate presentation in the income statement of service costs and other components and a prospective transition method as to the requirement to limit the capitalization of benefit costs to the service cost component. The Company utilized a practical expedient that permits it to use the amounts disclosed in its pension and other postretirement benefit plan note for the prior comparative periods as the estimation basis for applying the retrospective presentation requirements. Upon adoption, net periodic benefit cost (credit) other than service cost was reclassified to Other (income) expense, net from the previous classification within Materials and production costs, Marketing and administrative expenses and Research and development costs (see Note 12).
In August 2016, the FASB issued guidance on the classification of certain cash receipts and payments in the statement of cash flows intended to reduce diversity in practice. The Company adopted the new standard effective as of January 1, 2018 using a retrospective application. There were no changes to the presentation of the Consolidated Statement of Cash Flows in the prior year period as a result of adopting the new standard.
In November 2016, the FASB issued guidance requiring that amounts generally described as restricted cash and restricted cash equivalents be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. The new standard was effective as of January 1, 2018 and was adopted using a retrospective application. The adoption of the new guidance did not have a material effect on the Company’s Consolidated Statement of Cash Flows.
In May 2017, the FASB issued guidance clarifying when to account for a change to the terms or conditions of a share-based payment award as a modification. Under the new guidance, modification accounting is required only if the fair value, the vesting conditions, or the classification of the award (as equity or liability) changes as a result of the change in terms or conditions. The Company adopted the new standard effective as of January 1, 2018 and will apply the new guidance to future share-based payment award modifications should they occur.
Recently Issued Accounting Standards Not Yet Adopted
In February 2016, the FASB issued new accounting guidance for the accounting and reporting of leases. The new guidance requires that lessees recognize a right-of-use asset and a lease liability recorded on the balance sheet for each of its leases (other than leases that meet the definition of a short-term lease).  Leases will be classified as either operating or finance. Operating leases will result in straight-line expense in the income statement (similar to current operating leases) while finance leases will result in more expense being recognized in the earlier years of the lease term (similar to current capital leases). The new guidance will be effective for interim and annual periods beginning in 2019 and will be adopted using a modified retrospective approach. The Company intends to elect available practical expedients. The Company is currently evaluating the impact of adoption on its consolidated financial statements.

- 6 -

Notes to Condensed Consolidated Financial Statements (unaudited)

In June 2016, the FASB issued amended guidance on the accounting for credit losses on financial instruments. The guidance introduces an expected loss model for estimating credit losses, replacing the incurred loss model. The new guidance also changes the impairment model for available-for-sale debt securities, requiring the use of an allowance to record estimated credit losses (and subsequent recoveries). The new guidance is effective for interim and annual periods beginning in 2020, with earlier application permitted in 2019. The new guidance is to be applied on a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings in the beginning of the period of adoption. The Company is currently evaluating the impact of adoption on its consolidated financial statements.
In January 2017, the FASB issued guidance that provides for the elimination of Step 2 from the goodwill impairment test. Under the new guidance, impairment charges are recognized to the extent the carrying amount of a reporting unit exceeds its fair value with certain limitations. The new guidance is effective for interim and annual periods in 2020. Early adoption is permitted. The Company does not anticipate that the adoption of the new guidance will have a material effect on its consolidated financial statements.
2.
Summary of Significant Accounting Policies
On January 1, 2018, the Company adopted ASU 2014-09, Revenue from Contracts with Customers, and subsequent amendments (ASC 606 or new guidance), using the modified retrospective method. Merck applied the new guidance to all contracts with customers within the scope of the standard that were in effect on January 1, 2018 and recognized the cumulative effect of initially applying the new guidance as an adjustment to the opening balance of retained earnings (see Note 1). Comparative information for prior periods has not been restated and continues to be reported under the accounting standards in effect for those periods.
The new guidance provides principles that an entity applies to report useful information about the amount, timing, and uncertainty of revenue and cash flows arising from its contracts to provide goods or services to customers. The core principle requires an entity to recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration that it expects to be entitled to in exchange for those goods or services. The new guidance introduces a 5-step model to recognize revenue when or as control is transferred: identify the contract with a customer, identify the performance obligations in the contract, determine the transaction price, allocate the transaction price to the performance obligations in the contract, and recognize revenue when or as the performance obligations are satisfied. The Company’s significant accounting policies are detailed in Note 2 to the consolidated financial statements included in Merck’s Annual Report on Form 10-K for the year ended December 31, 2017. Changes to the Company’s revenue recognition policy as a result of adopting ASC 606 are described below. See Note 16 for disaggregated revenue disclosures.
Revenue Recognition — Recognition of revenue requires evidence of a contract, probable collection of sales proceeds and completion of substantially all performance obligations. Merck acts as the principal in substantially all of its customer arrangements and therefore records revenue on a gross basis. The majority of the Company’s contracts related to the Pharmaceutical and Animal Health segments have a single performance obligation - the promise to transfer goods. Shipping is considered immaterial in the context of the overall customer arrangement and damages or loss of goods in transit are rare. Therefore, shipping is not deemed a separately recognized performance obligation.
The vast majority of revenues from sales of products are recognized at a point in time when control of the goods is transferred to the customer, which the Company has determined is when title and risks and rewards of ownership transfer to the customer and the Company is entitled to payment. Certain Merck entities, including U.S. entities, have contract terms under which control of the goods passes to the customer upon shipment; however, either pursuant to the terms of the contract or as a business practice, Merck retains responsibility for goods lost or damaged in transit. Prior to the adoption of the new standard, Merck would recognize revenue for these entities upon delivery of the goods. Under the new guidance, the Company is now recognizing revenue at time of shipment for these entities.
For businesses within the Company’s Healthcare Services segment and certain services in the Animal Health segment, revenue is recognized over time, generally ratably over the contract term as services are provided.
Merck’s payment terms for U.S. pharmaceutical customers are typically net 36 days from receipt of invoice and for U.S. animal health customers are typically net 30 days from receipt of invoice; however, certain products, including Keytruda, have longer payment terms up to 90 days. Outside of the United States, payment terms are typically 30 days to 90 days although certain markets have longer payment terms.
The nature of the Company’s business gives rise to several types of variable consideration including discounts and returns, which are estimated at the time of sale generally using the expected value method, although the most likely amount method is also used for certain types of variable consideration. In the United States, sales discounts are issued to customers at the point-of-sale, through an intermediary wholesaler (known as chargebacks), or in the form of rebates. Additionally, sales are generally made with a limited right of return under certain conditions. Revenues are recorded net of provisions for sales discounts and

- 7 -

Notes to Condensed Consolidated Financial Statements (unaudited)

returns, which are established at the time of sale. In addition, revenues are recorded net of time value of money discounts if collection of accounts receivable is expected to be in excess of one year.
The provision for aggregate customer discounts covers chargebacks and rebates. Chargebacks are discounts that occur when a contracted customer purchases through an intermediary wholesaler. The contracted customer generally purchases product from the wholesaler at its contracted price plus a mark-up. The wholesaler, in turn, charges the Company back for the difference between the price initially paid by the wholesaler and the contract price paid to the wholesaler by the customer. The provision for chargebacks is based on expected sell-through levels by the Company’s wholesale customers to contracted customers, as well as estimated wholesaler inventory levels. Rebates are amounts owed based upon definitive contractual agreements or legal requirements with private sector and public sector (Medicaid and Medicare Part D) benefit providers, after the final dispensing of the product by a pharmacy to a benefit plan participant. The provision for rebates is based on expected patient usage, as well as inventory levels in the distribution channel to determine the contractual obligation to the benefit providers. The Company uses historical customer segment utilization mix, sales forecasts, changes to product mix and price, inventory levels in the distribution channel, government pricing calculations and prior payment history in order to estimate the expected provision. Amounts accrued for aggregate customer discounts are evaluated on a quarterly basis through comparison of information provided by the wholesalers, health maintenance organizations, pharmacy benefit managers, federal and state agencies, and other customers to the amounts accrued. These discounts, in the aggregate, reduced U.S. sales by $2.8 billion in both the second quarter of 2018 and 2017, and by $5.2 billion and $5.3 billion for the first six months of 2018 and 2017, respectively.
Outside of the United States, variable consideration in the form of discounts and rebates are a combination of commercially-driven discounts in highly competitive product classes, discounts required to gain or maintain reimbursement, or legislatively mandated rebates. In certain European countries, legislatively mandated rebates are calculated based on an estimate of the government’s total unbudgeted spending and the Company’s specific payback obligation. Rebates may also be required based on specific product sales thresholds. In all cases, the Company applies an estimated factor against its actual invoiced sales to represent the expected level of future discount or rebate obligation associated with the sale.
The Company maintains a returns policy that allows its U.S. pharmaceutical customers to return product within a specified period prior to and subsequent to the expiration date (generally, three to six months before and 12 months after product expiration). The estimate of the provision for returns is based upon historical experience with actual returns. Additionally, the Company considers factors such as levels of inventory in the distribution channel, product dating and expiration period, whether products have been discontinued, entrance in the market of generic competition, changes in formularies or launch of over-the-counter products, among others. Outside of the United States, returns are only allowed on a limited basis in certain countries.
The following table provides the effects of adopting ASC 606 on the Consolidated Statement of Income for the three and six months ended June 30, 2018:
 
Three Months Ended June 30, 2018
 
Six Months Ended June 30, 2018
($ in millions)
As Reported
 
Effects of Adopting ASC 606
 
Amounts Without Adoption of ASC 606
 
As Reported
 
Effects of Adopting ASC 606
 
Amounts Without Adoption of ASC 606
Sales
$
10,465

 
$
(6
)
 
$
10,459

 
$
20,502

 
$
(29
)
 
$
20,473

Materials and production
3,417

 
(5
)
 
3,412

 
6,601

 
(16
)
 
6,585

Income before taxes
2,086

 
(1
)
 
2,085

 
3,432

 
(13
)
 
3,419

Taxes on income
370

 
(1
)
 
369

 
975

 
(3
)
 
972

Net income attributable to Merck & Co., Inc.
1,707

 

 
1,707

 
2,443

 
(10
)
 
2,433


The following table provides the effects of adopting ASC 606 on the Consolidated Balance Sheet as of June 30, 2018:
 
June 30, 2018
($ in millions)
As Reported
 
Effects of Adopting ASC 606
 
Amounts Without Adoption of ASC 606
Assets
 
 
 
 
 
Accounts receivable
$
7,287

 
$
(47
)
 
$
7,240

Inventories
5,178

 
18

 
5,196

Liabilities
 
 
 
 


Accrued and other current liabilities
9,755

 
(9
)
 
9,746

Income taxes payable
661

 
(5
)
 
656

Equity
 
 
 
 


Retained earnings
41,523

 
(15
)
 
41,508


- 8 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

3.
Acquisitions, Divestitures, Research Collaborations and License Agreements
The Company continues to pursue the acquisition of businesses and establishment of external alliances such as research collaborations and licensing agreements to complement its internal research capabilities. These arrangements often include upfront payments, as well as expense reimbursements or payments to the third party, and milestone, royalty or profit share arrangements, contingent upon the occurrence of certain future events linked to the success of the asset in development. The Company also reviews its marketed products and pipeline to examine candidates which may provide more value through out-licensing and, as part of its portfolio assessment process, may also divest certain assets. Pro forma financial information for acquired businesses is not presented if the historical financial results of the acquired entity are not significant when compared with the Company’s financial results.
In June 2018, Merck acquired Viralytics Limited (Viralytics), an Australian publicly traded company focused on oncolytic immunotherapy treatments for a range of cancers, for AUD 502 million ($378 million). The transaction provided Merck with full rights to Cavatak (V937, formerly CVA21), Viralytics’s investigational oncolytic immunotherapy. Cavatak is based on Viralytics’s proprietary formulation of an oncolytic virus (Coxsackievirus Type A21) that has been shown to preferentially infect and kill cancer cells. Cavatak is currently being evaluated in multiple Phase 1 and Phase 2 clinical trials, both as an intratumoral and intravenous agent, including in combination with Keytruda. Under a previous agreement between Merck and Viralytics, a study is investigating the use of the Keytruda and Cavatak combination in melanoma, prostate, lung and bladder cancers. The transaction was accounted for as an asset acquisition. Merck recorded net assets of $34 million (primarily cash) at the acquisition date and Research and development expenses of $344 million for the second quarter and first six months of 2018 related to the transaction. There are no future contingent payments associated with the acquisition.
In April 2018, Merck sold C3i Solutions, a multi-channel customer engagement services provider which was part of the Healthcare Services segment, to HCL Technologies Limited for $65 million. The transaction resulted in a loss of $11 million recorded in Other (income) expense, net.
In March 2018, Merck and Eisai Co., Ltd. (Eisai) entered into a strategic collaboration for the worldwide co-development and co-commercialization of Lenvima, an orally available tyrosine kinase inhibitor discovered by Eisai (see Note 4).
In July 2017, Merck and AstraZeneca PLC (AstraZeneca) entered into a global strategic oncology collaboration to co-develop and co-commercialize AstraZeneca’s Lynparza for multiple cancer types (see Note 4).
In March 2017, Merck acquired a controlling interest in Vallée S.A. (Vallée), a leading privately held producer of animal health products in Brazil. Vallée has an extensive portfolio of products spanning parasiticides, anti-infectives and vaccines that include products for livestock, horses, and companion animals. Under the terms of the agreement, Merck acquired 93.5% of the shares of Vallée for $358 million. Of the total purchase price, $176 million was placed into escrow pending resolution of certain contingent items. The transaction was accounted for as an acquisition of a business. Merck recognized intangible assets of $297 million related to currently marketed products, net deferred tax liabilities of $102 million, other net assets of $32 million and noncontrolling interest of $25 million. In addition, the Company recorded liabilities of $37 million for contingencies identified at the acquisition date and corresponding indemnification assets of $37 million, representing the amounts to be reimbursed to Merck if and when the contingent liabilities are paid. The excess of the consideration transferred over the fair value of net assets acquired of $156 million was recorded as goodwill. The goodwill was allocated to the Animal Health segment and is not deductible for tax purposes. The estimated fair values of identifiable intangible assets related to currently marketed products were determined using an income approach. The probability-adjusted future net cash flows of each product were discounted to present value utilizing a discount rate of 15.5%. Actual cash flows are likely to be different than those assumed. The intangible assets related to currently marketed products are being amortized over their estimated useful lives of 15 years. In the fourth quarter of 2017, Merck acquired an additional 4.5% interest in Vallée for $18 million, which reduced the noncontrolling interest related to Vallée.
4.    Collaborative Arrangements
Merck has entered into collaborative arrangements that provide the Company with varying rights to develop, produce and market products together with its collaborative partners. Both parties in these arrangements are active participants and exposed to significant risks and rewards dependent on the commercial success of the activities of the collaboration. Merck’s more significant collaborative arrangements are discussed below.
AstraZeneca
In July 2017, Merck and AstraZeneca entered into a global strategic oncology collaboration to co-develop and co-commercialize AstraZeneca’s Lynparza for multiple cancer types. Lynparza is an oral poly (ADP-ribose) polymerase (PARP) inhibitor currently approved for certain types of ovarian and breast cancer. The companies are jointly developing and commercializing Lynparza, both as monotherapy and in combination trials with other potential medicines. Independently, Merck and AstraZeneca will develop and commercialize Lynparza in combinations with their respective PD-1 and PD-L1 medicines, Keytruda and Imfinzi. The companies will also jointly develop and commercialize AstraZeneca’s selumetinib, an oral, potent,

- 9 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

selective inhibitor of MEK, part of the mitogen-activated protein kinase (MAPK) pathway, currently being developed for multiple indications. Under the terms of the agreement, AstraZeneca and Merck will share the development and commercialization costs for Lynparza and selumetinib monotherapy and non-PD-L1/PD-1 combination therapy opportunities.
Gross profits from Lynparza and selumetinib product sales generated through monotherapies or combination therapies are shared equally. Merck will fund all development and commercialization costs of Keytruda in combination with Lynparza or selumetinib. AstraZeneca will fund all development and commercialization costs of Imfinzi in combination with Lynparza or selumetinib. AstraZeneca is currently the principal on Lynparza sales transactions. Merck is recording its share of Lynparza product sales, net of cost of sales and commercialization costs, as alliance revenue within the Pharmaceutical segment and its share of development costs associated with the collaboration as part of Research and development expenses. Reimbursements received from AstraZeneca for research and development expenses are recognized as reductions to Research and development costs.
As part of the agreement, Merck made an upfront payment to AstraZeneca of $1.6 billion and is making payments totaling $750 million over a multi-year period for certain license options ($250 million of which was paid in 2017). The Company recorded an aggregate charge of $2.35 billion in Research and development expenses in 2017 related to the upfront payment and future license options payments. In addition, the agreement provides for additional contingent payments from Merck to AstraZeneca of up to $6.15 billion, of which $2.05 billion relate to the successful achievement of regulatory milestones and $4.1 billion relate to the achievement of sales milestones for total aggregate consideration of up to $8.5 billion.
In the second quarter of 2018, Merck determined it was probable that annual sales of Lynparza in the future would trigger a $200 million sales-based milestone payment from Merck to AstraZeneca. Accordingly, in the second quarter of 2018, Merck recorded a $200 million noncurrent liability and a corresponding intangible asset and also recognized $17 million of cumulative amortization expense within Materials and production costs. The remaining intangible asset will be amortized over its estimated useful life of approximately 10 years as supported by projected future cash flows, subject to impairment testing. Merck previously accrued a $150 million sales-based milestone in the first quarter of 2018 (along with $9 million of cumulative amortization expense) and a $100 million sales-based milestone in 2017. The remaining $3.65 billion of potential future sales-based milestone payments have not yet been accrued as they are not deemed by the Company to be probable at this time.
In January 2018, Lynparza received approval in the United States for the treatment of certain patients with metastatic breast cancer, triggering a $70 million milestone payment from Merck to AstraZeneca. This milestone payment was capitalized and will be amortized over its estimated useful life, subject to impairment testing. Potential future regulatory milestone payments of $1.98 billion remain under the agreement.
Summarized information related to this collaboration is as follows:
($ in millions)
Three Months Ended 
 June 30, 2018
 
Six Months Ended 
 June 30, 2018
Alliance revenues
$
44

 
$
76

 
 
 
 
Materials and production (1)
24

 
36

Marketing and administrative
9

 
16

Research and development
42

 
71

 
 
 
 
($ in millions)
June 30, 2018
 
December 31, 2017
Receivables from AstraZeneca
$
40

 
$
12

Payables to AstraZeneca (2)
990

 
643

(1) Represents amortization of intangible assets.
(2) Includes accrued milestone and license option payments.
Eisai
In March 2018, Merck and Eisai announced a strategic collaboration for the worldwide co-development and co-commercialization of Lenvima, an orally available tyrosine kinase inhibitor discovered by Eisai. Under the agreement, Merck and Eisai will develop and commercialize Lenvima jointly, both as monotherapy and in combination with Merck’s anti-PD-1 therapy, Keytruda. Eisai records Lenvima product sales globally (Eisai is the principal on Lynparza sales transactions), and Merck and Eisai share gross profits equally. Merck records its share of Lenvima product sales net of cost of sales and commercialization costs, as alliance revenue. Expenses incurred during co-development, including for studies evaluating Lenvima as monotherapy, are shared equally by the two companies. Under the agreement, Merck made upfront payments to Eisai of $750 million and will make payments of up to $650 million for certain option rights through 2021 ($325 million in January 2019 or earlier in certain

- 10 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

circumstances, $200 million in January 2020 and $125 million in January 2021). The Company recorded an aggregate charge of $1.4 billion in Research and development expenses in the first six months of 2018 related to the upfront payments and future option payments. In addition, the agreement provides for Eisai to receive up to $385 million in the future associated with the achievement of certain clinical and regulatory milestones and up to $3.97 billion for the achievement of milestones associated with sales of Lenvima. In March 2018, Lenvima was approved in Japan for unresectable hepatocellular carcinoma, which was the first regulatory approval under the global strategic collaboration, triggering a $25 million milestone payment to Eisai. This milestone payment was capitalized and will be amortized over its estimated useful life of approximately nine years, subject to impairment testing.
Summarized information related to this collaboration is as follows:
($ in millions)
Three Months Ended 
 June 30, 2018
Alliance revenues
$
35

 
 
Materials and production (1)
1

Marketing and administrative
2

Research and development
36

 
 
($ in millions)
June 30, 2018
Receivables from Eisai
$
35

Payables to Eisai (2)
677

(1) Represents amortization of intangible assets.
(2) Includes accrued license option payments.
Bayer AG
In 2014, the Company entered into a worldwide clinical development collaboration with Bayer AG (Bayer) to market and develop soluble guanylate cyclase (sGC) modulators including Bayer’s Adempas, which is approved to treat pulmonary arterial hypertension and chronic thromboembolic pulmonary hypertension. The two companies have implemented a joint development and commercialization strategy. The collaboration also includes clinical development of Bayer’s vericiguat, which is in Phase 3 trials for worsening heart failure, as well as opt-in rights for other early-stage sGC compounds in development by Bayer. Merck in turn made available its early-stage sGC compounds under similar terms. Under the agreement, Bayer leads commercialization of Adempas in the Americas, while Merck leads commercialization in the rest of the world. For vericiguat and other potential opt-in products, Bayer will lead commercialization in the rest of world and Merck will lead in the Americas. For all products and candidates included in the agreement, both companies will share in development costs and profits on sales and will have the right to co-promote in territories where they are not the lead. In 2016, Merck began promoting and distributing Adempas in Europe. Transition from Bayer in other Merck territories, including Japan, continued in 2017. Revenue from Adempas includes sales in Merck’s marketing territories, as well as Merck’s share of profits from the sale of Adempas in Bayer’s marketing territories.
In the second quarter of 2018, Merck determined it was probable that annual sales of Adempas in the future would trigger a $375 million sales-based milestone payment from Merck to Bayer. Accordingly, in the second quarter of 2018, Merck recorded a $375 million noncurrent liability and a corresponding intangible asset and also recognized $106 million of cumulative amortization expense within Materials and production costs. The remaining intangible asset will be amortized over its estimated useful life of approximately 9.5 years as supported by projected future cash flows, subject to impairment testing. In 2017, annual sales of Adempas exceeded $500 million triggering a $350 million milestone payment from Merck to Bayer, which was accrued for in 2016 when Merck deemed the payment to be probable. The milestone was paid in the first quarter of 2018. There is an additional $400 million potential future sales-based milestone payment that has not yet been accrued as it is not deemed by the Company to be probable at this time.

- 11 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

Summarized information related to this collaboration is as follows:
 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
($ in millions)
2018
 
2017
 
2018
 
2017
Net product sales recorded by Merck
$
47

 
$
36

 
$
90

 
$
67

Merck’s profit share from sales in Bayer's marketing territories
28

 
31

 
53

 
84

Total sales
75

 
67

 
143

 
151

 
 
 
 
 
 
 
 
Materials and production (1)
132

 
24

 
159

 
47

Marketing and administrative
10

 
5

 
17

 
11

Research and development
28

 
25

 
56

 
51

 
 
 
 
 
 
 
 
($ in millions)
 
 
 
 
June 30, 2018
 
December 31, 2017
Receivables from Bayer
 
 


 
$
27

 
$
33

Payables to Bayer (2)
 
 


 
375

 
352

(1) Includes amortization of intangible assets.
(2) Includes accrued milestone payments.
5.
Restructuring
In 2010 and 2013, the Company commenced actions under global restructuring programs designed to streamline its cost structure. The actions under these programs include the elimination of positions in sales, administrative and headquarters organizations, as well as the sale or closure of certain manufacturing and research and development sites and the consolidation of office facilities. The Company also continues to reduce its global real estate footprint and improve the efficiency of its manufacturing and supply network.
The Company recorded total pretax costs of $235 million and $210 million in the second quarter of 2018 and 2017, respectively, and $339 million and $425 million for the first six months of 2018 and 2017, respectively, related to restructuring program activities. Since inception of the programs through June 30, 2018, Merck has recorded total pretax accumulated costs of approximately $13.8 billion and eliminated approximately 44,695 positions comprised of employee separations, as well as the elimination of contractors and vacant positions. The Company estimates that approximately two-thirds of the cumulative pretax costs are cash outlays, primarily related to employee separation expense. Approximately one-third of the cumulative pretax costs are non-cash, relating primarily to the accelerated depreciation of facilities to be closed or divested. While the Company has substantially completed the actions under these programs, approximately $500 million of pretax costs are expected to be incurred for the full year of 2018 relating to anticipated employee separations and remaining asset-related costs.
For segment reporting, restructuring charges are unallocated expenses.
The following tables summarize the charges related to restructuring program activities by type of cost:
 
Three Months Ended June 30, 2018
 
Six Months Ended June 30, 2018
($ in millions)
Separation
Costs
 
Accelerated
Depreciation
 
Other
 
Total
 
Separation
Costs
 
Accelerated
Depreciation
 
Other
 
Total
Materials and production
$

 
$

 
$
3

 
$
3

 
$

 
$

 
$
9

 
$
9

Marketing and administrative

 

 
1

 
1

 

 
1

 
1

 
2

Research and development

 

 
3

 
3

 

 
(3
)
 
8

 
5

Restructuring costs
200

 

 
28

 
228

 
255

 

 
68

 
323

 
$
200

 
$

 
$
35

 
$
235

 
$
255

 
$
(2
)
 
$
86

 
$
339

 
Three Months Ended June 30, 2017
 
Six Months Ended June 30, 2017
($ in millions)
Separation
Costs
 
Accelerated
Depreciation
 
Other
 
Total
 
Separation
Costs
 
Accelerated
Depreciation
 
Other
 
Total
Materials and production
$

 
$
(4
)
 
$
37

 
$
33

 
$

 
$
47

 
$
49

 
$
96

Marketing and administrative

 
2

 

 
2

 

 
2

 
1

 
3

Research and development

 
8

 
1

 
9

 

 
6

 
3

 
9

Restructuring costs
118

 

 
48

 
166

 
202

 

 
115

 
317

 
$
118

 
$
6

 
$
86

 
$
210

 
$
202

 
$
55

 
$
168

 
$
425


- 12 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

Separation costs are associated with actual headcount reductions, as well as those headcount reductions which were probable and could be reasonably estimated. In the second quarter of 2018 and 2017, approximately 635 positions and 475 positions, respectively, and for the first six months of 2018 and 2017, 1,345 positions and 1,020 positions, respectively, were eliminated under restructuring program activities.
Accelerated depreciation costs primarily relate to manufacturing, research and administrative facilities and equipment to be sold or closed as part of the programs. Accelerated depreciation costs represent the difference between the depreciation expense to be recognized over the revised useful life of the asset, based upon the anticipated date the site will be closed or divested or the equipment disposed of, and depreciation expense as determined utilizing the useful life prior to the restructuring actions. All of the sites have and will continue to operate up through the respective closure dates and, since future undiscounted cash flows were sufficient to recover the respective book values, Merck is recording accelerated depreciation over the revised useful life of the site assets. Anticipated site closure dates, particularly related to manufacturing locations, have been and may continue to be adjusted to reflect changes resulting from regulatory or other factors.
Other activity in 2018 and 2017 includes asset abandonment, shut-down and other related costs, as well as pretax gains and losses resulting from sales of facilities and related assets. Additionally, other activity includes certain employee-related costs associated with pension and other postretirement benefit plans (see Note 11) and share-based compensation.
The following table summarizes the charges and spending relating to restructuring program activities for the six months ended June 30, 2018:
($ in millions)
Separation
Costs
 
Accelerated
Depreciation
 
Other
 
Total
Restructuring reserves January 1, 2018
$
619

 
$

 
$
128

 
$
747

Expense
255

 
(2
)
 
86

 
339

(Payments) receipts, net
(389
)
 

 
(116
)
 
(505
)
Non-cash activity

 
2

 
7

 
9

Restructuring reserves June 30, 2018 (1)
$
485

 
$

 
$
105

 
$
590

(1) 
The remaining cash outlays are expected to be substantially completed by the end of 2020.
6.
Financial Instruments
Derivative Instruments and Hedging Activities
The Company manages the impact of foreign exchange rate movements and interest rate movements on its earnings, cash flows and fair values of assets and liabilities through operational means and through the use of various financial instruments, including derivative instruments.
A significant portion of the Company’s revenues and earnings in foreign affiliates is exposed to changes in foreign exchange rates. The objectives and accounting related to the Company’s foreign currency risk management program, as well as its interest rate risk management activities are discussed below.
Foreign Currency Risk Management
The Company has established revenue hedging, balance sheet risk management and net investment hedging programs to protect against volatility of future foreign currency cash flows and changes in fair value caused by volatility in foreign exchange rates.
The objective of the revenue hedging program is to reduce the variability caused by changes in foreign exchange rates that would affect the U.S. dollar value of future cash flows derived from foreign currency denominated sales, primarily the euro and Japanese yen. To achieve this objective, the Company will hedge a portion of its forecasted foreign currency denominated third-party and intercompany distributor entity sales (forecasted sales) that are expected to occur over its planning cycle, typically no more than two years into the future. The Company will layer in hedges over time, increasing the portion of forecasted sales hedged as it gets closer to the expected date of the forecasted sales. The portion of forecasted sales hedged is based on assessments of cost-benefit profiles that consider natural offsetting exposures, revenue and exchange rate volatilities and correlations, and the cost of hedging instruments. The Company manages its anticipated transaction exposure principally with purchased local currency put options, forward contracts and purchased collar options.
The fair values of these derivative contracts are recorded as either assets (gain positions) or liabilities (loss positions) in the Condensed Consolidated Balance Sheet. Changes in the fair value of derivative contracts are recorded each period in either current earnings or Other comprehensive income (OCI), depending on whether the derivative is designated as part of a hedge transaction and, if so, the type of hedge transaction. For derivatives that are designated as cash flow hedges, the unrealized gains or losses on these contracts is recorded in Accumulated other comprehensive income (AOCI) and reclassified into Sales when the hedged anticipated revenue is recognized. For those derivatives which are not designated as cash flow hedges, but serve as economic

- 13 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

hedges of forecasted sales, unrealized gains or losses are recorded in Sales each period. The cash flows from both designated and non-designated contracts are reported as operating activities in the Condensed Consolidated Statement of Cash Flows. The Company does not enter into derivatives for trading or speculative purposes.
The Company manages operating activities and net asset positions at each local subsidiary in order to mitigate the effects of exchange on monetary assets and liabilities. The Company also uses a balance sheet risk management program to mitigate the exposure of net monetary assets that are denominated in a currency other than a subsidiary’s functional currency from the effects of volatility in foreign exchange. In these instances, Merck principally utilizes forward exchange contracts to offset the effects of exchange on exposures denominated in developed country currencies, primarily the euro and Japanese yen. For exposures in developing country currencies, the Company will enter into forward contracts to partially offset the effects of exchange on exposures when it is deemed economical to do so based on a cost-benefit analysis that considers the magnitude of the exposure, the volatility of the exchange rate and the cost of the hedging instrument. The cash flows from these contracts are reported as operating activities in the Condensed Consolidated Statement of Cash Flows.
Monetary assets and liabilities denominated in a currency other than the functional currency of a given subsidiary are remeasured at spot rates in effect on the balance sheet date with the effects of changes in spot rates reported in Other (income) expense, net. The forward contracts are not designated as hedges and are marked to market through Other (income) expense, net. Accordingly, fair value changes in the forward contracts help mitigate the changes in the value of the remeasured assets and liabilities attributable to changes in foreign currency exchange rates, except to the extent of the spot-forward differences. These differences are not significant due to the short-term nature of the contracts, which typically have average maturities at inception of less than one year.
The Company also uses forward exchange contracts to hedge its net investment in foreign operations against movements in exchange rates. The forward contracts are designated as hedges of the net investment in a foreign operation. The Company hedges a portion of the net investment in certain of its foreign operations. The unrealized gains or losses on these contracts are recorded in foreign currency translation adjustment within OCI, and remain in AOCI until either the sale or complete or substantially complete liquidation of the subsidiary. The Company excludes certain portions of the change in fair value of its derivative instruments from the assessment of hedge effectiveness (excluded component). Changes in fair value of the excluded components are recognized in OCI. In accordance with the new guidance adopted on January 1, 2018 (see Note 1), the Company has elected to recognize in earnings the initial value of the excluded component on a straight-line basis over the life of the derivative instrument, rather than using the mark-to-market approach. The cash flows from these contracts are reported as investing activities in the Condensed Consolidated Statement of Cash Flows.
Foreign exchange risk is also managed through the use of foreign currency debt. The Company’s senior unsecured euro-denominated notes have been designated as, and are effective as, economic hedges of the net investment in a foreign operation. Accordingly, foreign currency transaction gains or losses due to spot rate fluctuations on the euro-denominated debt instruments are included in foreign currency translation adjustment within OCI.
The effect of the Company’s net investment hedges on OCI and the Consolidated Statement of Income is shown below:
 
Amount of Pretax (Gain) Loss Recognized in Other Comprehensive Income (1)
 
Amount of Pretax (Gain) Loss Recognized in Other (income) expense, net for Amounts Excluded from Effectiveness Testing
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
Three Months Ended June 30,
 
Six Months Ended June 30,
($ in millions)
2018
 
2017
 
2018
 
2017
 
2018
 
2017
 
2018
 
2017
Net Investment Hedging Relationships
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
$
(12
)
 
$

 
$
(14
)
 
$

 
$
(3
)
 
$

 
$
(3
)
 
$

Euro-denominated notes
(271
)
 
204

 
(92
)
 
339

 

 

 

 

(1) No amounts were reclassified from AOCI into income related to the sale of a subsidiary.
Interest Rate Risk Management
The Company may use interest rate swap contracts on certain investing and borrowing transactions to manage its net exposure to interest rate changes and to reduce its overall cost of borrowing. The Company does not use leveraged swaps and, in general, does not leverage any of its investment activities that would put principal capital at risk.
In May 2018, four interest rate swaps with notional amounts of $250 million each matured. These swaps effectively converted the Company’s $1.0 billion1.30% fixed-rate notes due 2018 to variable rate debt. At June 30, 2018, the Company was a party to 22 pay-floating, receive-fixed interest rate swap contracts designated as fair value hedges of fixed-rate notes in which the notional amounts match the amount of the hedged fixed-rate notes as detailed in the table below.

- 14 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

 
June 30, 2018
($ in millions)
Par Value of Debt
 
Number of Interest Rate Swaps Held
 
Total Swap Notional Amount
5.00% notes due 2019
1,250

 
3

 
550

1.85% notes due 2020
1,250

 
5

 
1,250

3.875% notes due 2021
1,150

 
5

 
1,150

2.40% notes due 2022
1,000

 
4

 
1,000

2.35% notes due 2022
1,250

 
5

 
1,250

The interest rate swap contracts are designated hedges of the fair value changes in the notes attributable to changes in the benchmark London Interbank Offered Rate (LIBOR) swap rate. The fair value changes in the notes attributable to changes in the LIBOR swap rate are recorded in interest expense along with the offsetting fair value changes in the swap contracts. The cash flows from these contracts are reported as operating activities in the Condensed Consolidated Statement of Cash Flows.
The table below presents the location of amounts recorded on the Consolidated Balance Sheet related to cumulative basis adjustments for fair value hedges:
 
Carrying Amount of Hedged Liabilities
 
Cumulative Amount of Fair Value Hedging Adjustment Increase (Decrease) Included in the Carrying Amount
($ in millions)
June 30, 2018
 
December 31, 2017
 
June 30, 2018
 
December 31, 2017
Balance Sheet Line Item in which Hedged Item is Included
 
 
 
 
 
 
 
Loans payable and current portion of long-term debt
$
554

 
$
983

 
$
5

 
$
(17
)
Long-Term Debt (1)
4,511

 
5,146

 
(129
)
 
(41
)
(1) Amounts include hedging adjustment gains related to discontinued hedging relationships of $7 million and $11 million at June 30, 2018 and December 31, 2017, respectively.
Presented in the table below is the fair value of derivatives on a gross basis segregated between those derivatives that are designated as hedging instruments and those that are not designated as hedging instruments:
 
 
June 30, 2018
 
December 31, 2017
 
 
Fair Value of Derivative
 
U.S. Dollar
Notional
 
Fair Value of Derivative
 
U.S. Dollar
Notional
($ in millions)
Balance Sheet Caption
Asset
 
Liability
 
Asset
 
Liability
 
Derivatives Designated as Hedging Instruments
 
 
 
 
 
 
 
 
 
 
 
 
Interest rate swap contracts
Other assets
$

 
$

 
$

 
$
2

 
$

 
$
550

Interest rate swap contracts
Accrued and other current liabilities

 
2

 
550

 

 
3

 
1,000

Interest rate swap contracts
Other noncurrent liabilities

 
130

 
4,650

 

 
52

 
4,650

Foreign exchange contracts
Other current assets
153

 

 
6,071

 
51

 

 
4,216

Foreign exchange contracts
Other assets
83

 

 
2,561

 
38

 

 
1,936

Foreign exchange contracts
Accrued and other current liabilities

 
8

 
590

 

 
71

 
2,014

Foreign exchange contracts
Other noncurrent liabilities

 
1

 
144

 

 
1

 
20

 
 
$
236


$
141


$
14,566


$
91


$
127


$
14,386

Derivatives Not Designated as Hedging Instruments
 
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
Other current assets
$
208

 
$

 
$
6,403

 
$
39

 
$

 
$
3,778

Foreign exchange contracts
Accrued and other current liabilities

 
56

 
4,681

 

 
90

 
7,431

 
 
$
208

 
$
56

 
$
11,084

 
$
39

 
$
90

 
$
11,209

 
 
$
444


$
197


$
25,650


$
130


$
217


$
25,595


- 15 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

As noted above, the Company records its derivatives on a gross basis in the Condensed Consolidated Balance Sheet. The Company has master netting agreements with several of its financial institution counterparties (see Concentrations of Credit Risk below). The following table provides information on the Company’s derivative positions subject to these master netting arrangements as if they were presented on a net basis, allowing for the right of offset by counterparty and cash collateral exchanged per the master agreements and related credit support annexes:
 
June 30, 2018
 
December 31, 2017
($ in millions)
Asset
 
Liability
 
Asset
 
Liability
Gross amounts recognized in the consolidated balance sheet
$
444

 
$
197

 
$
130

 
$
217

Gross amount subject to offset in master netting arrangements not offset in the consolidated
balance sheet
(152
)
 
(152
)
 
(94
)
 
(94
)
Cash collateral received
(90
)
 

 
(3
)
 

Net amounts
$
202

 
$
45

 
$
33

 
$
123

The table below provides information regarding the location and amount of pretax (gains) losses of derivatives designated in fair value or cash flow hedging relationships:
 
Sales
 
Other (income) expense, net (1)
 
Other comprehensive income (loss)
 
Sales
 
Other (income) expense, net (1)
 
Other comprehensive income (loss)
 
Three Months Ended June 30,
 
Three Months Ended June 30,
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
Six Months Ended June 30,
 
Six Months Ended June 30,
($ in millions)
2018
 
2017
 
2018
 
2017
 
2018
 
2017
 
2018
 
2017
 
2018
 
2017
 
2018
 
2017
Financial Statement Line Items in which Effects of Fair Value or Cash Flow Hedges are Recorded
$
10,465

 
$
9,930

 
$
(48
)
 
(73
)
 
$
(62
)
 
$
(14
)
 
20,502

 
$
19,365

 
$
(340
)
 
$
(143
)
 
$
62

 
$
132

(Gain) loss on fair value hedging relationships
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest rate swap contracts
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Hedged items

 

 
(15
)
 
20

 

 

 

 

 
(77
)
 
4

 

 

Derivatives designated as hedging instruments

 

 
22

 
(31
)
 

 

 

 

 
84

 
(27
)
 

 

Impact of cash flow hedging relationships
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Amount of gain (loss) recognized in OCI on derivatives

 

 

 

 
264

 
(169
)
 

 

 

 

 
84

 
(432
)
(Decrease) increase in Sales as a result of AOCI reclassifications
(73
)
 
49

 

 

 
73

 
(49
)
 
(166
)
 
144

 

 

 
166

 
(144
)
(1) Interest expense is a component of Other (income) expense, net.
The table below provides information regarding the income statement effects of derivatives not designated as hedging instruments:
 
 
 
 
Amount of Derivative Pretax (Gain) Loss Recognized in Income
 
 
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
($ in millions)
 
Income Statement Caption
 
2018
 
2017
 
2018
 
2017
Derivatives Not Designated as Hedging Instruments
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts (1)
 
Other (income) expense, net
 
$
(195
)
 
$
(3
)
 
$
(167
)
 
$
(49
)
Foreign exchange contracts (2)
 
Sales
 
(14
)
 

 
(5
)
 

(1) These derivative contracts mitigate changes in the value of remeasured foreign currency denominated monetary assets and liabilities attributable to changes in foreign currency exchange rates.
(2) These derivative contracts serve as economic hedges of forecasted transactions.
At June 30, 2018, the Company estimates $29 million of pretax net unrealized gains on derivatives maturing within the next 12 months that hedge foreign currency denominated sales over that same period will be reclassified from AOCI to Sales. The amount ultimately reclassified to Sales may differ as foreign exchange rates change. Realized gains and losses are ultimately determined by actual exchange rates at maturity.


- 16 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

Investments in Debt and Equity Securities
Information on investments in debt and equity securities is as follows:
 
June 30, 2018
 
December 31, 2017
 
Fair
Value
 
Amortized
Cost
 
Gross Unrealized
 
Fair
Value
 
Amortized
Cost
 
Gross Unrealized
($ in millions)
Gains
 
Losses
 
Gains
 
Losses
Corporate notes and bonds
$
8,782

 
$
8,902

 
$
2

 
$
(122
)
 
$
9,806

 
$
9,837

 
$
9

 
$
(40
)
U.S. government and agency securities
1,620

 
1,640

 

 
(20
)
 
2,042

 
2,059

 

 
(17
)
Asset-backed securities
1,441

 
1,456

 
1

 
(16
)
 
1,542

 
1,548

 
1

 
(7
)
Foreign government bonds
649

 
658

 

 
(9
)
 
733

 
739

 

 
(6
)
Mortgage-backed securities
65

 
66

 

 
(1
)
 
626

 
634

 
1

 
(9
)
Commercial paper
30

 
30

 

 

 
159

 
159

 

 

Total debt securities
$
12,587


$
12,752


$
3


$
(168
)

$
14,908


$
14,976


$
11


$
(79
)
Publicly traded equity securities (1)
375

 
 
 
 
 
 
 
275

 
265

 
16

 
(6
)
Total debt and publicly traded equity securities
$
12,962











$
15,183


$
15,241


$
27


$
(85
)
(1) Pursuant to the adoption of ASU 2016-01 (see Note 1), beginning on January 1, 2018, changes in the fair value of publicly traded equity securities are recognized in net income. Unrealized net gains of $7 million and $50 million, respectively, were recognized in Other (income) expense, net during the second quarter and first six months of 2018 on equity securities still held at June 30, 2018.
At June 30, 2018, the Company also had $675 million of equity investments without readily determinable fair values included in Other Assets. During the first six months of 2018, the Company recognized unrealized gains of $129 million on certain of these equity investments recorded in Other (income) expense, net based on favorable observable price changes from transactions involving similar investments of the same investee. In addition, during the first six months of 2018, the Company recognized unrealized losses of $26 million in Other (income) expense, net related to certain of these investments based on unfavorable observable price changes.
Available-for-sale debt securities included in Short-term investments totaled $2.3 billion at June 30, 2018. Of the remaining debt securities, $9.6 billion mature within five years. At June 30, 2018 and December 31, 2017, there were no debt securities pledged as collateral.
Fair Value Measurements
Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The Company uses a fair value hierarchy which maximizes the use of observable inputs and minimizes the use of unobservable inputs when measuring fair value. There are three levels of inputs used to measure fair value with Level 1 having the highest priority and Level 3 having the lowest: Level 1 - Quoted prices (unadjusted) in active markets for identical assets or liabilities, Level 2 - Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities, Level 3 - Unobservable inputs that are supported by little or no market activity. Level 3 assets or liabilities are those whose values are determined using pricing models, discounted cash flow methodologies, or similar techniques with significant unobservable inputs, as well as assets or liabilities for which the determination of fair value requires significant judgment or estimation. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.

- 17 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

Financial Assets and Liabilities Measured at Fair Value on a Recurring Basis
Financial assets and liabilities measured at fair value on a recurring basis are summarized below:
 
Fair Value Measurements Using
 
Fair Value Measurements Using
 
Quoted Prices
In Active
Markets for
Identical Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
 
Total
 
Quoted Prices
In Active
Markets for
Identical Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
 
Total
($ in millions)
June 30, 2018
 
December 31, 2017
Assets
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Investments
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate notes and bonds
$

 
$
8,684

 
$

 
$
8,684

 
$

 
$
9,678

 
$

 
$
9,678

U.S. government and agency securities

 
1,396

 

 
1,396

 
68

 
1,767

 

 
1,835

Asset-backed securities (1)

 
1,394

 

 
1,394

 

 
1,476

 

 
1,476

Foreign government bonds

 
649

 

 
649

 

 
732

 

 
732

Commercial paper

 
30

 

 
30

 

 
159

 

 
159

Mortgage-backed securities

 

 

 

 

 
547

 

 
547

Publicly traded equity securities
164

 

 

 
164

 
104

 

 

 
104

 
164

 
12,153

 

 
12,317

 
172

 
14,359

 

 
14,531

Other assets (2)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government and agency securities
64

 
160

 

 
224

 

 
207

 

 
207

Corporate notes and bonds

 
98

 

 
98

 

 
128

 

 
128

Mortgage-backed securities

 
65

 

 
65

 

 
79

 

 
79

Asset-backed securities (1)

 
47

 

 
47

 

 
66

 

 
66

Foreign government bonds

 

 

 

 

 
1

 

 
1

Publicly traded equity securities
211

 

 

 
211

 
171

 

 

 
171

 
275


370




645


171


481




652

Derivative assets (3)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Purchased currency options

 
142

 

 
142

 

 
80

 

 
80

Forward exchange contracts

 
302

 

 
302

 

 
48

 

 
48

Interest rate swaps

 

 

 

 

 
2

 

 
2

 

 
444

 

 
444

 

 
130

 

 
130

Total assets
$
439


$
12,967


$


$
13,406


$
343


$
14,970


$


$
15,313

Liabilities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other liabilities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Contingent consideration
$

 
$

 
$
830

 
$
830

 
$

 
$

 
$
935

 
$
935

Derivative liabilities (3)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Forward exchange contracts

 
62

 

 
62

 

 
162

 

 
162

Interest rate swaps

 
132

 

 
132

 

 
55

 

 
55

Written currency options

 
3

 

 
3

 

 

 

 

 

 
197

 

 
197

 

 
217

 

 
217

Total liabilities
$


$
197


$
830


$
1,027


$


$
217


$
935


$
1,152

(1) 
Primarily all of the asset-backed securities are highly-rated (Standard & Poor’s rating of AAA and Moody’s Investors Service rating of Aaa), secured primarily by auto loan, credit card and student loan receivables, with weighted-average lives of primarily 5 years or less.
(2) 
Investments included in other assets are restricted as to use, primarily for the payment of benefits under employee benefit plans.
(3) 
The fair value determination of derivatives includes the impact of the credit risk of counterparties to the derivatives and the Company’s own credit risk, the effects of which were not significant.
There were no transfers between Level 1 and Level 2 during the first six months of 2018. As of June 30, 2018, Cash and cash equivalents of $5.3 billion included $4.5 billion of cash equivalents (which would be considered Level 2 in the fair value hierarchy).

- 18 -

Notes to Condensed Consolidated Financial Statements (unaudited) (continued)

Contingent Consideration
Summarized information about the changes in liabilities for contingent consideration is as follows:
 
Six Months Ended June 30,
($ in millions)
2018
 
2017
Fair value January 1
$
935

 
$
891

Changes in fair value (1)
122

 
108

Additions
8

 
3

Payments
(235
)