Fair value measurement

To estimate the fair value of our financial assets and liabilities we use valuation approaches within a hierarchy that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions about the inputs that market participants would use in pricing the asset or liability and are developed based on the best information available in the circumstances. The fair value hierarchy is divided into three levels based on the source of inputs as follows:



Level 1	—	Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access
Level 2	—	Valuations for which all significant inputs are observable, either directly or indirectly, other than level 1 inputs
Level 3	—	Valuations based on inputs that are unobservable and significant to the overall fair value measurement

The availability of observable inputs can vary among the various types of financial assets and liabilities. To the extent that the valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. In certain cases, the inputs used for measuring fair value may fall into different levels of the fair value hierarchy. In such cases, for financial statement disclosure purposes, the level in the fair value hierarchy within which the fair value measurement is categorized is based on the lowest level of input used that is significant to the overall fair value measurement.

The fair value of each major class of the Company’s financial assets and liabilities measured at fair value on a recurring basis was as follows (in millions):



Fair value measurement as of December 31, 2013, using:	Quoted prices in active markets for identical assets (Level 1)		Significant other observable inputs (Level 2)		Significant unobservable inputs (Level 3)		Total
Assets:
Available-for-sale investments:
U.S. Treasury securities	$	4,730	$	—	$	—	$	4,730
Other government-related debt securities:
U.S.	—		1,079		—		1,079
Foreign and other	—		1,546		—		1,546
Corporate debt securities:
Financial	—		3,676		—		3,676
Industrial	—		3,760		—		3,760
Other	—		390		—		390
Residential mortgage-backed securities	—		1,460		—		1,460
Other mortgage- and asset-backed securities	—		1,511		—		1,511
Money market mutual funds	3,366		—		—		3,366
Other short-term interest bearing securities	—		750		—		750
Equity securities	95		—		—		95
Derivatives:
Foreign currency contracts	—		53		—		53
Cross-currency swap contracts	—		193		—		193
Total assets	$	8,191	$	14,418	$	—	$	22,609
Liabilities:
Derivatives:
Foreign currency contracts	$	—	$	107	$	—	$	107
Cross-currency swap contracts	—		4		—		4
Interest rate swap contracts	—		161		—		161
Contingent consideration obligations in connection with business combinations	—		—		595		595
Total liabilities	$	—	$	272	$	595	$	867



Fair value measurement as of December 31, 2012, using:	Quoted prices in active markets for identical assets (Level 1)		Significant other observable inputs (Level 2)		Significant unobservable inputs (Level 3)		Total
Assets:
Available-for-sale investments:
U.S. Treasury securities	$	4,458	$	—	$	—	$	4,458
Other government-related debt securities:
U.S.	—		1,030		—		1,030
Foreign and other	—		1,608		—		1,608
Corporate debt securities:
Financial	—		3,361		—		3,361
Industrial	—		4,380		—		4,380
Other	—		452		—		452
Residential mortgage-backed securities	—		1,829		—		1,829
Other mortgage- and asset-backed securities	—		1,767		—		1,767
Money market mutual funds	2,620		—		—		2,620
Other short-term interest-bearing securities	—		2,186		—		2,186
Equity securities	54		—		—		54
Derivatives:
Foreign currency contracts	—		46		—		46
Cross-currency swap contracts	—		65		—		65
Total assets	$	7,132	$	16,724	$	—	$	23,856
Liabilities:
Derivatives:
Foreign currency contracts	$	—	$	59	$	—	$	59
Cross-currency swap contracts	—		6		—		6
Contingent consideration obligations in connection with a business combination	—		—		221		221
Total liabilities	$	—	$	65	$	221	$	286

The fair values of our U.S. Treasury securities, money market mutual funds and equity securities are based on quoted market prices in active markets with no valuation adjustment.

Most of our other government-related and corporate debt securities are investment grade with maturity dates of five years or less from the balance sheet date. Our other government-related debt securities portfolio is composed of securities with weighted-average credit ratings of A+ by S&P, Moody's or Fitch, Inc. (Fitch); and our corporate debt securities portfolio has a weighted-average credit rating of A- or equivalent by S&P or Fitch and BBB+ by Moody's. We estimate the fair values of these securities by taking into consideration valuations obtained from third-party pricing services. The pricing services utilize industry standard valuation models, including both income- and market-based approaches, for which all significant inputs are observable, either directly or indirectly, to estimate fair value. These inputs include reported trades of and broker/dealer quotes on the same or similar securities; issuer credit spreads; benchmark securities; and other observable inputs.

Our residential mortgage-, other mortgage- and asset-backed securities portfolio is composed entirely of senior tranches, with credit ratings of AAA by S&P, Moody's or Fitch. We estimate the fair values of these securities by taking into consideration valuations obtained from third-party pricing services. The pricing services utilize industry standard valuation models, including both income- and market-based approaches, for which all significant inputs are observable, either directly or indirectly, to estimate fair value. These inputs include reported trades of and broker/dealer quotes on the same or similar securities; issuer credit spreads; benchmark securities; prepayment/default projections based on historical data; and other observable inputs.

We value our other short-term interest-bearing securities at amortized cost, which approximates fair value given their near term maturity dates.

All of our foreign currency forward and option derivatives contracts have maturities of three years or less and all are with counterparties that have minimum credit ratings of A- or equivalent by S&P, Moody’s or Fitch. We estimated the fair values of these contracts by taking into consideration valuations obtained from a third-party valuation service that utilizes an income-based industry standard valuation model for which all significant inputs are observable, either directly or indirectly. These inputs include foreign currency rates, LIBOR cash and swap rates and obligor credit default swap rates. In addition, inputs for our foreign currency option contracts also include implied volatility measures. These inputs, where applicable, are at commonly quoted intervals. See Note 17, Derivative instruments.

Our cross-currency swap contracts are with counterparties that have minimum credit ratings of A- or equivalent by S&P, Moody’s or Fitch. We estimated the fair values of these contracts by taking into consideration valuations obtained from a third-party valuation service that utilizes an income-based industry standard valuation model for which all significant inputs are observable either directly or indirectly. These inputs include foreign currency exchange rates, LIBOR, swap rates, obligor credit default swap rates and cross-currency basis swap spreads. See Note 17, Derivative instruments.

Our interest rate swap contracts are with counterparties that have minimum credit ratings of A- or equivalent by S&P, Moody’s or Fitch. We estimated the fair values of these contracts by using an income-based industry standard valuation model for which all significant inputs were observable either directly or indirectly. These inputs included LIBOR, swap rates and obligor credit default swap rates.

Contingent consideration obligations

We have incurred contingent consideration obligations as the result of our acquisition of a business and upon the assumption of contingent consideration obligations incurred by an acquired company discussed below. These contingent consideration obligations are recorded at their estimated fair values, and we revalue these obligations each reporting period until the related contingencies are resolved. Changes in fair values of contingent consideration obligations are recognized in Other operating expenses in the Consolidated Statements of Income.

The changes in carrying amounts of contingent consideration obligations for the years ended December 31, 2013 and 2012, were as follows (in millions):



	2013		2012
Beginning balance	$	221	$	190
Additions from Onyx acquisition	261		—
Net changes in valuation	113		31
Ending balance	$	595	$	221

As a result of our acquisition of BioVex in March 2011, we are obligated to pay its former shareholders up to $575 million of additional consideration contingent upon achieving up to eight separate regulatory and sales-related milestones with regard to talimogene laherparepvec, which was acquired in the acquisition and is currently in phase 3 clinical development for the treatment of melanoma. The three largest of these potential payments are $125 million each, including the amount due if a BLA is filed with the FDA. Potential payments are also due upon the first commercial sale in each of the United States and the EU following receipt of marketing approval which includes use of the product in specified patient populations and upon achievement of specified levels of sales within specified periods of time. The fair value measurements of these obligations are based on significant unobservable inputs, including the estimated probabilities and timing of achieving the related regulatory and commercial events in connection with these milestones and, as applicable, estimated annual sales. Significant changes which increase or decrease the probabilities of achieving the related regulatory and commercial events, shorten or lengthen the time required to achieve such events, or increase of decrease estimated annual sales would result in corresponding increases or decreases in the fair values of these obligations, as applicable.

We estimate the fair values of the obligations to the former shareholders of BioVex by using a combination of probability-adjusted discounted cash flows, option pricing techniques and a simulation model of expected annual sales. Quarterly, management in our R&D and commercial sales organizations review key assumptions used in the fair value measurements of these obligations. In the absence of any significant changes in key assumptions, the changes in fair values of these contingent consideration obligations reflect the passage of time and changes in our credit risk adjusted rate used to discount obligations to present value. During the year ended December 31, 2013, there were increases in management's estimates of the probabilities of completing the BLA filing and receiving approval to market talimogene laherparepvec in specified patient populations in the United States and EU. Due primarily to these changes in key assumptions, the estimated aggregate fair value of the contingent consideration obligations increased by $113 million and $31 million in the years ended December 31, 2013 and 2012, respectively.

We assumed contingent consideration obligations of $261 million upon the acquisition of Onyx arising from Onyx's 2009 acquisition of Proteolix, Inc. See Note 2, Business combinations. As of December 31, 2013, there are two separate milestone payments of $150 million each which would be triggered if Kyprolis^® receives specified marketing approvals for relapsed multiple myeloma on or before March 31, 2016, by each of the FDA and the EMA. The fair value measurements of these obligations are based on significant unobservable inputs, including the estimated probabilities and timing of achieving the related regulatory approvals. Significant changes which increase or decrease the probabilities of receiving regulatory approvals or shorten or lengthen the time required to achieve such approvals would result in corresponding increases or decreases in the fair values of these obligations. We estimate the fair values of contingent obligations to the former shareholders of Proteolix, Inc. by using probability-adjusted discounted cash flows. There was no significant change in the fair value of these contingent consideration obligations from the date of our acquisition of Onyx to December 31, 2013.

There have been no transfers of assets or liabilities between the fair value measurement levels, and there were no material remeasurements to fair value during the years ended December 31, 2013 and 2012, of assets and liabilities that are not measured at fair value on a recurring basis, except as discussed in Note 2, Business combinations, regarding the impairment of an intangible asset and Note 8, Other charges, regarding an impairment of fixed assets which were recognized during the year ended December 31, 2012.

Summary of the fair value of other financial instruments

Cash equivalents

The estimated fair values of cash equivalents approximate their carrying values due to the short-term nature of these financial instruments.

Borrowings

We estimated the fair value of our long-term debt (Level 2) by taking into consideration indicative prices obtained from a third-party financial institution that utilizes industry standard valuation models, including both income- and market-based approaches, for which all significant inputs are observable either directly or indirectly. These inputs include reported trades of and broker/dealer quotes on the same or similar securities; credit spreads; benchmark yields; foreign currency exchange rates, as applicable; and other observable inputs. As of December 31, 2013 and 2012, the aggregate fair values of our long-term debt were $33.5 billion and $29.9 billion, respectively, and the carrying values were $32.1 billion and $26.5 billion, respectively.