8. DEBT, FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS

Debt-for-equity exchanges

On January 27, 2016, Baxter exchanged Retained Shares for the extinguishment of $1.45 billion aggregate principal amount outstanding under its $1.8 billion U.S. dollar-denominated revolving credit facility. This exchange extinguished the indebtedness under the facility, which was terminated in connection with such debt-for-equity exchange. There were no material prepayment penalties or breakage costs associated with the termination of the facility. Baxter recognized a net realized gain of $1.25 billion related to the Retained Shares exchanged, which was included in other income, net for the period ended March 31, 2016.

On March 16, 2016, the company exchanged Retained Shares for the extinguishment of approximately $2.2 billion in principal amount of its 0.950% Notes due May 2016, 5.900% Notes due August 2016, 1.850% Notes due January 2017, 5.375% Notes due May 2018, 1.850% Notes due June 2018, 4.500% Notes due August 2019, and 4.250% Notes due February 2020 purchased by certain third party purchasers in the previously announced debt tender offers. As a result, the company recognized a net loss on extinguishment of debt totaling $101 million and a net realized gain of $2.0 billion on the Retained Shares exchanged, which are included in other income, net for the period ended March 31, 2016.

Commercial paper

During the first quarter of 2016, the company issued and redeemed commercial paper, of which $750 million was outstanding as of March 31, 2016 with a weighted-average interest rate of 0.75%. There was a balance of $300 million outstanding at December 31, 2015 with a weighted-average interest rate of 0.6%. This commercial paper is classified as short-term debt.

Securitization arrangement

The following is a summary of the activity relating to the company’s securitization arrangement in Japan.


	Three months ended March 31,
(in millions)	2016			2015
Sold receivables at beginning of period		$ 81			$ 104
Proceeds from sales of receivables		104			113
Cash collections (remitted to the owners of the receivables)		(107	)		(120	)
Effect of currency exchange rate changes		7			(1	)
Sold receivables at end of period		$ 85			$ 96

The impacts on the condensed consolidated statements of income relating to the sale of receivables were immaterial for each period. Refer to the 2015 Annual Report for further information regarding the company’s securitization agreements.

Concentrations of credit risk

The company invests excess cash in certificates of deposit or money market funds and diversifies the concentration of cash among different financial institutions. With respect to financial instruments, where appropriate, the company has diversified its selection of counterparties, and has arranged collateralization and master-netting agreements to minimize the risk of loss.

The company continues to do business with foreign governments in certain countries, including Greece, Spain, Portugal and Italy, that have experienced a deterioration in credit and economic conditions. As of March 31, 2016, the company’s net accounts receivable from the public sector in Greece, Spain, Portugal and Italy totaled $206 million.

Global economic conditions and liquidity issues in certain countries have resulted, and may continue to result, in delays in the collection of receivables and credit losses. Governmental actions and customer-specific factors may also require the company to re-evaluate the collectability of its receivables and the company could potentially incur additional credit losses. These conditions may also impact the stability of the Euro.

Derivatives and hedging activities

The company operates on a global basis and is exposed to the risk that its earnings, cash flows and equity could be adversely impacted by fluctuations in foreign exchange and interest rates. The company’s hedging policy attempts to manage these risks to an acceptable level based on the company’s judgment of the appropriate trade-off between risk, opportunity and costs.

The company is primarily exposed to foreign exchange risk with respect to recognized assets and liabilities, forecasted transactions and net assets denominated in the Euro, British Pound, Chinese Yuan, Korean Won, Australian Dollar, Canadian Dollar, Japanese Yen, Columbian Peso, Brazilian Real, Swedish Krona, and Mexican Peso. The company manages its foreign currency exposures on a consolidated basis, which allows the company to net exposures and take advantage of any natural offsets. In addition, the company uses derivative and nonderivative instruments to further reduce the net exposure to foreign exchange. Gains and losses on the hedging instruments offset losses and gains on the hedged transactions and reduce the earnings and equity volatility resulting from foreign exchange. Financial market and currency volatility may limit the company’s ability to cost-effectively hedge these exposures.

The company is also exposed to the risk that its earnings and cash flows could be adversely impacted by fluctuations in interest rates. The company’s policy is to manage interest costs using a mix of fixed- and floating-rate debt that the company believes is appropriate.

To manage this mix in a cost-efficient manner, the company periodically enters into interest rate swaps in which the company agrees to exchange, at specified intervals, the difference between fixed and floating interest amounts calculated by reference to an agreed-upon notional amount.

The company does not hold any instruments for trading purposes and none of the company’s outstanding derivative instruments contain credit-risk-related contingent features.

All derivative instruments are recognized as either assets or liabilities at fair value in the condensed consolidated balance sheets and are classified as short-term or long-term based on the scheduled maturity of the instrument. Based upon the exposure being hedged, the company designates its hedging instruments as cash flow or fair value hedges.

Cash Flow Hedges

The company may use options, including collars and purchased options, forwards and cross-currency swaps to hedge the foreign exchange risk to earnings relating to forecasted transactions and recognized assets and liabilities.

For each derivative instrument that is designated and effective as a cash flow hedge, the gain or loss on the derivative is accumulated in accumulated other comprehensive income (AOCI) and then recognized in earnings consistent with the underlying hedged item. Option premiums or net premiums paid are initially recorded as assets and reclassified to other comprehensive income (OCI) over the life of the option, and then recognized in earnings consistent with the underlying hedged item. Cash flow hedges are classified in net sales, cost of sales, and net interest expense, and primarily relate to forecasted third-party sales denominated in foreign currencies, forecasted intercompany sales denominated in foreign currencies, and anticipated issuances of debt, respectively.

The notional amounts of foreign exchange contracts were $415 million and $378 million as of March 31, 2016 and December 31, 2015, respectively. There were no outstanding interest rate contracts designated as cash flow hedges as of March 31, 2016 and December 31, 2015. The maximum term over which the company has cash flow hedge contracts in place related to forecasted transactions as of March 31, 2016 is 15 months.

Fair Value Hedges

The company uses interest rate swaps to convert a portion of its fixed-rate debt into variable-rate debt. These instruments hedge the company’s earnings from changes in the fair value of debt due to fluctuations in the designated benchmark interest rate. For each derivative instrument that is designated and effective as a fair value hedge, the gain or loss on the derivative is recognized immediately to earnings, and offsets the loss or gain on the underlying hedged item. Fair value hedges are classified in net interest expense, as they hedge the interest rate risk associated with certain of the company’s fixed-rate debt.

The total notional amount of interest rate contracts designated as fair value hedges was $535 million and $1.3 billion as of March 31, 2016 and December 31, 2015, respectively. The decrease is due to swaps terminated in conjunction with the aforementioned debt-for-equity exchanges.

Dedesignations

If it is determined that a derivative or nonderivative hedging instrument is no longer highly effective as a hedge, the company discontinues hedge accounting prospectively. If the company removes the cash flow hedge designation because the hedged forecasted transactions are no longer probable of occurring, any gains or losses are immediately reclassified from AOCI to earnings. Gains or losses relating to terminations of effective cash flow hedges in which the forecasted transactions are still probable of occurring are deferred and recognized consistent with the loss or income recognition of the underlying hedged items.

There were no hedge dedesignations in the first quarters of 2016 or 2015 resulting from changes in the company’s assessment of the probability that the hedged forecasted transactions would occur.

If the company terminates a fair value hedge, an amount equal to the cumulative fair value adjustment to the hedged items at the date of termination is amortized to earnings over the remaining term of the hedged item. In March 2016, the company terminated a total notional value of $765 million of interest rate contracts in connection with the March debt tender offers, resulting in a $34 million reduction to the debt extinguishment loss. There were no fair value hedges terminated during the first quarter of 2015.

Undesignated Derivative Instruments

The company uses forward contracts to hedge earnings from the effects of foreign exchange relating to certain of the company’s intercompany and third-party receivables and payables denominated in a foreign currency. These derivative instruments are generally not formally designated as hedges, and the change in fair value, which substantially offsets the change in book value of the hedged items, is recorded directly to other expense (income), net. The terms of these instruments generally do not exceed one month.

The total notional amount of undesignated derivative instruments was $630 million as of March 31, 2016 and $580 million as of December 31, 2015.

Gains and Losses on Derivative Instruments

The following tables summarize the income statement locations and gains and losses on the company’s derivative instruments for the three months ended March 31, 2016 and 2015.


	Gain (loss) recognized in OCI						Location of gain (loss) in income statement		Gain (loss) reclassified from AOCI into income
(in millions)	2016			2015			Location of gain (loss) in income statement		2016		2015
Cash flow hedges
Interest rate contracts		$—			$—			Other income, net		$ 4		$—
Foreign exchange contracts		—			(1	)		Net sales		—		—
Foreign exchange contracts		(4	)		64			Cost of sales		1		25
Total		$(4	)		$63					$ 5		$25


			Gain (loss) recognized in income
(in millions)	Location of gain (loss) in income statement		2016		2015
Fair value hedges
Interest rate contracts		Net interest expense		$22		$ 47
Undesignated derivative instruments
Foreign exchange contracts		Other income, net		$ 6		$ (8	)

For the company’s fair value hedges, equal and offsetting losses of $22 million and $47 million were recognized in net interest expense in the first quarters of 2016 and 2015, respectively, as adjustments to the underlying hedged item, fixed-rate debt. Ineffectiveness related to the company’s cash flow and fair value hedges for the first quarter of 2016 was not material.

As of March 31, 2016, $2 million of deferred, net after-tax losses on derivative instruments included in AOCI are expected to be recognized in earnings during the next 12 months, coinciding with when the hedged items are expected to impact earnings.

Fair Values of Derivative Instruments

The following table summarizes the classification and fair values of derivative instruments reported in the condensed consolidated balance sheet as of March 31, 2016.

Derivatives in asset positions

Derivatives in liability positions

(in millions)

Balance sheet location

Fair value

Balance sheet location

Fair value

Derivative instruments designated as hedges

Interest rate contracts

Other long-term assets

$ 33

Other long-term liabilities

$—

Foreign exchange contracts

Prepaid expenses and other

Accounts payable and
accrued liabilities

Foreign exchange contracts

Other long-term assets

—

Other long-term liabilities

—

Total derivative instruments designated as hedges

$ 42

$ 1

Undesignated derivative instruments

Foreign exchange contracts

Prepaid expenses and other

$ —

Accounts payable and
accrued liabilities

$ 2

Total derivative instruments

$ 42

$ 3

The following table summarizes the classification and fair values of derivative instruments reported in the condensed consolidated balance sheet as of December 31, 2015.

Derivatives in asset positions

Derivatives in liability positions

(in millions)

Balance sheet location

Fair value

Balance sheet location

Fair value

Derivative instruments designated as hedges

Interest rate contracts

Prepaid expenses and other

$ —

Accounts payable and
accrued liabilities

$ —

Interest rate contracts

Other long-term assets

Other long-term liabilities

—

Foreign exchange contracts

Prepaid expenses and other

Accounts payable and
accrued liabilities

Total derivative instruments designated as hedges

$ 55

$ 1

Undesignated derivative instruments

Foreign exchange contracts

Prepaid expenses and other

$ 1

Accounts payable and
accrued liabilities

$ 1

Total derivative instruments

$ 56

$ 2

While the company’s derivatives are all subject to master netting arrangements, the company presents its assets and liabilities related to derivative instruments on a gross basis within the condensed consolidated balance sheets. Additionally, the company is not required to post collateral for any of its outstanding derivatives.

The following table provides information on the company’s derivative positions as if they were presented on a net basis, allowing for the right of offset by counterparty.


	March 31, 2016						December 31, 2015
(in millions)	Asset			Liability			Asset			Liability
Gross amounts recognized in the consolidated balance sheet		$42			$ 3			$56			$ 2
Gross amount subject to offset in master netting arrangements not offset in the consolidated balance sheet		(3	)		(3	)		(2	)		(2	)
Total		$39			$—			$54			$—

Fair value measurements

The following tables summarize the bases used to measure financial assets and liabilities that are carried at fair value on a recurring basis in the condensed consolidated balance sheets.


			Basis of fair value measurement
(in millions)	Balance as of March 31, 2016		Quoted prices in active markets for identical assets (Level 1)		Significant other observable inputs (Level 2)		Significant unobservable inputs (Level 3)
Assets
Foreign currency hedges		$ 9		$—		$ 9		$—
Interest rate hedges		33		—		33		—
Available-for-sale securities		1,242		10		1,232		—
Total assets		$1,284		$10		$1,274		$—

Liabilities
Foreign currency hedges		$ 3		$—		$ 3		$—
Contingent payments related to acquisitions		20		—		—		20
Total liabilities		$ 23		$—		$ 3		$20


			Basis of fair value measurement
(in millions)	Balance as of December 31, 2015		Quoted prices in active markets for identical assets (Level 1)		Significant other observable inputs (Level 2)		Significant unobservable inputs (Level 3)
Assets
Foreign currency hedges		$ 10		$—		$ 10		$—
Interest rate hedges		46		—		46		—
Available-for-sale securities		5,162		14		5,148		—
Total assets		$5,218		$14		$5,204		$—

Liabilities
Foreign currency hedges		$ 2		$—		$ 2		$—
Contingent payments related to acquisitions		20		—		—		20
Total liabilities		$ 22		$—		$ 2		$20

As of March 31, 2016, cash and equivalents of $2.2 billion included money market funds of approximately $483 million, and as of December 31, 2015, cash and equivalents of $2.2 billion included money market funds of approximately $500 million. Money market funds would be considered Level 2 in the fair value hierarchy.

For assets that are measured using quoted prices in active markets, the fair value is the published market price per unit multiplied by the number of units held, without consideration of transaction costs. The investment in the Retained Shares of $1.2 billion as of March 31, 2016 and $5.1 billion as of December 31, 2015, is categorized as a Level 2 security as these securities were not registered as of those dates. The value of this investment is based on Baxalta’s common stock price as of March 31, 2016 and December 31, 2015, which represents an identical equity instrument registered under the Securities Act of 1933, as amended. The majority of the derivatives entered into by the company are valued using internal valuation techniques as no quoted market prices exist for such instruments. The principal techniques used to value these instruments are discounted cash flow and Black-Scholes models. The key inputs are considered observable and vary depending on the type of derivative, and include contractual terms, interest rate yield curves, foreign exchange rates and volatility.

Contingent payments related to acquisitions consist of commercial milestone payments and sales-based payments, and are valued using discounted cash flow techniques. The fair value of commercial milestone payments reflects management’s expectations of probability of payment, and increases as the probability of payment increases or expectation of timing of payments is accelerated. The fair value of sales-based payments is based upon probability-weighted future revenue estimates, and increases as revenue estimates increase, probability weighting of higher revenue scenarios increase or expectation of timing of payment is accelerated. Changes in the fair value of contingent payments related to Baxter’s acquisitions, which use significant unobservable inputs (Level 3) in the fair value measurement, were immaterial during the first quarter of 2016. The company made minor sales-based payments in the first quarter of 2016.

The following table provides information relating to the company’s investments in available-for-sale equity securities.


(in millions)	Amortized cost		Unrealized gains		Unrealized losses		Fair value
March 31, 2016		$179		$1,065		$ 2		$1,242
December 31, 2015		$732		$4,430		$—		$5,162

In the first quarter of 2016 the company recorded $3.2 billion of net realized gains within other income, net related to exchanges of available-for-sale equity securities, which represented gains from the Retained Share transactions. The company did not have any sales of available-for-sale or equity method investments in the first quarter of 2015.

Book Values and Fair Values of Financial Instruments

In addition to the financial instruments that the company is required to recognize at fair value in the condensed consolidated balance sheets, the company has certain financial instruments that are recognized at historical cost or some basis other than fair value. For these financial instruments, the following table provides the values recognized in the condensed consolidated balance sheets and the approximate fair values as of March 31, 2016 and December 31, 2015.


	Book values				Approximate fair values
(in millions)	2016		2015		2016		2015
Assets
Investments		$ 22		$ 21		$ 22		$ 21

Liabilities
Short-term debt		$ 817		$1,775		$ 817		$1,775
Current maturities of long-term debt and lease obligations		472		810		475		818
Long-term debt and lease obligations		2,068		3,922		2,232		4,077

The following tables summarize the bases used to measure the approximate fair value of the financial instruments as of March 31, 2016 and December 31, 2015.


			Basis of fair value measurement
(in millions)	Balance as of March 31, 2016		Quoted prices in active markets for identical assets (Level 1)		Significant other observable inputs (Level 2)		Significant unobservable inputs (Level 3)
Assets
Investments		$ 22		$—		$ 2		$20
Total assets		$ 22		$—		$ 2		$20

Liabilities
Short-term debt		$ 817		$—		$ 817		$—
Current maturities of long-term debt and lease obligations		475		—		475		—
Long-term debt and lease obligations		2,232		—		2,232		—
Total liabilities		$3,524		$—		$3,524		$—


			Basis of fair value measurement
(in millions)	Balance as of December 31, 2015		Quoted prices in active markets for identical assets (Level 1)		Significant other observable inputs (Level 2)		Significant unobservable inputs (Level 3)
Assets
Investments		$ 21		$—		$ 2		$19
Total assets		$ 21		$—		$ 2		$19

Liabilities
Short-term debt		$1,775		$—		$1,775		$—
Current maturities of long-term debt and lease obligations		818		—		818		—
Long-term debt and lease obligations		4,077		—		4,077		—
Total liabilities		$6,670		$—		$6,670		$—

Investments in 2016 and 2015 included certain cost method investments and held-to-maturity debt securities.

The fair value of held-to-maturity debt securities is calculated using a discounted cash flow model that incorporates observable inputs, including interest rate yields, which represents a Level 2 basis of fair value measurement.

In determining the fair value of cost method investments, the company takes into consideration recent transactions, as well as the financial information of the investee, which represents a Level 3 basis of fair value measurement.

The estimated fair values of current and long-term debt were computed by multiplying price by the notional amount of the respective debt instrument. Price is calculated using the stated terms of the respective debt instrument and yield curves commensurate with the company’s credit risk. The carrying values of the other financial instruments approximate their fair values due to the short-term maturities of most of these assets and liabilities.