Financial Instruments and Hedging Activities

The Company is exposed to global market risks, including the effect of changes in interest rates and foreign currency fluctuations. The Company uses foreign currency denominated debt and derivative instruments to mitigate the impact of these changes. The Company does not use derivatives with a level of complexity or with a risk higher than the exposures to be hedged and does not hold or issue derivatives for trading purposes.

The Company documents its risk management objective and strategy for undertaking hedging transactions, as well as all relationships between hedging instruments and hedged items. The Company’s derivatives that are designated as hedging instruments consist mainly of interest rate swaps, foreign currency forwards, foreign currency options, cross-currency swaps, and commodity forwards, further explained in the “Fair Value,” “Cash Flow” and “Net Investment” hedge sections.

The Company also enters into certain derivatives that are not designated as hedging instruments. The Company has entered into equity derivative contracts to hedge market-driven changes in certain of its supplemental benefit plan liabilities. Changes in the fair value of these derivatives are recorded in Selling, general & administrative expenses together with the changes in the supplemental benefit plan liabilities. In addition, the Company uses foreign currency forwards to mitigate the change in fair value of certain foreign currency denominated assets and liabilities. Since these derivatives are not designated for hedge accounting, the changes in the fair value of these derivatives are recognized immediately in nonoperating (income) expense together with the currency gain or loss from the hedged balance sheet position. A portion of the Company’s foreign currency options (more fully described in the “Cash Flow” hedge section) are undesignated as hedging instruments as the underlying foreign currency royalties are earned.

All derivative instruments designated as hedging instruments are classified as fair value, cash flow or net investment hedges. All derivatives (including those not designated for hedge accounting) are recognized on the Consolidated balance sheet at fair value and classified based on the instruments’ maturity date. Changes in the fair value measurements of the derivative instruments are reflected as adjustments to other comprehensive income (OCI) and/or current earnings.

The following table presents the fair values of derivative instruments included on the Consolidated balance sheet:

 

		Derivative Assets										Derivative Liabilities
In millions		Balance Sheet Classification		June 30, 2012				December 31, 2011				Balance Sheet Classification		June 30, 2012				December 31, 2011
Derivatives designated as hedging instruments
Foreign currency		Prepaid expenses and other       current assets		$	8.6			$	6.7			Accrued payroll and other       liabilities		$	(0.8	)		$	(0.3	)
Interest rate		Prepaid expenses and other       current assets			20.0				9.4
Commodity		Miscellaneous other assets			3.1				—
Foreign currency		Miscellaneous other assets			6.0				0.7			Other long-term liabilities			(5.0	)			(0.3	)
Interest rate		Miscellaneous other assets			26.9				46.0			Other long-term liabilities			—				(14.0	)
Total derivatives designated as hedging instruments				$	64.6			$	62.8					$	(5.8	)		$	(14.6	)
Derivatives not designated as hedging instruments
Foreign currency		Prepaid expenses and other       current assets		$	6.9			$	8.3			Accrued payroll and other       liabilities		$	(4.4	)		$	(1.0	)
Equity		Miscellaneous other assets			137.3				154.5
Total derivatives not designated as hedging instruments				$	144.2			$	162.8					$	(4.4	)		$	(1.0	)
Total derivatives				$	208.8			$	225.6					$	(10.2	)		$	(15.6	)

 

The following table presents the pretax amounts affecting income and OCI for the six months ended June 30, 2012 and 2011, respectively:

 

In millions
Derivatives in Fair Value Hedging Relationships		Gain (Loss) Recognized in  Income on Derivative								Hedged Items in Fair Value Hedging Relationships								Gain (Loss) Recognized in Income on Related Hedged Items
		2012				2011												2012				2011
Interest rate		$	(8.5	)		$	(13.8	)			Fixed-rate debt							$	8.5			$	13.8
Derivatives in Cash flow Hedging Relationships		Gain (Loss) Recognized in Accumulated OCI on Derivative (Effective Portion)								Gain (Loss) Reclassified  from Accumulated OCI into Income (Effective Portion)								Gain (Loss) Recognized in Income on Derivative (Amount Excluded from Effectiveness Testing and Ineffective Portion)
			2012				2011				2012				2011				2012				2011
Commodity		$	3.1			$	—			$	—			$	—			$	—			$	—
Foreign currency			8.3				(5.4	)			(4.7	)			(0.2	)			(4.6	)			(6.8	)
Interest rate(1)			(4.6	)			—				0.3				1.1				—				—
Total		$	6.8			$	(5.4	)		$	(4.4	)		$	0.9			$	(4.6	)		$	(6.8	)

Net Investment Hedging Relationships		Gain (Loss) Recognized in Accumulated OCI on Derivative (Effective portion)								Gain (Loss) Reclassified  from Accumulated OCI into Income (Effective Portion)								Derivatives Not Designated as Hedging Instruments		Gain (Loss) Recognized in Income on Derivative
			2012				2011				2012				2011						2012				2011
Foreign currency denominated debt		$	66.0			$	(266.5	)		$	—			$	—			Foreign Currency		$	(0.6	)		$	0.1
Foreign currency derivatives			(4.8	)			(9.4	)			—				(8.2	)		Equity(2)			(17.2	)			11.6
Total		$	61.2			$	(275.9	)		$	—			$	(8.2	)		Total		$	(17.8	)		$	11.7

Gains (losses) recognized in income on derivatives are recorded in “Nonoperating (income) expense, net” unless otherwise noted.

 

(1)	The amount of gain (loss) reclassified from accumulated OCI into income is recorded in Interest expense.

(2)	The amount of gain (loss) recognized in income on the derivatives used to hedge the supplemental benefit plan liabilities is recorded in Selling, general & administrative expenses.

 

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Fair Value Hedges

The Company enters into fair value hedges to reduce the exposure to changes in the fair values of certain liabilities. The fair value hedges the Company enters into consist of interest rate swaps which convert a portion of its fixed-rate debt into floating-rate debt. All of the Company’s interest rate swaps meet the shortcut method requirements. Accordingly, changes in the fair values of the interest rate swaps are exactly offset by changes in the fair value of the underlying debt. No ineffectiveness has been recorded to net income related to interest rate swaps designated as fair value hedges for the six months ended June 30, 2012. A total of $2.3 billion of the Company’s outstanding fixed-rate debt was effectively converted to floating-rate debt resulting from the use of interest rate swaps.

 

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Cash Flow Hedges

The Company enters into cash flow hedges to reduce the exposure to variability in certain expected future cash flows. The types of cash flow hedges the Company enters into include interest rate swaps, foreign currency forwards, foreign currency options, cross currency swaps, and commodity forwards.

The Company periodically uses interest rate swaps to effectively convert a portion of floating-rate debt, including forecasted debt issuances, into fixed-rate debt and the agreements are intended to reduce the impact of interest rate changes on future interest expense. At June 30, 2012, none of the Company’s anticipated debt issuances were effectively converted to fixed-rate resulting from the use of interest rate swaps.

To protect against the reduction in value of forecasted foreign currency cash flows (such as royalties denominated in foreign currencies), the Company uses foreign currency forwards and foreign currency options to hedge a portion of anticipated exposures.

When the U.S. dollar strengthens against foreign currencies, the decline in value of future foreign denominated royalties is offset by gains in the fair value of the foreign currency forwards and/or foreign currency options. Conversely, when the U.S. dollar weakens, the increase in the value of future foreign denominated royalties is offset by losses in the fair value of the foreign currency forwards and/or foreign currency options.

Although the fair value changes in the foreign currency options may fluctuate over the period of the contract, the Company’s total loss on a foreign currency option is limited to the upfront premium paid for the contract. However, the potential gains on a foreign currency option are unlimited as the settlement value of the contract is based upon the difference between the exchange rate at inception of the contract and the spot exchange rate at maturity. In limited situations, the Company uses foreign currency collars, which limit the potential gains and lower the upfront premium paid, to protect against currency movements.

 

The hedges cover the next 18 months for certain exposures and are denominated in various currencies. As of June 30, 2012, the Company had derivatives outstanding with an equivalent notional amount of $386.1 million that were used to hedge a portion of forecasted foreign currency denominated royalties.

The Company excludes the time value of foreign currency options from its effectiveness assessment on its cash flow hedges. As a result, changes in the fair value of the derivatives due to these components, as well as the ineffectiveness of the hedges, are recognized in earnings currently. The effective portion of the gains or losses on the derivatives is reported in the cash flow hedging component of OCI in shareholders’ equity and reclassified into earnings in the same period or periods in which the hedged transaction affects earnings.

The Company uses cross-currency swaps to hedge the risk of cash flows associated with certain foreign-currency denominated debt, including forecasted interest payments, and has elected cash flow hedge accounting. The hedges cover a period of 57 months and have an equivalent notional amount of $193.6 million.

The Company manages its exposure to the variability of cash flows for energy-related transactions in certain markets by entering into commodity forwards and has elected cash flow hedge accounting as appropriate. The hedges cover periods up to 22 years and have an equivalent notional amount of $477.4 million.

The Company recorded after tax adjustments to the cash flow hedging component of accumulated OCI in shareholders’ equity. The Company recorded a net increase of $8.0 million for the six months ended June 30, 2012 and a net decrease of $4.0 million for the six months ended June 30, 2011. Based on interest rates, foreign exchange rates, and commodity prices at June 30, 2012, the $12.6 million in cumulative cash flow hedging gains, after tax, at June 30, 2012, is not expected to have a significant effect on earnings over the next 12 months.

 

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Net Investment Hedges

The Company uses foreign currency denominated debt (third party and intercompany) and derivatives to hedge its investments in certain foreign subsidiaries and affiliates. Realized and unrealized translation adjustments from these hedges are included in shareholders’ equity in the foreign currency translation component of OCI and offset translation adjustments on the underlying net assets of foreign subsidiaries and affiliates, which are also recorded in OCI. As of June 30, 2012, a total of $4.4 billion of the Company’s foreign currency denominated debt and $507.0 million of derivatives were designated to hedge investments in certain foreign subsidiaries and affiliates.

 

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Credit Risk

The Company is exposed to credit-related losses in the event of non-performance by the counterparties to its hedging instruments. The counterparties to these agreements consist of a diverse group of financial institutions. The Company continually monitors its positions and the credit ratings of its counterparties and adjusts positions as appropriate. The Company did not have significant exposure to any individual counterparty at June 30, 2012 and has master agreements that contain netting arrangements. Some of these agreements also require each party to post collateral if credit ratings fall below, or aggregate exposures exceed, certain contractual limits. At June 30, 2012, neither the Company nor its counterparties were required to post collateral on any derivative position, other than on hedges of certain of the Company’s supplemental benefit plan liabilities where its counterparties were required to post collateral on their liability positions.