NOTE 6 FAIR VALUE MEASUREMENTS
SFAS No. 157 defines fair value as the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date and in the principal or most advantageous market for that asset or liability. The fair value should be calculated based on assumptions that market participants would use in pricing the asset or liability, not on assumptions specific to the entity. In addition, the fair value of liabilities should include consideration of non-performance risk, including our own credit risk.
In addition to defining fair value, SFAS No. 157 expands the disclosure requirements around fair value and establishes a fair value hierarchy for valuation inputs. The hierarchy prioritizes the inputs into three levels based on the extent to which inputs used in measuring fair value are observable in the market. Each fair value measurement is reported in one of the three levels, which is determined by the lowest level input that is significant to the fair value measurement in its entirety. These levels are:
- Level 1 – inputs are based upon unadjusted quoted prices for identical instruments traded in active markets.
- Level 2 – inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
- Level 3 – inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are therefore determined using model-based techniques that include option pricing models, discounted cash flow models, and similar techniques.
The following section describes the valuation methodologies we use to measure financial assets and liabilities at fair value.
INVESTMENTS OTHER THAN DERIVATIVES
Investments other than derivatives primarily include U.S. Government and Agency securities, foreign government bonds, mortgage-backed securities, commercial paper, corporate notes and bonds, and common and preferred stock.
In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine fair value. This pricing methodology applies to our Level 1 investments, such as domestic and international equities, U.S. treasuries, exchange-traded mutual funds, and agency securities. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. These investments are included in Level 2 and consist primarily of corporate notes and bonds, foreign government bonds, mortgage-backed securities, commercial paper, and certain agency securities. Our Level 3 assets primarily include investments in certain corporate bonds. We value the Level 3 corporate bonds using internally developed valuation models, inputs to which include interest rate curves, credit spreads, stock prices, and volatilities. Unobservable inputs used in these models are significant to the fair values of the investments.
DERIVATIVES
In general, and where applicable, we use quoted prices in an active market for identical derivative assets and liabilities that are traded on exchanges. These derivative assets and liabilities are included in Level 1. The fair values for the derivative assets and liabilities included in Level 2 are estimated using industry standard valuation models, such as the Black-Scholes model. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, foreign exchange rates, and forward and spot prices for currencies and commodities. Level 2 derivative assets and liabilities primarily include certain over-the-counter options, futures, and swap contracts. In certain cases, market-based observable inputs are not available and we use management judgment to develop assumptions to determine fair value. These derivative assets and liabilities are included in Level 3 and primarily represent derivatives for foreign equities.
ASSETS AND LIABILITIES MEASURED AT FAIR VALUE ON A RECURRING BASIS
The following table presents our assets and liabilities at June 30, 2009, which are measured at fair value on a recurring basis:
| (In millions) | Level 1 | Level 2 | Level 3 | Gross Fair Value | FIN No. 39 Netting(a) | Net Fair Value |
|---|---|---|---|---|---|---|
| Assets | ||||||
| Mutual funds | $ ,()982 | $ ,()())– | $(),– | $ ,()982 | $,(),(– | $,() 982 |
| Commercial paper | – | 2,601 | – | 2,601 | – | 2,601 |
| Certificates of deposit | – | 555 | – | 555 | – | 555 |
| U.S. Government and Agency securities | 7,134 | 6,105 | – | 13,239 | – | 13,239 |
| Foreign government bonds | 501 | 3,022 | – | 3,523 | – | 3,523 |
| Mortgage-backed securities | – | 3,593 | – | 3,593 | – | 3,593 |
| Corporate notes and bonds | – | 4,073 | 253 | 4,326 | – | 4,326 |
| Municipal securities | – | 256 | – | 256 | – | 256 |
| Common and preferred stock | 4,218 | 28 | 5 | 4,251 | – | 4,251 |
| Derivatives | 5 | 623 | 5 | 633 | (235) | 398 |
| Total | $12,840 | $20,856 | $263 | $33,959 | $(235) | $33,724 |
| Liabilities | ||||||
| Derivatives | $,()()) 5 | $,() 344 | $)))– | $,() 349 | $(231) | $,() 118 |
| (a) | FIN No. 39, Offsetting of Amounts Related to Certain Contracts – an interpretation of APB No. 10 and FASB Statement No. 105, permits the netting of derivative assets and derivative liabilities when a legally enforceable master netting agreement exists. These amounts include fair value adjustments related to our own credit risk and counterparty credit risk. |
CHANGES IN LEVEL 3 INSTRUMENTS MEASURED AT FAIR VALUE ON A RECURRING BASIS
The majority of our Level 3 instruments consist of investment securities classified as available-for-sale with changes in fair value included in other comprehensive income. The following table presents the changes in Level 3 instruments measured on a recurring basis for the year ended June 30, 2009:
| (In millions) | Corporate Notes and Bonds | Common and Preferred Stock | Derivative Assets | Total |
|---|---|---|---|---|
| Balance, beginning of period | $138 | $() 8 | $() 71 | $ 217 |
| Total realized and unrealized gains (losses): | ||||
| Included in other income (expense) | (6) | (6) | 51 | 39 |
| Included in other comprehensive income | 111 | – | – | 111 |
| Purchases, issuances, and settlements | – | ()) 5 | (119) | (114) |
| Transfers in (out) | 10 | (2) | 2 | 10 |
| Balance, end of period | $253 | $() 5 | $()) 5 | $ 263 |
| Change in unrealized gains (losses) included in other income (expense) related to assets held as of June 30, 2009 | $ (7) | $ (5) | $()) 4 | $, (8) |
ASSETS AND LIABILITIES MEASURED AT FAIR VALUE ON A NONRECURRING BASIS
We measure certain assets, including our cost and equity method investments, at fair value on a nonrecurring basis. These assets are recognized at fair value when they are deemed to be other-than-temporarily impaired. At June 30, 2009, the fair value of the common and preferred stock that we held that was required to be measured at fair value on a non-recurring basis was $164 million. This fair value was determined using models with significant unobservable inputs.
In accordance with the provisions of Accounting Principles Board Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock, we review the carrying values of our investments when events and circumstances warrant, and we consider all available evidence in evaluating when declines in fair value are other than temporary. The fair values of our investments are determined based on valuation techniques using the best information available, and may include quoted market prices, market comparables, and discounted cash flow projections. An impairment charge is recorded when the cost of the investment exceeds its fair value and this condition is determined to be other than temporary. During the fiscal year ended June 30, 2009, impairment charges of $86 million were recognized for certain investments measured at fair value on a nonrecurring basis as the decline in their respective fair values below their cost was determined to be other than temporary in all instances.