Notes to Consolidated Financial Statements Investment by Baxter International Inc., net Research and Development Costs Earnings Per Share Derivatives Investment by Baxter International Inc., net includes common stock, additional paid-in capital and net intercompany balances with Edwards Lifesciences that were contributed at the time of the spin-off. Baxter did not manage the activity in this account on the basis of separate legal entities. There is no distinction in this account between net investments in and net advances to Edwards Lifesciences as there was no term associated with the cash infusions and no intent or expectation that the infusions would be remitted to Baxter. Research and development costs are charged to expense  when incurred. Earnings per share are calculated in accordance with SFAS  No. 128 , “Earnings per Share,” which requires the Company to report both basic earnings per share, based on the weighted- average number of common shares outstanding, and diluted earnings per share, based on the weighted-average number of common shares outstanding adjusted to include the potentially dilutive effect of outstanding stock options. No earnings per share data are presented in the Consolidated Statements of Operations for  1999 and  2000 as the Edwards Lifesciences earnings were part of Baxter’s earnings through the close of business on March  31 , 2000 . Edwards Lifesciences maintains an overall risk management strategy that incorporates the use of a variety of interest rate and currency derivative financial instruments to mitigate its exposure to significant unplanned fluctuations in earnings caused by volatility in interest rate and currency exchange rates. Derivative instruments that are used as part of the Company’s interest and foreign exchange rate management strategy include interest rate swaps, option-based products and forward exchange contracts. These instruments are designated as cash flow hedges. Edwards Lifesciences does not use any of these instruments for trading or speculative purposes. 36 Edwards Lifesciences Corporation All derivatives are recognized on the balance sheet at their fair value. On the date that the Company enters into  a derivative contract, it designates the derivative as either  (a) a hedge of a forecasted transaction or the variability of cash flows that are to be received or paid in connection with  a recognized asset or liability (a “cash flow” hedge), or  (b) a hedge of an exposure to changes in the fair value of an asset, liability, or an unrecognized firm commitment (a “fair value” hedge). Changes in the fair value of a derivative that is highly effective, and that is designated and qualifies as a cash flow hedge to the extent that the hedge is effective, are Derivative instruments used by Edwards Lifesciences involve, to varying degrees, elements of credit risk, in the event a counter-party should default, and market risk, as the instruments are subject to rate and price fluctuations. Credit risk is managed through the use of credit standard guidelines, counter-party diversification, monitoring of counter-party financial condition and International Swap Dealers Association master netting agreements in place with all derivative counter- parties. All derivative financial instruments are with commercial banks and investment banking firms assigned investment grade ratings of “AA” or better with national rating agencies. The Company utilizes forward exchange contracts and option contracts to hedge a portion of its exposure to forecasted intercompany foreign currency transactions. These contracts provide for the purchase or sale of foreign currencies at specified future dates at specified exchange rates. These contracts are entered into to reduce the risk that the Company’s earnings and cash flows resulting from certain forecasted intercompany transactions will be adversely affected by changes in foreign currency exchange rates. The Company uses interest rate swaps to convert floating- rate debt to fixed-rate debt. The Company’s interest rate swap agreements involve agreements to pay a fixed rate and receive a floating rate, at specified intervals, calculated on an agreed- upon notional amount. The debt and amounts that the Company hedges are determined based on prevailing market conditions and the current shape of the yield curve. Interest rate swap agreements are executed as an integral part of specific debt transactions. recorded in Other Comprehensive Income until earnings are affected by the variability of cash flows of the hedged transaction (e.g., until periodic settlements of a variable asset or liability are recorded in earnings). Any hedge ineffectiveness (which represents the amount by which the changes in the fair value of the derivative exceed the variability in the cash flows of the forecasted transaction) is recorded in current- period earnings. Changes in the fair value of a derivative that is highly effective, and that is designated and qualifies as a foreign-currency hedge, are recorded in either current-period earnings or Other Comprehensive Income, depending on whether the hedging relationship satisfies the criteria for a fair-value or cash-flow hedge. The Company formally documents all relationships between hedging instruments and hedged items, as well as its risk-management objective and strategy for undertaking various hedge transactions. This process includes linking all derivatives that are designated as cash flow hedges or specific firm commitments or forecasted transactions. The Company also formally assesses (both at the hedge’s inception and on an ongoing basis) whether the derivatives that are used in hedging transactions have been highly effective in offsetting changes in the cash flows of hedged items and whether those derivatives may be expected to remain highly effective in future periods. All components of each derivative’s gain or loss are included in the assessment of hedge effectiveness. When it is determined that a derivative is not, or has ceased to be, highly effective as a hedge, the Company discontinues hedge accounting prospectively. A derivative ceases to be highly effective when (a) the Company determines that the derivative is no longer effective in offsetting changes in the cash flows of a hedged item such as firm commitments or forecasted transactions, (b) it is no longer probable that the forecasted transaction will occur, (c) the derivative expires or is sold, terminated or exercised, or (d) management determines that designating the derivative as a hedging instrument is no longer appropriate. When the Company discontinues hedge accounting because it is no longer probable that the forecasted transaction will occur in the originally expected period, the gain or  loss on the derivative remains in Accumulated Other Comprehensive Income and is reclassified into earnings when the forecasted transaction affects earnings. However, if it is probable that a forecasted transaction will not occur by the 37 Edwards Lifesciences Corporation Effective January  1 , 2001 , Edwards Lifesciences adopted the provisions of SFAS No. 133 , “Accounting for Derivative Instruments and Hedging Activities,” as amended. SFAS  No. 133 requires companies to record derivatives on the balance sheet as assets and liabilities, measured at fair value. Accounting for the gain or loss due to changes in fair value of the derivative instrument depends on whether the derivative qualifies as a hedge. If the derivative instrument does not qualify as a hedge, the gains or losses are reported in earnings when they occur. If the derivative instrument qualifies as a hedge, the accounting varies based upon the type of risk being hedged. Adopting the provisions of SFAS No. 133 on January  1, 2001 resulted  in a one-time cumulative after-tax increase in net loss of  $ 1 million. In addition, the Company recorded the following one-time cumulative after-tax adjustments to Accumulated Other Comprehensive Income: Comprehensive income encompasses all changes in equity other than those arising from transactions with stockholders, and consists of net income, currency translation adjustments and unrealized net gains and losses on cash flow hedges and investments in unconsolidated affiliates. end of the originally specified time period or within an additional two-month period of time thereafter, the gains and losses that were accumulated in Accumulated Other Comprehensive Income will be recognized immediately in earnings. In a situation in which hedge accounting is discontinued and the derivative remains outstanding, the Company will carry the derivative at its fair value on the balance sheet, recognizing changes in the fair value in current- period earnings. Comprehensive Income New Accounting and Disclosure Standards Adopted Unrealized (in millions) Gain (Loss) Related to previously designated  cash flow hedging relationships: Fair value of hedging instruments $ ( 7 ) Previously deferred hedging gains and losses 2 Total cumulative effect of adoption on  Accumulated Other Comprehensive  Income, net of tax $ ( 5 ) Notes to Consolidated Financial Statements