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International Business Machines 10-Q 2012

Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

FORM 10 - Q

 

QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

FOR THE QUARTER ENDED JUNE 30, 2012

 

1-2360

(Commission file number)

 

INTERNATIONAL BUSINESS MACHINES CORPORATION

(Exact name of registrant as specified in its charter)

 

New York

 

13-0871985

(State of incorporation)

 

(IRS employer identification number)

 

Armonk, New York

 

10504

(Address of principal executive offices)

 

(Zip Code)

 

914-499-1900

(Registrant’s telephone number)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section l3 or l5(d) of the Securities Exchange Act of 1934 during the preceding l2 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer x

 

Accelerated filer o

 

 

 

Non-accelerated filer o

 

Smaller reporting company o

(Do not check if a smaller reporting company)

 

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

 

The registrant has 1,142,774,594 shares of common stock outstanding at June 30, 2012.

 

 

 



Table of Contents

 

Index

 

 

Page

Part I - Financial Information:

 

 

 

Item 1. Consolidated Financial Statements:

 

 

 

Consolidated Statement of Earnings for the three and six months ended June 30, 2012 and 2011

3

 

 

Consolidated Statement of Comprehensive Income for the three and six months ended June 30, 2012 and 2011

4

 

 

Consolidated Statement of Financial Position at June 30, 2012 and December 31, 2011

5

 

 

Consolidated Statement of Cash Flows for the six months ended June 30, 2012 and 2011

7

 

 

Consolidated Statement of Changes in Equity for the six months ended June 30, 2012 and 2011

8

 

 

Notes to Consolidated Financial Statements

9

 

 

Item 2. Management’s Discussion and Analysis of Results of Operations and Financial Condition

39

 

 

Item 4. Controls and Procedures

77

 

 

Part II - Other Information:

77

 

 

Item 1. Legal Proceedings

77

 

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds and Issuer Repurchases of Equity Securities

78

 

 

Item 6. Exhibits

78

 

2



Table of Contents

 

PART I - Financial Information

 

ITEM 1. Consolidated Financial Statements:

 

INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF EARNINGS

(UNAUDITED)

 

 

 

Three Months Ended June 30,

 

Six Months Ended June 30,

 

(Dollars in millions except per share amounts)

 

2012

 

2011

 

2012

 

2011

 

Revenue:

 

 

 

 

 

 

 

 

 

Services

 

$

14,833

 

$

15,246

 

$

29,653

 

$

29,942

 

Sales

 

10,426

 

10,894

 

19,782

 

20,281

 

Financing

 

523

 

526

 

1,021

 

1,050

 

Total revenue

 

25,783

 

26,666

 

50,456

 

51,273

 

 

 

 

 

 

 

 

 

 

 

Cost:

 

 

 

 

 

 

 

 

 

Services

 

9,785

 

10,315

 

19,770

 

20,431

 

Sales

 

3,435

 

3,698

 

6,761

 

7,088

 

Financing

 

282

 

269

 

526

 

511

 

Total cost

 

13,502

 

14,282

 

27,056

 

28,030

 

 

 

 

 

 

 

 

 

 

 

Gross profit

 

12,281

 

12,385

 

23,400

 

23,243

 

 

 

 

 

 

 

 

 

 

 

Expense and other income:

 

 

 

 

 

 

 

 

 

Selling, general and administrative

 

5,837

 

6,030

 

11,723

 

11,856

 

Research, development and engineering

 

1,587

 

1,569

 

3,188

 

3,156

 

Intellectual property and custom development income

 

(289

)

(295

)

(545

)

(557

)

Other (income) and expense

 

(132

)

97

 

(190

)

(105

)

Interest expense

 

117

 

97

 

226

 

190

 

Total expense and other income

 

7,120

 

7,500

 

14,403

 

14,541

 

 

 

 

 

 

 

 

 

 

 

Income before income taxes

 

5,161

 

4,885

 

8,997

 

8,702

 

Provision for income taxes

 

1,280

 

1,221

 

2,049

 

2,175

 

Net income

 

$

3,881

 

$

3,664

 

$

6,948

 

$

6,526

 

 

 

 

 

 

 

 

 

 

 

Earnings per share of common stock:

 

 

 

 

 

 

 

 

 

Assuming dilution

 

$

3.34

 

$

3.00

 

$

5.95

 

$

5.30

 

Basic

 

$

3.38

 

$

3.04

 

$

6.02

 

$

5.38

 

 

 

 

 

 

 

 

 

 

 

Weighted-average number of common shares outstanding: (millions)

 

 

 

 

 

 

 

 

 

Assuming dilution

 

1,161.9

 

1,221.4

 

1,168.1

 

1,230.7

 

Basic

 

1,149.0

 

1,204.8

 

1,154.1

 

1,213.5

 

 

 

 

 

 

 

 

 

 

 

Cash dividend per common share

 

$

0.85

 

$

0.75

 

$

1.60

 

$

1.40

 

 

(Amounts may not add due to rounding.)

 

(The accompanying notes are an integral part of the financial statements.)

 

3



Table of Contents

 

INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME

(UNAUDITED)

 

 

 

Three Months Ended June 30,

 

Six Months Ended June 30,

 

(Dollars in millions)

 

2012

 

2011

 

2012

 

2011

 

Net income

 

$

3,881

 

$

3,664

 

$

6,948

 

$

6,526

 

Other comprehensive income/(loss), before tax

 

 

 

 

 

 

 

 

 

Foreign currency translation adjustments

 

(724

)

350

 

(337

)

826

 

Net changes related to available-for-sale securities:

 

 

 

 

 

 

 

 

 

Unrealized gains/(losses) arising during the period

 

(3

)

(7

)

3

 

(14

)

Reclassification of (gains)/losses to net income

 

(2

)

(29

)

(16

)

(232

)

Subsequent changes in previously impaired securities arising during the period

 

9

 

0

 

27

 

11

 

Total net changes related to available-for-sale securities

 

4

 

(35

)

14

 

(234

)

Unrealized gains/(losses) on cash flow hedges:

 

 

 

 

 

 

 

 

 

Unrealized gains/(losses) arising during the period

 

68

 

(217

)

119

 

(454

)

Reclassification of (gains)/losses to net income

 

(111

)

227

 

(135

)

327

 

Total unrealized gains/(losses) on cash flow hedges

 

(42

)

10

 

(16

)

(127

)

Retirement-related benefit plans:

 

 

 

 

 

 

 

 

 

Prior service costs/(credits)

 

0

 

(31

)

0

 

(32

)

Net (losses)/gains arising during the period

 

70

 

585

 

65

 

606

 

Curtailments and settlements

 

0

 

4

 

0

 

13

 

Amortization of prior service (credits)/costs

 

(37

)

(39

)

(74

)

(77

)

Amorization of net (gains)/losses

 

613

 

458

 

1,232

 

932

 

Total retirement-related benefit plans

 

647

 

977

 

1,223

 

1,441

 

Other comprehensive income/(loss), before tax

 

(115

)

1,301

 

884

 

1,906

 

Income tax (expense)/benefit related to items of other comprehensive income

 

(268

)

(292

)

(497

)

(272

)

Other comprehensive income/(loss)

 

(383

)

1,010

 

387

 

1,634

 

Total comprehensive income/(loss)

 

$

3,498

 

$

4,673

 

$

7,335

 

$

8,160

 

 

(Amounts may not add due to rounding.)

 

(The accompanying notes are an integral part of the financial statements.)

 

4



Table of Contents

 

INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF FINANCIAL POSITION

(UNAUDITED)

 

ASSETS

 

 

 

At June 30,

 

At December 31,

 

(Dollars in millions)

 

2012

 

2011

 

Assets:

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

10,864

 

$

11,922

 

Marketable securities

 

323

 

0

 

Notes and accounts receivable — trade (net of allowances of $264 in 2012 and $256 in 2011)

 

10,172

 

11,179

 

Short-term financing receivables (net of allowances of $271 in 2012 and $311 in 2011)

 

14,982

 

16,901

 

Other accounts receivable (net of allowances of $11 in 2012 and $11 in 2011)

 

1,703

 

1,481

 

Inventories, at lower of average cost or market:

 

 

 

 

 

Finished goods

 

752

 

589

 

Work in process and raw materials

 

2,006

 

2,007

 

Total inventories

 

2,758

 

2,595

 

Deferred taxes

 

1,478

 

1,601

 

Prepaid expenses and other current assets

 

5,113

 

5,249

 

Total current assets

 

47,392

 

50,928

 

 

 

 

 

 

 

Property, plant and equipment

 

40,158

 

40,124

 

Less: Accumulated depreciation

 

26,293

 

26,241

 

Property, plant and equipment — net

 

13,865

 

13,883

 

Long-term financing receivables (net of allowances of $55 in 2012 and $38 in 2011)

 

10,795

 

10,776

 

Prepaid pension assets

 

2,862

 

2,843

 

Deferred taxes

 

2,795

 

3,503

 

Goodwill

 

27,735

 

26,213

 

Intangible assets — net

 

3,657

 

3,392

 

Investments and sundry assets

 

4,730

 

4,895

 

Total assets

 

$

113,832

 

$

116,433

 

 

(Amounts may not add due to rounding.)

 

(The accompanying notes are an integral part of the financial statements.)

 

5



Table of Contents

 

INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF FINANCIAL POSITION — (CONTINUED)

(UNAUDITED)

 

LIABILITIES AND EQUITY

 

 

 

At June 30,

 

At December 31,

 

(Dollars in millions)

 

2012

 

2011

 

Liabilities:

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Taxes

 

$

2,183

 

$

3,313

 

Short-term debt

 

7,669

 

8,463

 

Accounts payable

 

7,482

 

8,517

 

Compensation and benefits

 

4,656

 

5,099

 

Deferred income

 

12,311

 

12,197

 

Other accrued expenses and liabilities

 

4,602

 

4,535

 

Total current liabilities

 

38,903

 

42,123

 

Long-term debt

 

24,766

 

22,857

 

Retirement and nonpension postretirement benefit obligations

 

16,544

 

18,374

 

Deferred income

 

3,889

 

3,847

 

Other liabilities

 

9,166

 

8,996

 

Total liabilities

 

93,269

 

96,197

 

Equity:

 

 

 

 

 

IBM stockholders’ equity:

 

 

 

 

 

Common stock, par value $0.20 per share, and additional paid-in capital

 

49,157

 

48,129

 

Shares authorized: 4,687,500,000

 

 

 

 

 

Shares issued:  2012 - 2,192,562,656

 

 

 

 

 

2011 - 2,182,469,838

 

 

 

 

 

Retained earnings

 

109,928

 

104,857

 

Treasury stock - at cost

 

(117,116

)

(110,963

)

Shares:  2012 - 1,049,788,062

 

 

 

 

 

2011 - 1,019,287,274

 

 

 

 

 

Accumulated other comprehensive income/(loss)

 

(21,498

)

(21,885

)

Total IBM stockholders’ equity

 

20,472

 

20,138

 

Noncontrolling interests

 

92

 

97

 

Total equity

 

20,563

 

20,236

 

Total liabilities and equity

 

$

113,832

 

$

116,433

 

 

(Amounts may not add due to rounding.)

 

(The accompanying notes are an integral part of the financial statements.)

 

6



Table of Contents

 

INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF CASH FLOWS

FOR THE SIX MONTHS ENDED JUNE 30,

(UNAUDITED)

 

(Dollars in millions)

 

2012

 

2011*

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

6,948

 

$

6,526

 

Adjustments to reconcile net income to cash provided by operating activities

 

 

 

 

 

Depreciation

 

1,706

 

1,816

 

Amortization of intangibles

 

627

 

619

 

Stock-based compensation

 

328

 

332

 

Net (gain)/loss on asset sales and other

 

(118

)

(383

)

Changes in operating assets and liabilities, net of acquisitions/divestitures

 

(764

)

(839

)

Net cash provided by operating activities

 

8,726

 

8,071

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Payments for property, plant and equipment

 

(2,135

)

(2,061

)

Proceeds from disposition of property, plant and equipment

 

175

 

336

 

Investment in software

 

(320

)

(285

)

Acquisition of businesses, net of cash acquired

 

(1,925

)

(159

)

Divestitures of businesses, net of cash transferred

 

13

 

4

 

Non-operating finance receivables — net

 

686

 

477

 

Purchases of marketable securities and other investments

 

(1,655

)

(774

)

Proceeds from disposition of marketable securities and other investments

 

1,247

 

2,375

 

Net cash used in investing activities

 

(3,913

)

(86

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from new debt

 

7,559

 

3,656

 

Payments to settle debt

 

(4,069

)

(3,587

)

Short-term borrowings/(repayments) less than 90 days — net

 

(2,236

)

883

 

Common stock repurchases

 

(6,002

)

(8,021

)

Common stock transactions — other

 

918

 

1,551

 

Cash dividends paid

 

(1,848

)

(1,700

)

Net cash used in financing activities

 

(5,678

)

(7,217

)

 

 

 

 

 

 

Effect of exchange rate changes on cash and cash equivalents

 

(193

)

285

 

Net change in cash and cash equivalents

 

(1,058

)

1,054

 

 

 

 

 

 

 

Cash and cash equivalents at January 1

 

11,922

 

10,661

 

Cash and cash equivalents at June 30

 

$

10,864

 

$

11,714

 

 


* Reclassified to conform with 2012 presentation.

 

(Amounts may not add due to rounding.)

 

(The accompanying notes are an integral part of the financial statements.)

 

7



Table of Contents

 

INTERNATIONAL BUSINESS MACHINES CORPORATION
 AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF CHANGES IN EQUITY

(UNAUDITED)

 

 

 

Common

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock and

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

 

 

Additional

 

 

 

 

 

Other

 

Total IBM

 

Non-

 

 

 

 

 

Paid-in

 

Retained

 

Treasury

 

Comprehensive

 

Stockholders’

 

Controlling

 

Total

 

(Dollars in millions)

 

Capital

 

Earnings

 

Stock

 

Income/(Loss)

 

Equity

 

Interests

 

Equity

 

Equity - January 1, 2012

 

$

48,129

 

$

104,857

 

$

(110,963

)

$

(21,885

)

$

20,138

 

$

97

 

$

20,236

 

Net income plus other comprehensive income/(loss)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

6,948

 

 

 

 

 

6,948

 

 

 

6,948

 

Other comprehensive income/(loss)

 

 

 

 

 

 

 

387

 

387

 

 

 

387

 

Total comprehensive income/(loss)

 

 

 

 

 

 

 

 

 

$

7,335

 

 

 

$

7,335

 

Cash dividends declared – common stock

 

 

 

(1,848

)

 

 

 

 

(1,848

)

 

 

(1,848

)

Common stock issued under employee plans (10,092,817 shares)

 

780

 

 

 

 

 

 

 

780

 

 

 

780

 

Purchases (1,905,803 shares) and sales (2,034,612 shares) of treasury stock under employee plans – net

 

 

 

(29

)

(146

)

 

 

(174

)

 

 

(174

)

Other treasury shares purchased, not retired (30,629,597 shares)

 

 

 

 

 

(6,007

)

 

 

(6,007

)

 

 

(6,007

)

Changes in other equity

 

248

 

 

 

 

 

 

 

248

 

 

 

248

 

Changes in noncontrolling interests

 

 

 

 

 

 

 

 

 

 

 

(6

)

(6

)

Equity - June 30, 2012

 

$

49,157

 

$

109,928

 

$

(117,116

)

$

(21,498

)

$

20,472

 

$

92

 

$

20,563

 

 

 

 

Common

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock and

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

 

 

Additional

 

 

 

 

 

Other

 

Total IBM

 

Non-

 

 

 

 

 

Paid-in

 

Retained

 

Treasury

 

Comprehensive

 

Stockholders’

 

Controlling

 

Total

 

(Dollars in millions)

 

Capital

 

Earnings

 

Stock

 

Income/(Loss)

 

Equity

 

Interests

 

Equity

 

Equity - January 1, 2011

 

$

45,418

 

$

92,532

 

$

(96,161

)

$

(18,743

)

$

23,046

 

$

126

 

$

23,172

 

Net income plus other comprehensive income/(loss)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

6,526

 

 

 

 

 

6,526

 

 

 

6,526

 

Other comprehensive income/(loss)

 

 

 

 

 

 

 

1,634

 

1,634

 

 

 

1,634

 

Total comprehensive income/(loss)

 

 

 

 

 

 

 

 

 

$

8,160

 

 

 

$

8,160

 

Cash dividends declared – common stock

 

 

 

(1,700

)

 

 

 

 

(1,700

)

 

 

(1,700

)

Common stock issued under employee plans (13,794,550 shares)

 

1,383

 

 

 

 

 

 

 

1,383

 

 

 

1,383

 

Purchases (1,416,882 shares) and sales (3,461,423 shares) of treasury stock under employee plans – net

 

 

 

(24

)

129

 

 

 

105

 

 

 

105

 

Other treasury shares purchased, not retired (49,554,480 shares)

 

 

 

 

 

(8,041

)

 

 

(8,041

)

 

 

(8,041

)

Changes in other equity

 

173

 

 

 

 

 

 

 

173

 

 

 

173

 

Changes in noncontrolling interests

 

 

 

 

 

 

 

 

 

 

 

(43

)

(43

)

Equity - June 30, 2011

 

$

46,975

 

$

97,334

 

$

(104,073

)

$

(17,109

)

$

23,127

 

$

84

 

$

23,210

 

 

(Amounts may not add due to rounding.)

 

(The accompanying notes are an integral part of the financial statements.)

 

8



Table of Contents

 

Notes to Consolidated Financial Statements:

 

1. Basis of Presentation: The accompanying Consolidated Financial Statements and footnotes of the International Business Machines Corporation (IBM or the company) have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial statements and footnotes are unaudited. In the opinion of the company’s management, these statements include all adjustments, which are of a normal recurring nature, necessary to present a fair statement of the company’s results of operations, financial position and cash flows.

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the assets, liabilities, revenue, costs, expenses and accumulated other comprehensive income/(loss) that are reported in the Consolidated Financial Statements and accompanying disclosures. Actual results may be different. See the company’s 2011 Annual Report on pages 58 to 61 for a discussion of the company’s critical accounting estimates.

 

Interim results are not necessarily indicative of financial results for a full year. The information included in this Form 10-Q should be read in conjunction with the company’s 2011 Annual Report.

 

Noncontrolling interest amounts in income of $2.0 million and $2.1 million, net of tax, for the three months ended June 30, 2012 and 2011, respectively, and $5.7 million and $4.8 million, net of tax, for the six months ended June 30, 2012 and 2011, respectively, are included in the Consolidated Statement of Earnings within the other (income) and expense line item. Additionally, changes to noncontrolling interests which are presented in the Consolidated Statement of Changes in Equity on page 8 were $(6) million and $(43) million for the six months ended June 30, 2012 and 2011, respectively.

 

Within the financial statements and tables presented, certain columns and rows may not add due to the use of rounded numbers for disclosure purposes. Percentages presented are calculated from the underlying whole-dollar amounts. Certain prior year amounts have been reclassified to conform to the current year presentation. This is annotated where applicable.

 

2. Accounting Changes: In May 2011, the Financial Accounting Standards Board (FASB) issued amended guidance and disclosure requirements for fair value measurements. These amendments did not have a material impact on the consolidated financial results. These changes became effective January 1, 2012 on a prospective basis. See Note 3, “Financial Instruments” on pages 9 to 14 for fair value disclosures.

 

In July 2012, the FASB issued amended guidance that simplifies how entities test indefinite-lived intangible assets other than goodwill for impairment.  After an assessment of certain qualitative factors, if it is determined to be more likely than not that an indefinite-lived asset is impaired, entities must perform the quantitative impairment test.  Otherwise, the quantitative test is optional.  The amended guidance is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, with early adoption permitted.  The adoption of this guidance is not expected to have a material impact on the company’s financial results.

 

3. Financial Instruments:

 

Fair Value Measurements

 

Accounting guidance defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Under this guidance, the company is required to classify certain assets and liabilities based on the following fair value hierarchy:

 

·                  Level 1—Quoted prices (unadjusted) in active markets for identical assets or liabilities that can be accessed at the measurement date;

·                  Level 2—Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly; and

·                  Level 3—Unobservable inputs for the asset or liability.

 

The guidance requires the use of observable market data if such data is available without undue cost and effort.

 

When available, the company uses unadjusted quoted market prices in active markets to measure the fair value and classifies such items within Level 1. If quoted market prices are not available, fair value is based upon internally developed models that use current market-based or independently sourced market parameters such as interest rates and currency rates. Items valued using internally generated models are classified according to the lowest level input or value driver that is significant to the valuation.

 

9



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

The determination of fair value considers various factors including interest rate yield curves and time value underlying the financial instruments. For derivatives and debt securities, the company uses a discounted cash flow analysis using discount rates commensurate with the duration of the instrument.

 

In determining the fair value of financial instruments, the company considers certain market valuation adjustments to the “base valuations” calculated using the methodologies described below for several parameters that market participants would consider in determining fair value:

 

·                  Counterparty credit risk adjustments are applied to financial instruments, taking into account the actual credit risk of a counterparty as observed in the credit default swap market to determine the true fair value of such an instrument.

·                  Credit risk adjustments are applied to reflect the company’s own credit risk when valuing all liabilities measured at fair value. The methodology is consistent with that applied in developing counterparty credit risk adjustments, but incorporates the company’s own credit risk as observed in the credit default swap market.

 

As an example, the fair value of derivatives is derived utilizing a discounted cash flow model that uses observable market inputs such as known notional value amounts, yield curves, spot and forward exchange rates as well as discount rates. These inputs relate to liquid, heavily traded currencies with active markets which are available for the full term of the derivative.

 

Certain financial assets are measured at fair value on a nonrecurring basis. These assets include equity method investments that are recognized at fair value at the measurement date to the extent that they are deemed to be other-than-temporarily impaired. Certain assets that are measured at fair value on a recurring basis can be subject to nonrecurring fair value measurements. These assets include available-for-sale equity investments that are deemed to be other-than-temporarily impaired. In the event of an other-than-temporary impairment of a financial investment, fair value is measured using a model described above.

 

Non-financial assets such as property, plant and equipment, land, goodwill and intangible assets are also subject to nonrecurring fair value measurements if they are deemed to be impaired. The impairment models used for nonfinancial assets depend on the type of asset. See Note A, “Significant Accounting Policies,” on pages 76 to 86 in the company’s 2011 Annual Report for further information. There were no material impairments of non-financial assets for the six months ended June 30, 2012 and 2011, respectively.

 

Accounting guidance permits the measurement of eligible financial assets, financial liabilities and firm commitments at fair value, on an instrument-by-instrument basis, that are otherwise not permitted to be accounted for at fair value under other accounting standards. This election is irrevocable. The company does not apply the fair value option to any eligible assets or liabilities.

 

10



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

The following tables present the company’s financial assets and financial liabilities that are measured at fair value on a recurring basis at June 30, 2012 and December 31, 2011.

 

(Dollars in millions)

 

 

 

 

 

 

 

 

 

At June 30, 2012

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Assets:

 

 

 

 

 

 

 

 

 

Cash equivalents (1)

 

 

 

 

 

 

 

 

 

Time deposits and certificates of deposit

 

$

 

$

1,987

 

$

 

$

1,987

 

Commercial paper

 

 

1,670

 

 

1,670

 

Money market funds

 

1,106

 

 

 

1,106

 

U.S. government securities

 

 

960

 

 

960

 

Canada government securities

 

 

1,565

 

 

1,565

 

Other securities

 

 

7

 

 

7

 

Total

 

1,106

 

6,189

 

 

7,295

(6)

Debt securities - current (2)

 

 

323

 

 

 

323

(6)

Debt securities - noncurrent (3)

 

1

 

7

 

 

8

 

Available-for-sale equity investments (3)  

 

24

 

41

 

 

65

 

Derivative assets (4)

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

 

784

 

 

784

 

Foreign exchange contracts

 

 

548

 

 

548

 

Equity contracts

 

 

24

 

 

24

 

Total

 

 

1,356

 

 

1,356

(7)

Total assets

 

$

1,131

 

$

7,916

 

$

 

$

9,047

(7)

Liabilities:

 

 

 

 

 

 

 

 

 

Derivative liabilities (5)

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

$

 

$

505

 

$

 

$

505

 

Equity contracts

 

 

7

 

 

7

 

Total liabilities

 

$

 

$

512

 

$

 

$

512

(7)

 


(1)     Included within cash and cash equivalents in the Consolidated Statement of Financial Position.

(2)     Canada government securities reported as marketable securities in the Consolidated Statement of Financial Position.

(3)     Included within investments and sundry assets in the Consolidated Statement of Financial Position.

(4)     The gross balances of derivative assets contained within prepaid expenses and other current assets, and investments and sundry assets in the Consolidated Statement of Financial Position at June 30, 2012 are $598 million and $758 million, respectively.

(5)     The gross balances of derivative liabilities contained within other accrued expenses and liabilities, and other liabilities in the Consolidated Statement of Financial Position at June 30, 2012 are $360 million and $152 million, respectively.

(6)     Available-for-sale securities with carrying values that approximate fair value.

(7)     If derivative exposures covered by a qualifying master netting agreement had been netted in the Consolidated Statement of Financial Position, the total derivative asset and liability positions would have been reduced by $376 million each.

 

11



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

(Dollars in millions)

 

 

 

 

 

 

 

 

 

At December 31, 2011

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Assets:

 

 

 

 

 

 

 

 

 

Cash equivalents (1)

 

 

 

 

 

 

 

 

 

Time deposits and certificates of deposit

 

$

 

$

2,082

 

$

 

$

2,082

 

Commercial paper *

 

 

777

 

 

777

 

Money market funds

 

1,886

 

 

 

1,886

 

U.S. government securities

 

 

2,750

 

 

2,750

 

Canada government securities *

 

 

983

 

 

983

 

Other securities

 

 

8

 

 

8

 

Total

 

1,886

 

6,600

 

 

8,486

(5)

Debt securities - noncurrent (2)

 

1

 

7

 

 

8

 

Available-for-sale equity investments (2)  

 

69

 

14

 

 

83

 

Derivative assets (3)

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

 

783

 

 

783

 

Foreign exchange contracts

 

 

510

 

 

510

 

Equity contracts

 

 

7

 

 

7

 

Total

 

 

1,300

 

 

1,300

(6)

Total assets

 

$

1,956

 

$

7,921

 

$

 

$

9,877

(6)

Liabilities:

 

 

 

 

 

 

 

 

 

Derivative liabilities (4)

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

$

 

$

523

 

$

 

$

523

 

Equity contracts

 

 

8

 

 

8

 

Total liabilities

 

$

 

$

531

 

$

 

$

531

(6)

 


* Reclassified to conform with 2012 presentation.

 

(1)     Included within cash and cash equivalents in the Consolidated Statement of Financial Position.

(2)     Included within investments and sundry assets in the Consolidated Statement of Financial Position.

(3)     The gross balances of derivative assets contained within prepaid expenses and other current assets, and investments and sundry assets in the Consolidated Statement of Financial Position at December 31, 2011 are $546 million and $754 million, respectively.

(4)     The gross balances of derivative liabilities contained within other accrued expenses and liabilities, and other liabilities in the Consolidated Statement of Financial Position at December 31, 2011 are $365 million and $166 million, respectively.

(5)     Available-for-sale securities with carrying values that approximate fair value.

(6)     If derivative exposures covered by a qualifying master netting agreement had been netted in the Consolidated Statement of Financial Position, the total derivative asset and liability positions would have been reduced by $324 million each.

 

There were no transfers between Levels 1 and 2 for the six months ended June 30, 2012 and for the year ended December 31, 2011.

 

Financial Assets and Liabilities Not Measured at Fair Value

 

Short-Term Receivables and Payables

 

Notes and other accounts receivable and other investments are financial assets with carrying values that approximate fair value. Accounts payable, other accrued expenses and short-term debt (excluding the current portion of long-term debt) are financial liabilities with carrying values that approximate fair value. If measured at fair value in the financial statements, these financial instruments would be classified as Level 3 in the fair value hierarchy.

 

Loans and Long-term Receivables

 

Fair values are based on discounted future cash flows using current interest rates offered for similar loans to clients with similar credit ratings for the same remaining maturities. At June 30, 2012 and December 31, 2011, the difference between the carrying amount and estimated fair value for loans and long-term receivables was immaterial.  If measured at fair value in the financial statements, these financial instruments would be classified as Level 3 in the fair value hierarchy.

 

12



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

Long-term Debt

 

Fair value of publicly-traded long-term debt is based on quoted market prices for the identical liability when traded as an asset in an active market. For other long-term debt for which a quoted market price is not available, an expected present value technique that uses rates currently available to the company for debt with similar terms and remaining maturities is used to estimate fair value. The carrying amount of long-term debt is $24,766 million and $22,857 million and the estimated fair value is $27,688 million and $27,383 million at June 30, 2012 and December 31, 2011, respectively.  If measured at fair value in the financial statements, long-term debt (including the current portion) would be classified as Level 2 in the fair value hierarchy.

 

Debt and Marketable Equity Securities

 

The company’s cash equivalents and current debt securities are considered available-for-sale and recorded at fair value, which is not materially different from carrying value, in the Consolidated Statement of Financial Position. The following tables summarize the company’s noncurrent debt and marketable equity securities which are also considered available-for-sale and recorded at fair value in the Consolidated Statement of Financial Position.

 

 

 

 

 

Gross

 

Gross

 

 

 

(Dollars in millions)

 

Adjusted

 

Unrealized

 

Unrealized

 

Fair

 

At June 30, 2012:

 

Cost

 

Gains

 

Losses

 

Value

 

Debt securities — noncurrent(1)

 

$

7

 

$

1

 

$

 

$

8

 

Available-for-sale equity investments(1) 

 

$

28

 

$

39

 

$

(2

)

$

65

 

 


(1) Included within investments and sundry assets in the Consolidated Statement of Financial Position.

 

 

 

 

 

Gross

 

Gross

 

 

 

(Dollars in millions)

 

Adjusted

 

Unrealized

 

Unrealized

 

Fair

 

At December 31, 2011:

 

Cost

 

Gains

 

Losses

 

Value

 

Debt securities — noncurrent(1)

 

$

7

 

$

1

 

$

 

$

8

 

Available-for-sale equity investments(1) 

 

$

58

 

$

27

 

$

(2

)

$

83

 

 


(1) Included within investments and sundry assets in the Consolidated Statement of Financial Position.

 

Based on an evaluation of available evidence as of June 30, 2012, the company believes that unrealized losses on debt and available-for-sale equity investments are temporary and do not represent a need for an other-than-temporary impairment.

 

Sales of debt and available-for-sale equity investments during the period were as follows:

 

(Dollars in millions)

 

 

 

 

 

For the three months ended June 30:

 

2012

 

2011

 

Proceeds

 

$

6

 

$

87

 

Gross realized gains (before taxes)

 

2

 

29

 

Gross realized losses (before taxes)

 

(0

)

(0

)

 

(Dollars in millions)

 

 

 

 

 

For the six months ended June 30:

 

2012

 

2011

 

Proceeds

 

$

51

 

$

402

 

Gross realized gains (before taxes)

 

16

 

232

 

Gross realized losses (before taxes)

 

(0

)

(0

)

 

13



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

The after-tax net unrealized holding gains/(losses) on available-for-sale debt and equity securities that have been included in other comprehensive income/(loss) for the period and the after-tax net (gains)/losses reclassified from accumulated other comprehensive income/(loss) to net income were as follows:

 

(Dollars in millions)

 

 

 

 

 

For the three months ended June 30:

 

2012

 

2011**

 

Net unrealized gains/(losses) arising during the period

 

$

4

 

$

(3

)

Net unrealized (gains)/losses reclassified to net income*

 

(1

)

(19

)

 


*   There were no writedowns for the three months ended June 30, 2012 and 2011 respectively.

** Reclassified to conform with 2012 presentation.

 

(Dollars in millions)

 

 

 

 

 

For the six months ended June 30:

 

2012

 

2011**

 

Net unrealized gains/(losses) arising during the period

 

$

18

 

$

(2

)

Net unrealized (gains)/losses reclassified to net income*

 

(10

)

(144

)

 


*   There were no significant writedowns for the six months ended June 30, 2012 and 2011 respectively.

** Reclassified to conform with 2012 presentation.

 

The contractual maturities of substantially all available-for-sale debt securities are less than one year at June 30, 2012.

 

Derivative Financial Instruments

 

The company operates in multiple functional currencies and is a significant lender and borrower in the global markets. In the normal course of business, the company is exposed to the impact of interest rate changes and foreign currency fluctuations, and to a lesser extent equity and commodity price changes and client credit risk. The company limits these risks by following established risk management policies and procedures, including the use of derivatives and, where cost effective, financing with debt in the currencies in which assets are denominated. For interest rate exposures, derivatives are used to better align rate movements between the interest rates associated with the company’s lease and other financial assets and the interest rates associated with its financing debt. Derivatives are also used to manage the related cost of debt. For foreign currency exposures, derivatives are used to better manage the cash flow volatility arising from foreign exchange rate fluctuations.

 

As a result of the use of derivative instruments, the company is exposed to the risk that counterparties to derivative contracts will fail to meet their contractual obligations. To mitigate the counterparty credit risk, the company has a policy of only entering into contracts with carefully selected major financial institutions based upon their credit ratings and other factors. The company’s established policies and procedures for mitigating credit risk on principal transactions include reviewing and establishing limits for credit exposure and continually assessing the creditworthiness of counterparties. The right of set-off that exists under certain of these arrangements enables the legal entities of the company subject to the arrangement to net amounts due to and from the counterparty reducing the maximum loss from credit risk in the event of counterparty default.

 

The company is also a party to collateral security arrangements with most of its major counterparties. These arrangements require the company to hold or post collateral (cash or U.S. Treasury securities) when the derivative fair values exceed contractually established thresholds. Posting thresholds can be fixed or can vary based on credit default swap pricing or credit ratings received from the major credit agencies. The aggregate fair value of all derivative instruments under these collateralized arrangements that were in a liability position at June 30, 2012 and December 31, 2011 was $77 million and $131 million, respectively, for which no collateral was posted at June 30, 2012 and December 31, 2011.  Full collateralization of these agreements would be required in the event that the company’s credit rating falls below investment grade or if its credit default swap spread exceeds 250 basis points, as applicable, pursuant to the terms of the collateral security arrangements. The aggregate fair value of derivative instruments in net asset positions as of June 30, 2012 and December 31, 2011 was $1,356 million and $1,300 million, respectively. This amount represents the maximum exposure to loss at the reporting date as a result of the counterparties failing to perform as contracted. This exposure was reduced by $376 million and $324 million at June 30, 2012 and December 31, 2011, respectively, of liabilities included in master netting arrangements with those counterparties. Additionally, at June 30, 2012 and December 31, 2011, this exposure was reduced by $465 million and $466 million of cash collateral, respectively, received by the company. In addition to cash collateral, the company held

 

14



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

$93 million in non-cash collateral, in U.S. Treasury securities, at June 30, 2012.  Per accounting guidance, non-cash collateral is not recorded on the Statement of Financial Position.

 

The company does not offset derivative assets against liabilities in master netting arrangements nor does it offset receivables or payables recognized upon payment or receipt of cash collateral against the fair values of the related derivative instruments. No amount was recognized in other receivables at June 30, 2012 or December 31, 2011 for the right to reclaim cash collateral. The amount recognized in accounts payable for the obligation to return cash collateral totaled $465 million and $466 million at June 30, 2012 and December 31, 2011, respectively. The company restricts the use of cash collateral received to rehypothecation, and therefore reports it in prepaid expenses and other current assets in the Consolidated Statement of Financial Position. No amount was rehypothecated at June 30, 2012 or at December 31, 2011.

 

The company may employ derivative instruments to hedge the volatility in stockholders’ equity resulting from changes in currency exchange rates of significant foreign subsidiaries of the company with respect to the U.S. dollar. These instruments, designated as net investment hedges, expose the company to liquidity risk as the derivatives have an immediate cash flow impact upon maturity which is not offset by a cash flow from the translation of the underlying hedged equity. The company monitors this cash loss potential on an ongoing basis and may discontinue some of these hedging relationships by de-designating or terminating the derivative instrument in order to manage the liquidity risk. Although not designated as accounting hedges, the company may utilize derivatives to offset the changes in the fair value of the de-designated instruments from the date of de-designation until maturity.

 

In its hedging programs, the company uses forward contracts, futures contracts, interest-rate swaps and cross-currency swaps, depending upon the underlying exposure. The company is not a party to leveraged derivative instruments.

 

A brief description of the major hedging programs, categorized by underlying risk, follows.

 

Interest Rate Risk

 

Fixed and Variable Rate Borrowings

 

The company issues debt in the global capital markets, principally to fund its financing lease and loan portfolio. Access to cost-effective financing can result in interest rate mismatches with the underlying assets. To manage these mismatches and to reduce overall interest cost, the company uses interest-rate swaps to convert specific fixed-rate debt issuances into variable-rate debt (i.e., fair value hedges) and to convert specific variable-rate debt issuances into fixed-rate debt (i.e., cash flow hedges). At June 30, 2012 and December 31, 2011, the total notional amount of the company’s interest rate swaps was $5.9 billion and $5.9 billion, respectively. The weighted-average remaining maturity of these instruments at June 30, 2012 and December 31, 2011 was approximately 5.0 years and 5.5 years, respectively.

 

Forecasted Debt Issuance

 

The company is exposed to interest rate volatility on future debt issuances. To manage this risk, the company may use forward starting interest-rate swaps to lock in the rate on the interest payments related to the forecasted debt issuance. These swaps are accounted for as cash flow hedges. The company did not have any derivative instruments relating to this program outstanding at June 30, 2012 and December 31, 2011.

 

At June 30, 2012 and December 31, 2011, net losses of approximately $1 million and $5 million (before taxes), respectively, were recorded in accumulated other comprehensive income/(loss) in connection with cash flow hedges of the company’s borrowings. Within these amounts, $2 million and $6 million of losses are expected to be reclassified to net income within the next 12 months, providing an offsetting economic impact against the underlying transactions.

 

Foreign Exchange Risk

 

Long-Term Investments in Foreign Subsidiaries (Net Investment)

 

A large portion of the company’s foreign currency denominated debt portfolio is designated as a hedge of net investment in foreign subsidiaries to reduce the volatility in stockholders’ equity caused by changes in foreign currency exchange rates in the functional currency of major foreign subsidiaries with respect to the U.S. dollar. The company also uses cross-currency swaps and foreign exchange forward contracts for this risk management purpose. At June 30, 2012 and December 31, 2011, the total notional amount of derivative instruments designated as net investment hedges was $6.7 billion and $5.0 billion,

 

15



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

respectively. The weighted-average remaining maturity of these instruments at June 30, 2012 and December 31, 2011 was approximately 0.2 years and 0.4 years, respectively.

 

Anticipated Royalties and Cost Transactions

 

The company’s operations generate significant nonfunctional currency, third-party vendor payments and intercompany payments for royalties and goods and services among the company’s non-U.S. subsidiaries and with the parent company. In anticipation of these foreign currency cash flows and in view of the volatility of the currency markets, the company selectively employs foreign exchange forward contracts to manage its currency risk. These forward contracts are accounted for as cash flow hedges. The maximum length of time over which the company is hedging its exposure to the variability in future cash flows is four years. At June 30, 2012 and December 31, 2011, the total notional amount of forward contracts designated as cash flow hedges of forecasted royalty and cost transactions was $11.4 billion and $10.9 billion, respectively, with a weighted-average remaining maturity of 0.7 years and 0.7 years, respectively.

 

At June 30, 2012 and December 31, 2011, in connection with cash flow hedges of anticipated royalties and cost transactions, the company recorded net gains of $69 million and $88 million (before taxes), respectively, in accumulated other comprehensive income/(loss). Within these amounts $199 million and $191 million of gains, respectively, are expected to be reclassified to net income within the next 12 months, providing an offsetting economic impact against the underlying anticipated transactions.

 

Foreign Currency Denominated Borrowings

 

The company is exposed to exchange rate volatility on foreign currency denominated debt. To manage this risk, the company employs cross-currency swaps to convert fixed-rate foreign currency denominated debt to fixed-rate debt denominated in the functional currency of the borrowing entity. These swaps are accounted for as cash flow hedges. At June 30, 2012 and December 31, 2011, no instruments relating to this program were outstanding.

 

Subsidiary Cash and Foreign Currency Asset/Liability Management

 

The company uses its Global Treasury Centers to manage the cash of its subsidiaries. These centers principally use currency swaps to convert cash flows in a cost-effective manner. In addition, the company uses foreign exchange forward contracts to economically hedge, on a net basis, the foreign currency exposure of a portion of the company’s nonfunctional currency assets and liabilities. The terms of these forward and swap contracts are generally less than one year. The changes in the fair values of these contracts and of the underlying hedged exposures are generally offsetting and are recorded in other (income) and expense in the Consolidated Statement of Earnings. At June 30, 2012 and December 31, 2011, the total notional amount of derivative instruments in economic hedges of foreign currency exposure was $14.1 billion and $13.6 billion, respectively.

 

Equity Risk Management

 

The company is exposed to market price changes in certain broad market indices and in the company’s own stock primarily related to certain obligations to employees. Changes in the overall value of these employee compensation obligations are recorded in selling, general and administrative (SG&A) expense in the Consolidated Statement of Earnings. Although not designated as accounting hedges, the company utilizes derivatives, including equity swaps and futures, to economically hedge the exposures related to its employee compensation obligations. The derivatives are linked to the total return on certain broad market indices or the total return on the company’s common stock. They are recorded at fair value with gains or losses also reported in SG&A expense in the Consolidated Statement of Earnings. At June 30, 2012 and December 31, 2011, the total notional amount of derivative instruments in economic hedges of these compensation obligations was $1.1 billion and $1.0 billion, respectively.

 

Other Risks

 

The company may hold warrants to purchase shares of common stock in connection with various investments that are deemed derivatives because they contain net share or net cash settlement provisions. The company records the changes in the fair value of these warrants in other (income) and expense in the Consolidated Statement of Earnings. The company did not have any warrants qualifying as derivatives outstanding at June 30, 2012 and December 31, 2011.

 

The company is exposed to a potential loss if a client fails to pay amounts due under contractual terms. The company utilizes credit default swaps to economically hedge its credit exposures. These derivatives have terms of one year or less. The

 

16



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

swaps are recorded at fair value with gains and losses reported in other (income) and expense in the Consolidated Statement of Earnings. The company did not have any derivative instruments relating to this program outstanding at June 30, 2012 and December 31, 2011.

 

The following tables provide a quantitative summary of the derivative and non-derivative instrument related risk management activity as of June 30, 2012 and December 31, 2011 as well as for the three and six months ended June 30, 2012 and 2011, respectively:

 

Fair Values of Derivative Instruments in the Consolidated Statement of Financial Position

As of June 30, 2012 and December 31, 2011

 

 

 

Fair Value of Derivative Assets

 

Fair Value of Derivative Liabilities

 

 

 

Balance Sheet

 

 

 

 

 

Balance Sheet

 

 

 

 

 

(Dollars in millions)  

 

Classification

 

6/30/2012

 

12/31/2011

 

Classification

 

6/30/2012

 

12/31/2011

 

Designated as hedging instruments:

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate contracts:

 

Prepaid expenses and other current assets

 

$

43

 

$

50

 

Other accrued expenses and liabilities

 

$

 

$

 

 

 

Investments and sundry assets

 

742

 

733

 

Other liabilities

 

 

 

Foreign exchange contracts:

 

Prepaid expenses and other current assets

 

397

 

407

 

Other accrued expenses and liabilities

 

266

 

273

 

 

 

Investments and sundry assets

 

 

 

Other liabilities

 

141

 

155

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fair value of derivative assets

 

 

 

$

1,182

 

$

1,190

 

Fair value of derivative liabilities

 

$

408

 

$

428

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Not designated as hedging instruments:

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts:

 

Prepaid expenses and other current assets

 

$

134

 

$

82

 

Other accrued expenses and liabilities

 

$

87

 

$

84

 

 

 

Investments and sundry