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International Business Machines 10-Q 2016

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, 2016

 

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 12 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  ¨

 

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  ¨

 

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 ¨

 

 

 

Non-accelerated filer ¨

 

Smaller reporting company ¨

(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  ¨   No  x

 

The registrant had 955,844,217 shares of common stock outstanding at June 30, 2016.

 

 

 



Table of Contents

 

Index

 

 

Page

Part I - Financial Information:

 

 

 

Item 1. Consolidated Financial Statements (Unaudited):

 

 

 

Consolidated Statement of Earnings for the three and six months ended June 30, 2016 and 2015

3

 

 

Consolidated Statement of Comprehensive Income for the three and six months ended June 30, 2016 and 2015

4

 

 

Consolidated Statement of Financial Position at June 30, 2016 and December 31, 2015

5

 

 

Consolidated Statement of Cash Flows for the six months ended June 30, 2016 and 2015

7

 

 

Consolidated Statement of Changes in Equity for the six months ended June 30, 2016 and 2015

8

 

 

Notes to Consolidated Financial Statements

9

 

 

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

47

 

 

Item 4. Controls and Procedures

89

 

 

Part II - Other Information:

 

 

 

Item 1. Legal Proceedings

89

 

 

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

89

 

 

Item 6. Exhibits

90

 

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)

 

2016

 

2015

 

2016

 

2015

 

Revenue:

 

 

 

 

 

 

 

 

 

Services

 

$

13,018

 

$

12,597

 

$

25,409

 

$

24,963

 

Sales

 

6,792

 

7,733

 

12,671

 

14,489

 

Financing

 

429

 

484

 

843

 

950

 

Total revenue

 

20,238

 

20,813

 

38,923

 

40,403

 

Cost:

 

 

 

 

 

 

 

 

 

Services

 

8,691

 

8,431

 

17,074

 

16,709

 

Sales

 

1,582

 

1,726

 

2,960

 

3,351

 

Financing

 

263

 

266

 

501

 

501

 

Total cost

 

10,536

 

10,423

 

20,535

 

20,561

 

Gross profit

 

9,702

 

10,390

 

18,388

 

19,842

 

Expense and other (income):

 

 

 

 

 

 

 

 

 

Selling, general and administrative

 

5,349

 

5,179

 

11,361

 

10,541

 

Research, development and engineering

 

1,465

 

1,300

 

2,923

 

2,598

 

Intellectual property and custom development income

 

(365

)

(128

)

(582

)

(301

)

Other (income) and expense

 

37

 

(301

)

289

 

(444

)

Interest expense

 

167

 

115

 

315

 

223

 

Total expense and other (income)

 

6,653

 

6,165

 

14,306

 

12,617

 

Income from continuing operations before income taxes

 

3,049

 

4,224

 

4,082

 

7,225

 

Provision for/(benefit from) income taxes

 

544

 

698

 

(439

)

1,283

 

Income from continuing operations

 

$

2,505

 

$

3,526

 

$

4,521

 

$

5,942

 

Loss from discontinued operations, net of tax

 

0

 

(77

)

(3

)

(165

)

Net income

 

$

2,504

 

$

3,449

 

$

4,518

 

$

5,777

 

Earnings/(loss) per share of common stock:

 

 

 

 

 

 

 

 

 

Assuming dilution:

 

 

 

 

 

 

 

 

 

Continuing operations

 

$

2.61

 

$

3.58

 

$

4.69

 

$

6.01

 

Discontinued operations

 

0.00

 

(0.08

)

0.00

 

(0.17

)

Total

 

$

2.61

 

$

3.50

 

$

4.69

 

$

5.84

 

Basic:

 

 

 

 

 

 

 

 

 

Continuing operations

 

$

2.62

 

$

3.59

 

$

4.71

 

$

6.03

 

Discontinued operations

 

0.00

 

(0.08

)

0.00

 

(0.17

)

Total

 

$

2.62

 

$

3.51

 

$

4.71

 

$

5.86

 

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

 

 

 

 

 

 

 

 

 

Assuming dilution

 

960.5

 

986.7

 

962.4

 

989.5

 

Basic

 

957.4

 

982.3

 

959.5

 

985.2

 

Cash dividend per common share

 

$

1.40

 

$

1.30

 

$

2.70

 

$

2.40

 

 

(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)

 

2016

 

2015

 

2016

 

2015

 

Net income

 

$

2,504

 

$

3,449

 

$

4,518

 

$

5,777

 

Other comprehensive income/(loss), before tax:

 

 

 

 

 

 

 

 

 

Foreign currency translation adjustments

 

(248

)

102

 

(10

)

(350

)

Net changes related to available-for-sale securities:

 

 

 

 

 

 

 

 

 

Unrealized gains/(losses) arising during the period

 

1

 

(15

)

(35

)

17

 

Reclassification of (gains)/losses to net income

 

0

 

0

 

37

 

0

 

Total net changes related to available-for-sale securities

 

1

 

(15

)

2

 

16

 

Unrealized gains/(losses) on cash flow hedges:

 

 

 

 

 

 

 

 

 

Unrealized gains/(losses) arising during the period

 

9

 

(187

)

(256

)

432

 

Reclassification of (gains)/losses to net income

 

102

 

(321

)

11

 

(570

)

Total unrealized gains/(losses) on cash flow hedges

 

111

 

(508

)

(245

)

(138

)

Retirement-related benefit plans:

 

 

 

 

 

 

 

 

 

Prior service costs/(credits)

 

 

1

 

 

6

 

Net (losses)/gains arising during the period

 

78

 

93

 

(68

)

16

 

Curtailments and settlements

 

10

 

3

 

14

 

7

 

Amortization of prior service (credits)/costs

 

(27

)

(25

)

(53

)

(51

)

Amortization of net (gains)/losses

 

693

 

821

 

1,383

 

1,656

 

Total retirement-related benefit plans

 

754

 

894

 

1,277

 

1,635

 

Other comprehensive income/(loss), before tax

 

617

 

472

 

1,023

 

1,163

 

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

 

(223

)

(62

)

(21

)

(719

)

Other comprehensive income/(loss)

 

394

 

411

 

1,002

 

444

 

Total comprehensive income/(loss)

 

$

2,899

 

$

3,860

 

$

5,520

 

$

6,221

 

 

(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)

 

2016

 

2015

 

Assets:

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

10,017

 

$

7,686

 

Marketable securities

 

600

 

508

 

Notes and accounts receivable - trade (net of allowances of $352 in 2016 and $367 in 2015)

 

8,782

 

8,333

 

Short-term financing receivables (net of allowances of $526 in 2016 and $490 in 2015)

 

16,635

 

19,020

 

Other accounts receivable (net of allowances of $58 in 2016 and $51 in 2015)

 

1,130

 

1,201

 

Inventories, at lower of average cost or market:

 

 

 

 

 

Finished goods

 

414

 

352

 

Work in process and raw materials

 

1,271

 

1,199

 

Total inventories

 

1,685

 

1,551

 

Prepaid expenses and other current assets

 

4,676

 

4,205

 

Total current assets

 

43,524

 

42,504

 

Property, plant and equipment

 

30,136

 

29,342

 

Less: Accumulated depreciation

 

19,044

 

18,615

 

Property, plant and equipment — net

 

11,092

 

10,727

 

Long-term financing receivables (net of allowances of $142 in 2016 and $118 in 2015)

 

9,267

 

10,013

 

Prepaid pension assets

 

2,957

 

1,734

 

Deferred taxes

 

4,387

 

4,822

 

Goodwill

 

36,422

 

32,021

 

Intangible assets — net

 

5,148

 

3,487

 

Investments and sundry assets

 

5,259

 

5,187

 

Total assets

 

$

118,056

 

$

110,495

 

 

(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)

 

2016

 

2015

 

Liabilities:

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Taxes

 

$

2,275

 

$

2,847

 

Short-term debt

 

4,887

 

6,461

 

Accounts payable

 

5,484

 

6,028

 

Compensation and benefits

 

3,950

 

3,560

 

Deferred income

 

11,508

 

11,021

 

Other accrued expenses and liabilities

 

5,480

 

4,353

 

Total current liabilities

 

33,585

 

34,269

 

Long-term debt

 

39,638

 

33,428

 

Retirement and nonpension postretirement benefit obligations

 

16,723

 

16,504

 

Deferred income

 

3,837

 

3,771

 

Other liabilities

 

8,385

 

8,099

 

Total liabilities

 

102,167

 

96,071

 

Equity:

 

 

 

 

 

IBM stockholders’ equity:

 

 

 

 

 

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

 

53,565

 

53,262

 

Shares authorized: 4,687,500,000

 

 

 

 

 

Shares issued:2016 - 2,224,090,577

 

 

 

 

 

2015 - 2,221,223,449

 

 

 

 

 

Retained earnings

 

148,071

 

146,124

 

Treasury stock - at cost

 

(157,298

)

(155,518

)

Shares:2016 - 1,268,246,360

 

 

 

 

 

2015 - 1,255,494,724

 

 

 

 

 

Accumulated other comprehensive income/(loss)

 

(28,604

)

(29,607

)

Total IBM stockholders’ equity

 

15,733

 

14,262

 

Noncontrolling interests

 

156

 

162

 

Total equity

 

15,889

 

14,424

 

Total liabilities and equity

 

$

118,056

 

$

110,495

 

 

(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

(UNAUDITED)

 

 

 

Six Months Ended June 30,

 

(Dollars in millions)

 

2016

 

2015

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

4,518

 

$

5,777

 

Adjustments to reconcile net income to cash provided by operating activities

 

 

 

 

 

Depreciation

 

1,382

 

1,335

 

Amortization of intangibles

 

745

 

594

 

Stock-based compensation

 

261

 

257

 

Net (gain)/loss on asset sales and other

 

167

 

152

 

Loss on Microelectronics business disposal

 

 

37

 

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

 

2,015

 

(659

)

Net cash provided by operating activities

 

9,088

 

7,494

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Payments for property, plant and equipment

 

(1,826

)

(1,722

)

Proceeds from disposition of property, plant and equipment

 

172

 

182

 

Investment in software

 

(295

)

(290

)

Acquisition of businesses, net of cash acquired

 

(5,405

)

(708

)

Divestitures of businesses, net of cash transferred

 

35

 

81

 

Non-operating finance receivables — net

 

1,127

 

1,338

 

Purchases of marketable securities and other investments

 

(2,386

)

(1,716

)

Proceeds from disposition of marketable securities and other investments

 

2,028

 

1,464

 

Net cash used in investing activities

 

(6,550

)

(1,371

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from new debt

 

8,263

 

2,765

 

Payments to settle debt

 

(3,425

)

(4,463

)

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

 

(909

)

177

 

Common stock repurchases

 

(1,775

)

(2,303

)

Common stock transactions — other

 

115

 

221

 

Cash dividends paid

 

(2,590

)

(2,366

)

Net cash used in financing activities

 

(322

)

(5,970

)

 

 

 

 

 

 

Effect of exchange rate changes on cash and cash equivalents

 

114

 

(236

)

Net change in cash and cash equivalents

 

2,330

 

(83

)

 

 

 

 

 

 

Cash and cash equivalents at January 1

 

7,686

 

8,476

 

Cash and cash equivalents at June 30

 

$

10,017

 

$

8,393

 

 

(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, 2016

 

$

53,262

 

$

146,124

 

$

(155,518

)

$

(29,607

)

$

14,262

 

$

162

 

$

14,424

 

Net income plus other comprehensive income/(loss)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

4,518

 

 

 

 

 

4,518

 

 

 

4,518

 

Other comprehensive income/(loss)

 

 

 

 

 

 

 

1,002

 

1,002

 

 

 

1,002

 

Total comprehensive income/(loss)

 

 

 

 

 

 

 

 

 

$

5,520

 

 

 

$

5,520

 

Cash dividends paid — common stock

 

 

 

(2,590

)

 

 

 

 

(2,590

)

 

 

(2,590

)

Common stock issued under employee plans (2,867,128 shares)

 

321

 

 

 

 

 

 

 

321

 

 

 

321

 

Purchases (769,837 shares) and sales (323,578 shares) of treasury stock under employee plans — net

 

 

 

16

 

(71

)

 

 

(56

)

 

 

(56

)

Other treasury shares purchased, not retired (12,305,377 shares)

 

 

 

 

 

(1,709

)

 

 

(1,709

)

 

 

(1,709

)

Changes in other equity

 

(18

)

2

 

 

 

 

 

(16

)

 

 

(16

)

Changes in noncontrolling interests

 

 

 

 

 

 

 

 

 

 

 

(6

)

(6

)

Equity - June 30, 2016

 

$

53,565

 

$

148,071

 

$

(157,298

)

$

(28,604

)

$

15,733

 

$

156

 

$

15,889

 

 

 

 

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, 2015

 

$

52,666

 

$

137,793

 

$

(150,715

)

$

(27,875

)

$

11,868

 

$

146

 

$

12,014

 

Net income plus other comprehensive income/(loss)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

5,777

 

 

 

 

 

5,777

 

 

 

5,777

 

Other comprehensive income/(loss)

 

 

 

 

 

 

 

444

 

444

 

 

 

444

 

Total comprehensive income/(loss)

 

 

 

 

 

 

 

 

 

$

6,221

 

 

 

$

6,221

 

Cash dividends paid — common stock

 

 

 

(2,366

)

 

 

 

 

(2,366

)

 

 

(2,366

)

Common stock issued under employee plans (3,929,697 shares)

 

395

 

 

 

 

 

 

 

395

 

 

 

395

 

Purchases (931,120 shares) and sales (475,037 shares) of treasury stock under employee plans — net

 

 

 

14

 

(91

)

 

 

(77

)

 

 

(77

)

Other treasury shares purchased, not retired (14,467,545 shares)

 

 

 

 

 

(2,356

)

 

 

(2,356

)

 

 

(2,356

)

Changes in other equity

 

(2

)

 

 

 

 

 

 

(2

)

 

 

(2

)

Changes in noncontrolling interests

 

 

 

 

 

 

 

 

 

 

 

8

 

8

 

Equity - June 30, 2015

 

$

53,059

 

$

141,218

 

$

(153,162

)

$

(27,432

)

$

13,684

 

$

153

 

$

13,837

 

 

(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 only 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 amount of assets, liabilities, revenue, costs, expenses and other comprehensive income/(loss) that are reported in the Consolidated Financial Statements and accompanying disclosures. These estimates are based on management’s best knowledge of current events, historical experience, actions that the company may undertake in the future and on various other assumptions that are believed to be reasonable under the circumstances. As a result, actual results may be different from these estimates. Refer to the company’s recast 2015 Annual Report on Form 8-K, dated June 13, 2016, pages 48 to 51, for a discussion of the company’s critical accounting estimates.

 

On October 20, 2014, the company announced a definitive agreement to divest its Microelectronics business and manufacturing operations to GLOBALFOUNDRIES. The assets and liabilities of the Microelectronics business were reported as held for sale at December 31, 2014, and the operating results of the Microelectronics business have been reported as discontinued operations. The transaction closed on July 1, 2015. Refer to note 9, “Acquisitions/Divestitures,” for additional information on the transaction.

 

In January 2016, the company made a number of changes to its organizational structure and management system. These changes impacted the company’s reportable segments, but did not impact the Consolidated Financial Statements. Refer to note 6, “Segments,” on pages 27 to 29 for additional information on the changes in reportable segments. The periods presented in this Form 10-Q are reported on a comparable basis. The company filed a recast 2015 Annual Report in a Form 8-K on June 13, 2016 to recast its historical segment information to reflect these changes.

 

In the first quarter of 2016, the company classified certain properties, primarily office space, as held for sale. As a result of the company’s reassessment of its real estate portfolio, certain properties were approved for sale and are being actively marketed. The sales are expected to be completed within twelve months from the date of classification as held for sale. A pre-tax impairment charge of $252 million was recorded to other income (expense) related to the applicable land, buildings and furniture and fixtures as of March 31, 2016. The pre-tax charge reflected the difference between the net book value and the fair value (estimated proceeds) less the estimated costs to sell the properties. The fair value of these assets is not material.

 

In the first quarter of 2016, the company reported a benefit from income taxes of $983 million, and its effective tax rate was (95.1) percent, primarily driven by the resolution of a long-standing non-U.S. tax matter in February 2016. For the six months ended June 30, 2016, the company’s benefit from income taxes is $439 million and its effective tax rate is (10.8) percent. See Taxes on page 71 for additional information.

 

Noncontrolling interest amounts of $3.0 million and $2.4 million, net of tax, for the three months ended June 30, 2016 and 2015, respectively, and $4.4 million and $3.5 million, net of tax, for the six months ended June 30, 2016 and 2015, respectively, are included in the Consolidated Statement of Earnings within the other (income) and expense line item.

 

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 2015 Annual Report and Form 8-K dated June 13, 2016.

 

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:

 

New Standards to be Implemented

 

In June 2016, the Financial Accounting Standards Board (FASB) issued guidance for credit impairment based on an expected loss rather than incurred loss model. The guidance requires the consideration of all available relevant information when estimating expected credit losses, including past events, current conditions and forecasts and their implications for expected credit losses. The guidance is effective January 1, 2020 with a one year early adoption permitted. The company is evaluating the impact of the new guidance and the effective date.

 

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Notes to Consolidated Financial Statements — (continued)

 

In March 2016, the FASB issued guidance which changes the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification in the Consolidated Statement of Cash Flows. The guidance is effective January 1, 2017 and early adoption is permitted. The impact of the guidance could result in increased volatility of the company’s provision for income taxes and earnings per share in the Consolidated Statement of Earnings, depending on the company’s share price at exercise or vesting of share-based awards compared to grant date. The standard is not expected to have a material impact upon adoption.

 

In February 2016, the FASB issued guidance which changes the accounting for leases. The guidance requires lessees to recognize right-of-use assets and lease liabilities for most leases in the Consolidated Statement of Financial Position. The guidance makes some changes to lessor accounting, including the elimination of the use of residual value guarantee insurance in the capital lease test, and overall aligns with the new revenue recognition guidance. The guidance also requires qualitative and quantitative disclosures to assess the amount, timing and uncertainty of cash flows arising from leases. The guidance is effective January 1, 2019 and early adoption is permitted. The company is currently evaluating the impact of the new guidance and the effective date. The company’s operating lease commitments were $6.4 billion at December 31, 2015, and in 2015, the use of residual value guarantee insurance resulted in the company recognizing $608 million of sales-type lease revenue that would otherwise have been recognized as operating lease revenue over the lease term.

 

In January 2016, the FASB issued guidance which addresses aspects of recognition, measurement, presentation and disclosure of financial instruments. Certain equity investments will be measured at fair value with changes recognized in net income. The amendment also simplifies the impairment test of equity investments that lack readily determinable fair value. The guidance is effective January 1, 2018 and early adoption is not permitted except for limited provisions. The guidance is not expected to have a material impact in the consolidated financial results.

 

The FASB issued guidance on the recognition of revenue from contracts with customers in May 2014 with amendments in 2015 and 2016. Revenue recognition will depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance also requires disclosures regarding the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. The guidance permits two methods of adoption: retrospectively to each prior reporting period presented, or retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial application (the cumulative catch-up transition method). The guidance was initially effective January 1, 2017 and early adoption was not permitted. The amended guidance provides for a one-year deferral of the effective date to January 1, 2018, with an option of applying the standard on the original effective date. The company will adopt the guidance on January 1, 2018 and apply the cumulative catch-up transition method. The company is continuing to evaluate the impact of the new guidance in the consolidated financial results.

 

Standards Implemented

 

In November 2015, the FASB issued guidance which requires deferred tax liabilities and assets be classified as noncurrent in the statement of financial position. The guidance was effective January 1, 2016 with early adoption permitted. The company adopted the guidance in the fourth quarter of 2015 on a retrospective basis. The company reclassified current deferred tax assets of $2.0 billion at December 31, 2014 to deferred tax assets and current deferred tax liabilities of $19 million at December 31, 2014 to other liabilities from other accrued expenses and liabilities in the Consolidated Statement of Financial Position. In order to offset deferred tax assets and liabilities for presentation as a single noncurrent amount by tax jurisdiction, the company also reclassified $178 million at December 31, 2014 from deferred tax assets to other liabilities in the Consolidated Statement of Financial Position.

 

In September 2015, the FASB issued guidance eliminating the requirement that an acquirer in a business combination account for a measurement-period adjustment retrospectively. Instead, an acquirer will recognize a measurement-period adjustment during the period in which the amount of the adjustment is determined. In addition, the portion of the amount recorded in current-period earnings by line item that would have been recorded in previous reporting periods if the adjustment to the provisional amounts had been recognized as of the acquisition date should be presented separately on the face of the income statement or disclosed in the notes. The guidance was effective January 1, 2016 on a prospective basis. The guidance did not have a material impact in the consolidated financial results.

 

In May 2015, the FASB issued guidance which removed the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the net asset value per share practical expedient. The amendments also removed the requirement to make certain disclosures for all investments that are eligible to be measured at fair value using the net asset value per share practical expedient. Rather, those disclosures are limited to investments for which the entity has elected to measure the fair value using that practical expedient. The guidance was effective January 1, 2016. The guidance was a change in disclosure only and did not have an impact in the consolidated financial results.

 

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Notes to Consolidated Financial Statements — (continued)

 

In April 2015, the FASB issued guidance about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, then the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a services contract. All software licenses recognized under this guidance will be accounted for consistent with other licenses of intangible assets. The guidance was effective January 1, 2016 and the company adopted it on a prospective basis. The guidance did not have a material impact in the consolidated financial results.

 

In April 2015, the FASB issued guidance which requires debt issuance costs related to a recognized debt liability to be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The guidance was effective January 1, 2016 with early adoption permitted. The company adopted the guidance in the fourth quarter of 2015 on a retrospective basis. The company had debt issuance costs of $90 million and $74 million at June 30, 2016 and December 31, 2015, respectively. Debt issuance costs were previously included in investments and sundry assets in the Consolidated Statement of Financial Position.

 

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 as 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.

 

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

 

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Notes to Consolidated Financial Statements — (continued)

 

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. During the six months ended June 30, 2016, the company recorded an impairment on certain assets that are classified as held for sale. See note 1, “Basis of Presentation,” for additional information. There were no material impairments of non-financial assets for the six months ended June 30, 2015.

 

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 has not applied the fair value option to any eligible assets or liabilities.

 

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, 2016 and December 31, 2015.

 

(Dollars in millions)

 

 

 

 

 

 

 

 

 

At June 30, 2016

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Assets:

 

 

 

 

 

 

 

 

 

Cash equivalents (1)

 

 

 

 

 

 

 

 

 

Time deposits and certificates of deposit

 

$

 

$

3,198

 

$

 

$

3,198

 

Commercial paper

 

 

 

 

 

Money market funds

 

2,141

 

 

 

2,141

 

U.S. government securities

 

 

1,500

 

 

1,500

 

Canadian government securities

 

 

462

 

 

462

 

Total

 

2,141

 

5,160

 

 

7,301

(6)

Debt securities - current (2)

 

 

599

 

 

599

(6)

Debt securities - noncurrent (3)

 

1

 

7

 

 

9

 

Available-for-sale equity investments (3)

 

11

 

 

 

11

 

Derivative assets (4)

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

 

1,015

 

 

1,015

 

Foreign exchange contracts

 

 

258

 

 

258

 

Equity contracts

 

 

11

 

 

11

 

Total

 

 

1,284

 

 

1,284

(7)

Total assets

 

$

2,153

 

$

7,051

 

$

 

$

9,204

(7)

Liabilities:

 

 

 

 

 

 

 

 

 

Derivative liabilities (5)

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

$

 

$

406

 

$

 

$

406

 

Equity contracts

 

 

8

 

 

8

 

Total liabilities

 

$

 

$

414

 

$

 

$

414

(7)

 


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

(2) U.S. government securities, time deposits and certificates of deposit 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, 2016 were $262 million and $1,022 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, 2016 were $374 million and $40 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 each would have been reduced by $280 million.

 

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Notes to Consolidated Financial Statements — (continued)

 

(Dollars in millions)

 

 

 

 

 

 

 

 

 

At December 31, 2015

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Assets:

 

 

 

 

 

 

 

 

 

Cash equivalents (1)

 

 

 

 

 

 

 

 

 

Time deposits and certificates of deposit

 

$

 

$

2,856

 

$

 

$

2,856

 

Money market funds

 

2,069

 

 

 

2,069

 

Other securities

 

 

18

 

 

18

 

Total

 

2,069

 

2,874

 

 

4,943

(6)

Debt securities - current (2)

 

 

506

 

 

506

(6)

Debt securities - noncurrent (3)

 

1

 

6

 

 

8

 

Trading security investments (3)

 

28

 

 

 

28

 

Available-for-sale equity investments (3)

 

192

 

 

 

192

 

Derivative assets (4)

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

 

656

 

 

656

 

Foreign exchange contracts

 

 

332

 

 

332

 

Equity contracts

 

 

6

 

 

6

 

Total

 

 

994

 

 

994

(7)

Total assets

 

$

2,290

 

$

4,381

 

$

 

$

6,671

(7)

Liabilities:

 

 

 

 

 

 

 

 

 

Derivative liabilities (5)

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

$

 

$

164

 

$

 

$

164

 

Equity contracts

 

 

19

 

 

19

 

Interest rate contracts

 

 

3

 

 

3

 

Total liabilities

 

$

 

$

186

 

$

 

$

186

(7)

 


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

(2) Commercial paper and certificates of deposit 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 December 31, 2015 were $292 million and $702 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 December 31, 2015 were $164 million and $22 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 each would have been reduced by $139 million.

 

There were no transfers between Levels 1 and 2 for the six months ended June 30, 2016 and the year ended December 31, 2015.

 

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, 2016 and December 31, 2015, 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.

 

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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 was $39,638 million and $33,428 million, and the estimated fair value was $42,506 million and $35,220 million at June 30, 2016 and December 31, 2015, 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 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, 2016:

 

Cost

 

Gains

 

Losses

 

Value

 

Debt securities — noncurrent(1)

 

$

6

 

$

3

 

$

 

$

9

 

Available-for-sale equity investments(1)

 

$

2

 

$

9

 

$

0

 

$

11

 

 


(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, 2015:

 

Cost

 

Gains

 

Losses

 

Value

 

Debt securities — noncurrent(1)

 

$

5

 

$

3

 

$

 

$

8

 

Available-for-sale equity investments(1)

 

$

186

 

$

6

 

$

0

 

$

192

 

 


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

 

During the fourth quarter of 2014, the company acquired equity securities in conjunction with the sale of the System x business which were classified as available-for-sale securities. Based on an evaluation of available evidence as of December 31, 2015, the company recorded an other-than-temporary impairment loss of $86 million resulting in an adjusted cost basis of $185 million as of December 31, 2015. In the first quarter of 2016, the company recorded a gross realized loss of $37 million (before taxes) related to the sale of all the outstanding shares. The loss on this sale was recorded in other (income) and expense in the Consolidated Statement of Earnings.

 

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:

 

2016

 

2015

 

Proceeds

 

$

1

 

$

1

 

Gross realized gains (before taxes)

 

0

 

0

 

Gross realized losses (before taxes)

 

0

 

0

 

 

(Dollars in millions)

 

 

 

 

 

For the six months ended June 30:

 

2016

 

2015

 

Proceeds

 

$

149

 

$

6

 

Gross realized gains (before taxes)

 

0

 

1

 

Gross realized losses (before taxes)

 

37

 

0

 

 

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 after-tax net (gains)/losses reclassified from accumulated other comprehensive income/(loss) to net income were as follows:

 

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Notes to Consolidated Financial Statements — (continued)

 

(Dollars in millions)

 

 

 

 

 

For the three months ended June 30:

 

2016

 

2015

 

Net unrealized gains/(losses) arising during the period

 

$

1

 

$

(10

)

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

 

0

 

0

 

 

 


*There were no writedowns for the three months ended June 30, 2016 and 2015, respectively.

 

(Dollars in millions)

 

 

 

 

 

For the six months ended June 30:

 

2016

 

2015

 

Net unrealized gains/(losses) arising during the period

 

$

(22

)

$

10

 

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

 

23

 

0

 

 


* There were no writedowns for the six months ended June 30, 2016 and 2015, respectively.

 

The contractual maturities of substantially all available-for-sale debt securities are less than one year at June 30, 2016.

 

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 overall credit profile. 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 derivative 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, 2016 and December 31, 2015 was $99 million and $28 million, respectively, for which no collateral was posted at June 30, 2016 and December 31, 2015. 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 asset positions as of June 30, 2016 and December 31, 2015 was $1,284 million and $994 million, respectively. This amount represents the maximum exposure to loss at the reporting date if the counterparties failed to perform as contracted. This exposure was reduced by $280 million and $139 million at June 30, 2016 and December 31, 2015, respectively, of liabilities included in master netting arrangements with those counterparties. Additionally, at June 30, 2016 and December 31, 2015, this exposure was reduced by $230 million and $90 million of cash collateral, and $96 million and $40 million of non-cash collateral in U.S. Treasury securities, respectively, received by the company. At June 30, 2016 and December 31, 2015, the net exposure related to derivative assets recorded in the Consolidated Statement of Financial Position was $678 million and $726 million, respectively.  At June 30, 2016 and December 31, 2015, the net exposure related to derivative liabilities recorded in the Consolidated Statement of Financial Position was $134 million and $47 million, respectively.

 

In the Consolidated 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, 2016 or December 31, 2015 for the right to reclaim cash collateral. The amount recognized in accounts payable for the obligation

 

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Notes to Consolidated Financial Statements — (continued)

 

to return cash collateral was $230 million and $90 million at June 30, 2016 and December 31, 2015, 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, 2016 and December 31, 2015.

 

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, cross-currency swaps, and options 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 to fund its operations and financing business. 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