10-Q 1 a11-25576_110q.htm 10-Q

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 SEPTEMBER 30, 2011

 

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 definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

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 1,178,618,168 shares of common stock outstanding at September 30, 2011.

 

 

 



Table of Contents

 

Index

 

 

Page

Part I - Financial Information:

3

 

 

Item 1. Consolidated Financial Statements:

3

 

 

Consolidated Statement of Earnings for the three and nine months ended September 30, 2011 and 2010

3

 

 

Consolidated Statement of Financial Position at September 30, 2011 and December 31, 2010

4

 

 

Consolidated Statement of Cash Flows for the nine months ended September 30, 2011 and 2010

6

 

 

Notes to Consolidated Financial Statements

7

 

 

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

37

 

 

Item 4. Controls and Procedures

74

 

 

Part II - Other Information:

74

 

 

Item 1. Legal Proceedings

74

 

 

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

75

 

 

Item 6. Exhibits

75

 

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 September 30,

 

Nine Months Ended September 30,

 

(Dollars in millions except per share amounts)

 

2011

 

2010

 

2011

 

2010

 

Revenue:

 

 

 

 

 

 

 

 

 

Services

 

$

15,299

 

$

14,179

 

$

45,241

 

$

41,808

 

Sales

 

10,331

 

9,556

 

30,612

 

27,413

 

Financing

 

527

 

536

 

1,577

 

1,630

 

Total revenue

 

26,157

 

24,271

 

77,430

 

70,852

 

 

 

 

 

 

 

 

 

 

 

Cost:

 

 

 

 

 

 

 

 

 

Services

 

10,138

 

9,509

 

30,569

 

28,221

 

Sales

 

3,570

 

3,512

 

10,657

 

10,049

 

Financing

 

276

 

249

 

787

 

795

 

Total cost

 

13,984

 

13,270

 

42,014

 

39,065

 

 

 

 

 

 

 

 

 

 

 

Gross profit

 

12,173

 

11,001

 

35,416

 

31,787

 

 

 

 

 

 

 

 

 

 

 

Expense and other income:

 

 

 

 

 

 

 

 

 

Selling, general and administrative

 

5,662

 

5,149

 

17,518

 

15,886

 

Research, development and engineering

 

1,546

 

1,464

 

4,703

 

4,448

 

Intellectual property and custom development income

 

(298

)

(278

)

(855

)

(836

)

Other (income) and expense

 

128

 

(106

)

23

 

(746

)

Interest expense

 

107

 

95

 

298

 

267

 

Total expense and other income

 

7,146

 

6,324

 

21,687

 

19,019

 

 

 

 

 

 

 

 

 

 

 

Income before income taxes

 

5,027

 

4,677

 

13,729

 

12,767

 

Provision for income taxes

 

1,188

 

1,088

 

3,364

 

3,192

 

Net income

 

$

3,839

 

$

3,589

 

$

10,365

 

$

9,576

 

 

 

 

 

 

 

 

 

 

 

Earnings per share of common stock:

 

 

 

 

 

 

 

 

 

Assuming dilution

 

$

3.19

 

$

2.82

 

$

8.48

 

$

7.38

 

Basic

 

$

3.23

 

$

2.86

 

$

8.60

 

$

7.49

 

 

 

 

 

 

 

 

 

 

 

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

 

 

 

 

 

 

 

 

 

Assuming dilution

 

1,204.9

 

1,272.8

 

1,222.1

 

1,297.0

 

Basic

 

1,188.6

 

1,255.2

 

1,205.2

 

1,278.3

 

 

 

 

 

 

 

 

 

 

 

Cash dividend per common share

 

$

0.75

 

$

0.65

 

$

2.15

 

$

1.85

 

 

(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 FINANCIAL POSITION

(UNAUDITED)

 

ASSETS

 

(Dollars in millions)

 

At September 30,
2011

 

At December 31,
2010

 

Assets:

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

11,303

 

$

10,661

 

Marketable securities

 

 

990

 

Notes and accounts receivable — trade (net of allowances of $282 in 2011 and $324 in 2010)

 

9,719

 

10,834

 

Short-term financing receivables (net of allowances of $266 in 2011 and $342 in 2010)

 

14,145

 

16,257

 

Other accounts receivable (net of allowances of $11 in 2011 and $10 in 2010)

 

1,123

 

1,134

 

Inventories, at lower of average cost or market:

 

 

 

 

 

Finished goods

 

618

 

432

 

Work in process and raw materials

 

2,045

 

2,018

 

Total inventories

 

2,663

 

2,450

 

Deferred taxes

 

1,247

 

1,564

 

Prepaid expenses and other current assets

 

5,172

 

4,226

 

Total current assets

 

45,373

 

48,116

 

 

 

 

 

 

 

Plant, rental machines and other property

 

40,139

 

40,289

 

Less: Accumulated depreciation

 

26,252

 

26,193

 

Plant, rental machines and other property — net

 

13,887

 

14,096

 

Long-term financing receivables (net of allowances of $37 in 2011 and $58 in 2010)

 

9,830

 

10,548

 

Prepaid pension assets

 

5,131

 

3,068

 

Deferred taxes

 

2,570

 

3,220

 

Goodwill

 

24,913

 

25,136

 

Intangible assets — net

 

3,033

 

3,488

 

Investments and sundry assets

 

5,422

 

5,778

 

Total assets

 

$

110,158

 

$

113,452

 

 

 (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 — (CONTINUED)

(UNAUDITED)

 

LIABILITIES AND EQUITY

 

(Dollars in millions)

 

At September 30,
2011

 

At December 31,
2010

 

Liabilities:

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Taxes

 

$

2,360

 

$

4,216

 

Short-term debt

 

6,071

 

6,778

 

Accounts payable

 

7,093

 

7,804

 

Compensation and benefits

 

4,826

 

5,028

 

Deferred income

 

11,252

 

11,580

 

Other accrued expenses and liabilities

 

4,426

 

5,156

 

Total current liabilities

 

36,028

 

40,562

 

Long-term debt

 

24,089

 

21,846

 

Retirement and nonpension postretirement benefit obligations

 

15,375

 

15,978

 

Deferred income

 

3,634

 

3,666

 

Other liabilities

 

8,654

 

8,226

 

Total liabilities

 

87,781

 

90,279

 

 

 

 

 

 

 

Equity:

 

 

 

 

 

 

 

 

 

 

 

IBM stockholders’ equity:

 

 

 

 

 

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

 

47,558

 

45,418

 

Shares authorized: 4,687,500,000

 

 

 

 

 

Shares issued:

2011 – 2,179,118,982

 

 

 

 

 

 

2010 – 2,161,800,054

 

 

 

 

 

Retained earnings

 

100,266

 

92,532

 

Treasury stock - at cost

 

(107,434

)

(96,161

)

Shares:

2011 – 1,000,500,814

 

 

 

 

 

 

 

2010 –    933,806,510

 

 

 

 

 

 

Accumulated other comprehensive income/(loss)

 

(18,099

)

(18,743

)

Total IBM stockholders’ equity

 

22,291

 

23,046

 

Noncontrolling interests

 

87

 

126

 

Total equity

 

22,378

 

23,172

 

Total liabilities and equity

 

$

110,158

 

$

113,452

 

 

(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 CASH FLOWS

FOR THE NINE MONTHS ENDED SEPTEMBER 30,

(UNAUDITED)

 

(Dollars in millions)

 

2011

 

2010*

 

Cash flow from operating activities:

 

 

 

 

 

Net income

 

$

10,365

 

$

9,576

 

Adjustments to reconcile net income to cash provided from operating activities:

 

 

 

 

 

Depreciation

 

2,701

 

2,737

 

Amortization of intangibles

 

926

 

859

 

Stock-based compensation

 

498

 

474

 

Net (gain)/loss on asset sales and other

 

(252

)

(671

)

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

 

(1,488

)

(221

)

Net cash provided by operating activities

 

12,750

 

12,754

 

 

 

 

 

 

 

Cash flow from investing activities:

 

 

 

 

 

Payments for plant, rental machines and other property

 

(3,060

)

(3,033

)

Proceeds from disposition of plant, rental machines and other property

 

480

 

585

 

Investment in software

 

(421

)

(433

)

Acquisition of businesses, net of cash acquired

 

(223

)

(2,993

)

Divestiture of businesses, net of cash transferred

 

4

 

0

 

Non-operating finance receivables — net

 

534

 

173

 

Purchases of marketable securities and other investments

 

(1,156

)

(5,237

)

Proceeds from disposition of marketable securities and other investments

 

2,950

 

6,513

 

Net cash used in investing activities

 

(891

)

(4,425

)

 

 

 

 

 

 

Cash flow from financing activities:

 

 

 

 

 

Proceeds from new debt

 

6,652

 

4,665

 

Payments to settle debt

 

(5,625

)

(5,122

)

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

 

116

 

1,405

 

Common stock repurchases

 

(11,465

)

(11,774

)

Common stock transactions — other

 

2,029

 

2,625

 

Cash dividends paid

 

(2,593

)

(2,369

)

Net cash used in financing activities

 

(10,886

)

(10,569

)

 

 

 

 

 

 

Effect of exchange rate changes on cash and cash equivalents

 

(330

)

(83

)

Net change in cash and cash equivalents

 

643

 

(2,324

)

 

 

 

 

 

 

Cash and cash equivalents at January 1

 

10,661

 

12,183

 

Cash and cash equivalents at September 30

 

$

11,303

 

$

9,859

 

 


* Reclassified to conform with 2011 presentation.

 

(Amounts may not add due to rounding.)

 

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

 

6



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 2010 Annual Report on pages 50 to 53 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 2010 Annual Report.

 

Noncontrolling interest amounts in income of $0.9 million and $2.6 million, net of tax, for the three months ended September 30, 2011 and 2010, respectively, and $5.7 million and $5.4 million for the nine months ended September 30, 2011 and 2010, respectively, are presented in the Consolidated Statement of Earnings within the other (income) and expense line item. Additionally, changes to noncontrolling interests which are presented in Note 9, “Equity Activity,” on pages 27 and 28 were $(40) million and $2 million at September 30, 2011 and 2010, respectively.

 

Within the financial 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 September 2011, the Financial Accounting Standards Board (FASB) issued amended guidance that will simplify how entities test goodwill for impairment. After assessment of certain qualitative factors, if it is determined to be more likely than not that the fair value of a reporting unit is less than its carrying amount, entities must perform the quantitative analysis of the goodwill impairment test. Otherwise, the quantitative test(s) become optional. The guidance is effective January 1, 2012 with early adoption permitted. The company will elect to adopt this guidance for the 2011 goodwill impairment test performed in the fourth quarter.

 

In September 2011, the FASB issued additional disclosure requirements for entities which participate in multi-employer pension plans. The purpose of the new disclosures is to provide financial statement users with information about an employer’s level of participation in and the financial health of significant plans. The new disclosures are effective for the December 31, 2011 financial statements. The company does not participate in any material multi-employer plans. There will be no impact to the consolidated financial results as the changes relate only to additional disclosures.

 

In June 2011, the FASB issued amended disclosure requirements for the presentation of comprehensive income. The amended guidance eliminates the option to present components of other comprehensive income (OCI) as part of the statement of changes in equity. Under the amended guidance, all changes in OCI are to be presented either in a single continuous statement of comprehensive income, or in two separate but consecutive financial statements. The changes are effective January 1, 2012 with early adoption permitted. There will be no impact to the consolidated financial results as the amendments relate only to changes in financial statement presentation.

 

In May 2011, the FASB issued amended guidance and disclosure requirements for fair value measurements.  These amendments are not expected to have a material impact to the consolidated financial results. These changes will be effective January 1, 2012 on a prospective basis. Early application is not permitted.

 

In January 2011, the FASB temporarily deferred the disclosures regarding troubled debt restructurings which were included in the disclosure requirements concerning the credit quality of financing receivables and the allowance for credit losses which were issued in July 2010.  In April 2011, the FASB issued additional guidance and clarifications to help creditors in determining whether a creditor has granted a concession, and whether a debtor is experiencing financial difficulties for purposes of determining whether a restructuring constitutes a troubled debt restructuring. The new guidance and the previously deferred disclosures became effective July 1, 2011 applied retrospectively to January 1, 2011. Prospective application is required for any new impairments identified as a result of this guidance. These changes did not have a material impact on the Consolidated Financial Statements. For further information on the disclosures regarding the credit quality of financing receivables, see Note 5 on pages 13 to 17.

 

7



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

In December 2010, the FASB issued amended guidance to clarify the acquisition date that should be used for reporting pro-forma financial information for business combinations. If comparative financial statements are presented, the pro-forma revenue and earnings of the combined entity for the comparable prior reporting period should be reported as though the acquisition date for all business combinations that occurred during the current year had been completed as of the beginning of the comparable prior annual reporting period. The amendments in this guidance became effective prospectively for business combinations for which the acquisition date was on or after January 1, 2011. There was no impact in the consolidated financial results as the amendments relate only to additional disclosures.

 

In December 2010, the FASB issued amendments to the guidance on goodwill impairment testing. The amendments modify step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity is required to perform step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In making that determination, an entity should consider whether there are any adverse qualitative factors indicating that impairment may exist. The amendments were effective January 1, 2011 and did not have a material impact in the Consolidated Financial Statements.

 

In January 2010, the FASB issued additional disclosure requirements for fair value measurements which the company included in its interim and annual financial statements in 2010.  Certain disclosure requirements relating to fair value measurements using significant unobservable inputs (Level 3) were deferred until January 1, 2011. These new requirements did not have an impact in the consolidated financial results as they relate only to additional disclosures.

 

3. 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 in active markets that are unadjusted and accessible at the measurement date for identical, unrestricted assets or liabilities;

·                  Level 2—Quoted prices for identical assets and liabilities in markets that are not active, quoted prices for similar assets and liabilities in active markets or financial instruments for which significant inputs are observable, either directly or indirectly; and

·                  Level 3—Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable, including the company’s own assumptions in determining fair value.

 

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 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.

 

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.

 

8



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

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 public cost method 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 on page 8.

 

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 68 to 79 in the company’s 2010 Annual Report for further information. There were no material impairments of non-financial assets for the nine months ended September 30, 2011 and 2010, 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.

 

The following tables present the company’s financial assets and financial liabilities that are measured at fair value on a recurring basis at September 30, 2011 and December 31, 2010.

 

(Dollars in millions)

 

 

 

 

 

 

 

 

 

At September 30, 2011

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Assets:

 

 

 

 

 

 

 

 

 

Cash and cash equivalents(1)

 

 

 

 

 

 

 

 

 

Time deposits and certificates of deposit

 

$

 

$

3,602

 

$

 

$

3,602

 

Commercial paper

 

 

2,794

 

 

2,794

 

Money market funds

 

319

 

 

 

319

 

U.S. government securities

 

 

1,110

 

 

 

1,110

 

Other securities

 

 

40

 

 

40

 

Total

 

319

 

7,545

 

 

7,864

 

Debt securities — noncurrent(2)

 

1

 

7

 

 

8

 

Available-for-sale equity investments(2)

 

61

 

13

 

 

74

 

Derivative assets(3)

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

 

895

 

 

895

 

Foreign exchange contracts

 

 

489

 

 

489

 

Equity contracts

 

 

7

 

 

7

 

Total

 

 

1,391

 

 

1,391

(5)

Total assets

 

$

381

 

$

8,956

 

$

 

$

9,337

(5)

 

 

 

 

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

 

 

 

 

Derivative liabilities(4)

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

$

 

$

535

 

$

 

$

535

 

Equity contracts

 

 

25

 

 

25

 

Total liabilities

 

$

 

$

560

 

$

 

$

560

(5)

 


(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 September 30, 2011 are $492 million and $900 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 September 30, 2011 are $447 million and $112 million, respectively.

(5)

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 $336 million each.

 

9



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

(Dollars in millions)

 

 

 

 

 

 

 

 

 

At December 31, 2010

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Assets:

 

 

 

 

 

 

 

 

 

Cash and cash equivalents(1)

 

 

 

 

 

 

 

 

 

Time deposits and certificates of deposit

 

$

 

$

2,473

 

$

 

$

2,473

 

Commercial paper

 

 

2,673

 

 

2,673

 

Money market funds

 

1,532

 

 

 

1,532

 

Foreign government securities

 

 

1,054

 

 

1,054

 

U.S. government securities

 

 

44

 

 

44

 

U.S. government agency securities

 

 

22

 

 

22

 

Other securities

 

 

3

 

 

3

 

Total

 

1,532

 

6,269

 

 

7,801

 

Debt securities — current(2)

 

 

 

 

 

 

 

 

 

Commercial paper

 

 

490

 

 

490

 

U.S. government securities

 

 

500

 

 

500

 

Other securities

 

 

1

 

 

1

 

Total

 

 

990

 

 

990

 

Debt securities — noncurrent(3)

 

1

 

6

 

 

7

 

Available-for-sale equity investments(3) 

 

445

 

13

 

 

458

 

Derivative assets(4)

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

 

548

 

 

548

 

Foreign exchange contracts

 

 

539

 

 

539

 

Equity contracts

 

 

12

 

 

12

 

Total

 

 

1,099

 

 

1,099

(6)

Total assets

 

$

1,978

 

$

8,377

 

$

 

$

10,355

(6)

 

 

 

 

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

 

 

 

 

Derivative liabilities(5) 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

$

 

$

1,003

 

$

 

$

1,003

 

Equity contracts

 

 

3

 

 

3

 

Total liabilities

 

$

 

$

1,006

 

$

 

$

1,006

(6)

 


(1)

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

(2)

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, 2010 are $511 million and $588 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, 2010 are $871 million and $135 million, respectively.

(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 $475 million each.

 

There were no significant transfers between Levels 1 and 2 for the nine months ended September 30, 2011 and for the year ended December 31, 2010.

 

10



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

4. Financial Instruments (excluding derivatives): Cash and cash equivalents, debt and marketable equity securities are recognized and measured at fair value in the company’s Consolidated Financial Statements. 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 are financial liabilities with carrying values that approximate fair value. In the absence of quoted prices in active markets, judgment is required in developing estimates of fair value. Estimates are not necessarily indicative of the amounts the company could realize in a current market transaction. The following methods and assumptions are used to estimate fair values:

 

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 September 30, 2011 and December 31, 2010, the difference between the carrying amount and estimated fair value for loans and long-term receivables was immaterial.

 

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 $24,089 million and $21,846 million and the estimated fair value is $26,592 million and $24,006 million at September 30, 2011 and December 31, 2010, respectively.

 

Debt and Marketable Equity Securities

 

The following tables summarize the company’s debt and marketable equity securities all of 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 September 30, 2011

 

Cost

 

Gains

 

Losses

 

Value

 

Cash and cash equivalents(1)

 

 

 

 

 

 

 

 

 

Time deposits and certificates of deposit

 

$

3,602

 

$

 

$

(0

)

$

3,602

 

Commercial paper

 

2,794

 

 

(0

)

2,794

 

Money market funds

 

319

 

 

 

319

 

U.S. government securities

 

1,110

 

 

 

1,110

 

Other securities

 

40

 

 

 

40

 

Total

 

$

7,864

 

$

 

$

(0

)

$

7,864

 

Debt securities — noncurrent(2)

 

 

 

 

 

 

 

 

 

Other securities

 

$

7

 

$

1

 

$

 

$

8

 

Total

 

$

7

 

$

1

 

$

 

$

8

 

Available-for-sale equity investments(2) 

 

$

57

 

$

19

 

$

(2

)

$

74

 

 


(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.

 

11



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

 

 

 

 

Gross

 

Gross

 

 

 

(Dollars in millions)

 

Adjusted

 

Unrealized

 

Unrealized

 

Fair

 

At December 31, 2010

 

Cost

 

Gains

 

Losses

 

Value

 

Cash and cash equivalents(1)

 

 

 

 

 

 

 

 

 

Time deposits and certificates of deposit

 

$

2,473

 

$

 

$

(0

)

$

2,473

 

Commercial paper

 

2,673

 

 

(0

)

2,673

 

Money market funds

 

1,532

 

 

 

1,532

 

Foreign government securities

 

1,054

 

 

 

1,054

 

U.S. government securities

 

44

 

0

 

(0

)

44

 

U.S. government agency securities

 

22

 

0

 

(0

)

22

 

Other securities

 

3

 

 

 

3

 

Total

 

$

7,801

 

$

0

 

$

(0

)

$

7,801

 

Debt securities — current(2)

 

 

 

 

 

 

 

 

 

Commercial paper

 

$

490

 

$

 

$

(0

)

$

490

 

U.S. government securities

 

500

 

 

(0

)

500

 

Other securities

 

1

 

 

(0

)

1

 

Total

 

$

990

 

$

 

$

(0

)

$

990

 

Debt securities — noncurrent(3)

 

 

 

 

 

 

 

 

 

Other securities

 

$

6

 

$

1

 

$

(0

)

$

7

 

Total

 

$

6

 

$

1

 

$

(0

)

$

7

 

Available-for-sale equity investments(3) 

 

$

194

 

$

264

 

$

(0

)

$

458

 

 


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

(2) Reported as marketable securities within the Consolidated Statement of Financial Position.

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

 

Based on an evaluation of available evidence as of September 30, 2011, the company believes that unrealized losses on debt and marketable equity securities are temporary and do not represent a need for an other-than-temporary impairment.

 

Proceeds from sales of debt securities and marketable equity securities were approximately $402 million for the first nine months of 2011. The gross realized gains (before taxes) on these sales totaled $232 million and gross realized losses (before taxes) totaled less than $1 million. There were no sales of debt and marketable equity securities in the third quarter of 2011. Proceeds from sales of debt securities and marketable equity securities were approximately $1 million and $14 million for the third quarter and first nine months of 2010, respectively. The gross realized gains (before taxes) on these sales were less than $1 million and $5 million for the third quarter and first nine months of 2010, respectively. The gross realized losses (before taxes) on these sales were less than $1 million in the third quarter and first nine months of 2010.

 

The after tax net unrealized holding gains/(losses) on available-for-sale debt and marketable equity securities that have been included in accumulated other comprehensive income/(loss) 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 September 30:

 

2011

 

2010

 

Net unrealized gains/(losses) arising during the period

 

$

(9

)

$

56

 

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

 

0

 

0

 

 


* Includes writedowns of $0.2 million and $0.5 million for the three months ended September 30, 2011 and 2010, respectively.

 

(Dollars in millions)

 

 

 

 

 

For the nine months ended September 30:

 

2011

 

2010

 

Net unrealized gains/(losses) arising during the period

 

$

(12

)

$

50

 

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

 

(142

)

0

 

 


* Includes writedowns of $0.2 million and $3.6 million for the nine months ended September 30, 2011 and 2010, respectively.

 

12



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

The contractual maturities of substantially all available-for-sale debt securities are less than one year at September 30, 2011.

 

5. Financing Receivables: The following table presents financing receivables, net of allowances for credit losses, including residual values.

 

(Dollars in millions)

 

At September 30,
2011

 

At December 31,
2010

 

Current:

 

 

 

 

 

Net investment in sales-type and direct financing leases

 

$

3,834

 

$

3,945

 

Commercial financing receivables

 

5,027

 

6,777

 

Client loan receivables

 

4,531

 

4,718

 

Installment payment receivables

 

754

 

816

 

Total

 

$

14,145

 

$

16,257

 

Noncurrent:

 

 

 

 

 

Net investment in sales-type and direct financing leases

 

$

5,117

 

$

5,384

 

Commercial financing receivables

 

37

 

43

 

Client loan receivables

 

4,303

 

4,734

 

Installment payment receivables

 

372

 

388

 

Total

 

$

9,830

 

$

10,548

 

 

Net investment in sales-type and direct financing leases relates principally to the company’s systems products and are for terms ranging generally from two to six years. Net investment in sales-type and direct financing leases includes unguaranteed residual values of $738 million and $871 million at September 30, 2011 and December 31, 2010, respectively, and is reflected net of unearned income of $746 million and $816 million and net of the allowance for credit losses of $109 million and $126 million at those dates, respectively.

 

Commercial financing receivables, net of allowance for credit losses of $45 million and $58 million at September 30, 2011 and December 31, 2010, respectively, relate primarily to inventory and accounts receivable financing for dealers and remarketers of IBM and non-IBM products. Payment terms for inventory and accounts receivable financing generally range from 30 to 90 days.

 

Client loan receivables, net of allowance for credit losses of $99 million and $160 million at September 30, 2011 and December 31, 2010, respectively, are loans that are provided by Global Financing primarily to clients to finance the purchase of software and services. Separate contractual relationships on these financing arrangements are for terms ranging generally from two to seven years.

 

Installment payment receivables, net of allowance for credit losses of $49 million and $56 million at September 30, 2011 and December 31, 2010, respectively, are secured loans that are provided primarily to clients to finance hardware and software ranging generally from two to three years.

 

Both client loan receivables and installment payment receivables financing contracts are priced independently at competitive market rates. The company has a history of enforcing the terms of these separate financing agreements.

 

The company utilizes certain of its financing receivables as collateral for non-recourse borrowings. Financing receivables pledged as collateral for borrowings were $307 million and $302 million at September 30, 2011 and December 31, 2010, respectively.

 

The company did not have any financing receivables held for sale as of September 30, 2011 and December 31, 2010.

 

Financing Receivables by Portfolio Segment

 

The following tables present financing receivables on a gross basis excluding the allowance for credit losses and residual value, by portfolio segment and by class, excluding current commercial financing receivables and other miscellaneous current

 

13



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

financing receivables at September 30, 2011 and December 31, 2010. The company determines its allowance for credit losses based on two portfolio segments: lease receivables and loan receivables, and further segments the portfolio via two classes: major markets and growth markets. For additional information on the company’s accounting policies for the allowance for credit losses, see the company’s 2010 Annual Report beginning on page 77.

 

(Dollars in millions)
At September 30, 2011

 

Major
Markets

 

Growth
Markets

 

Total

 

Financing receivables:

 

 

 

 

 

 

 

Lease receivables

 

$

6,290

 

$

1,935

 

$

8,225

 

Loan receivables

 

8,105

 

2,079

 

10,184

 

Ending balance

 

$

14,395

 

$

4,014

 

$

18,409

 

Collectively evaluated for impairment

 

$

14,111

 

$

3,905

 

$

18,016

 

Individually evaluated for impairment

 

$

284

 

$

109

 

$

393

 

 

 

 

 

 

 

 

 

Allowance for credit losses:

 

 

 

 

 

 

 

Lease receivables

 

$

84

 

$

42

 

$

126

 

Loan receivables

 

150

 

76

 

226

 

Beginning balance at January 1, 2011

 

$

234

 

$

119

 

$

353

 

Charge-offs

 

(56

)

(13

)

(69

)

Provision

 

(15

)

1

 

(14

)

Other

 

2

 

(4

)

(2

)

Lease receivables

 

68

 

41

 

109

 

Loan receivables

 

96

 

62

 

158

 

Ending balance at September 30, 2011

 

$

165

 

$

102

 

$

267

 

Collectively evaluated for impairment

 

$

43

 

$

13

 

$

56

 

Individually evaluated for impairment

 

$

122

 

$

89

 

$

211

 

 

(Dollars in millions)
At December 31, 2010

 

Major
Markets

 

Growth
Markets

 

Total

 

Financing receivables:

 

 

 

 

 

 

 

Lease receivables

 

$

6,562

 

$

1,983

 

$

8,545

 

Loan receivables

 

9,087

 

1,993

 

11,080

 

Ending balance

 

$

15,650

 

$

3,975

 

$

19,625

 

Collectively evaluated for impairment

 

$

15,199

 

$

3,794

 

$

18,993

 

Individually evaluated for impairment

 

$

451

 

$

181

 

$

632

 

 

 

 

 

 

 

 

 

Allowance for credit losses:

 

 

 

 

 

 

 

Lease receivables*

 

$

84

 

$

42

 

$

126

 

Loan receivables*

 

150

 

76

 

226

 

Ending balance at December 31, 2010

 

$

234

 

$

119

 

$

353

 

Collectively evaluated for impairment

 

$

60

 

$

11

 

$

71

 

Individually evaluated for impairment

 

$

174

 

$

108

 

$

282

 

 


* Reclassified to conform with 2011 presentation.

 

When calculating the allowances, financing receivables are evaluated either on an individual or a collective basis. For individually evaluated receivables, the company determines the expected cash flow for the receivable and calculates an estimate of the potential loss and the probability of loss. For those accounts in which the loss is probable, the company records a specific reserve. In addition, the company records an unallocated reserve that is calculated by applying a reserve rate to its different portfolios, excluding accounts that have been specifically reserved. This reserve rate is based upon credit rating, probability of default, term, characteristics (lease/loan) and loss history.

 

Financing Receivables on Non-Accrual Status

 

Certain receivables for which the company has recorded a specific reserve may also be placed on non-accrual status. Non-accrual assets are those receivables with specific reserves or other receivables for which it is likely that the company will be unable to collect all amounts due according to original terms of the lease or loan agreement. Income recognition is discontinued on these receivables.

 

14



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

The following table presents the recorded investment in financing receivables which were on non-accrual status at September 30, 2011 and December 31, 2010.

 

(Dollars in millions)

 

At September 30,
2011

 

At December 31,
 2010

 

Major markets

 

$

46

 

$

69

 

Growth markets

 

20

 

33

 

Total lease receivables

 

$

66

 

$

101

 

 

 

 

 

 

 

Major markets

 

$

77

 

$

141

 

Growth markets

 

18

 

123

 

Total loan receivables

 

$

95

 

$

264

 

 

 

 

 

 

 

Total receivables

 

$

161

 

$

366

 

 

Impaired Loans

 

The company considers any loan with an individually evaluated reserve as an impaired loan. Depending on the level of impairment, loans will also be placed on non-accrual status (see section “Financing Receivables on Non-Accrual Status”).

 

The following tables present impaired client loan receivables at September 30, 2011 and December 31, 2010.

 

 

 

At September 30, 2011

 

At December 31, 2010

 

(Dollars in millions)

 

Recorded
Investment

 

Related
Allowance

 

Recorded
Investment

 

Related
Allowance

 

Major markets

 

$

111

 

$

75

 

$

196

 

$

119

 

Growth markets

 

59

 

52

 

132

 

68

 

Total

 

$

170

 

$

127

 

$

328

 

$

187

 

 

(Dollars in millions)
For the three months ended September 30, 2011:

 

Average
Recorded
Investment

 

Interest
Income
Recognized*

 

Interest
Income
Recognized on
 Cash Basis

 

Major markets

 

$

125

 

$

1

 

$

0

 

Growth markets

 

60

 

0

 

0

 

Total

 

$

185

 

$

1

 

$

0

 

 


* Impaired loans are placed on non-accrual status, depending on the level of impairment.

 

(Dollars in millions)
For the nine months ended September 30, 2011:

 

Average
Recorded
Investment

 

Interest
Income
Recognized*

 

Interest
Income
Recognized on
 Cash Basis

 

Major markets

 

$

150

 

$

2

 

$

0

 

Growth markets

 

97

 

0

 

0

 

Total

 

$

248

 

$

2

 

$

0

 

 


* Impaired loans are placed on non-accrual status, depending on the level of impairment.

 

15



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

Credit Quality Indicators

 

The company’s credit quality indicators are based on rating agency data, publicly available information and information provided by the companies, and are reviewed periodically based on the relative level of risk. The resulting indicators are a numerical rating system that maps to Moody’s Investors Service credit ratings as shown below. Moody’s has not provided to the company a credit rating on its clients.

 

The tables below present the gross recorded investment for each class of receivables, by credit quality indicator, at September 30, 2011 and December 31, 2010. Receivables with a credit quality indicator ranging from Aaa to Baa3 are considered investment grade. All others are considered non-investment grade.

 

 

 

Lease Receivables

 

Loan Receivables

 

(Dollars in millions)
At September 30, 2011:

 

Major
Markets

 

Growth
Markets

 

Major
Markets

 

Growth
Markets

 

Credit Rating:

 

 

 

 

 

 

 

 

 

Aaa — Aa3

 

$

810

 

$

151

 

$

1,043

 

$

162

 

A1 — A3

 

1,357

 

188

 

1,748

 

202

 

Baal — Baa3

 

2,296

 

738

 

2,958

 

793

 

Bal — Ba2

 

944

 

471

 

1,217

 

506

 

Ba3 — B1

 

548

 

259

 

706

 

278

 

B2 — B3

 

230

 

109

 

297

 

117

 

Caa — D

 

105

 

19

 

135

 

20

 

Total

 

$

6,290

 

$

1,935

 

$

8,105

 

$

2,079

 

 

At September 30, 2011, the industries which made up Global Financing’s receivables portfolio consist of: Financial (38 percent), Government (16 percent), Manufacturing (13 percent), Retail (9 percent), Services (8 percent), Communications (5 percent) and Other (11 percent).

 

 

 

Lease Receivables*

 

Loan Receivables*

 

(Dollars in millions)
At December 31, 2010:

 

Major
Markets

 

Growth
Markets

 

Major
Markets

 

Growth
Markets

 

Credit Rating:

 

 

 

 

 

 

 

 

 

Aaa — Aa3

 

$

794

 

$

173

 

$

1,100

 

$

173

 

A1 — A3

 

1,463

 

182

 

2,026

 

183

 

Baal — Baa3

 

2,494

 

837

 

3,453

 

841

 

Bal — Ba2

 

899

 

403

 

1,245

 

405

 

Ba3 — B1

 

518

 

242

 

718

 

243

 

B2 — B3

 

230

 

93

 

318

 

94

 

Caa — D

 

164

 

54

 

227

 

54

 

Total

 

$

6,562

 

$

1,983

 

$

9,087

 

$

1,993

 

 


* Reclassified to conform with 2011 presentation.

 

At December 31, 2010, the industries which make up Global Financing’s receivables portfolio consist of:  Financial (36 percent), Government (16 percent), Manufacturing (14 percent), Retail (9 percent), Services (8 percent), Communications (5 percent) and Other (12 percent).

 

16



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

Past Due Financing Receivables

 

The company views receivables as past due when payment has not been received after 90 days, measured from billing date.

 

(Dollars in millions)
At September 30, 2011:

 

Total
Past Due
> 90 days*

 

Current

 

Total
Financing
Receivables

 

Recorded
Investment
> 90 Days
and Accruing

 

Major markets

 

$

10

 

$

6,279

 

$

6,290

 

$

10

 

Growth markets

 

13

 

1,923

 

1,935

 

10

 

Total lease receivables

 

$

23

 

$

8,202

 

$

8,225

 

$

19

 

 

 

 

 

 

 

 

 

 

 

Major markets

 

$

28

 

$

8,077

 

$

8,105

 

$

11

 

Growth markets

 

20

 

2,059

 

2,079

 

18

 

Total loan receivables

 

$

48

 

$

10,136

 

$

10,184

 

$

30

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

71

 

$

18,337

 

$

18,409

 

$

49

 

 


* Does not include accounts that are fully reserved.

 

(Dollars in millions)
At December 31, 2010:

 

Total
Past Due
> 90 days*

 

Current

 

Total
Financing
Receivables

 

Recorded
Investment
> 90 Days
and Accruing

 

Major markets

 

$

10

 

$

6,552

 

$

6,562

 

$

5

 

Growth markets

 

13

 

1,970

 

1,983

 

5

 

Total lease receivables

 

$

22

 

$

8,523

 

$

8,545

 

$

10

 

 

 

 

 

 

 

 

 

 

 

Major markets

 

$

11

 

$

9,076

 

$

9,087

 

$

4

 

Growth markets

 

32

 

1,961

 

1,993

 

17

 

Total loan receivables

 

$

43

 

$

11,037

 

$

11,080

 

$

21

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

65

 

$

19,560

 

$

19,625

 

$

31

 

 


* Does not include accounts that are fully reserved.

 

Troubled Debt Restructurings

 

As noted in Note 2, “Accounting Changes,” the company adopted new FASB guidance to help creditors determine whether a restructuring constitutes a troubled debt restructuring. The company assessed all restructurings that occurred on or after January 1, 2011 and determined that there were no troubled debt restructurings for the nine months ended September 30, 2011.

 

6. 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.

 

17



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

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 September 30, 2011 and December 31, 2010 was $90 million and $363 million, respectively. The company posted no collateral at September 30, 2011, and posted collateral of $9 million at December 31, 2010. 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 September 30, 2011 and December 31, 2010 was $1,391 million and $1,099 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 $336 million and $475 million at September 30, 2011 and December 31, 2010, respectively, of liabilities included in master netting arrangements with those counterparties. Additionally, at September 30, 2011 and December 31, 2010, this exposure was reduced by $469 million and $88 million of collateral, respectively, received by the company.

 

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 September 30, 2011 for the right to reclaim cash collateral. At December 31, 2010, $9 million was recognized in other receivables for the right to reclaim cash collateral. The amount recognized in accounts payable for the obligation to return cash collateral totaled $469 million and $88 million at September 30, 2011 and December 31, 2010, 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 September 30, 2011. At December 31, 2010, $9 million was rehypothecated.

 

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 September 30, 2011 and December 31, 2010, the total notional amount of the company’s interest rate swaps

 

18



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

was  $6.7 billion and $7.1 billion, respectively. The weighted-average remaining maturity of these instruments at September 30, 2011 and December 31, 2010 was approximately 5.1 years and 5.7 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 September 30, 2011 and December 31, 2010.

 

At September 30, 2011 and December 31, 2010, net losses of approximately $7 million and $13 million (before taxes), respectively, were recorded in accumulated other comprehensive income/(loss) in connection with cash flow hedges of the company’s borrowings. For both periods, $8 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 September 30, 2011 and December 31, 2010, the total notional amount of derivative instruments designated as net investment hedges was $2.0 billion and $1.9 billion, respectively. The weighted-average remaining maturity of these instruments at September 30, 2011 and December 31, 2010 was approximately 0.2 years and 0.4 years, respectively.

 

In addition, at December 31, 2010, the company had liabilities of $221 million, representing the fair value of derivative instruments that were previously designated in qualifying net investment hedging relationships, but were de-designated prior to December 31, 2010; this amount is expected to mature over the next 12 months. The notional amount of these instruments at December 31, 2010 was $1.6 billion, including original and offsetting transactions. No similar instruments were outstanding at September 30, 2011.

 

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 3.9 years. At September 30, 2011 and December 31, 2010, the total notional amount of forward contracts designated as cash flow hedges of forecasted royalty and cost transactions was $11.2 billion and $11.3 billion, respectively, with a weighted-average remaining maturity of 0.6 years and 0.8 years, respectively.

 

At September 30, 2011 and December 31, 2010, in connection with cash flow hedges of anticipated royalties and cost transactions, the company recorded net gains of $183 million and net losses of $147 million (before taxes), respectively, in accumulated other comprehensive income/(loss). Within these amounts $195 million of gains and $249 million of losses, 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. The maximum length of time over which the company is hedging its exposure to the variability in future cash flows is 2.3 years.

 

19



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

At September 30, 2011 and December 31, 2010, the total notional amount of cross-currency swaps designated as cash flow hedges of foreign currency denominated debt was $0.1 billion and $0.2 billion, respectively.

 

At September 30, 2011 and December 31, 2010, net losses of approximately $2 million and $1 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 approximately $1 million of losses are expected to be reclassified to net income within the next 12 months for both periods, providing an offsetting economic impact against the underlying transactions.

 

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 two years. 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 September 30, 2011 and December 31, 2010, the total notional amount of derivative instruments in economic hedges of foreign currency exposure was $9.6 billion and $13.0 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 September 30, 2011 and December 31, 2010, the total notional amount of derivative instruments in economic hedges of these compensation obligations was $0.9 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 September 30, 2011 and December 31, 2010.

 

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 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 September 30, 2011 and December 31, 2010.

 

The following tables provide a quantitative summary of the derivative and non-derivative instrument related risk management activity as of September 30, 2011 and December 31, 2010 as well as for the three months and nine months ended September 30, 2011 and 2010, respectively:

 

20



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

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

As of September 30, 2011 and December 31, 2010

 

 

 

Fair Value of Derivative Assets

 

Fair Value of Derivative Liabilities

 

 

 

Balance Sheet

 

 

 

 

 

Balance Sheet

 

 

 

 

 

(Dollars in millions)

 

Classification

 

9/30/2011

 

12/31/2010

 

Classification

 

9/30/2011

 

12/31/2010

 

Designated as hedging instruments:

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate contracts:

 

Prepaid expenses and other current assets

 

$

26

 

$

33

 

Other accrued expenses and liabilities

 

$

 

$

 

 

 

Investments and sundry assets

 

870

 

514

 

Other liabilities

 

 

 

Foreign exchange contracts:

 

Prepaid expenses and other current assets

 

358

 

224

 

Other accrued expenses and liabilities

 

363

 

498

 

 

 

Investments and sundry assets

 

4

 

22

 

Other liabilities

 

112

 

135

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fair value of derivative assets

 

 

 

$

1,257

 

$

794

 

Fair value of derivative liabilities

 

$

475

 

$

633

 

Not designated as hedging instruments:

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts:

 

Prepaid expenses and other current assets

 

$

101

 

$

242

 

Other accrued expenses and liabilities

 

$

60

 

$

370

 

 

 

Investments and sundry assets

 

26

 

51

 

Other liabilities

 

 

 

Equity contracts:

 

Prepaid expenses and other current assets

 

7

 

12

 

Other accrued expenses and liabilities

 

25

 

3

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fair value of derivative assets

 

 

 

$

134

 

$

305

 

Fair value of derivative liabilities

 

$

84

 

$

373

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total debt designated as hedging instruments:

 

 

 

 

 

 

 

 

 

 

 

 

 

Short-term debt

 

 

 

N/A

 

N/A

 

 

 

$

808

 

$

823

 

Long-term debt

 

 

 

N/A

 

N/A

 

 

 

1,915

 

1,746

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

$

1,391

 

$

1,099

 

 

 

$

3,282

 

$

3,576

 

 

N/A—not applicable

 

21



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

The Effect of Derivative Instruments in the Consolidated Statement of Earnings

For the three months ended September 30, 2011 and 2010

 

 

 

Gain (Loss) Recognized in Earnings

 

 

 

Consolidated

 

Recognized on

 

Attributable to Risk

 

(Dollars in millions)

 

Statement of

 

Derivatives(1)

 

Being Hedged(2)

 

For the three months ended September 30:

 

Earnings Line Item

 

2011

 

2010

 

2011

 

2010

 

Derivative instruments in fair value hedges:

 

 

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

Cost of financing

 

$

204

 

$

135

 

$

(166

)

$

(90

)

 

 

Interest expense

 

141

 

86

 

(115

)

(58

)

Derivative instruments not designated as hedging instruments:(1)

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

Other (income) and expense

 

183

 

584

 

N/A

 

N/A

 

Equity contracts

 

SG&A expense

 

(100

)

76

 

N/A

 

N/A

 

Warrants

 

Other (income) and expense