10-Q 1 a16-17246_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, 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 o

 

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

 

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

 

Large accelerated filer x

 

Accelerated filer o

 

 

 

Non-accelerated filer o

 

Smaller reporting company o

(Do not check if a smaller reporting company)

 

 

 

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

 

The registrant had 950,854,551 shares of common stock outstanding at September 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 nine months ended September 30, 2016 and 2015

3

 

 

Consolidated Statement of Comprehensive Income for the three and nine months ended September 30, 2016 and 2015

4

 

 

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

5

 

 

Consolidated Statement of Cash Flows for the nine months ended September 30, 2016 and 2015

7

 

 

Consolidated Statement of Changes in Equity for the nine months ended September 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 September 30,

 

Nine Months Ended September 30,

 

(Dollars in millions except per share amounts)

 

2016

 

2015

 

2016

 

2015

 

Revenue:

 

 

 

 

 

 

 

 

 

Services

 

$

12,938

 

$

12,327

 

$

38,347

 

$

37,290

 

Sales

 

5,872

 

6,501

 

18,542

 

20,990

 

Financing

 

417

 

452

 

1,260

 

1,403

 

Total revenue

 

19,226

 

19,280

 

58,149

 

59,682

 

Cost:

 

 

 

 

 

 

 

 

 

Services

 

8,418

 

8,067

 

25,492

 

24,776

 

Sales

 

1,536

 

1,544

 

4,496

 

4,895

 

Financing

 

259

 

233

 

760

 

733

 

Total cost

 

10,213

 

9,844

 

30,748

 

30,405

 

Gross profit

 

9,013

 

9,436

 

27,401

 

29,278

 

Expense and other (income):

 

 

 

 

 

 

 

 

 

Selling, general and administrative

 

4,732

 

4,731

 

16,093

 

15,273

 

Research, development and engineering

 

1,397

 

1,287

 

4,320

 

3,885

 

Intellectual property and custom development income

 

(528

)

(188

)

(1,110

)

(489

)

Other (income) and expense

 

(8

)

(133

)

281

 

(578

)

Interest expense

 

158

 

117

 

473

 

340

 

Total expense and other (income)

 

5,751

 

5,815

 

20,056

 

18,431

 

Income from continuing operations before income taxes

 

3,263

 

3,621

 

7,345

 

10,846

 

Provision for/(benefit from) income taxes

 

409

 

659

 

(31

)

1,943

 

Income from continuing operations

 

$

2,854

 

$

2,962

 

$

7,375

 

$

8,904

 

Loss from discontinued operations, net of tax

 

(1

)

(12

)

(4

)

(176

)

Net income

 

$

2,853

 

$

2,950

 

$

7,371

 

$

8,727

 

 

 

 

 

 

 

 

 

 

 

Earnings/(loss) per share of common stock:

 

 

 

 

 

 

 

 

 

Assuming dilution:

 

 

 

 

 

 

 

 

 

Continuing operations

 

$

2.98

 

$

3.02

 

$

7.67

 

$

9.03

 

Discontinued operations

 

0.00

 

(0.01

)

0.00

 

(0.18

)

Total

 

$

2.98

 

$

3.01

 

$

7.67

 

$

8.85

 

Basic:

 

 

 

 

 

 

 

 

 

Continuing operations

 

$

2.99

 

$

3.04

 

$

7.70

 

$

9.07

 

Discontinued operations

 

0.00

 

(0.01

)

0.00

 

(0.18

)

Total

 

$

2.99

 

$

3.03

 

$

7.70

 

$

8.89

 

 

 

 

 

 

 

 

 

 

 

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

 

 

 

 

 

 

 

 

 

Assuming dilution

 

957.3

 

979.0

 

960.7

 

986.0

 

Basic

 

954.0

 

975.1

 

957.7

 

981.8

 

 

 

 

 

 

 

 

 

 

 

Cash dividend per common share

 

$

1.40

 

$

1.30

 

$

4.10

 

$

3.70

 

 

(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 September 30,

 

Nine Months Ended September 30,

 

(Dollars in millions)

 

2016

 

2015

 

2016

 

2015

 

Net income

 

$

2,853

 

$

2,950

 

$

7,371

 

$

8,727

 

Other comprehensive income/(loss), before tax:

 

 

 

 

 

 

 

 

 

Foreign currency translation adjustments

 

(99

)

(1,015

)

(109

)

(1,365

)

Net changes related to available-for-sale securities:

 

 

 

 

 

 

 

 

 

Unrealized gains/(losses) arising during the period

 

(1

)

(102

)

(36

)

(85

)

Reclassification of (gains)/losses to net income

 

(1

)

0

 

36

 

0

 

Total net changes related to available-for-sale securities

 

(2

)

(101

)

0

 

(85

)

Unrealized gains/(losses) on cash flow hedges:

 

 

 

 

 

 

 

 

 

Unrealized gains/(losses) arising during the period

 

35

 

36

 

(221

)

467

 

Reclassification of (gains)/losses to net income

 

15

 

(273

)

26

 

(843

)

Total unrealized gains/(losses) on cash flow hedges

 

50

 

(237

)

(195

)

(376

)

Retirement-related benefit plans:

 

 

 

 

 

 

 

 

 

Prior service costs/(credits)

 

 

0

 

 

6

 

Net (losses)/gains arising during the period

 

11

 

(2

)

(57

)

14

 

Curtailments and settlements

 

4

 

11

 

19

 

19

 

Amortization of prior service (credits)/costs

 

(28

)

(25

)

(81

)

(76

)

Amortization of net (gains)/losses

 

696

 

823

 

2,079

 

2,479

 

Total retirement-related benefit plans

 

683

 

807

 

1,960

 

2,441

 

Other comprehensive income/(loss), before tax

 

632

 

(547

)

1,656

 

616

 

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

 

(192

)

(176

)

(213

)

(895

)

Other comprehensive income/(loss)

 

440

 

(724

)

1,442

 

(280

)

Total comprehensive income/(loss)

 

$

3,293

 

$

2,227

 

$

8,813

 

$

8,448

 

 

(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 September 30,

 

At December 31,

 

(Dollars in millions)

 

2016

 

2015

 

Assets:

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

9,039

 

$

7,686

 

Marketable securities

 

929

 

508

 

Notes and accounts receivable - trade (net of allowances of $325 in 2016 and $367 in 2015)

 

8,291

 

8,333

 

Short-term financing receivables (net of allowances of $532 in 2016 and $490 in 2015)

 

16,032

 

19,020

 

Other accounts receivable (net of allowances of $48 in 2016 and $51 in 2015)

 

873

 

1,201

 

Inventories, at lower of average cost or market:

 

 

 

 

 

Finished goods

 

433

 

352

 

Work in process and raw materials

 

1,297

 

1,199

 

Total inventories

 

1,729

 

1,551

 

Prepaid expenses and other current assets

 

4,539

 

4,205

 

Total current assets

 

41,433

 

42,504

 

Property, plant and equipment

 

30,842

 

29,342

 

Less: Accumulated depreciation

 

19,738

 

18,615

 

Property, plant and equipment — net

 

11,104

 

10,727

 

Long-term financing receivables (net of allowances of $116 in 2016 and $118 in 2015)

 

8,936

 

10,013

 

Prepaid pension assets

 

3,487

 

1,734

 

Deferred taxes

 

4,289

 

4,822

 

Goodwill

 

36,401

 

32,021

 

Intangible assets — net

 

4,881

 

3,487

 

Investments and sundry assets

 

5,075

 

5,187

 

Total assets

 

$

115,606

 

$

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 September 30,

 

At December 31,

 

(Dollars in millions)

 

2016

 

2015

 

Liabilities:

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Taxes

 

$

2,137

 

$

2,847

 

Short-term debt

 

6,920

 

6,461

 

Accounts payable

 

5,271

 

6,028

 

Compensation and benefits

 

3,958

 

3,560

 

Deferred income

 

10,815

 

11,021

 

Other accrued expenses and liabilities

 

5,346

 

4,353

 

Total current liabilities

 

34,447

 

34,269

 

Long-term debt

 

35,563

 

33,428

 

Retirement and nonpension postretirement benefit obligations

 

16,688

 

16,504

 

Deferred income

 

3,611

 

3,771

 

Other liabilities

 

8,138

 

8,099

 

Total liabilities

 

98,447

 

96,071

 

Equity:

 

 

 

 

 

IBM stockholders’ equity:

 

 

 

 

 

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

 

53,759

 

53,262

 

Shares authorized: 4,687,500,000

 

 

 

 

 

Shares issued:   2016 - 2,224,594,441

 

 

 

 

 

2015 - 2,221,223,449

 

 

 

 

 

Retained earnings

 

149,585

 

146,124

 

Treasury stock - at cost

 

(158,170

)

(155,518

)

Shares:  2016 - 1,273,739,890

 

 

 

 

 

2015 - 1,255,494,724

 

 

 

 

 

Accumulated other comprehensive income/(loss)

 

(28,164

)

(29,607

)

Total IBM stockholders’ equity

 

17,010

 

14,262

 

Noncontrolling interests

 

149

 

162

 

Total equity

 

17,159

 

14,424

 

Total liabilities and equity

 

$

115,606

 

$

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)

 

 

 

Nine Months Ended September 30,

 

(Dollars in millions)

 

2016

 

2015

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

7,371

 

$

8,727

 

Adjustments to reconcile net income to cash provided by operating activities

 

 

 

 

 

Depreciation

 

2,106

 

1,981

 

Amortization of intangibles

 

1,148

 

884

 

Stock-based compensation

 

403

 

369

 

Net (gain)/loss on asset sales and other

 

100

 

584

 

Loss on Microelectronics business disposal

 

 

48

 

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

 

2,174

 

(864

)

Net cash provided by operating activities

 

13,301

 

11,729

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Payments for property, plant and equipment

 

(2,594

)

(2,670

)

Proceeds from disposition of property, plant and equipment

 

234

 

314

 

Investment in software

 

(441

)

(407

)

Acquisition of businesses, net of cash acquired

 

(5,445

)

(821

)

Divestitures of businesses, net of cash transferred

 

35

 

(488

)

Non-operating finance receivables — net

 

1,130

 

1,334

 

Purchases of marketable securities and other investments

 

(4,021

)

(2,101

)

Proceeds from disposition of marketable securities and other investments

 

3,501

 

2,125

 

Net cash used in investing activities

 

(7,600

)

(2,714

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from new debt

 

8,368

 

3,701

 

Payments to settle debt

 

(5,616

)

(5,389

)

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

 

(864

)

1,080

 

Common stock repurchases

 

(2,632

)

(3,846

)

Common stock transactions — other

 

166

 

271

 

Cash dividends paid

 

(3,927

)

(3,636

)

Net cash used in financing activities

 

(4,504

)

(7,818

)

 

 

 

 

 

 

Effect of exchange rate changes on cash and cash equivalents

 

155

 

(194

)

Net change in cash and cash equivalents

 

1,352

 

1,004

 

 

 

 

 

 

 

Cash and cash equivalents at January 1

 

7,686

 

8,476

 

Cash and cash equivalents at September 30

 

$

9,039

 

$

9,480

 

 

(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

 

 

 

7,371

 

 

 

 

 

7,371

 

 

 

7,371

 

Other comprehensive income/(loss)

 

 

 

 

 

 

 

1,442

 

1,442

 

 

 

1,442

 

Total comprehensive income/(loss)

 

 

 

 

 

 

 

 

 

$

8,813

 

 

 

$

8,813

 

Cash dividends paid — common stock

 

 

 

(3,927

)

 

 

 

 

(3,927

)

 

 

(3,927

)

Common stock issued under employee plans (3,370,992 shares)

 

513

 

 

 

 

 

 

 

513

 

 

 

513

 

Purchases (787,805 shares) and sales (336,480 shares) of treasury stock under employee plans — net

 

 

 

16

 

(72

)

 

 

(56

)

 

 

(56

)

Other treasury shares purchased, not retired (17,793,841 shares)

 

 

 

 

 

(2,579

)

 

 

(2,579

)

 

 

(2,579

)

Changes in other equity

 

(16

)

0

 

 

 

 

 

(17

)

 

 

(17

)

Changes in noncontrolling interests

 

 

 

 

 

 

 

 

 

 

 

(12

)

(12

)

Equity - September 30, 2016

 

$

53,759

 

$

149,585

 

$

(158,170

)

$

(28,164

)

$

17,010

 

$

149

 

$

17,159

 

 

 

 

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

 

 

 

8,727

 

 

 

 

 

8,727

 

 

 

8,727

 

Other comprehensive income/(loss)

 

 

 

 

 

 

 

(280

)

(280

)

 

 

(280

)

Total comprehensive income/(loss)

 

 

 

 

 

 

 

 

 

$

8,448

 

 

 

$

8,448

 

Cash dividends paid — common stock

 

 

 

(3,636

)

 

 

 

 

(3,636

)

 

 

(3,636

)

Common stock issued under employee plans (4,349,552 shares)

 

556

 

 

 

 

 

 

 

556

 

 

 

556

 

Purchases (954,158 shares) and sales (484,817 shares) of treasury stock under employee plans — net

 

 

 

14

 

(93

)

 

 

(79

)

 

 

(79

)

Other treasury shares purchased, not retired (24,293,844 shares)

 

 

 

 

 

(3,861

)

 

 

(3,861

)

 

 

(3,861

)

Changes in other equity

 

(2

)

 

 

 

 

 

 

(2

)

 

 

(2

)

Changes in noncontrolling interests

 

 

 

 

 

 

 

 

 

 

 

11

 

11

 

Equity - September 30, 2015

 

$

53,220

 

$

142,898

 

$

(154,669

)

$

(28,155

)

$

13,294

 

$

157

 

$

13,450

 

 

(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 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 nine months ended September 30, 2016, the company’s benefit from income taxes is $31 million and its effective tax rate is (0.4) percent. See Taxes on pages 71 and 72 for additional information.

 

Noncontrolling interest amounts of $3.1 million and $2.4 million, net of tax, for the three months ended September 30, 2016 and 2015, respectively, and $7.5 million and $5.9 million, net of tax, for the nine months ended September 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 model rather than an 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.

 

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.

 

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Notes to Consolidated Financial Statements — (continued)

 

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. 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.

 

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

 

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Notes to Consolidated Financial Statements — (continued)

 

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 $86 million and $74 million at September 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 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 nine months ended September 30, 2016, a pre-tax impairment charge related to

 

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Notes to Consolidated Financial Statements — (continued)

 

certain property, plant and equipment of $218 million was recorded. There were no material impairments of non-financial assets for the nine months ended September 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 September 30, 2016 and December 31, 2015.

 

(Dollars in millions)

 

 

 

 

 

 

 

 

 

At September 30, 2016

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Assets:

 

 

 

 

 

 

 

 

 

Cash equivalents (1)

 

 

 

 

 

 

 

 

 

Time deposits and certificates of deposit

 

$

 

$

1,948

 

$

 

$

1,948

 

Money market funds

 

2,237

 

 

 

2,237

 

U.S. government securities

 

 

1,299

 

 

1,299

 

Canadian government securities

 

 

456

 

 

456

 

Other securities

 

 

34

 

 

34

 

Total

 

2,237

 

3,737

 

 

5,974

(6)

Debt securities - current (2)

 

 

929

 

 

929

(6)

Debt securities - noncurrent (3)

 

1

 

7

 

 

9

 

Available-for-sale equity investments (3)

 

12

 

 

 

12

 

Derivative assets (4)

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

 

919

 

 

919

 

Foreign exchange contracts

 

 

245

 

 

245

 

Equity contracts

 

 

2

 

 

2

 

Total

 

 

1,166

 

 

1,166

(7)

Total assets

 

$

2,250

 

$

5,840

 

$

 

$

8,090

(7)

Liabilities:

 

 

 

 

 

 

 

 

 

Derivative liabilities (5)

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

$

 

$

277

 

$

 

$

277

 

Equity contracts

 

 

9

 

 

9

 

Total liabilities

 

$

 

$

286

 

$

 

$

286

(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 September 30, 2016 were $198 million and $967 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 September 30, 2016 were $282 million and $3 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 $185 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 nine months ended September 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 September 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 $35,563 million and $33,428 million, and the estimated fair value was $38,455 million and $35,220 million at September 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 September 30, 2016:

 

Cost

 

Gains

 

Losses

 

Value

 

Debt securities — noncurrent(1)

 

$

6

 

$

3

 

$

 

$

9

 

Available-for-sale equity investments(1)

 

$

3

 

$

9

 

$

0

 

$

12

 

 


(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 September 30:

 

2016

 

2015

 

Proceeds

 

$

1

 

$

1

 

Gross realized gains (before taxes)

 

1

 

0

 

Gross realized losses (before taxes)

 

 

0

 

 

 

 

 

 

 

(Dollars in millions)

 

 

 

 

 

For the nine months ended September 30:

 

2016

 

2015

 

Proceeds

 

$

150

 

$

7

 

Gross realized gains (before taxes)

 

1

 

1

 

Gross realized losses (before taxes)

 

37

 

1

 

 

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 September 30:

 

2016

 

2015

 

Net unrealized gains/(losses) arising during the period

 

$

(1

)

$

(63

)

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

 

(1

)

0

 

 


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

 

(Dollars in millions)

 

 

 

 

 

For the nine months ended September 30:

 

2016

 

2015

 

Net unrealized gains/(losses) arising during the period

 

$

(22

)

$

(52

)

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

 

22

 

0

 

 


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

 

The contractual maturities of substantially all available-for-sale debt securities are less than one year at September 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 September 30, 2016 and December 31, 2015 was $64 million and $28 million, respectively, for which no collateral was posted at September 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 September 30, 2016 and December 31, 2015 was $1,166 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 $185 million and $139 million at September 30, 2016 and December 31, 2015, respectively, of liabilities included in master netting arrangements with those counterparties. Additionally, at September 30, 2016 and December 31, 2015, this exposure was reduced by $224 million and $90 million of cash collateral, and $100 million and $40 million of non-cash collateral in U.S. Treasury securities, respectively, received by the company. At September 30, 2016 and December 31, 2015, the net exposure related to derivative assets recorded in the Consolidated Statement of Financial Position was $656 million and $726 million, respectively.  At September 30, 2016 and December 31, 2015, the net exposure related to derivative liabilities recorded in the Consolidated Statement of Financial Position was $100 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 September 30,

 

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Notes to Consolidated Financial Statements — (continued)

 

2016 or December 31, 2015 for the right to reclaim cash collateral. The amount recognized in accounts payable for the obligation to return cash collateral was $224 million and $90 million at September 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 September 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-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, 2016 and December 31, 2015, the total notional amount of the company’s interest rate swaps was $7.3 billion at both periods. The weighted-average remaining maturity of these instruments at September 30, 2016 and December 31, 2015 was approximately 6.5 years and 7.2 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, 2016 and December 31, 2015.

 

At September 30, 2016 and December 31, 2015, net gains of less than $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, less than $1 million of gains, respectively, are expected to be reclassified to net income within the next 12 months, providing an offsetting economic impact against the underlying 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, 2016 and December 31, 2015, the total notional amount of derivative instruments designated as net investment hedges was $9.1 billion and $5.5 billion, respectively. At  September 30, 2016 and December 31, 2015, the weighted-average remaining maturity of these instruments was approximately 0.2 years at both dates.

 

16



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

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 has hedged its exposure to the variability in future cash flows is four years. At September 30, 2016 and December 31, 2015, the total notional amount of forward contracts designated as cash flow hedges of forecasted royalty and cost transactions was $7.8 billion and $8.2 billion, respectively. The weighted-average remaining maturity of these instruments at September 30, 2016 and December 31, 2015 was 0.6 years and 0.7 years, respectively.

 

At September 30, 2016 and December 31, 2015, in connection with cash flow hedges of anticipated royalties and cost transactions, the company recorded net losses of $45 million and net gains of $147 million (before taxes), respectively, in accumulated other comprehensive income/(loss). Within these amounts, $108 million of losses and $121 million of gains, respectively, are expected to be reclassified to net income within the next 12 months, providing an offsetting economic impact against the underlying anticipated transactions.

 

Foreign Currency Denominated Borrowings

 

The company is exposed to exchange rate volatility on foreign currency denominated debt. To manage this risk, the company employs cross-currency swaps to convert fixed-rate foreign currency denominated debt to fixed-rate debt denominated in the functional currency of the borrowing entity. These swaps are accounted for as cash flow hedges. The maximum length of time over which the company has hedged its exposure to the variability in future cash flows is approximately nine years. At September 30, 2016 the total notional amount of cross-currency swaps designated as cash flow hedges of foreign currency denominated debt was $1.4 billion. At December 31, 2015, no amounts were outstanding under this program.

 

At September 30, 2016 and December 31, 2015, in connection with cash flow hedges of foreign currency denominated borrowings, the company recorded net losses of $4 million and net losses of $2 million (before taxes), respectively, in accumulated other comprehensive income/(loss). Within these amounts, $25 million of gains and less than $1 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 exposure.

 

Subsidiary Cash and Foreign Currency Asset/Liability Management

 

The company uses its Global Treasury Centers to manage the cash of its subsidiaries. These centers principally use currency swaps to convert cash flows in a cost-effective manner. In addition, the company uses foreign exchange forward contracts to economically hedge, on a net basis, the foreign currency exposure of a portion of the company’s nonfunctional currency assets and liabilities. The terms of these forward and swap contracts are generally less than one year. The changes in the fair values of these contracts and of the underlying hedged exposures are generally offsetting and are recorded in other (income) and expense in the Consolidated Statement of Earnings. At September 30, 2016 and December 31, 2015, the total notional amount of derivative instruments in economic hedges of foreign currency exposure was $13.7 billion and $11.7 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, and are recorded at fair value with gains or losses also reported in SG&A expense in the Consolidated Statement of Earnings. At September 30, 2016 and December 31, 2015, the total notional amount of derivative instruments in economic hedges of these compensation obligations was $1.2 billion for both periods.

 

17



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

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, 2016 and December 31, 2015.

 

The company is exposed to a potential loss if a client fails to pay amounts due under contractual terms. The company may utilize credit default swaps to economically hedge its credit exposures. 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, 2016 and December 31, 2015.

 

The company is exposed to market volatility on certain investment securities. The company may utilize options or forwards to economically hedge its market exposure. The derivatives are recorded at fair value with gains and losses reported in other (income) and expense in the Consolidated Statement of Earnings. At September 30, 2016 the company did not have any derivative instruments relating to this program outstanding. At December 31, 2015 the total notional amount of derivative instruments in economic hedges of investment securities was less than $0.1 billion.

 

The following tables provide a quantitative summary of the derivative and non-derivative instrument-related risk management activity as of September 30, 2016 and December 31, 2015, as well as for the three and nine months ended September 30, 2016 and 2015, respectively.

 

18



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, 2016 and December 31, 2015

 

 

 

Fair Value of Derivative Assets

 

Fair Value of Derivative Liabilities

 

 

 

Balance Sheet

 

 

 

 

 

Balance Sheet

 

 

 

 

 

(Dollars in millions) 

 

Classification

 

9/30/2016

 

12/31/2015

 

Classification

 

9/30/2016

 

12/31/2015

 

Designated as hedging instruments:

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate contracts:

 

Prepaid expenses and other current assets

 

$

 

$

 

Other accrued expenses and liabilities

 

$

 

$

 

 

 

Investments and sundry assets

 

919

 

656

 

Other liabilities

 

 

3

 

Foreign exchange contracts:

 

Prepaid expenses and other current assets

 

123

 

197

 

Other accrued expenses and liabilities

 

200

 

70

 

 

 

Investments and sundry assets

 

49

 

5

 

Other liabilities

 

3

 

19

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fair value of derivative assets

 

 

 

$

1,091

 

$

858

 

Fair value of derivative liabilities

 

$

203

 

$

92

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Not designated as hedging instruments:

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts:

 

Prepaid expenses and other current assets

 

$

73

 

$

90

 

Other accrued expenses and liabilities

 

$

74

 

$

75

 

 

 

Investments and sundry assets

 

0

 

40

 

Other liabilities

 

 

 

Equity contracts:

 

Prepaid expenses and other current assets

 

2

 

6

 

Other accrued expenses and liabilities

 

9

 

19

 

 

 

Investments and sundry assets

 

 

 

Other liabilities

 

 

 

Fair value of derivative assets

 

 

 

$

75

 

$

136

 

Fair value of derivative liabilities

 

$

82

 

$

94

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total debt designated as hedging instruments:

 

 

 

 

 

 

 

 

 

 

 

 

 

Short-term debt

 

 

 

N/A

 

N/A

 

 

 

$

829

 

$

 

Long-term debt

 

 

 

N/A

 

N/A

 

 

 

$

8,412

 

$

7,945

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

$

1,166

 

$

994

 

 

 

$

9,526

 

$

8,131

 

 


N/A-not applicable

 

19



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, 2016 and 2015

 

 

 

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

 

2016

 

2015

 

2016

 

2015

 

Derivative instruments in fair value hedges(5):

 

 

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

Cost of financing

 

$

(20

)

$

125

 

$

40

 

$

(99

)

 

 

Interest expense

 

(21

)

112

 

43

 

(88

)

Derivative instruments not designated as hedging instruments(1):

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

Other (income) and expense

 

30

 

208

 

N/A

 

N/A

 

Interest rate contracts

 

Other (income) and expense

 

0

 

0

 

N/A

 

N/A

 

Equity contracts

 

SG&A expense

 

45

 

(81

)

N/A

 

N/A

 

 

 

Other (income) and expense

 

0

 

(8

)

N/A

 

N/A

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

$

34

 

$

357

 

$

83

 

$

(187

)

 

 

 

Gain (Loss) Recognized in Earnings and Other Comprehensive Income

 

 

 

 

 

 

 

 

 

 

 

 

 

(Ineffectiveness) and

 

(Dollars in millions)

 

Effective Portion

 

Consolidated

 

Effective Portion Reclassified

 

Amounts Excluded from

 

For the three months

 

Recognized in OCI

 

Statement of

 

from AOCI

 

Effectiveness Testing(3)

 

ended September 30:

 

2016

 

2015

 

Earnings Line Item

 

2016

 

2015

 

2016

 

2015

 

Derivative instruments in cash flow hedges:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

$

 

$

 

Interest expense

 

$

(7

)

$

0

 

$

 

$

 

Foreign exchange contracts

 

35

 

36

 

Other (income) and expense

 

(6

)

185

 

(1

)

0

 

 

 

 

 

 

 

Cost of sales

 

(4

)

46

 

 

 

 

 

 

 

 

 

SG&A expense

 

2

 

43

 

 

 

Instruments in net investment hedges(4):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

(131

)

73

 

Interest expense

 

 

 

25

 

4

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

(96

)

$

109

 

 

 

$

(15

)

$

273

 

$

24

 

$

4

 

 


N/A-not applicable

 

Note: OCI represents Other comprehensive income/(loss) in the Consolidated Statement of Comprehensive Income and AOCI represents Accumulated other comprehensive income/(loss) in the Consolidated Statement of Changes in Equity.

 

(1)         The amount includes changes in clean fair values of the derivative instruments in fair value hedging relationships and the periodic accrual for coupon payments required under these derivative contracts.

(2)         The amount includes basis adjustments to the carrying value of the hedged item recorded during the period and amortization of basis adjustments recorded on de-designated hedging relationships during the period.

(3)         The amount of gain/(loss) recognized in income represents ineffectiveness on hedge relationships.

(4)         Instruments in net investment hedges include derivative and non-derivative instruments.

(5)         For the three month periods ended September 30, 2016 and September 30, 2015, fair value hedges resulted in a loss of $3 million and a gain of $1 million in ineffectiveness, respectively.

 

20



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

The Effect of Derivative Instruments in the Consolidated Statement of Earnings

For the nine months ended September 30, 2016 and 2015

 

 

 

Gain (Loss) Recognized in Earnings

 

 

 

Consolidated

 

Recognized on

 

Attributable to Risk

 

(Dollars in millions)

 

Statement of

 

Derivatives(1)

 

Being Hedged(2)

 

For the nine months ended September 30:

 

Earnings Line Item

 

2016

 

2015

 

2016

 

2015

 

Derivative instruments in fair value hedges(4):

 

 

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

Cost of financing

 

$

195

 

$

145

 

$

(127

)

$

(63

)

 

 

Interest expense

 

214

 

121

 

(140

)

(53

)

Derivative instruments not designated as hedging instruments(1):

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

Other (income) and expense

 

335

 

134

 

N/A

 

N/A

 

Interest rate contracts

 

Other (income) and expense

 

0

 

(2

)

N/A

 

N/A

 

Equity contracts

 

SG&A expense

 

87

 

(63

)

N/A

 

N/A

 

 

 

Other (income) and expense

 

(1

)

(5

)

N/A

 

N/A

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

$

830

 

$

330

 

$

(267

)

$

(116

)

 

 

 

Gain (Loss) Recognized in Earnings and Other Comprehensive Income

 

 

 

 

 

 

 

 

 

 

 

 

 

(Ineffectiveness) and

 

(Dollars in millions)

 

Effective Portion

 

Consolidated

 

Effective Portion Reclassified

 

Amounts Excluded from

 

For the nine months

 

Recognized in OCI

 

Statement of

 

from AOCI

 

Effectiveness Testing

 

ended September 30:

 

2016

 

2015

 

Earnings Line Item

 

2016

 

2015

 

2016

 

2015

 

Derivative instruments in cash flow hedges:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

$

 

$

 

Interest expense

 

$

(17

)

$

0

 

$

 

$

 

Foreign exchange contracts

 

(221

)

467

 

Other (income) and expense

 

6

 

565

 

(1

)

4

 

 

 

 

 

 

 

Cost of sales

 

(14

)

154

 

 

 

 

 

 

 

 

 

SG&A expense

 

(1

)

124

 

 

 

Instruments in net investment hedges(3):

 

 

 

 

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