10-Q 1 a18-8695_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 MARCH 31, 2018

 

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, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer x

 

Accelerated filer ¨

 

 

 

Non-accelerated filer o

 

Smaller reporting company ¨

(Do not check if a smaller reporting company)

 

 

 

 

Emerging growth company ¨

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act).  o

 

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 917,968,306 shares of common stock outstanding at March 31, 2018.

 

 

 



Table of Contents

 

Index

 

 

Page

Part I - Financial Information:

 

 

 

Item 1. Consolidated Financial Statements (Unaudited):

 

 

 

Consolidated Statement of Earnings for the three months ended March 31, 2018 and 2017

3

 

 

Consolidated Statement of Comprehensive Income for the three months ended March 31, 2018 and 2017

4

 

 

Consolidated Statement of Financial Position at March 31, 2018 and December 31, 2017

5

 

 

Consolidated Statement of Cash Flows for the three months ended March 31, 2018 and 2017

7

 

 

Consolidated Statement of Changes in Equity for the three months ended March 31, 2018 and 2017

8

 

 

Notes to Consolidated Financial Statements

10

 

 

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

49

 

 

Item 4. Controls and Procedures

74

 

 

Part II - Other Information:

 

 

 

Item 1. Legal Proceedings

74

 

 

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

74

 

 

Item 5. Other Information

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 March 31,

 

(Dollars in millions except per share amounts)

 

2018

 

2017

 

Revenue:

 

 

 

 

 

Services

 

$

12,961

 

$

12,342

 

Sales

 

5,700

 

5,404

 

Financing

 

410

 

409

 

Total revenue

 

19,072

 

18,155

 

Cost:

 

 

 

 

 

Services

 

8,835

 

8,401

*

Sales

 

1,722

 

1,530

*

Financing

 

269

 

279

 

Total cost

 

10,825

 

10,211

*

Gross profit

 

8,247

 

7,944

*

Expense and other (income):

 

 

 

 

 

Selling, general and administrative

 

5,445

 

5,027

*

Research, development and engineering

 

1,405

 

1,484

*

Intellectual property and custom development income

 

(317

)

(445

)

Other (income) and expense

 

413

 

319

*

Interest expense

 

165

 

135

 

Total expense and other (income)

 

7,111

 

6,521

*

Income from continuing operations before income taxes

 

1,136

 

1,424

 

Provision for/(benefit from) income taxes

 

(540

)

(329

)

Income from continuing operations

 

$

1,675

 

$

1,753

 

Income/(loss) from discontinued operations, net of tax

 

4

 

(3

)

Net income

 

$

1,679

 

$

1,750

 

 

 

 

 

 

 

Earnings/(loss) per share of common stock:

 

 

 

 

 

Assuming dilution:

 

 

 

 

 

Continuing operations

 

$

1.81

 

$

1.85

 

Discontinued operations

 

0.00

 

0.00

 

Total

 

$

1.81

 

$

1.85

 

Basic:

 

 

 

 

 

Continuing operations

 

$

1.82

 

$

1.86

 

Discontinued operations

 

0.00

 

0.00

 

Total

 

$

1.82

 

$

1.86

 

 

 

 

 

 

 

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

 

 

 

 

 

Assuming dilution

 

925.4

 

947.8

 

Basic

 

920.7

 

942.4

 

 

 

 

 

 

 

Cash dividend per common share

 

$

1.50

 

$

1.40

 

 


* Recast to reflect adoption of the FASB guidance on presentation of net periodic pension and nonpension postretirement benefit costs.

 

(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 March 31,

 

(Dollars in millions)

 

2018

 

2017

 

Net income

 

$

1,679

 

$

1,750

 

Other comprehensive income/(loss), before tax:

 

 

 

 

 

Foreign currency translation adjustments

 

(167

)

161

 

Net changes related to available-for-sale securities:

 

 

 

 

 

Unrealized gains/(losses) arising during the period

 

(2

)

(1

)

Reclassification of (gains)/losses to net income

 

0

 

1

 

Total net changes related to available-for-sale securities

 

(3

)

0

 

Unrealized gains/(losses) on cash flow hedges:

 

 

 

 

 

Unrealized gains/(losses) arising during the period

 

61

 

(33

)

Reclassification of (gains)/losses to net income

 

(54

)

(98

)

Total unrealized gains/(losses) on cash flow hedges

 

7

 

(130

)

Retirement-related benefit plans:

 

 

 

 

 

Prior service costs/(credits)

 

(1

)

0

 

Net (losses)/gains arising during the period

 

2

 

61

 

Curtailments and settlements

 

0

 

(1

)

Amortization of prior service (credits)/costs

 

(19

)

(21

)

Amortization of net (gains)/losses

 

753

 

710

 

Total retirement-related benefit plans

 

735

 

748

 

Other comprehensive income/(loss), before tax

 

573

 

779

 

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

 

(143

)

(92

)

Other comprehensive income/(loss), net of tax

 

430

 

688

 

Total comprehensive income/(loss)

 

$

2,109

 

$

2,438

 

 

(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 March 31,

 

At December 31,

 

(Dollars in millions)

 

2018

 

2017

 

Assets:

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

11,949

 

$

11,972

 

Restricted cash

 

313

 

262

*

Marketable securities

 

893

 

608

 

Notes and accounts receivable - trade (net of allowances of $307 in 2018 and $297 in 2017)

 

7,778

 

8,928

 

Short-term financing receivables (net of allowances of $287 in 2018 and $261 in 2017)

 

20,245

 

21,721

 

Other accounts receivable (net of allowances of $37 in 2018 and $36 in 2017)

 

1,206

 

981

 

Inventories, at lower of average cost or market:

 

 

 

 

 

Finished goods

 

544

 

333

 

Work in process and raw materials

 

1,209

 

1,250

 

Total inventories

 

1,753

 

1,583

 

Deferred costs

 

2,413

 

1,820

**

Prepaid expenses and other current assets

 

2,573

 

1,860

* **

Total current assets

 

49,122

 

49,735

 

Property, plant and equipment

 

32,775

 

32,331

 

Less: Accumulated depreciation

 

21,497

 

21,215

 

Property, plant and equipment — net

 

11,278

 

11,116

 

Long-term financing receivables (net of allowances of $54 in 2018 and $74 in 2017)

 

8,856

 

9,550

 

Prepaid pension assets

 

5,129

 

4,643

 

Deferred costs

 

2,593

 

2,136

**

Deferred taxes

 

5,111

 

4,862

 

Goodwill

 

36,732

 

36,788

 

Intangible assets — net

 

3,521

 

3,742

 

Investments and sundry assets

 

2,942

 

2,783

**

Total assets

 

$

125,285

 

$

125,356

 

 


*   Recast to reflect adoption of the FASB guidance on restricted cash.

** Recast to conform to current period presentation.

 

(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 March 31,

 

At December 31,

 

(Dollars in millions)

 

2018

 

2017

 

Liabilities:

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Taxes

 

$

2,918

 

$

4,219

 

Short-term debt

 

5,977

 

6,987

 

Accounts payable

 

5,736

 

6,451

 

Compensation and benefits

 

3,289

 

3,644

 

Deferred income

 

13,059

 

11,552

 

Other accrued expenses and liabilities

 

4,754

 

4,510

 

Total current liabilities

 

35,733

 

37,363

 

Long-term debt

 

40,410

 

39,837

 

Retirement and nonpension postretirement benefit obligations

 

16,750

 

16,720

 

Deferred income

 

3,852

 

3,746

 

Other liabilities

 

10,250

 

9,965

 

Total liabilities

 

106,995

 

107,631

 

Equity:

 

 

 

 

 

IBM stockholders’ equity:

 

 

 

 

 

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

 

54,712

 

54,566

 

Shares authorized: 4,687,500,000

 

 

 

 

 

Shares issued: 2018 - 2,230,466,068

 

 

 

 

 

2017 - 2,229,428,813

 

 

 

 

 

Retained earnings

 

156,371

 

153,126

 

Treasury stock - at cost

 

(164,334

)

(163,507

)

Shares: 2018 - 1,312,497,762

 

 

 

 

 

2017 - 1,307,249,588

 

 

 

 

 

Accumulated other comprehensive income/(loss)

 

(28,583

)

(26,592

)

Total IBM stockholders’ equity

 

18,166

 

17,594

 

Noncontrolling interests

 

124

 

131

 

Total equity

 

18,290

 

17,725

 

Total liabilities and equity

 

$

125,285

 

$

125,356

 

 

(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)

 

 

 

Three Months Ended March 31,

 

(Dollars in millions)

 

2018

 

2017

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

1,679

 

$

1,750

 

Adjustments to reconcile net income to cash provided by operating activities

 

 

 

 

 

Depreciation

 

774

 

709

 

Amortization of intangibles

 

340

 

390

 

Stock-based compensation

 

116

 

129

 

Net (gain)/loss on asset sales and other

 

34

 

13

 

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

 

1,658

 

964

 

Net cash provided by operating activities

 

4,602

 

3,955

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Payments for property, plant and equipment

 

(870

)

(740

)

Proceeds from disposition of property, plant and equipment

 

103

 

58

 

Investment in software

 

(126

)

(137

)

Acquisition of businesses, net of cash acquired

 

(71

)

(109

)

Divestitures of businesses, net of cash transferred

 

 

(1

)

Non-operating finance receivables — net

 

(89

)

1,570

 

Purchases of marketable securities and other investments

 

(1,521

)

(1,320

)*

Proceeds from disposition of marketable securities and other investments

 

810

 

981

 

Net cash (used in)/provided by investing activities

 

(1,764

)

303

*

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from new debt

 

2,170

 

2,887

 

Payments to settle debt

 

(3,295

)

(1,531

)

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

 

412

 

(880

)

Common stock repurchases

 

(777

)

(1,293

)

Common stock repurchases for tax withholdings

 

(53

)

(50

)

Financing — other

 

16

 

54

 

Cash dividends paid

 

(1,382

)

(1,321

)

Net cash used in financing activities

 

(2,909

)

(2,134

)

 

 

 

 

 

 

Effect of exchange rate changes on cash, cash equivalents and restricted cash

 

100

 

100

 

Net change in cash, cash equivalents and restricted cash

 

28

 

2,223

*

 

 

 

 

 

 

Cash, cash equivalents and restricted cash at January 1

 

12,234

 

8,073

*

Cash, cash equivalents and restricted cash at March 31

 

$

12,262

 

$

10,296

*

 


* Recast to reflect adoption of the FASB guidance on restricted cash.

 

(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, 2018

 

$

54,566

 

$

153,126

 

$

(163,507

)

$

(26,592

)

$

17,594

 

$

131

 

$

17,725

 

Cumulative effect of change in accounting principle:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

 

 

524

 

 

 

 

 

524

 

 

 

524

 

Stranded tax effects/other *

 

 

 

2,422

 

 

 

(2,422

)

 

 

 

 

 

 

Net income plus other comprehensive income/(loss):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

1,679

 

 

 

 

 

1,679

 

 

 

1,679

 

Other comprehensive income/(loss)

 

 

 

 

 

 

 

430

 

430

 

 

 

430

 

Total comprehensive income/(loss)

 

 

 

 

 

 

 

 

 

$

2,109

 

 

 

$

2,109

 

Cash dividends paid — common stock

 

 

 

(1,382

)

 

 

 

 

(1,382

)

 

 

(1,382

)

Common stock issued under employee plans (1,037,255 shares)

 

146

 

 

 

 

 

 

 

146

 

 

 

146

 

Purchases (325,635 shares) and sales (45,878 shares) of treasury stock under employee plans — net

 

 

 

1

 

(47

)

 

 

(45

)

 

 

(45

)

Other treasury shares purchased, not retired (4,968,417 shares)

 

 

 

 

 

(780

)

 

 

(780

)

 

 

(780

)

Changes in noncontrolling interests

 

 

 

 

 

 

 

 

 

 

 

(7

)

(7

)

Equity - March 31, 2018

 

$

54,712

 

$

156,371

 

$

(164,334

)

$

(28,583

)

$

18,166

 

$

124

 

$

18,290

 

 


* Reflects the adoption of the FASB guidance on stranded tax effects, hedging and financial instruments. Refer to note 2, “Accounting Changes”.

 

(Amounts may not add due to rounding.)

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

 

8



Table of Contents

 

INTERNATIONAL BUSINESS MACHINES CORPORATION
 AND SUBSIDIARY COMPANIES
CONSOLIDATED STATEMENT OF CHANGES IN EQUITY — (CONTINUED)
(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, 2017

 

$

53,935

 

$

152,759

 

$

(159,050

)

$

(29,398

)

$

18,246

 

$

146

 

$

18,392

 

Cumulative effect of change in accounting principle *

 

 

 

102

 

 

 

 

 

102

 

 

 

102

 

Net income plus other comprehensive income/(loss):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

1,750

 

 

 

 

 

1,750

 

 

 

1,750

 

Other comprehensive income/(loss)

 

 

 

 

 

 

 

688

 

688

 

 

 

688

 

Total comprehensive income/(loss)

 

 

 

 

 

 

 

 

 

$

2,438

 

 

 

$

2,438

 

Cash dividends paid — common stock

 

 

 

(1,321

)

 

 

 

 

(1,321

)

 

 

(1,321

)

Common stock issued under employee plans (1,059,160 shares)

 

169

 

 

 

 

 

 

 

169

 

 

 

169

 

Purchases (289,364 shares) and sales (43,179 shares) of treasury stock under employee plans — net

 

 

 

1

 

(45

)

 

 

(44

)

 

 

(44

)

Other treasury shares purchased, not retired (7,183,494 shares)

 

 

 

 

 

(1,264

)

 

 

(1,264

)

 

 

(1,264

)

Changes in noncontrolling interests

 

 

 

 

 

 

 

 

 

 

 

(25

)

(25

)

Equity - March 31, 2017

 

$

54,104

 

$

153,292

 

$

(160,359

)

$

(28,710

)

$

18,327

 

$

121

 

$

18,448

 

 


* Reflects the adoption of the FASB guidance on intra-entity transfers of assets.

 

(Amounts may not add due to rounding.)

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

 

9



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. For a discussion of significant estimates and judgments made in recognizing revenue under the new revenue standard, see note 3, “Revenue Recognition”. Also, refer to the company’s 2017 Annual Report on pages 70 to 73, for a discussion of the company’s critical accounting estimates.

 

Noncontrolling interest amounts of $7.8 million and $3.6 million, net of tax, for the three months ended March 31, 2018 and 2017, respectively, are included as a reduction within other (income) and expense in the Consolidated Statement of Earnings.

 

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 2017 Annual Report.

 

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 has established an implementation team and is evaluating the impact of the new guidance.

 

The FASB issued guidance in February 2016, with amendments in 2018, 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 third-party 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. There are certain practical expedients that can be elected which the company is currently evaluating for application. The guidance is effective January 1, 2019 and early adoption is permitted. The company will adopt the guidance as of the effective date.

 

A cross-functional implementation team has been established which is evaluating the lease portfolio, system, process and policy change requirements. The company has made progress in gathering the necessary data elements for the lease population and a system provider has been selected, with system configuration and implementation underway. The company is currently evaluating the impact of the new guidance on its consolidated financial results and expects it will have a material impact on the Consolidated Statement of Financial Position. The company is currently planning on electing the package of practical expedients to not reassess prior conclusions related to contracts containing leases, lease classification and initial direct costs and is evaluating the other practical expedients available under the guidance.

 

The company’s operating lease commitments were $6.6 billion at December 31, 2017. In 2017, the use of third-party residual value guarantee insurance resulted in the company recognizing $452 million of sales-type lease revenue that would otherwise have been recognized over the lease period as operating lease revenue. The company continues to assess the potential impacts of the guidance, including normal ongoing business dynamics or potential changes in contracting terms.

 

10



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

Standards Implemented

 

In February 2018, the FASB issued guidance that allows entities to elect an option to reclassify the stranded tax effects related to the application of the Tax Cuts and Jobs Act (“U.S. tax reform”) from accumulated other comprehensive income/(loss) (“AOCI”) to retained earnings. The guidance is effective January 1, 2019 with early adoption permitted, and can be applied either in the period of adoption or retrospectively to all applicable periods. The company adopted the guidance effective January 1, 2018, and elected not to reclassify prior periods. In accordance with its accounting policy, the company releases income tax effects from AOCI once the reason the tax effects were established cease to exist (e.g., when available-for-sale debt securities are sold or if a pension plan is liquidated). This guidance allows for the reclassification of stranded tax effects as a result of the change in tax rates from U.S. tax reform to be recorded upon adoption of the guidance rather than at an actual cessation date. At adoption, $2,420 million was reclassified from AOCI to retained earnings, primarily comprised of amounts relating to retirement-related benefit plans.

 

In August 2017, the FASB issued guidance to simplify the application of current hedge accounting in certain areas, better portray the economic results of an entity’s risk management activities in its financial statements and make targeted improvements to presentation and disclosure requirements. The guidance is effective January 1, 2019 with early adoption permitted. The company adopted the guidance as of January 1, 2018, and it did not have a material impact in the consolidated financial results.

 

In March 2017, the FASB issued guidance that impacts the presentation of net periodic pension and postretirement benefit costs (“net benefit cost”). Under the guidance, the service cost component of net benefit cost continues to be presented within cost, selling, general and administrative expense and research, development and engineering expense in the Consolidated Statement of Earnings, unless eligible for capitalization. The other components of net benefit cost are presented separately from service cost within other (income) and expense in the Consolidated Statement of Earnings. The guidance was effective January 1, 2018 with early adoption permitted. The company adopted the guidance as of the effective date. The guidance is primarily a change in financial statement presentation and did not have a material impact in the consolidated financial results. This presentation change was applied retrospectively upon adoption. For the period ended March 31, 2017, $172 million, $125 million, and $49 million was recast from total cost, selling, general and administrative (SG&A) expense, and research, development, and engineering (RD&E) expense, respectively, into other (income) and expense. Refer to note 9, “Retirement-Related Benefits,” for additional information.

 

In January 2016, the FASB issued guidance which addresses aspects of recognition, measurement, presentation and disclosure of financial instruments. The guidance was effective January 1, 2018 and early adoption was not permitted except for limited provisions. The company adopted the guidance on the effective date. Certain equity investments are now measured at fair value with changes recognized in net income. The amendment also simplified the impairment test of equity investments that lack readily determinable fair value. The guidance did not 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 depicts 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 specific disclosures relating to revenue recognition. The company adopted the guidance effective January 1, 2018 using the modified retrospective transition method. At adoption, $557 million was reclassified from notes and accounts receivable-trade and deferred income-current to prepaid expenses and other current assets to establish the opening balance for net contract assets. In-scope sales commission costs previously recorded in the Consolidated Statement of Earnings were capitalized in deferred costs in accordance with the transition guidance, in the amount of $737 million. Deferred income of $29 million was recorded for certain software licenses that will be recognized over time versus at a point in time under previous guidance. Additionally, net deferred taxes were reduced $184 million in the Consolidated Statement of Financial Position, resulting in a cumulative-effect net increase to retained earnings of $524 million. The guidance did not have a material impact in the company’s consolidated financial results. The company expects revenue recognition for its broad portfolio of hardware, software, and services offerings to remain largely unchanged. Refer to note 3, “Revenue Recognition,” for additional information, including further discussion on the impact of adoption and changes in accounting policies relating to revenue recognition.

 

In January 2017, the FASB issued guidance which clarifies the definition of a business. The guidance provides a more robust framework to use in determining when a set of assets and activities acquired or sold is a business. The guidance was effective January 1, 2018 and early adoption was permitted. The company adopted the guidance effective January 1, 2017, and it did not have a material impact in the consolidated financial results.

 

11



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

In October 2016, the FASB issued guidance which requires an entity to recognize the income tax consequences of intra-entity transfers of assets, other than inventory, at the time of transfer. Assets within the scope of the guidance include intellectual property and property, plant and equipment. The guidance was effective January 1, 2018 and early adoption was permitted. The company adopted the guidance on January 1, 2017 using the required modified retrospective method. At adoption, $95 million and $47 million were reclassified from investments and sundry assets and prepaid expenses and other current assets, respectively into retained earnings. Additionally, net deferred taxes of $244 million were established in deferred taxes in the Consolidated Statement of Financial Position, resulting in a cumulative-effect net increase to retained earnings of $102 million. In January 2017, the company had one transaction that generated a $582 million benefit to income tax expense, income from continuing operations and net income and a benefit to both basic and diluted earnings per share of $0.62 per share for the year ended December 31, 2017. The benefit to basic and diluted earnings per share for the period ending March 31, 2017 was $0.62 and $0.61, respectively, with no transactions impacting the consolidated financial results for the period ending March 31, 2018. The ongoing impact of this guidance will be dependent on any transaction that is within its scope.

 

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 was effective and adopted by the company on January 1, 2017, and it did not have a material impact in the Consolidated Statement of Financial Position. The ongoing impact of the guidance could result in increased volatility in the 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, however these impacts are not expected to be material. These impacts are recorded on a prospective basis. The company continues to estimate forfeitures in conjunction with measuring stock-based compensation cost. The guidance also requires cash payments on behalf of employees for shares directly withheld for taxes to be presented as financing outflows in the Consolidated Statement of Cash Flows. Prior to adoption, the company reported this activity as an operating cash outflow and as a result, prior periods have been reclassified as required. The FASB also issued guidance in May 2017, which relates to the accounting for modifications of share-based payment awards. The company adopted the guidance in the second quarter of 2017. The guidance had no impact in the consolidated financial results.

 

3. Revenue Recognition: Effective January 1, 2018, the company adopted the new accounting standard related to the recognition of revenue in contracts with customers under the modified retrospective transition method.  This method was applied to contracts that were not complete as of the date of initial application. The following is a summary of new and/or revised significant accounting policies, which relate primarily to revenue and cost recognition. Refer to note A, “Significant Accounting Policies,” in the company’s 2017 Annual Report for the policies in effect for revenue and cost prior to January 1, 2018 and for all other significant accounting policies. The impact related to adopting the new standard was not material. For further information regarding the adoption of the new standard, see note 2, “Accounting Changes”.

 

Revenue

 

The company accounts for a contract with a client when it has written approval, the contract is committed, the rights of the parties, including payment terms, are identified, the contract has commercial substance and consideration is probable of collection.

 

Revenue is recognized when, or as, control of a promised product or service transfers to a client, in an amount that reflects the consideration to which the company expects to be entitled in exchange for transferring those products or services. If the consideration promised in a contract includes a variable amount, the company estimates the amount to which it expects to be entitled using either the expected value or most likely amount method. The company’s contracts may include terms that could cause variability in the transaction price, including, for example, rebates, volume discounts, service-level penalties, and performance bonuses or other forms of contingent revenue.

 

The company only includes estimated amounts in the transaction price to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is resolved. The company may not be able to reliably estimate contingent revenue in certain long-term arrangements due to uncertainties that are not expected to be resolved for a long period of time or when the company’s experience with similar types of contracts is limited. The company’s arrangements infrequently include contingent revenue. Estimates of variable consideration and the determination of whether to include estimated amounts in the transaction price are based on all information (historical, current and forecasted) that is reasonably available to the company, taking into consideration the type of client, the type of transaction and the specific facts and circumstances of each arrangement. Changes in estimates of variable consideration are included in the disclosure on page 19.

 

12



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

The company’s standard billing terms are that payment is due upon receipt of invoice, payable within 30 days.  Invoices are generally issued as control transfers and/or as services are rendered. Additionally, in determining the transaction price, the company adjusts the promised amount of consideration for the effects of the time value of money if the billing terms are not standard and the timing of payments agreed to by the parties to the contract provide the client or the company with a significant benefit of financing, in which case the contract contains a significant financing component. As a practical expedient, the company does not account for significant financing components if the period between when the company transfers the promised product or service to the client and when the client pays for that product or service will be one year or less.  Most arrangements that contain a financing component are financed through the company’s Global Financing business and include explicit financing terms.

 

The company may include subcontractor services or third-party vendor equipment or software in certain integrated services arrangements. In these types of arrangements, revenue from sales of third-party vendor products or services is recorded net of costs when the company is acting as an agent between the client and the vendor, and gross when the company is the principal for the transaction. To determine whether the company is an agent or principal, the company considers whether it obtains control of the products or services before they are transferred to the customer.  In making this evaluation, several factors are considered, most notably whether the company has primary responsibility for fulfillment to the client, as well as inventory risk and pricing discretion.

 

The company recognizes revenue on sales to solution providers, resellers and distributors (herein referred to as “resellers”) when the reseller has economic substance apart from the company and the reseller is considered the principal for the transaction with the end-user client.

 

The company reports revenue net of any revenue-based taxes assessed by governmental authorities that are imposed on and concurrent with specific revenue-producing transactions.

 

In addition to the aforementioned general policies, the following are the specific revenue recognition policies for arrangements with multiple performance obligations and for each major category of revenue.

 

Arrangements with Multiple Performance Obligations

 

The company’s global capabilities as a cognitive solutions and cloud platform company include services, software, hardware and related financing. The company enters into revenue arrangements that may consist of any combination of these products and services based on the needs of its clients. For example, a client may purchase a server that includes operating system software. In addition, the arrangement may include post-contract support for the software and a contract for post-warranty maintenance service for the hardware. These types of arrangements may also include financing provided by the company. These arrangements consist of multiple products and services, whereby the hardware and software may be delivered in one period and the software support and hardware maintenance services are delivered over time. In another example, the company may assist the client in building and running an enterprise information technology (IT) environment utilizing a private cloud on a long-term basis and the client periodically purchases hardware and/or software products from the company to upgrade or expand the facility. The services delivered on the cloud are provided on a continuous basis across multiple reporting periods, and the hardware and software products are provided in each period the products are purchased.

 

The company continues to build new products and offerings and continuously reinvent its platforms and delivery methods, including through the use of cloud and as-a-Service models. These are not separate businesses; they are offerings across the segments that address market opportunities in analytics, data, cloud and security. Revenue from these offerings follows the specific revenue recognition policies for arrangements with multiple performance obligations and for each major category of revenue, depending on the type of offering, which are comprised of services, hardware and/or software.

 

To the extent that a product or service in multiple performance obligation arrangements is subject to other specific accounting guidance, such as leasing guidance, that product or service is accounted for in accordance with such specific guidance. For all other products or services in these arrangements, the criteria below are considered to determine when the products or services are distinct and how to allocate the arrangement consideration to each distinct performance obligation. A performance obligation is a promise in a contract with a client to transfer products or services that are distinct.  If the company enters into two or more contracts at or near the same time, the contracts may be combined and accounted for as one contract, in which case the company determines whether the products or services in the combined contract are distinct. A product or service that is promised to a client is distinct if both of the following criteria are met:

 

·                  The client can benefit from the product or service either on its own or together with other resources that are readily available to the client (that is, the product or service is capable of being distinct); and

 

13



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

·                  The company’s promise to transfer the product or service to the client is separately identifiable from other promises in the contract (that is, the product or service is distinct within the context of the contract).

 

If these criteria are not met, the company determines an appropriate measure of progress based on the nature of its overall promise for the single performance obligation. When products and services are distinct, the arrangement consideration is allocated to each performance obligation on a relative standalone selling price basis. The revenue policies in the Services, Hardware and/or Software sections below are then applied to each performance obligation, as applicable.

 

To the extent the company grants the customer the option to acquire additional products or services in one of these arrangements, the company accounts for the option as a distinct performance obligation in the contract only if the option provides a material right to the customer that it would not receive without entering into the contract (e.g., a discount incremental to the range of discounts typically given for the product or service), in which case the client in effect pays in advance for the option to purchase future products or services.  The company recognizes revenue when those future products or services are transferred or when the option expires.

 

Services

 

The company’s primary services offerings include infrastructure services, including outsourcing, and other managed services; application management services; global process services (GPS); maintenance and support; and consulting, including the design and development of complex IT systems to a client’s specifications (e.g., design and build). Many of these services can be delivered entirely or partially through cloud or as-a-Service delivery models. The company’s services are provided on a time-and-material basis, as a fixed-price contract or as a fixed-price per measure of output contract and the contract terms range from less than one year to over 10 years.

 

In services arrangements, the company typically satisfies the performance obligation and recognizes revenue over time.  In design and build arrangements, the performance obligation is satisfied over time either because the client controls the asset as it is created (e.g., when the asset is built at the customer site) or because the company’s performance does not create an asset with an alternative use and the company has an enforceable right to payment plus a reasonable profit for performance completed to date.  In most other services arrangements, the performance obligation is satisfied over time because the client simultaneously receives and consumes the benefits provided as the company performs the services.

 

In outsourcing, other managed services, application management, GPS and other cloud-based services arrangements, the company determines whether the services performed during the initial phases of the arrangement, such as setup activities, are distinct. In most cases, the arrangement is a single performance obligation comprised of a series of distinct services that are substantially the same and that have the same pattern of transfer (i.e., distinct days of service). The company applies a measure of progress (typically time-based) to any fixed consideration and allocates variable consideration to the distinct periods of service based on usage. As a result, revenue is generally recognized over the period the services are provided on a usage basis. This results in revenue recognition that corresponds with the value to the client of the services transferred to date relative to the remaining services promised.

 

Revenue from time-and-material contracts is recognized on an output basis as labor hours are delivered and/or direct expenses are incurred. Revenue from as-a-Service type contracts, such as Infrastructure-as-a-Service, is recognized either on a straight-line basis or on a usage basis, depending on the terms of the arrangement (such as whether the company is standing ready to perform or whether the contract has usage-based metrics). If the as-a-Service contract includes setup activities, those promises in the arrangement are evaluated to determine if they are distinct.

 

Revenue related to maintenance and support services and extended warranty is recognized on a straight-line basis over the period of performance because the company is standing ready to provide services.

 

In fixed-price design and build contracts, revenue is recognized based on progress towards completion of the performance obligation using a cost-to-cost measure of progress (i.e., percentage-of-completion (POC) method of accounting). Revenue is recognized based on the labor costs incurred to date as a percentage of the total estimated labor costs to fulfill the contract. Due to the nature of the work performed in these arrangements, the estimation of cost at completion is complex, subject to many variables and requires significant judgment. Key factors reviewed by the company to estimate costs to complete each contract are future labor and product costs and expected productivity efficiencies. If circumstances arise that change the original estimates of revenues, costs, or extent of progress toward completion, revisions to the estimates are made. These revisions may result in increases or decreases in estimated revenues or costs, and such revisions are reflected in revenue on a cumulative catch-up basis in the period in which the circumstances that gave rise to the revision become known

 

14



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

by the company. Refer to page 19 for the amount of revenue recognized in the reporting period on a cumulative catch-up basis (i.e., from performance obligations satisfied, or partially satisfied, in previous periods).

 

The company performs ongoing profitability analyses of its design and build services contracts accounted for using a cost-to-cost measure of progress in order to determine whether the latest estimates of revenues, costs and profits require updating. If at any time these estimates indicate that the contract will be unprofitable, the entire estimated loss for the remainder of the contract is recorded immediately. For other types of services contracts, any losses are recorded as incurred.

 

In some services contracts, the company bills the client prior to recognizing revenue from performing the services. In other services contracts, the company performs the services prior to billing the client. When the company performs services prior to billing the client in design and build contracts, the right to consideration is typically subject to milestone completion or client acceptance and the unbilled accounts receivable is classified as a contract asset. Refer to page 85 of the company’s 2017 Annual Report for the amount of deferred income and unbilled accounts receivable at December 31, 2017 and 2016.

 

Billings usually occur in the month after the company performs the services or in accordance with specific contractual provisions.

 

Hardware

 

The company’s hardware offerings include the sale or lease of system servers and storage solutions. These products can also be delivered through as-a-Service or cloud delivery models, such as Storage-as-a-Service. The company also offers installation services for its more complex hardware products. Hardware offerings are often sold with distinct maintenance services, described under the Services section above.

 

Revenue from hardware sales is recognized when control has transferred to the customer which typically occurs when the hardware has been shipped to the client, risk of loss has transferred to the client and the company has a present right to payment for the hardware. In limited circumstances when a hardware sale includes client acceptance provisions, revenue is recognized either when client acceptance has been obtained, client acceptance provisions have lapsed, or the company has objective evidence that the criteria specified in the client acceptance provisions have been satisfied. Revenue from hardware sales-type leases is recognized at the beginning of the lease term. Revenue from rentals and operating leases is recognized on a straight-line basis over the term of the rental or lease.

 

Revenue from as-a-Service arrangements is recognized either on a straight-line basis or on a usage basis as described in the Services section above. Installation services are accounted for as distinct performance obligations with revenue recognized as the services are performed. Any cost of standard warranties is accrued when the corresponding revenue is recognized. Shipping and handling activities that occur after the client has obtained control of a product are accounted for as an activity to fulfill the promise to transfer the product rather than as an additional promised service and, therefore, no revenue is deferred and recognized over the shipping period.

 

Software

 

The company’s software offerings include solutions software, which contains many of the company’s strategic areas including analytics, data and security; transaction processing software, which primarily runs mission-critical systems for clients; integration software, which helps clients to create, connect and optimize their applications data and infrastructure; and, operating systems software, which provides operating systems for IBM Z and Power Systems hardware. Many of these offerings can be delivered entirely or partially through as-a-Service or cloud delivery models, while others are delivered as on-premise software licenses.

 

Revenue from perpetual (one-time charge) license software is recognized at a point in time at the inception of the arrangement when control transfers to the client, if the software license is distinct from the post-contract support offered by the company. In limited circumstances, when the software requires continuous updates to provide the intended functionality, the software license and post-contract support are not distinct and revenue for the single performance obligation is recognized over time as the post-contract support is provided. This is only applicable to certain security software perpetual licenses offered by the company. Prior to the adoption of the new revenue standard, the company recognized revenue for these software licenses at a point in time at the inception of the arrangement. This change did not have a material impact on the company’s financial statements.

 

15



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

Revenue from post-contract support is recognized over the contract term on a straight-line basis because the company is providing a service of standing ready to provide support, when-and-if needed, and is providing unspecified software upgrades on a when-and-if available basis over the contract term.

 

Revenue from software hosting or Software-as-a-Service arrangements is recognized either on a straight-line basis or on a usage basis as described in the Services section above. In software hosting arrangements, the rights provided to the client (e.g., ownership of a license, contract termination provisions and the feasibility of the client to operate the software) are considered in determining whether the arrangement includes a license. In arrangements that include a software license, the associated revenue is recognized in accordance with the software license recognition policy above rather than over time as a service.

 

Revenue from term license software is recognized at a point in time for the committed term of the contract (which is typically one month due to client termination rights).  However, if the amount of consideration to be paid in exchange for the license depends on client usage, revenue is recognized when the usage occurs.

 

Financing

 

Financing income attributable to sales-type leases, direct financing leases and loans is recognized on the accrual basis using the effective interest method. Operating lease income is recognized on a straight-line basis over the term of the lease.

 

Standalone Selling Price

 

The company allocates the transaction price to each performance obligation on a relative standalone selling price basis. The standalone selling price (SSP) is the price at which the company would sell a promised product or service separately to a client. In most cases, the company is able to establish SSP based on the observable prices of products or services sold separately in comparable circumstances to similar clients. The company typically establishes a standalone selling price range for its products and services which are reassessed on a periodic basis or when facts and circumstances change.

 

In certain instances, the company may not be able to establish a standalone selling price range based on observable prices and the company estimates the standalone selling price. The company estimates SSP by considering multiple factors including, but not limited to, overall market conditions, including geographic or regional specific factors, competitive positioning, competitor actions, internal costs, profit objectives and pricing practices. Additionally, in certain circumstances, the company may estimate SSP for a product or service by applying the residual approach. This approach has been most commonly used when certain perpetual software licenses are only sold bundled with one year of post-contract support and a price has not been established for the software. Estimating SSP is a formal process that includes review and approval by the company’s management.

 

Services Costs

 

Recurring operating costs for services contracts are recognized as incurred. For fixed-price design and build contracts, the costs of external hardware and software accounted for under the cost-to-cost measure of progress are deferred and recognized based on the labor costs incurred to date (i.e., the measure of progress), as a percentage of the total estimated labor costs to fulfill the contract as control transfers over time for these performance obligations. Certain eligible, nonrecurring costs incurred in the initial phases of outsourcing contracts and other cloud-based services contracts (i.e., setup costs) are capitalized when the costs relate directly to the contract, the costs generate or enhance resources of the company that will be used in satisfying the performance obligation in the future, and the costs are expected to be recovered. These costs consist of transition and setup costs related to the installation of systems and processes and other deferred fulfillment costs, including, prepaid assets used in services contracts (i.e., prepaid software or prepaid maintenance), and other deferred fulfillment costs eligible for capitalization.  Capitalized costs are amortized on a straight-line basis over the expected period of benefit, which includes anticipated contract renewals or extensions, consistent with the transfer to the client of the services to which the asset relates. Additionally, fixed assets associated with these contracts are capitalized and depreciated on a straight-line basis over the expected useful life of the asset. If an asset is contract specific, then the depreciation period is the shorter of the useful life of the asset or the contract term. Amounts paid to clients in excess of the fair value of acquired assets used in outsourcing arrangements are deferred and amortized on a straight-line basis as a reduction of revenue over the expected period of benefit. The company performs periodic reviews to assess the recoverability of deferred contract transition and setup costs. This review is done by comparing the carrying amount of the asset to the remaining amount of consideration the company expects to receive for the services to which the asset relates, less the costs that relate directly to providing those services that have not yet been recognized. If the carrying amount is deemed not recoverable, an impairment loss is recognized.

 

16



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

In situations in which an outsourcing contract is terminated, the terms of the contract may require the client to reimburse the company for the recovery of unbilled accounts receivable, unamortized deferred costs incurred to purchase specific assets utilized in the delivery of services and to pay any additional costs incurred by the company to transition the services.

 

Software Costs

 

Certain eligible, non-recurring costs incurred in the initial phases of Software-as-a-Service contracts are deferred and amortized over the expected period of benefit, which includes anticipated contract renewals or extensions, consistent with the policy described for Services Costs. Recurring operating costs in these contracts are recognized as incurred.

 

Incremental Costs of Obtaining a Contract

 

Incremental costs of obtaining a contract (e.g., sales commissions) are capitalized and amortized on a straight-line basis over the expected customer relationship period if the company expects to recover those costs. The company previously expensed these costs as incurred. The expected customer relationship is determined based on the average customer relationship period, including expected renewals, for each offering type and ranges from three to six years. Expected renewal periods are only included in the expected customer relationship period if commission amounts paid upon renewal are not commensurate with amounts paid on the initial contract. Incremental costs of obtaining a contract include only those costs the company incurs to obtain a contract that it would not have incurred if the contract had not been obtained. The company has determined that certain commissions programs meet the requirements to be capitalized.  Some commission programs are not subject to capitalization as the commission expense is paid and recognized as the related revenue is recognized. Additionally, as a practical expedient, the company expenses costs to obtain a contract as incurred if the amortization period would have been a year or less. These costs are included in selling, general and administrative expenses.

 

Product Warranties

 

The company offers warranties for its hardware products that generally range up to three years, with the majority being either one or three years. Estimated costs for standard warranty terms are recognized when revenue is recorded for the related product. The company estimates its warranty costs standard to the product based on historical warranty claim experience and estimates of future spending, and applies this estimate to the revenue stream for products under warranty. Estimated future costs for warranties applicable to revenue recognized in the current period are charged to cost of sales. The warranty liability is reviewed quarterly to verify that it properly reflects the remaining obligation based on the anticipated expenditures over the balance of the obligation period. Adjustments are made when actual warranty claim experience differs from estimates. Costs from fixed-price support or maintenance contracts, including extended warranty contracts, are recognized as incurred.

 

Revenue from extended warranty contracts is initially recorded as deferred income and subsequently recognized on a straight-line basis over the delivery period because the company is providing a service of standing ready to provide services over such term.

 

Contract Assets and Notes and Accounts Receivable—Trade

 

The company classifies the right to consideration in exchange for products or services transferred to a client as either a receivable or a contract asset. A receivable is a right to consideration that is unconditional as compared to a contract asset which is a right to consideration that is conditional upon factors other than the passage of time. The majority of the company’s contract assets represent unbilled amounts related to design and build services contracts when the cost-to-cost method of revenue recognition is utilized, revenue recognized exceeds the amount billed to the client, and the right to consideration is subject to milestone completion or client acceptance. Contract assets are generally classified as current and are recorded on a net basis with deferred income (i.e., contract liabilities) at the contract level. At January 1, 2018 and March 31, 2018 contract assets of $557 million and $582 million, respectively, are included in prepaid expenses and other current assets in the Consolidated Statement of Financial Position. At December 31, 2017, these assets were classified as notes and accounts receivable-trade in the Consolidated Statement of Financial Position.

 

An allowance for contract assets, if needed, and uncollectible trade receivables is estimated based on a combination of write-off history, aging analysis and any specific, known troubled accounts.

 

17



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

Disaggregation of Revenue

 

The following tables provide details of revenue by major products/service offerings and by geography.

 

Revenue by Major Products/Service Offerings

 

 

 

 

 

 

 

Technology

 

 

 

 

 

 

 

 

 

 

 

 

 

Global

 

Services &

 

 

 

 

 

 

 

 

 

 

 

Cognitive

 

Business

 

Cloud

 

 

 

Global

 

 

 

Total

 

(Dollars in millions)

 

Solutions

 

Services

 

Platforms

 

Systems

 

Financing

 

Other

 

Revenue

 

For the three months ended March 31, 2018:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Solutions Software

 

$

2,957

 

$

 

$

 

$

 

$

 

$

 

$

2,957

 

Transaction Processing Software

 

1,341

 

 

 

 

 

 

1,341

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Consulting

 

 

1,867

 

 

 

 

 

1,867

 

Global Process Services

 

 

305

 

 

 

 

 

305

 

Application Management

 

 

2,002

 

 

 

 

 

2,002

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Infrastructure Services

 

 

 

5,825

 

 

 

 

5,825

 

Technical Support Services

 

 

 

1,782

 

 

 

 

1,782

 

Integration Software

 

 

 

1,019

 

 

 

 

1,019

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Systems Hardware

 

 

 

 

1,093

 

 

 

1,093

 

Operating Systems Software

 

 

 

 

407

 

 

 

407

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Global Financing*

 

 

 

 

 

405

 

 

405

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other Revenue

 

 

 

 

 

 

69

 

69

 

Total

 

$

4,299

 

$

4,174

 

$

8,625

 

$

1,500

 

$

405

 

$

69

 

$

19,072

 

 


* Contains lease and loan/working capital financing arrangements which are not subject to the guidance on revenue from contracts with customers.

 

Revenue by Geography

 

 

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

(Dollars in millions)

 

Revenue

 

 

 

 

 

 

 

 

 

 

 

 

 

For the three months ended March 31, 2018:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Americas

 

$

8,707

 

 

 

 

 

 

 

 

 

 

 

 

 

Europe/Middle East/Africa

 

6,176

 

 

 

 

 

 

 

 

 

 

 

 

 

Asia Pacific

 

4,188

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

19,072

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Remaining Performance Obligations

 

The remaining performance obligation disclosure provides the aggregate amount of the transaction price yet to be recognized as of the end of the reporting period and an explanation as to when the company expects to recognize these amounts in revenue. It is intended to be a statement of overall work under contract that has not yet been performed and does not include contracts in which the customer is not committed, such as certain as-a-Service, governmental, term software license and services offerings. The customer is not considered committed when they are able to terminate for convenience without payment of a substantive penalty. The disclosure includes estimates of variable consideration, except when the variable consideration is a sales-based or usage-based royalty promised in exchange for a license of intellectual property. Additionally, as a practical expedient, the company does not include contracts that have an original duration of one year or less. Remaining performance obligation estimates are subject to change and are affected by several factors, including terminations, changes in the scope of contracts, periodic revalidations, adjustment for revenue that has not materialized and adjustments for currency.

 

18



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

At March 31, 2018, the aggregate amount of the transaction price allocated to the remaining performance obligations related to customer contracts that are unsatisfied or partially unsatisfied was $131 billion. Given the profile of contract terms, approximately 60 percent of this amount is expected to be recognized as revenue over the next two years, approximately 30 percent between three and five years and the balance (mostly Infrastructure Services) thereafter.

 

Revenue Recognized for Performance Obligations Satisfied (or Partially Satisfied) in Prior Periods

 

For the three months ending March 31, 2018, revenue was reduced by $22 million for performance obligations satisfied (or partially satisfied) in previous periods, mainly due to changes in estimates on percentage-of-completion based contracts. See pages 14 and 15 for additional information on percentage-of-completion contracts and estimates of costs to complete.

 

Reconciliation of Contract Balances

 

The following table provides information about notes and accounts receivables-trade, contract assets and deferred income balances:

 

 

 

At March 31,

 

At January 1,

 

(Dollars in millions)

 

2018

 

2018 (as adjusted)

 

Notes and accounts receivable-trade (net of allowances of $307 and $297 at March 31, 2018 and January 1, 2018, respectively)

 

$

7,778

 

$

8,295

 

Contract assets (1)

 

582

 

557

 

Deferred income (current)

 

13,059

 

11,493

 

Deferred income (non-current)

 

3,852

 

3,758

 

 


(1) Included within prepaid expenses and other current assets in the Consolidated Statement of Financial Position.

 

 

The amount of revenue recognized during the three months ended March 31, 2018 that was included within the deferred income balance at January 1, 2018 was $3.5 billion and primarily relates to services and software.

 

Deferred Costs

 

 

 

At March 31,

 

 

 

(Dollars in millions)

 

2018

 

 

 

Capitalized costs to obtain a contract

 

$

719

 

 

 

Deferred costs to fulfill a contract:

 

 

 

 

 

Deferred setup costs

 

2,149

 

 

 

Other deferred fulfillment costs

 

2,138

 

 

 

Total deferred costs (1)

 

$

5,006

 

 

 

 


(1) Of the total, $2,413 million is current and $2,593 million is noncurrent. In prior periods, the current and noncurrent balance of deferred costs were included within prepaid expenses and other current assets and investments and sundry assets, respectively.

 

On January 1, 2018, in accordance with the transition guidance, $737 million of in-scope sales commissions that were previously recorded in the Consolidated Statement of Earnings were capitalized as costs to obtain a contract.

 

The amount of total deferred costs amortized during the quarter ended March 31, 2018 was $855 million. There were no material impairment losses incurred during the period. Refer to pages 16 and 17 for additional information on deferred costs to fulfill a contract and capitalized costs of obtaining a contract.

 

Transition Disclosures

 

In accordance with the modified retrospective method transition requirements, the company will present the financial statement line items impacted and adjusted to compare to presentation under the prior GAAP for each of the interim and annual periods during the first year of adoption of the new revenue standard.  The following tables summarize the impacts as of and for the quarter ended March 31, 2018. The impacts to adjust to prior GAAP are primarily the result of the transition adjustments recorded at adoption.  Current period impacts were not material.  Refer to note 2, “Accounting Changes,” for additional information on the transition adjustments.

 

19



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

Consolidated Statement of Earnings Impacts

 

 

 

As reported under

 

Adjustments to

 

Adjusted

 

(Dollars in millions except per share amounts)

 

new revenue

 

convert to

 

amounts under

 

For the three months ended March 31, 2018:

 

standard

 

prior GAAP

 

prior GAAP

 

Revenue

 

$

19,072

 

$

(52

)

$

19,020

 

Cost

 

10,825

 

(25

)

10,800

 

Gross profit

 

8,247

 

(28

)

8,220

 

Selling, general and administrative expense

 

5,445

 

(21

)

5,424

 

Income from continuing operations before income taxes

 

1,136

 

(7

)

1,129

 

Provision for/(benefit from) income taxes

 

(540

)

(2

)

(542

)

Net income

 

$

1,679

 

$

(5

)

$

1,674

 

Earnings/(loss) per share of common stock:

 

 

 

 

 

 

 

Assuming dilution

 

$

1.81

 

$

0.00

 

$

1.81

 

Basic

 

$

1.82

 

$

(0.01

)

$

1.81

 

 

Consolidated Statement of Financial Position Impacts

 

 

 

As reported under

 

Adjustments to

 

Adjusted

 

(Dollars in millions)

 

new revenue

 

convert to

 

amounts under

 

At March 31, 2018:

 

standard

 

prior GAAP

 

prior GAAP

 

Assets:

 

 

 

 

 

 

 

Notes and accounts receivable - trade (net of allowances)

 

$

7,778

 

$

640

 

$

8,418

 

Deferred costs (current)

 

2,413

 

(340

)

2,073

 

Prepaid expenses and other current assets

 

2,573

 

(582

)

1,991

 

Deferred taxes

 

5,111

 

186

 

5,297

 

Deferred costs (noncurrent)

 

2,593

 

(351

)

2,242

 

Investments and sundry assets

 

2,942

 

 

2,942

 

Total assets

 

$

125,285

 

$

(447

)

$

124,838

 

Liabilities:

 

 

 

 

 

 

 

Taxes

 

$

2,918

 

$

 

$

2,918

 

Deferred income (current)

 

13,059

 

89

 

13,148

 

Deferred income (noncurrent)

 

3,852

 

(8

)

3,844

 

Total liabilities

 

$

106,995

 

$

81

 

$

107,076

 

Equity:

 

 

 

 

 

 

 

Retained earnings

 

$

156,371

 

$

(528

)

$

155,843

 

Total stockholders’ equity

 

18,290

 

(528

)

17,762

 

Total liabilities and stockholders’ equity

 

$

125,285

 

$

(447

)

$

124,838

 

 

Consolidated Statement of Cash Flows Impacts

 

 

 

As reported under

 

Adjustments to

 

Adjusted

 

(Dollars in millions)

 

new revenue

 

convert to

 

amounts under

 

For the three months ended March 31, 2018:

 

standard

 

prior GAAP

 

prior GAAP

 

Cash flows from operating activities:

 

 

 

 

 

 

 

Net income

 

$

1,679

 

$

(5

)

$

1,674

 

Adjustments to reconcile net income to cash provided by operating activities

 

 

 

 

 

 

 

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

 

1,658

 

5

 

1,663

 

Net cash provided by operating activities

 

$

4,602

 

$

 

$

4,602

 

 

20



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

4. 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 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 debt securities that are deemed to be other-than-temporarily impaired. In the event of an other-than-temporary impairment of a debt security, fair value is measured using a model described above.

 

Certain 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. There were no material impairments of non-financial assets for the three months ended March 31, 2018 and 2017, 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 has not applied the fair value option to any eligible assets or liabilities.

 

Effective January 1, 2018, the company adopted the new FASB guidance on recognition, measurement, presentation and disclosure of financial instruments using the cumulative catch-up transition method. Under the new standard, the company measures equity investments at fair value with changes recognized in net income. Based on the method of adoption, prior year information has not been updated to conform with the new guidance. Refer to note 2, “Accounting Changes,” for further information.

 

21



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

The following tables present the company’s financial assets and financial liabilities that are measured at fair value on a recurring basis at March 31, 2018 and December 31, 2017.

 

(Dollars in millions)

 

 

 

 

 

 

 

 

 

At March 31, 2018

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Assets:

 

 

 

 

 

 

 

 

 

Cash equivalents (1)

 

 

 

 

 

 

 

 

 

Time deposits and certificates of deposit

 

$

 

$

8,323

 

$

 

$

8,323

(6)

Money market funds

 

25

 

 

 

25

 

Total

 

25

 

8,323

 

 

8,348

 

Equity investments (2)

 

4

 

 

 

4

 

Debt securities - current (3)

 

 

893

 

 

893

(6)

Derivative assets (4)

 

 

940

 

 

940

(7)

Total assets

 

$

29

 

$

10,156

 

$

 

$

10,185

 

Liabilities:

 

 

 

 

 

 

 

 

 

Derivative liabilities (5)

 

$

 

$

352

 

$

 

$

352

(7)

 


(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) Included within marketable securities 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 March 31, 2018 were $118 million and $822 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 March 31, 2018 were $273 million and $79 million, respectively.

(6) Available-for-sale debt 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 $272 million.

 

22



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

(Dollars in millions)

 

 

 

 

 

 

 

 

 

At December 31, 2017

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Assets:

 

 

 

 

 

 

 

 

 

Cash equivalents (1)

 

 

 

 

 

 

 

 

 

Time deposits and certificates of deposit

 

$

 

$

8,066

 

$

 

$

8,066

 

Commercial paper

 

 

96

 

 

96

 

Money market funds

 

26

 

 

 

26

 

Canadian government securities

 

 

398

 

 

398

 

Total

 

26

 

8,560

 

 

8,586

(6)

Equity investments (2)

 

4

 

 

 

4

 

Debt securities - current (3)

 

 

608

 

 

608

(6)

Debt securities - noncurrent (2)

 

4

 

7

 

 

11

 

Derivative assets (4)

 

 

942

 

 

942

(7)

Total assets

 

$

33

 

$

10,117

 

$

 

$

10,151

 

Liabilities:

 

 

 

 

 

 

 

 

 

Derivative liabilities (5)

 

$

 

$

415

 

$

 

$

415

(7)

 


(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) U.S government securities reported as marketable securities 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, 2017 were $185 million and $757 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, 2017 were $377 million and $38 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 $255 million.

 

There were no transfers between Levels 1 and 2 for the three months ended March 31, 2018 and the year ended December 31, 2017.

 

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, except for short-term debt, which would be classified as Level 2.

 

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 March 31, 2018 and December 31, 2017, 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.

 

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 $40,410 million and $39,837 million, and the estimated fair value was $42,334 million and $42,264 million at March 31, 2018 and December 31, 2017, respectively. If measured at fair

 

23



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

value in the financial statements, long-term debt (including the current portion) would be classified as Level 2 in the fair value hierarchy.

 

Available-for-sale securities

 

Sales of available-for-sale securities during the period were as follows:

 

(Dollars in millions)

 

 

 

 

 

For the three months ended March 31:

 

2018

 

2017

 

Proceeds

 

$

0

 

$

5

 

Gross realized gains (before taxes)

 

 

1

 

Gross realized losses (before taxes)

 

 

2

 

 

The after-tax net unrealized holding gains/(losses) on available-for-sale 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:

 

(Dollars in millions)

 

 

 

 

 

For the three months ended March 31:

 

2018

 

2017

 

Net unrealized gains/(losses) arising during the period

 

$

(2

)

$

(1

)

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

 

0

 

1

 

 


* There were no writedowns for the three months ended March 31, 2018 and 2017, respectively.

 

The contractual maturities of substantially all available-for-sale debt securities are less than one year at March 31, 2018.

 

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 March 31, 2018 and December 31, 2017 was $42 million and $126 million, respectively, for which no collateral was posted at either date. 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 at March 31, 2018 and December 31, 2017 was $940 million and $942 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 $272 million and $255 million at March 31, 2018 and December 31, 2017, respectively, of liabilities included in master netting arrangements with those counterparties. Additionally, at March 31,

 

24



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

2018 and December 31, 2017, this exposure was reduced by $162 million and $114 million of cash collateral, respectively. There were no non-cash collateral balances in U.S. Treasury securities at March 31, 2018 and December 31, 2017. At March 31, 2018 and December 31, 2017, the net exposure related to derivative assets recorded in the Consolidated Statement of Financial Position was $506 million and $572 million, respectively. At March 31, 2018 and December 31, 2017, the net position related to derivative liabilities recorded in the Consolidated Statement of Financial Position was $80 million and $160 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 March 31, 2018 or December 31, 2017 for the right to reclaim cash collateral. The amount recognized in accounts payable for the obligation to return cash collateral was $162 million and $114 million at March 31, 2018 and December 31, 2017, respectively. The company restricts the use of cash collateral received to rehypothecation, and therefore reports it in restricted cash in the Consolidated Statement of Financial Position. No amount was rehypothecated at March 31, 2018 and December 31, 2017.

 

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 March 31, 2018 and December 31, 2017, the total notional amount of the company’s interest rate swaps was $9.9 billion and $9.1 billion, respectively. The weighted-average remaining maturity of these instruments at March 31, 2018 and December 31, 2017 was approximately 4.8 years at both periods.

 

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 March 31, 2018 and December 31, 2017.

 

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 March 31, 2018 and December 31, 2017, the total notional amount of derivative instruments designated as net investment hedges was $6.7 billion and $7.0 billion,

 

25



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

respectively. At March 31, 2018 and December 31, 2017, the weighted-average remaining maturity of these instruments was approximately 0.2 years at both periods.

 

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 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 March 31, 2018 and December 31, 2017, the total notional amount of forward contracts designated as cash flow hedges of forecasted royalty and cost transactions was $8.2 billion and $7.8 billion, respectively. The weighted-average remaining maturity of these instruments at March 31, 2018 and December 31, 2017 was 0.7 years at both periods.

 

At March 31, 2018 and December 31, 2017, in connection with cash flow hedges of anticipated royalties and cost transactions, the company recorded net losses of $46 million and net gains of $27 million (before taxes), respectively, in AOCI. The company estimates that $137 million (before taxes) of deferred net losses on derivatives in AOCI at March 31, 2018, will 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 ten years. At March 31, 2018 and December 31, 2017, the total notional amount of cross-currency swaps designated as cash flow hedges of foreign currency denominated debt was $6.5 billion at both periods.

 

At March 31, 2018 and December 31, 2017, in connection with cash flow hedges of foreign currency denominated borrowings, the company recorded net gains of $122 million and net gains of $42 million (before taxes), respectively, in AOCI. The company estimates that $194 million (before taxes) of deferred net gains on derivatives in AOCI at March 31, 2018, will 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 March 31, 2018 and December 31, 2017, the total notional amount of derivative instruments in economic hedges of foreign currency exposure was $8.9 billion and $11.5 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 March 31, 2018 and December 31, 2017, the total notional amount of derivative instruments in economic hedges of these compensation obligations was $1.2 billion and $1.3 billion, respectively.

 

26



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 March 31, 2018 and December 31, 2017.

 

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 March 31, 2018 and December 31, 2017.

 

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 March 31, 2018 and December 31, 2017, the company did not have any derivative instruments relating to this program outstanding.

 

The following tables provide a quantitative summary of the derivative and non-derivative instrument-related risk management activity at March 31, 2018 and December 31, 2017, as well as for the three months ended March 31, 2018 and 2017, respectively.

 

27



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

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

 

 

 

Fair Value of Derivative Assets

 

Fair Value of Derivative Liabilities

 

 

 

Balance Sheet

 

 

 

 

 

Balance Sheet

 

 

 

 

 

(Dollars in millions) 

 

Classification

 

3/31/2018

 

12/31/2017

 

Classification

 

3/31/2018

 

12/31/2017

 

Designated as hedging instruments:

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate contracts:

 

Prepaid expenses and other current assets

 

$

 

$

2

 

Other accrued expenses and liabilities

 

$

5

 

$

 

 

 

Investments and sundry assets

 

303

 

459

 

Other liabilities

 

73

 

34

 

Foreign exchange contracts:

 

Prepaid expenses and other current assets

 

98

 

111

 

Other accrued expenses and liabilities

 

223

 

318

 

 

 

Investments and sundry assets

 

519

 

298

 

Other liabilities

 

6

 

3

 

 

 

Fair value of derivative assets

 

$

920

 

$

870

 

Fair value of derivative liabilities

 

$

307

 

$

355

 

Not designated as hedging instruments:

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts:

 

Prepaid expenses and other current assets

 

$

18

 

$

61

 

Other accrued expenses and liabilities

 

$

15

 

$

57

 

Equity contracts:

 

Prepaid expenses and other current assets

 

2

 

12

 

Other accrued expenses and liabilities

 

30

 

3

 

 

 

Fair value of derivative assets

 

$

20

 

$

72

 

Fair value of derivative liabilities

 

$

45

 

$

60

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Derivatives

 

 

 

$

940

 

$

942

 

 

 

$

352

 

$

415

 

Total debt designated as hedging instruments(1):

 

 

 

 

 

 

 

 

 

 

 

 

 

Short-term debt

 

 

 

N/A

 

N/A

 

 

 

$

 

$

 

Long-term debt

 

 

 

N/A

 

N/A

 

 

 

6,692

 

6,471

 

 

 

 

 

N/A

 

N/A

 

 

 

$

6,692

 

$

6,471

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

$

940

 

$

942

 

 

 

$

7,044

 

$

6,886

 

 


N/A - not applicable

(1) Debt designated as hedging instruments are reported at carrying value.

 

At March 31, 2018, the following amounts were recorded in the Consolidated Statement of Financial Position related to cumulative basis adjustments for fair value hedges:

 

(Dollars in millions)

 

 

 

Cumulative Amount of

 

Line Item in the

 

Carrying Amount of the

 

Fair Value Hedging Adjustment

 

Consolidated Statement of Financial Position

 

Hedged Item

 

Included in the Carrying

 

in which the Hedged Item is Included

 

Assets/(Liabilities)

 

Amount of Assets/(Liabilities)

 

Short-term debt

 

$

(744

)

$

5

 

Long-term debt

 

$

(9,503

)

$

(348

) (1)

 


(1) Includes ($190) million of hedging adjustments on discontinued hedging relationships.

 

28



Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

The Effect of Derivative Instruments in the Consolidated Statement of Earnings

 

The total amounts of income and expense line items presented in the Consolidated Statement of Earnings in which the effects of fair value hedges, cash flow hedges, net investment hedges and derivatives not designated as hedging instruments are recorded and the total effect of hedge activity on these income and expense line items, are as follows:

 

 

 

 

 

 

 

 

 

 

 

Other

 

 

 

(Dollars in millions)

 

Cost of

 

Cost of

 

Cost of

 

SG&A

 

(Income) and

 

Interest

 

For the three months ended March 31, 2018:

 

Services

 

Sales

 

Financing

 

Expense

 

Expense

 

Expense

 

Total

 

$

8,835

 

$

1,722

 

$

269

 

$

5,445

 

$

413

 

$

165

 

Gains/(losses) of total hedge activity

 

19

 

(17

)

23

 

(33

)

49

 

(15

)