10-Q 1 a19-6867_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, 2019

 

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 every Interactive Data File required to be submitted 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 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 o

Non-accelerated filer o

 

Smaller reporting company o

 

 

Emerging growth company o

 

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 886,642,873 shares of common stock outstanding at March 31, 2019.

 

z

 


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, 2019 and 2018

3

 

 

Consolidated Statement of Comprehensive Income for the three months ended March 31, 2019 and 2018

4

-

 

Consolidated Statement of Financial Position at March 31, 2019 and December 31, 2018

5

 

 

Consolidated Statement of Cash Flows for the three months ended March 31, 2019 and 2018

7

 

 

Consolidated Statement of Changes in Equity for the three months ended March 31, 2019 and 2018

8

 

 

Notes to Consolidated Financial Statements

10

 

 

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

50

 

 

Item 4. Controls and Procedures

75

 

 

Part II - Other Information:

 

 

 

Item 1. Legal Proceedings

75

 

 

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

75

 

 

Item 5. Other Information

76

 

 

Item 6. Exhibits

76

 

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)

 

2019

 

2018

 

Revenue:

 

 

 

 

 

Services

 

$

12,423

 

$

12,961

 

Sales

 

5,354

 

5,700

 

Financing

 

404

 

410

 

Total revenue

 

18,182

 

19,072

 

Cost:

 

 

 

 

 

Services

 

8,359

 

8,835

 

Sales

 

1,516

 

1,722

 

Financing

 

264

 

269

 

Total cost

 

10,139

 

10,825

 

Gross profit

 

8,043

 

8,247

 

Expense and other (income):

 

 

 

 

 

Selling, general and administrative

 

4,691

 

5,445

 

Research, development and engineering

 

1,433

 

1,405

 

Intellectual property and custom development income

 

(101

)

(317

)

Other (income) and expense

 

(73

)

413

 

Interest expense

 

210

 

165

 

Total expense and other (income)

 

6,160

 

7,111

 

Income from continuing operations before income taxes

 

1,883

 

1,136

 

Provision for/(benefit from) income taxes

 

289

 

(540

)

Income from continuing operations

 

$

1,593

 

$

1,675

 

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

 

(2

)

4

 

Net income

 

$

1,591

 

$

1,679

 

 

 

 

 

 

 

Earnings/(loss) per share of common stock:

 

 

 

 

 

Assuming dilution:

 

 

 

 

 

Continuing operations

 

$

1.78

 

$

1.81

 

Discontinued operations

 

0.00

 

0.00

 

Total

 

$

1.78

 

$

1.81

 

Basic:

 

 

 

 

 

Continuing operations

 

$

1.79

 

$

1.82

 

Discontinued operations

 

0.00

 

0.00

 

Total

 

$

1.79

 

$

1.82

 

 

 

 

 

 

 

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

 

 

 

 

 

Assuming dilution

 

893.9

 

925.4

 

Basic

 

889.6

 

920.7

 

 

(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)

 

2019

 

2018

 

Net income

 

$

1,591

 

$

1,679

 

Other comprehensive income/(loss), before tax:

 

 

 

 

 

Foreign currency translation adjustments

 

171

 

(167

)

Net changes related to available-for-sale securities:

 

 

 

 

 

Unrealized gains/(losses) arising during the period

 

(1

)

(2

)

Reclassification of (gains)/losses to net income

 

 

0

 

Total net changes related to available-for-sale securities

 

(1

)

(3

)

Unrealized gains/(losses) on cash flow hedges:

 

 

 

 

 

Unrealized gains/(losses) arising during the period

 

(352

)

61

 

Reclassification of (gains)/losses to net income

 

98

 

(54

)

Total unrealized gains/(losses) on cash flow hedges

 

(254

)

7

 

Retirement-related benefit plans:

 

 

 

 

 

Prior service costs/(credits)

 

 

(1

)

Net (losses)/gains arising during the period

 

(4

)

2

 

Curtailments and settlements

 

1

 

0

 

Amortization of prior service (credits)/costs

 

(3

)

(19

)

Amortization of net (gains)/losses

 

464

 

753

 

Total retirement-related benefit plans

 

458

 

735

 

Other comprehensive income/(loss), before tax

 

375

 

573

 

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

 

(67

)

(143

)

Other comprehensive income/(loss), net of tax

 

308

 

430

 

Total comprehensive income/(loss)

 

$

1,899

 

$

2,109

 

 

(Amounts may not add due to rounding.)

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

 

4


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INTERNATIONAL BUSINESS MACHINES CORPORATION

AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF FINANCIAL POSITION

(UNAUDITED)

 

ASSETS

 

 

 

At March 31,

 

At December 31,

 

(Dollars in millions)

 

2019

 

2018

 

Assets:

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

17,134

 

$

11,379

 

Restricted cash

 

137

 

225

 

Marketable securities

 

872

 

618

 

Notes and accounts receivable — trade (net of allowances of $316 in 2019 and $309 in 2018)

 

6,987

 

7,432

 

Short-term financing receivables (net of allowances of $248 in 2019 and $244 in 2018)

 

20,287

 

22,388

 

Other accounts receivable (net of allowances of $33 in 2019 and $38 in 2018)

 

671

 

743

 

Inventories, at lower of average cost or net realizable value:

 

 

 

 

 

Finished goods

 

369

 

266

 

Work in process and raw materials

 

1,402

 

1,415

 

Total inventories

 

1,771

 

1,682

 

Deferred costs

 

2,368

 

2,300

 

Prepaid expenses and other current assets

 

2,478

 

2,378

 

Total current assets

 

52,705

 

49,146

 

Property, plant and equipment

 

32,692

 

32,460

 

Less: Accumulated depreciation

 

22,017

 

21,668

 

Property, plant and equipment — net

 

10,675

 

10,792

 

Operating right-of-use assets — net*

 

4,634

 

 

Long-term financing receivables (net of allowances of $38 in 2019 and $48 in 2018)

 

8,361

 

9,148

 

Prepaid pension assets

 

4,966

 

4,666

 

Deferred costs

 

2,663

 

2,676

 

Deferred taxes

 

5,284

 

5,216

 

Goodwill

 

36,281

 

36,265

 

Intangible assets — net

 

2,956

 

3,087

 

Investments and sundry assets

 

2,403

 

2,386

 

Total assets

 

$

130,926

 

$

123,382

 

 


* Reflects the adoption of the FASB guidance on leases. Refer to note 2, “Accounting Changes” and note 5, “Leases.”

(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)

 

2019

 

2018

 

Liabilities:

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Taxes

 

$

2,484

 

$

3,046

 

Short-term debt

 

10,250

 

10,207

 

Accounts payable

 

5,711

 

6,558

 

Compensation and benefits

 

3,027

 

3,310

 

Deferred income

 

12,134

 

11,165

 

Operating lease liabilities*

 

1,313

 

 

Other accrued expenses and liabilities

 

3,952

 

3,941

 

Total current liabilities

 

38,871

 

38,227

 

Long-term debt

 

39,727

 

35,605

 

Retirement and nonpension postretirement benefit obligations

 

16,467

 

17,002

 

Deferred income

 

3,481

 

3,445

 

Operating lease liabilities*

 

3,590

 

 

Other liabilities

 

12,184

 

12,174

 

Total liabilities

 

114,320

 

106,452

 

Equity:

 

 

 

 

 

IBM stockholders’ equity:

 

 

 

 

 

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

 

55,287

 

55,151

 

Shares authorized: 4,687,500,000

 

 

 

 

 

Shares issued: 2019 - 2,234,819,047

 

 

 

 

 

2018 - 2,233,427,058

 

 

 

 

 

Retained earnings

 

159,396

 

159,206

 

Treasury stock - at cost

 

(169,021

)

(168,071

)

Shares: 2019 - 1,348,176,174

 

 

 

 

 

2018 - 1,340,947,648

 

 

 

 

 

Accumulated other comprehensive income/(loss)

 

(29,182

)

(29,490

)

Total IBM stockholders’ equity

 

16,481

 

16,796

 

Noncontrolling interests

 

126

 

134

 

Total equity

 

16,607

 

16,929

 

Total liabilities and equity

 

$

130,926

 

$

123,382

 

 


* Reflects the adoption of the FASB guidance on leases. Refer to note 2, “Accounting Changes” and note 5, “Leases.”

(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)

 

2019

 

2018

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

1,591

 

$

1,679

 

Adjustments to reconcile net income to cash provided by operating activities

 

 

 

 

 

Depreciation

 

1,143

 

774

 

Amortization of intangibles

 

303

 

340

 

Stock-based compensation

 

113

 

116

 

Net (gain)/loss on asset sales and other

 

(176

)

34

 

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

 

1,785

 

1,658

 

Net cash provided by operating activities

 

4,759

 

4,602

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Payments for property, plant and equipment

 

(539

)

(870

)

Proceeds from disposition of property, plant and equipment

 

81

 

103

 

Investment in software

 

(156

)

(126

)

Acquisition of businesses, net of cash acquired

 

(1

)

(71

)

Divestitures of businesses, net of cash transferred

 

33

 

 

Non-operating finance receivables — net

 

193

 

(89

)

Purchases of marketable securities and other investments

 

(1,138

)

(1,521

)

Proceeds from disposition of marketable securities and other investments

 

674

 

810

 

Net cash used in investing activities

 

(853

)

(1,764

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from new debt

 

5,979

 

2,170

 

Payments to settle debt

 

(1,768

)

(3,295

)

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

 

21

 

412

 

Common stock repurchases

 

(920

)

(777

)

Common stock repurchases for tax withholdings

 

(61

)

(53

)

Financing — other

 

9

 

16

 

Cash dividends paid

 

(1,397

)

(1,382

)

Net cash provided by/(used in) financing activities

 

1,863

 

(2,909

)

 

 

 

 

 

 

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

 

(102

)

100

 

Net change in cash, cash equivalents and restricted cash

 

5,668

 

28

 

 

 

 

 

 

 

Cash, cash equivalents and restricted cash at January 1

 

11,604

 

12,234

 

Cash, cash equivalents and restricted cash at March 31

 

$

17,272

 

$

12,262

 

 

(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, 2019

 

$

55,151

 

$

159,206

 

$

(168,071

)

$

(29,490

)

$

16,796

 

$

134

 

$

16,929

 

Net income plus other comprehensive income/(loss):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

1,591

 

 

 

 

 

1,591

 

 

 

1,591

 

Other comprehensive income/(loss)

 

 

 

 

 

 

 

308

 

308

 

 

 

308

 

Total comprehensive income/(loss)

 

 

 

 

 

 

 

 

 

$

1,899

 

 

 

$

1,899

 

Cash dividends paid — common stock ($1.57 per share)

 

 

 

(1,397

)

 

 

 

 

(1,397

)

 

 

(1,397

)

Common stock issued under employee plans (1,391,989 shares)

 

137

 

 

 

 

 

 

 

137

 

 

 

137

 

Purchases (454,710 shares) and sales (82,862 shares) of treasury stock under employee plans — net

 

 

 

2

 

(50

)

 

 

(48

)

 

 

(48

)

Other treasury shares purchased, not retired (6,856,678 shares)

 

 

 

 

 

(900

)

 

 

(900

)

 

 

(900

)

Changes in other equity

 

 

 

(5

)

 

 

 

 

(5

)

 

 

(5

)

Changes in noncontrolling interests

 

 

 

 

 

 

 

 

 

 

 

(8

)

(8

)

Equity - March 31, 2019

 

$

55,287

 

$

159,396

 

$

(169,021

)

$

(29,182

)

$

16,481

 

$

126

 

$

16,607

 

 

(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, 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 ($1.50 per share)

 

 

 

(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.)

 

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.

 

In the first quarter of 2019, the company made a number of changes to its organizational structure and management system. These changes impacted the company’s reportable segments, but did not impact the company’s Consolidated Financial Statements. Refer to note 8, “Segments,” for additional information on the changes in reportable segments. The periods presented in this Form 10-Q are reported on a comparable basis. The company provided recast historical segment information reflecting these changes in a Form 8-K dated April 4, 2019.

 

For the three months ended March 31, 2019, the company recorded a provision for income taxes of $289 million and its effective tax rate was 15.4 percent. The rate was primarily driven by the geographical mix of income and foreign and domestic audit activity, partially offset by a discrete tax charge of $129 million related to the January 2019 additional tax reform guidance issued by the U.S. Treasury.  In the first quarter of 2018, the company reported a benefit from income taxes of $540 million and its effective tax rate was (47.5) percent.  This benefit was primarily driven by audit resolutions partially offset by a discrete provisional charge related to U.S. tax reform guidance.

 

Noncontrolling interest amounts of $7.0 million and $7.8 million, net of tax, for the three months ended March 31, 2019 and 2018, 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 2018 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 August 2018, the Financial Accounting Standards Board (FASB) issued guidance which changed the disclosure requirements for fair value measurements and defined benefit plans. The guidance is effective for each of the topics on January 1, 2020 and December 31, 2020, respectively, with early adoption of certain provisions permitted. The company early adopted the provision in the fair value guidance that removed the Level 1/Level 2 transfer disclosures. The company is evaluating the adoption date for the remaining changes. As the guidance is a change to disclosures only, the company does not expect the guidance to have a material impact in the consolidated financial results.

 

In January 2017, the FASB issued guidance that simplifies the goodwill impairment test by removing Step 2. The guidance also changes the requirements for reporting units with zero or negative carrying amounts and requires additional disclosures for these reporting units. The guidance is effective January 1, 2020 and early adoption is permitted. The company expects to adopt the guidance on a prospective basis on the effective date. The company is evaluating the impact of the guidance.

 

In June 2016, with amendments in 2018, the 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

 

10


Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

credit losses. A cross-functional team was established that is evaluating the financial instruments portfolio and the system, process and policy change requirements and continues to make substantial progress. The new guidance expands the scope of financial instruments subject to impairment, including off-balance sheet commitments and residual value. The guidance is effective January 1, 2020 with one-year early adoption permitted. The company will adopt the guidance as of the effective date and is continuing to evaluate the impact.

 

Standards Implemented

 

The FASB issued guidance in February 2016, with amendments in 2018 and 2019, which changed 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 also made some changes to lessor accounting, including elimination of the use of third-party residual value guarantee insurance in the lease classification test, and overall aligns with the new revenue recognition guidance. The guidance requires qualitative and quantitative disclosures to assess the amount, timing and uncertainty of cash flows arising from leases. The company adopted the guidance effective January 1, 2019, using the transition option whereby prior comparative periods were not retrospectively presented in the Consolidated Financial Statements. The company elected the package of practical expedients not to reassess prior conclusions related to contracts containing leases, lease classification and initial direct costs and the lessee practical expedient to combine lease and nonlease components for all asset classes. The company made a policy election to not recognize right-of-use assets and lease liabilities for short-term leases for all asset classes. The guidance had a material impact on the Consolidated Statement of Financial Position as of the effective date. As a lessee, at adoption, the company recognized operating and financing right-of-use (ROU) assets of $4.8 billion and $0.2 billion, respectively, and operating and financing lease liabilities of $5.1 billion and $0.2 billion, respectively. The transition adjustment recognized in retained earnings at January 1, 2019 was not material. From a lessor perspective, the changes in lease termination guidance and removal of third-party residual value guarantee insurance in the lease classification test did not have a material impact in the consolidated financial results. Refer to note 5, “Leases,” for additional information, including further discussion on the impact of adoption.

 

In August 2018, the FASB issued guidance on a customer’s accounting for implementation costs incurred in cloud-computing arrangements that are hosted by a vendor. Certain types of implementation costs should be capitalized and amortized over the term of the hosting arrangement. The guidance is effective January 1, 2020 and early adoption is permitted. The company adopted the guidance on January 1, 2019 on a prospective basis. The guidance did not have a material impact in the consolidated financial results.

 

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 U.S. tax reform from accumulated other comprehensive income/(loss) (AOCI) to retained earnings. The guidance was 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 the actual cessation date. At adoption on January 1, 2018, $2.4 billion 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 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 was 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, SG&A expense and RD&E 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.

 

11


Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

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. The guidance required certain equity investments to be 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 point in time under previous guidance. Additionally, net deferred taxes were reduced by $184 million in the Consolidated Statement of Financial Position, resulting in a cumulative-effect net increase to retained earnings of $524 million. In the fourth quarter of 2018, the company recognized an additional impact to net deferred taxes and retained earnings of $56 million, resulting in a total net increase to retained earnings of $580 million. The decrease to net deferred taxes was the result of the company’s election to include Global Intangible Low-Taxed Income (GILTI) in measuring deferred taxes. The revenue guidance did not have a material impact in the company’s consolidated financial results. Refer to note 3, “Revenue Recognition,” for additional information.

 

In March 2016, the FASB issued guidance which changed 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. The FASB also issued guidance in May 2017 and June 2018, which relates to the accounting for modifications of share-based payment awards and accounting for share-based payments issued to non-employees, respectively. The company adopted the guidance for modifications in the second quarter of 2017, and guidance for non-employees’ payments in the second quarter of 2018. The guidance had no impact in the consolidated financial results.

 

12


Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

3. Revenue Recognition:

 

Disaggregation of Revenue

 

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

 

Revenue by Major Products/Service Offerings

 

(Dollars in millions)

 

Cloud &

 

Global

 

Global

 

 

 

 

 

 

 

 

 

For the three months

 

Cognitive

 

Business

 

Technology

 

 

 

Global

 

 

 

Total

 

ended March 31, 2019:

 

Software

 

Services

 

Services

 

Systems

 

Financing

 

Other

 

Revenue

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cognitive Applications

 

$

1,308

 

$

 

$

 

$

 

$

 

$

 

$

1,308

 

Cloud & Data Platforms

 

1,917

 

 

 

 

 

 

1,917

 

Transaction Processing Platforms

 

1,812

 

 

 

 

 

 

1,812

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Consulting

 

 

1,964

 

 

 

 

 

1,964

 

Application Management

 

 

1,908

 

 

 

 

 

1,908

 

Global Process Services

 

 

247

 

 

 

 

 

247

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Infrastructure & Cloud Services

 

 

 

5,209

 

 

 

 

5,209

 

Technology Support Services

 

 

 

1,665

 

 

 

 

1,665

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Systems Hardware

 

 

 

 

914

 

 

 

914

 

Operating Systems Software

 

 

 

 

414

 

 

 

414

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Global Financing*

 

 

 

 

 

406

 

 

406

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other Revenue

 

 

 

 

 

 

417

 

417

 

Total

 

$

5,037

 

$

4,119

 

$

6,875

 

$

1,328

 

$

406

 

$

417

 

$

18,182

 

 


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

 

Revenue by Geography

 

(Dollars in millions)

 

 

 

For the three months

 

Total

 

ended March 31, 2019:

 

Revenue

 

 

 

 

 

Americas

 

$

8,493

 

Europe/Middle East/Africa

 

5,727

 

Asia Pacific

 

3,961

 

Total

 

$

18,182

 

 

13


Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

Revenue by Major Products/Service Offerings

 

(Dollars in millions)

 

Cloud &

 

Global

 

Global

 

 

 

 

 

 

 

 

 

For the three months

 

Cognitive

 

Business

 

Technology

 

 

 

Global

 

 

 

Total

 

ended March 31, 2018:

 

Software*

 

Services*

 

Services*

 

Systems

 

Financing

 

Other*

 

Revenue

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cognitive Applications

 

$

1,286

 

$

 

$

 

$

 

$

 

$

 

$

1,286

 

Cloud & Data Platforms

 

1,950

 

 

 

 

 

 

1,950

 

Transaction Processing Platforms

 

1,880

 

 

 

 

 

 

1,880

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Consulting

 

 

1,867

 

 

 

 

 

1,867

 

Application Management

 

 

2,002

 

 

 

 

 

2,002

 

Global Process Services

 

 

246

 

 

 

 

 

246

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Infrastructure & Cloud Services

 

 

 

5,639

 

 

 

 

5,639

 

Technology Support Services

 

 

 

1,782

 

 

 

 

1,782

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Systems Hardware

 

 

 

 

1,093

 

 

 

1,093

 

Operating Systems Software

 

 

 

 

407

 

 

 

407

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Global Financing**

 

 

 

 

 

405

 

 

405

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other Revenue

 

 

 

 

 

 

515

 

515

 

Total

 

$

5,116

 

$

4,115

 

$

7,421

 

$

1,500

 

$

405

 

$

515

 

$

19,072

 

 


*   Recast to conform to 2019 presentation.

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

 

Revenue by Geography

 

(Dollars in millions)

 

 

 

For the three months

 

Total

 

ended March 31, 2018:

 

Revenue

 

 

 

 

 

Americas

 

$

8,707

 

Europe/Middle East/Africa

 

6,176

 

Asia Pacific

 

4,188

 

Total

 

$

19,072

 

 

Remaining Performance Obligations

 

The remaining performance obligation (RPO) 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.

 

At March 31, 2019, the aggregate amount of the transaction price allocated to RPO related to customer contracts that are unsatisfied or partially unsatisfied was $118 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 35 percent between three and five years and the balance (mostly Infrastructure & Cloud Services) thereafter.

 

14


Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

At December 31, 2018, the aggregate amount of the transaction price allocated to RPO related to customer contracts that were unsatisfied or partially unsatisfied was $124 billion. Given the profile of contract terms, approximately 60 percent of this amount was expected to be recognized as revenue over the next two years, approximately 35 percent between three and five years and the balance (mostly Infrastructure & Cloud Services) thereafter.

 

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

 

For the three months ending March 31, 2019, the impact to revenue from performance obligations satisfied (or partially satisfied) in previous periods was immaterial. 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. Refer to note A, “Significant Accounting Policies,” in the company’s 2018 Annual Report 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 December 31,

 

(Dollars in millions)

 

2019

 

2018

 

Notes and accounts receivable—trade (net of allowances of $316 and $309 at March 31, 2019 and December 31, 2018, respectively)

 

$

6,987

 

$

7,432

 

Contract assets (1)

 

528

 

470

 

Deferred income (current)

 

12,134

 

11,165

 

Deferred income (noncurrent)

 

3,481

 

3,445

 

 


(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, 2019 that was included within the deferred income balance at December 31, 2018 was $3.5 billion and primarily related to services and software. 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 was also primarily related to services and software.

 

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.

 

15


Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

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, operating right-of-use assets, 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 non-financial assets depend on the type of asset. There were no material impairments of non-financial assets for the three months ended March 31, 2019 and 2018, 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. Since adoption, the company measures equity investments at fair value with changes recognized in net income. Refer to note 2, “Accounting Changes,” for further information.

 

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, 2019 and December 31, 2018.

 

16


Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

(Dollars in millions)

 

 

 

 

 

 

 

 

 

At March 31, 2019

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Assets:

 

 

 

 

 

 

 

 

 

Cash equivalents (1)

 

 

 

 

 

 

 

 

 

Time deposits and certificates of deposit

 

$

 

$

12,686

 

$

 

$

12,686

(6)

Money market funds

 

25

 

 

 

25

 

U.S. government securities

 

 

1,498

 

 

1,498

(6)

Total

 

$

25

 

$

14,184

 

$

 

$

14,209

 

Equity investments (2) 

 

0

 

 

 

0

 

Debt securities - current (3)

 

 

872

 

 

872

(6)

Derivative assets (4)

 

4

 

690

 

 

694

(7)

Total assets

 

$

29

 

$

15,747

 

$

 

$

15,776

 

Liabilities:

 

 

 

 

 

 

 

 

 

Derivative liabilities (5)

 

$

 

$

705

 

$

 

$

705

(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, 2019 were $346 million and $348 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, 2019 were $316 million and $389 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 $353 million.

 

(Dollars in millions)

 

 

 

 

 

 

 

 

 

At December 31, 2018

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Assets:

 

 

 

 

 

 

 

 

 

Cash equivalents (1)

 

 

 

 

 

 

 

 

 

Time deposits and certificates of deposit

 

$

 

$

7,679

 

$

 

$

7,679

(6)

Money market funds

 

25

 

 

 

25

 

Total

 

$

25

 

$

7,679

 

$

 

$

7,704

 

Equity investments (2) 

 

0

 

 

 

0

 

Debt securities - current (3)

 

 

618

 

 

618

(6)

Derivative assets (4)

 

1

 

731

 

 

731

(7)

Total assets

 

$

26

 

$

9,028

 

$

 

$

9,053

 

Liabilities:

 

 

 

 

 

 

 

 

 

Derivative liabilities (5)

 

$

40

 

$

343

 

$

 

$

383

(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 December 31, 2018 were $385 million and $347 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, 2018 were $177 million and $206 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 $267 million.

 

17


Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

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 and including short-term finance lease liabilities) 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, 2019 and December 31, 2018, 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 (including long-term finance lease liabilities) for which a quoted market price is not available, an expected present value technique that uses rates currently available to the company for debt with similar terms and remaining maturities is used to estimate fair value. The carrying amount of long-term debt was $39,727 million and $35,605 million, and the estimated fair value was $41,675 million and $36,599 million at March 31, 2019 and December 31, 2018, respectively. If measured at fair value in the financial statements, long-term debt (including the current portion) would be classified as Level 2 in the fair value hierarchy.

 

Available-for-Sale Securities

 

Gross realized gains/losses from the sale of available-for-sale securities during the three month periods ended March 31, 2019 and 2018 were immaterial. After-tax net unrealized holding gains/losses on available-for-sale securities that have been included in other comprehensive income/loss for the three month periods ended March 31, 2019 and 2018 were immaterial.

 

The contractual maturities of substantially all available-for-sale debt securities are less than one year at March 31, 2019.

 

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

 

18


Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

collateralized arrangements that were in a liability position at March 31, 2019 and December 31, 2018 was $359 million and $74 million, respectively, for which $14 million of collateral was posted and reduced the position at March 31, 2019 and no collateral was posted at December 31, 2018. 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, 2019 and December 31, 2018 was $694 million and $731 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 $353 million and $267 million at March 31, 2019 and December 31, 2018, respectively, of liabilities included in master netting arrangements with those counterparties. Additionally, at March 31, 2019 and December 31, 2018, this exposure was reduced by $20 million and $70 million of cash collateral, respectively. There were no non-cash collateral balances in U.S. Treasury securities at March 31, 2019 and December 31, 2018. At March 31, 2019 and December 31, 2018, the net exposure related to derivative assets recorded in the Consolidated Statement of Financial Position was $321 million and $395 million, respectively. At March 31, 2019 and December 31, 2018, the net position related to derivative liabilities recorded in the Consolidated Statement of Financial Position was $338 million and $116 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. The amount recognized in other receivables for the right to reclaim cash collateral was $14 million at March 31, 2019. No amount was recognized in other receivables at December 31, 2018 for the right to reclaim cash collateral. The amount recognized in accounts payable for the obligation to return cash collateral was $20 million and $70 million at March 31, 2019 and December 31, 2018, 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. The company rehypothecated $14 million of cash collateral received at March 31, 2019 and no amount was rehypothecated at December 31, 2018.

 

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 may use forward contracts, futures contracts, interest-rate swaps, cross-currency swaps, equity 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 may use 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, 2019 and December 31, 2018, the total notional amount of the company’s interest-rate swaps was $6.8 billion and $7.6 billion, respectively. The weighted-average remaining maturity of these instruments at March 31, 2019 and December 31, 2018 was approximately 3.6 years and 3.5 years, respectively. These interest-rate contracts were accounted for as fair value hedges. The company did not have any cash flow hedges relating to this program outstanding at March 31, 2019 and December 31, 2018.

 

Forecasted Debt Issuance

 

The company is exposed to interest rate volatility on future debt issuances. To manage this risk, the company may use instruments such as forward starting interest-rate swaps to lock in the rate on the interest payments related to the forecasted debt issuances. At March 31, 2019 and December 31, 2018, the total notional amount of forward starting interest-rate swaps

 

19


Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

outstanding was $5.5 billion at both periods. These swaps are linked to future interest payments on anticipated U.S. dollar debt issuances forecasted to occur throughout 2019 and 2020. The maximum length of time over which the company has hedged its exposure to the variability in future cash flows is 30 years. These swaps are accounted for as cash flow hedges.

 

In connection with cash flow hedges of forecasted interest payments related to the company’s borrowings, the company recorded net losses of $206 million and net losses of $35 million (before taxes) at March 31, 2019 and December 31, 2018, respectively, in AOCI. The company estimates that $11 million (before taxes) of the deferred net losses on derivatives in AOCI at March 31, 2019 will be reclassified to net income within the next 12 months, providing an offsetting economic impact against the underlying anticipated transactions.

 

Foreign Exchange Risk

 

Long-Term Investments in Foreign Subsidiaries (Net Investment)

 

A large portion of the company’s foreign currency denominated debt portfolio is designated as a hedge of net investment in foreign subsidiaries to reduce the volatility in stockholders’ equity caused by changes in foreign currency exchange rates in the functional currency of major foreign subsidiaries with respect to the U.S. dollar. The company also uses cross-currency swaps and foreign exchange forward contracts for this risk management purpose. At March 31, 2019 and December 31, 2018, the total notional amount of derivative instruments designated as net investment hedges was $6.0 billion and $6.4 billion, respectively. At March 31, 2019 and December 31, 2018, 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, 2019 and December 31, 2018, the total notional amount of forward contracts designated as cash flow hedges of forecasted royalty and cost transactions was $10.0 billion and $9.8 billion, respectively. At March 31, 2019 and December 31, 2018, the weighted-average remaining maturity of these instruments was approximately 0.8 years at both periods.

 

At March 31, 2019 and December 31, 2018, in connection with cash flow hedges of anticipated royalties and cost transactions, the company recorded net gains of $356 million and net gains of $342 million (before taxes), respectively, in AOCI. The company estimates that $256 million (before taxes) of deferred net gains on derivatives in AOCI at March 31, 2019 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 12 years. At March 31, 2019 and December 31, 2018, the total notional amount of cross-currency swaps designated as cash flow hedges of foreign currency denominated debt was $12.2 billion and $6.5 billion, respectively.

 

At March 31, 2019 and December 31, 2018, in connection with cash flow hedges of foreign currency denominated borrowings, the company recorded net losses of $21 million and net gains of $75 million (before taxes), respectively, in AOCI. The company estimates that $346 million (before taxes) of deferred net gains on derivatives in AOCI at March 31, 2019 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

 

20


Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

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, 2019 and December 31, 2018, the total notional amount of derivative instruments in economic hedges of foreign currency exposure was $5.0 billion and $5.2 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 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, 2019 and December 31, 2018, the total notional amount of derivative instruments in economic hedges of these compensation obligations was $1.2 billion at both periods.

 

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, 2019 and December 31, 2018.

 

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, 2019 and December 31, 2018.

 

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, 2019 and December 31, 2018, 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, 2019 and December 31, 2018, as well as for the three months ended March 31, 2019 and 2018, respectively.

 

21


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

 

3/31/2019

 

12/31/2018

 

Classification

 

3/31/2019

 

12/31/2018

 

Designated as hedging instruments:

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

Prepaid expenses and other current assets

 

$

12

 

$

9

 

Other accrued expenses and liabilities

 

$

211

 

$

4

 

 

 

Investments and sundry assets

 

245

 

212

 

Other liabilities

 

24

 

76

 

Foreign exchange contracts

 

Prepaid expenses and other current assets

 

301

 

348

 

Other accrued expenses and liabilities

 

99

 

110

 

 

 

Investments and sundry assets

 

104

 

135

 

Other liabilities

 

365

 

129

 

 

 

Fair value of derivative assets

 

$

662

 

$

704

 

Fair value of derivative liabilities

 

$

699

 

$

320

 

Not designated as hedging instruments:

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

Prepaid expenses and other current assets

 

$

22

 

$

26

 

Other accrued expenses and liabilities

 

$

5

 

$

13

 

Equity contracts

 

Prepaid expenses and other current assets

 

10

 

2

 

Other accrued expenses and liabilities

 

0

 

51

 

 

 

Fair value of derivative assets

 

$

32

 

$

28

 

Fair value of derivative liabilities

 

$

6

 

$

63

 

Total derivatives

 

 

 

$

694

 

$

731

 

 

 

$

705

 

$

383

 

Total debt designated as hedging instruments(1):

 

 

 

 

 

 

 

 

 

 

 

 

 

Short-term debt

 

 

 

N/A

 

N/A

 

 

 

$

 

$

 

Long-term debt

 

 

 

N/A

 

N/A

 

 

 

6,175

 

6,261

 

 

 

 

 

N/A

 

N/A

 

 

 

$

6,175

 

$

6,261

 

Total

 

 

 

$

694

 

$

731

 

 

 

$

6,880

 

$

6,644

 

 


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

N/A - not applicable

 

22


Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

At March 31, 2019 and December 31, 2018, the following amounts were recorded in the Consolidated Statement of Financial Position related to cumulative basis adjustments for fair value hedges:

 

 

 

March 31,

 

December 31,

 

(Dollars in millions)

 

2019

 

2018

 

Short-term debt:

 

 

 

 

 

Carrying amount of the hedged item

 

$

(1,129

)

$

(1,878

)

Cumulative hedging adjustments included in the carrying amount - assets/(liabilities)

 

(4

)(1)

(4

)(1)

Long-term debt:

 

 

 

 

 

Carrying amount of the hedged item

 

$

(6,073

)

$

(6,004

)

Cumulative hedging adjustments included in the carrying amount - assets/(liabilities)

 

(402

)(2)

(333

)(2)

 


(1) Includes ($4) million and ($6) million of hedging adjustments on discontinued hedging relationships at March 31, 2019 and December 31, 2018, respectively.

(2) Includes ($209) million and ($213) million of hedging adjustments on discontinued hedging relationships at March 31, 2019 and December 31, 2018, respectively.

 

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:

 

 

 

 

 

Gains/(Losses) of

 

(Dollars in millions)

 

Total

 

Total Hedge Activity

 

For the three months ended March 31:

 

2019

 

2018

 

2019

 

2018

 

Cost of services

 

$

8,359

 

$

8,835

 

$

10

 

$

19

 

Cost of sales

 

1,516

 

1,722

 

18

 

(17

)

Cost of financing

 

264

 

269

 

(18

)

4

*

SG&A expense

 

4,691

 

5,445

 

141

 

(33

)

Other (income) and expense

 

(73

)

413

 

(69

)

49

 

Interest expense

 

210

 

165

 

(20

)

4

*

 


* Reclassified to conform to 2019 presentation.

 

23


Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

 

 

Gain (Loss) Recognized in Earnings

 

 

 

Consolidated

 

Recognized on

 

Attributable to Risk

 

(Dollars in millions)

 

Statement of

 

Derivatives

 

Being Hedged(2)

 

For the three months ended March 31:

 

Earnings Line Item

 

2019

 

2018

 

2019

 

2018

 

Derivative instruments in fair value hedges(1):

 

 

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

Cost of financing

 

$

36

 

$

(80

)

$

(33

)

$

96

 

 

 

Interest expense

 

39

 

(72

)

(36

)

87

 

Derivative instruments not designated as hedging instruments:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

Other (income) and expense

 

18

 

(55

)

N/A

 

N/A

 

Equity contracts

 

SG&A expense

 

119

 

(14

)

N/A

 

N/A

 

Total

 

 

 

$

212

 

$

(222

)

$

(69

)

$

182

 

 

 

 

Gain (Loss) Recognized in Earnings and Other Comprehensive Income

 

(Dollars in millions)

 

 

 

Consolidated

 

Reclassified

 

Amounts Excluded from

 

For the three months

 

Recognized in OCI

 

Statement of

 

from AOCI

 

Effectiveness Testing(3)

 

ended March 31:

 

2019

 

2018

 

Earnings Line Item

 

2019

 

2018

 

2019

 

2018

 

Derivative instruments in cash flow hedges:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

$

(171

)

$

 

Cost of financing

 

$

 

$

 

$

 

$

 

 

 

 

 

 

 

Interest expense

 

 

 

 

 

Foreign exchange contracts

 

(181

)

61

 

Cost of services

 

10

 

19

 

 

 

 

 

 

 

 

 

Cost of sales

 

18

 

(17

)

 

 

 

 

 

 

 

 

Cost of financing

 

(29

)

(18

)*

 

 

 

 

 

 

 

 

 

 

SG&A expense

 

22

 

(18

)

 

 

 

 

 

 

 

 

Other (income) and expense

 

(87

)

104

 

 

 

 

 

 

 

 

 

Interest expense

 

(33

)

(16

)*

 

 

 

 

Instruments in net investment hedges(4):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

 

 

 

 

Cost of financing

 

 

 

8

 

6

*

 

 

19

 

(204

)

Interest expense

 

 

 

9

 

6

*

Total

 

$

(333

)

$

(143

)

 

 

$

(98

)

$

54

 

$

17