Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

FORM 10 - Q

 

QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

FOR THE QUARTER ENDED SEPTEMBER 30, 2017

 

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 o
Non-accelerated filer o		Smaller reporting company o
(Do not check if a smaller reporting company)
		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 925,791,378 shares of common stock outstanding at September 30, 2017.

 

 

 

 

Table of Contents

 

Index

 

	Page
Part I - Financial Information:
Item 1. Consolidated Financial Statements (Unaudited):
Consolidated Statement of Earnings for the three and nine months ended September 30, 2017 and 2016	3
Consolidated Statement of Comprehensive Income for the three and nine months ended September 30, 2017 and 2016	4
Consolidated Statement of Financial Position at September 30, 2017 and December 31, 2016	5
Consolidated Statement of Cash Flows for the nine months ended September 30, 2017 and 2016	7
Consolidated Statement of Changes in Equity for the nine months ended September 30, 2017 and 2016	8
Notes to Consolidated Financial Statements	9
Item 2. Management’s Discussion and Analysis of Results of Operations and Financial Condition	50
Item 4. Controls and Procedures	87
Part II - Other Information:
Item 1. Legal Proceedings	87
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds and Issuer Repurchases of Equity Securities	87
Item 6. Exhibits	88

 

2

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Part I - Financial Information

 

Item 1. Consolidated Financial Statements:

 

INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF EARNINGS

(UNAUDITED)

 

		Three Months Ended September 30,						Nine Months Ended September 30,
(Dollars in millions except per share amounts)		2017			2016			2017			2016
Revenue:
Services		$	12,703		$	12,938		$	37,592		$	38,347
Sales		6,017			5,872			17,744			18,542
Financing		433			417			1,260			1,260
Total revenue		19,153			19,226			56,597			58,149
Cost:
Services		8,426			8,418			25,502			25,492
Sales		1,605			1,536			4,839			4,496
Financing		322			259			890			760
Total cost		10,353			10,213			31,232			30,748
Gross profit		8,800			9,013			25,365			27,401
Expense and other (income):
Selling, general and administrative		4,648			4,732			14,959			16,093
Research, development and engineering		1,342			1,397			4,360			4,320
Intellectual property and custom development income		(308		)	(528		)	(1,118		)	(1,110		)
Other (income) and expense		(114		)	(8		)	(218		)	281
Interest expense		168			158			451			473
Total expense and other (income)		5,735			5,751			18,434			20,056
Income from continuing operations before income taxes		3,065			3,263			6,931			7,345
Provision for/(benefit from) income taxes		339			409			120			(31		)
Income from continuing operations		$	2,726		$	2,854		$	6,811		$	7,375
Loss from discontinued operations, net of tax		0			(1		)	(3		)	(4		)
Net income		$	2,726		$	2,853		$	6,807		$	7,371
Earnings/(loss) per share of common stock:
Assuming dilution:
Continuing operations		$	2.92		$	2.98		$	7.24		$	7.67
Discontinued operations		0.00			0.00			0.00			0.00
Total		$	2.92		$	2.98		$	7.24		$	7.67
Basic:
Continuing operations		$	2.93		$	2.99		$	7.28		$	7.70
Discontinued operations		0.00			0.00			0.00			0.00
Total		$	2.93		$	2.99		$	7.28		$	7.70
Weighted-average number of common shares outstanding: (millions)
Assuming dilution		933.2			957.3			940.2			960.7
Basic		929.4			954.0			935.6			957.7
Cash dividend per common share		$	1.50		$	1.40		$	4.40		$	4.10

 

(Amounts may not add due to rounding.)

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

 

3

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INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME

 (UNAUDITED)

 

		Three Months Ended September 30,						Nine Months Ended September 30,
(Dollars in millions)		2017			2016			2017			2016
Net income		$	2,726		$	2,853		$	6,807		$	7,371
Other comprehensive income/(loss), before tax:
Foreign currency translation adjustments		89			(99		)	213			(109		)
Net changes related to available-for-sale securities:
Unrealized gains/(losses) arising during the period		(1		)	(1		)	2			(36		)
Reclassification of (gains)/losses to net income		0			(1		)	1			36
Total net changes related to available-for-sale securities		(2		)	(2		)	2			0
Unrealized gains/(losses) on cash flow hedges:
Unrealized gains/(losses) arising during the period		(70		)	35			(198		)	(221		)
Reclassification of (gains)/losses to net income		(73		)	15			(347		)	26
Total unrealized gains/(losses) on cash flow hedges		(143		)	50			(545		)	(195		)
Retirement-related benefit plans:
Prior service costs/(credits)		0			—			0			—
Net (losses)/gains arising during the period		1			11			106			(57		)
Curtailments and settlements		2			4			3			19
Amortization of prior service (credits)/costs		(22		)	(28		)	(66		)	(81		)
Amortization of net (gains)/losses		733			696			2,156			2,079
Total retirement-related benefit plans		713			683			2,200			1,960
Other comprehensive income/(loss), before tax		658			632			1,869			1,656
Income tax (expense)/benefit related to items of other comprehensive income		11			(192		)	7			(213		)
Other comprehensive income/(loss)		669			440			1,877			1,442
Total comprehensive income/(loss)		$	3,394		$	3,293		$	8,684		$	8,813

 

(Amounts may not add due to rounding.)

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

 

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INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF FINANCIAL POSITION

(UNAUDITED)

 

ASSETS

 

		At September 30,			At December 31,
(Dollars in millions)		2017			2016
Assets:
Current assets:
Cash and cash equivalents		$	10,915		$	7,826
Marketable securities		600			701
Notes and accounts receivable - trade (net of allowances of $296 in 2017 and $290 in 2016)		8,150			9,182
Short-term financing receivables (net of allowances of $270 in 2017 and $337 in 2016)		18,050			19,006
Other accounts receivable (net of allowances of $39 in 2017 and $48 in 2016)		926			1,057
Inventories, at lower of average cost or market:
Finished goods		430			358
Work in process and raw materials		1,281			1,195
Total inventories		1,711			1,553
Prepaid expenses and other current assets		4,389			4,564
Total current assets		44,742			43,888
Property, plant and equipment		31,937			30,133
Less: Accumulated depreciation		20,880			19,303
Property, plant and equipment — net		11,057			10,830
Long-term financing receivables (net of allowances of $84 in 2017 and $101 in 2016)		8,459			9,021
Prepaid pension assets		4,521			3,034
Deferred taxes		7,289			5,224
Goodwill		36,782			36,199
Intangible assets — net		3,981			4,688
Investments and sundry assets		4,806			4,585
Total assets		$	121,636		$	117,470

 

(Amounts may not add due to rounding.)

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

 

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INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF FINANCIAL POSITION — (CONTINUED)
(UNAUDITED)

 

LIABILITIES AND EQUITY

 

		At September 30,			At December 31,
(Dollars in millions)		2017			2016
Liabilities:
Current liabilities:
Taxes		$	3,038		$	3,235
Short-term debt		4,299			7,513
Accounts payable		5,442			6,209
Compensation and benefits		3,918			3,577
Deferred income		10,649			11,035
Other accrued expenses and liabilities		4,352			4,705
Total current liabilities		31,697			36,275
Long-term debt		41,327			34,655
Retirement and nonpension postretirement benefit obligations		17,554			17,070
Deferred income		3,579			3,600
Other liabilities		7,723			7,477
Total liabilities		101,879			99,078
Equity:
IBM stockholders’ equity:
Common stock, par value $0.20 per share, and additional paid-in capital		54,395			53,935
Shares authorized: 4,687,500,000
Shares issued: 2017 - 2,228,489,401
2016 - 2,225,116,815
Retained earnings		155,565			152,759
Treasury stock - at cost		(162,812		)	(159,050		)
Shares: 2017 - 1,302,698,023
2016 - 1,279,249,412
Accumulated other comprehensive income/(loss)		(27,521		)	(29,398		)
Total IBM stockholders’ equity		19,627			18,246
Noncontrolling interests		130			146
Total equity		19,757			18,392
Total liabilities and equity		$	121,636		$	117,470

 

(Amounts may not add due to rounding.)

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

 

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INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF CASH FLOWS

(UNAUDITED)

 

		Nine Months Ended September 30,
(Dollars in millions)		2017			2016
Cash flows from operating activities:
Net income		$	6,807		$	7,371
Adjustments to reconcile net income to cash provided by operating activities
Depreciation		2,231			2,106
Amortization of intangibles		1,161			1,148
Stock-based compensation		388			403
Net (gain)/loss on asset sales and other		92			100
Changes in operating assets and liabilities, net of acquisitions/divestitures		312			1,978		* **
Net cash provided by operating activities		10,991			13,105		* **
Cash flows from investing activities:
Payments for property, plant and equipment		(2,273		)	(2,594		)
Proceeds from disposition of property, plant and equipment		337			234
Investment in software		(411		)	(441		)
Acquisition of businesses, net of cash acquired		(442		)	(5,445		)
Divestitures of businesses, net of cash transferred		35			35
Non-operating finance receivables — net		469			1,441		*
Purchases of marketable securities and other investments		(3,770		)	(4,021		)
Proceeds from disposition of marketable securities and other investments		2,778			3,501
Net cash used in investing activities		(3,278		)	(7,289		)*
Cash flows from financing activities:
Proceeds from new debt		9,355			8,368
Payments to settle debt		(6,252		)	(5,616		)
Short-term borrowings/(repayments) less than 90 days — net		(794		)	(864		)
Common stock repurchases		(3,674		)	(2,632		)
Common stock repurchases for tax withholdings		(153		)	(115		)**
Common stock transactions — other		137			166
Cash dividends paid		(4,119		)	(3,927		)
Net cash used in financing activities		(5,499		)	(4,619		)**
Effect of exchange rate changes on cash and cash equivalents		875			155
Net change in cash and cash equivalents		3,089			1,352
Cash and cash equivalents at January 1		7,826			7,686
Cash and cash equivalents at September 30		$	10,915		$	9,039

 

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*   Revised classification of certain financing receivables.

** Reclassified to reflect adoption of the FASB guidance on share-based compensation.

 

(Amounts may not add due to rounding.)

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

 

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INTERNATIONAL BUSINESS MACHINES CORPORATION
 AND SUBSIDIARY COMPANIES
CONSOLIDATED STATEMENT OF CHANGES IN E QUITY
(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					6,807									6,807						6,807
Other comprehensive income/(loss)											1,877			1,877						1,877
Total comprehensive income/(loss)														$	8,684					$	8,684
Cash dividends paid — common stock					(4,119		)							(4,119		)				(4,119		)
Common stock issued under employee plans (3,372,586 shares)		460												460						460
Purchases (960,186 shares) and sales (363,335 shares) of treasury stock under employee plans — net					15			(106		)				(91		)				(91		)
Other treasury shares purchased, not retired (22,851,760 shares)								(3,655		)				(3,655		)				(3,655		)
Changes in noncontrolling interests																	(16		)	(16		)
Equity - September 30, 2017		$	54,395		$	155,565		$	(162,812	)	$	(27,521	)	$	19,627		$	130		$	19,757

 

		Common
		Stock and									Accumulated
		Additional									Other			Total IBM			Non-
		Paid-in			Retained			Treasury			Comprehensive			Stockholders’			Controlling			Total
(Dollars in millions)		Capital			Earnings			Stock			Income/(Loss)			Equity			Interests			Equity
Equity - January 1, 2016		$	53,262		$	146,124		$	(155,518	)	$	(29,607	)	$	14,262		$	162		$	14,424
Net income					7,371									7,371						7,371
Other comprehensive income/(loss)											1,442			1,442						1,442
Total comprehensive income/(loss)														$	8,813					$	8,813
Cash dividends paid — common stock					(3,927		)							(3,927		)				(3,927		)
Common stock issued under employee plans (3,370,992 shares)		513												513						513
Purchases (787,805 shares) and sales (336,480 shares) of treasury stock under employee plans — net					16			(72		)				(56		)				(56		)
Other treasury shares purchased, not retired (17,793,841 shares)								(2,579		)				(2,579		)				(2,579		)
Changes in other equity		(16		)	0									(17		)				(17		)
Changes in noncontrolling interests																	(12		)	(12		)
Equity - September 30, 2016		$	53,759		$	149,585		$	(158,170	)	$	(28,164	)	$	17,010		$	149		$	17,159

 

---

* Reflects the adoption of the FASB guidance on intra-entity transfers of assets in the first-quarter 2017.

 

(Amounts may not add due to rounding.)

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

 

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Notes to Consolidated Financial Statements:

 

1. Basis of Presentation: The accompanying Consolidated Financial Statements and footnotes of the International Business Machines Corporation (IBM or the company) have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial statements and footnotes are unaudited. In the opinion of the company’s management, these statements include all adjustments, which are only of a normal recurring nature, necessary to present a fair statement of the company’s results of operations, financial position and cash flows.

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amount of assets, liabilities, revenue, costs, expenses and other comprehensive income/(loss) that are reported in the Consolidated Financial Statements and accompanying disclosures. These estimates are based on management’s best knowledge of current events, historical experience, actions that the company may undertake in the future and on various other assumptions that are believed to be reasonable under the circumstances. As a result, actual results may be different from these estimates. Refer to the company’s 2016 Annual Report on pages 71 to 74, for a discussion of the company’s critical accounting estimates.

 

The company revised the classification of certain financing receivables for the three and nine months ended September 30, 2016, decreasing net cash provided by operating activities and net cash used in investing activities in the amount of $99 million and $311 million, respectively, which the company concluded to be immaterial to the periods presented. The twelve-month revision for the period ended December 31, 2016 was provided in the company’s 2016 Annual Report on page 26. There was no impact to total GAAP cash flows or free cash flow.

 

In the first quarter of 2017, the company reported a benefit from income taxes of $329 million, and its effective tax rate was (23.1) percent. This was primarily driven by a discrete tax benefit of $582 million from a first-quarter 2017 transaction accounted for under the new Financial Accounting Standards Board (FASB) guidance related to intra-entity transfers of assets. This benefit was partially offset by a discrete tax charge related to foreign audit activity of $99 million. The company had additional discrete tax benefits of $170 million in second-quarter 2017. For the nine months ended September 30, 2017, the company reported a provision for income taxes of $120 million and its effective tax rate was 1.7 percent, primarily as a result of the first and second quarter discrete items. For the nine months ended September 30, 2016, the company reported a benefit from income taxes of $31 million and its effective tax rate was (0.4) percent. The negative effective tax rate in the comparable period of 2016 was due to the resolution of a long-standing Japan tax matter in February 2016. Refer to note 2, “Accounting Changes,” and the Taxes section of the Management Discussion for additional information.

 

Noncontrolling interest amounts of $4.4 million and $3.1 million, net of tax, for the three months ended September 30, 2017 and 2016, respectively, and $11.5 million and $7.5 million, net of tax, for the nine months ended September 30, 2017 and 2016, 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 2016 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 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 plans to adopt the guidance as of January 1, 2018. The guidance is not expected to 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. Under the guidance, the service cost component of net benefit cost will continue to be presented in the same line items as other employee compensation costs, unless eligible for capitalization in the Consolidated Statement of Financial Position. The other components of net benefit costs will be presented separately from service cost as non-operating costs in the Consolidated Statement of Earnings or Notes to the Consolidated Financial Statements. The guidance is effective

 

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Notes to Consolidated Financial Statements — (continued)

 

January 1, 2018 with early adoption permitted. The company will adopt the guidance as of the effective date. The guidance is primarily a change in financial statement presentation and is not expected to have a material impact in the consolidated financial results.

 

In June 2016, 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 credit losses. The guidance is effective January 1, 2020 with a one year early adoption permitted. The company is evaluating the impact of the new guidance.

 

In February 2016, the FASB issued guidance which changes the accounting for leases. The guidance requires lessees to recognize right-of-use assets and lease liabilities for most leases in the Consolidated Statement of Financial Position. The guidance makes some changes to lessor accounting, including the elimination of the use of 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. 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 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’s operating lease commitments were $6.9 billion at December 31, 2016. In 2016, the use of third-party residual value guarantee insurance resulted in the company recognizing $220 million of sales-type lease revenue that would otherwise have been recognized over the lease period as operating lease revenue.

 

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

 

The FASB issued guidance on the recognition of revenue from contracts with customers in May 2014 with amendments in 2015 and 2016. Revenue recognition will depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance also requires disclosures regarding the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. The guidance permits two methods of adoption: retrospectively to each prior reporting period presented, or retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial application (the cumulative catch-up transition method). The company will adopt the guidance on January 1, 2018 and apply the cumulative catch-up transition method. The transition adjustment to be recorded to stockholders’ equity upon adoption of the new standard is not expected to be material.

 

Given the scope of work required to implement the recognition and disclosure requirements under the new standard, the company began its assessment process in 2014 and has identified changes to policy, processes, systems and controls. This also includes the assessment of data availability and presentation necessary to meet the additional disclosure requirements of the guidance in the Notes to the Consolidated Financial Statements.

 

The company expects revenue recognition for its broad portfolio of hardware, software and services offerings to remain largely unchanged. However, the guidance is expected to change the timing of revenue recognition in certain areas, including accounting for certain software licenses. These impacts are not expected to be material. The company expects to continue to recognize revenue for term license (recurring license charge) software arrangements on a monthly basis over the period that the client is entitled to use the license due to the contractual terms in these arrangements.

 

Since the company currently expenses sales commissions as incurred, the requirement in the new standard to capitalize certain in-scope sales commissions will result in an accounting change for the company.  However, the impact to the consolidated financial statements is not expected to be material, with no impact to cash flows.

 

The company continues to assess all potential impacts of the guidance and given normal ongoing business dynamics, preliminary conclusions are subject to change.

 

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Notes to Consolidated Financial Statements — (continued)

 

Standards Implemented

 

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 is effective January 1, 2018 and early adoption is permitted. The company adopted the guidance effective January 1, 2017, and it did not have a material impact in the consolidated financial results.

 

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 is effective January 1, 2018 and early adoption is 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 credit 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 nine months ended September 30, 2017. There was no impact in the consolidated financial results for the three months ended September 30, 2017. 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. See note 5, “Stock-Based Compensation,” for additional information. 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.

 

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

 

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

 

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

 

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Notes to Consolidated Financial Statements — (continued)

 

3. Financial Instruments:

 

Fair Value Measurements

 

Accounting guidance defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Under this guidance, the company is required to classify certain assets and liabilities based on the following fair value hierarchy:

 

·                   Level 1—Quoted prices (unadjusted) in active markets for identical assets or liabilities that can be accessed at the measurement date;

·                   Level 2—Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly; and

·                   Level 3—Unobservable inputs for the asset or liability.

 

The guidance requires the use of observable market data if such data is available without undue cost and effort.

 

When available, the company uses unadjusted quoted market prices in active markets to measure the fair value and classifies such items as Level 1. If quoted market prices are not available, fair value is based upon internally developed models that use current market-based or independently sourced market parameters such as interest rates and currency rates. Items valued using internally generated models are classified according to the lowest level input or value driver that is significant to the valuation.

 

The determination of fair value considers various factors including interest rate yield curves and time value underlying the financial instruments. For derivatives and debt securities, the company uses a discounted cash flow analysis using discount rates commensurate with the duration of the instrument.

 

In determining the fair value of financial instruments, the company considers certain market valuation adjustments to the “base valuations” calculated using the methodologies described below for several parameters that market participants would consider in determining fair value:

 

·                   Counterparty credit risk adjustments are applied to financial instruments, taking into account the actual credit risk of a counterparty as observed in the credit default swap market to determine the true fair value of such an instrument.

·                   Credit risk adjustments are applied to reflect the company’s own credit risk when valuing all liabilities measured at fair value. The methodology is consistent with that applied in developing counterparty credit risk adjustments, but incorporates the company’s own credit risk as observed in the credit default swap market.

 

As an example, the fair value of derivatives is derived utilizing a discounted cash flow model that uses observable market inputs such as known notional value amounts, yield curves, spot and forward exchange rates as well as discount rates. These inputs relate to liquid, heavily traded currencies with active markets which are available for the full term of the derivative.

 

Certain financial assets are measured at fair value on a nonrecurring basis. These assets include equity method investments that are recognized at fair value at the measurement date to the extent that they are deemed to be other-than-temporarily impaired. Certain assets that are measured at fair value on a recurring basis can be subject to nonrecurring fair value measurements. These assets include available-for-sale equity investments that are deemed to be other-than-temporarily impaired. In the event of an other-than-temporary impairment of a financial investment, fair value is measured using a model described above.

 

Non-financial assets such as property, plant and equipment, land, goodwill and intangible assets are also subject to nonrecurring fair value measurements if they are deemed to be impaired. The impairment models used for nonfinancial assets depend on the type of asset. During the nine months ended September 30, 2016, a pre-tax impairment charge related to certain property, plant and equipment of $218 million was recorded. There were no material impairments of non-financial assets for the nine months ended September 30, 2017.

 

Accounting guidance permits the measurement of eligible financial assets, financial liabilities and firm commitments at fair value, on an instrument-by-instrument basis, that are otherwise not permitted to be accounted for at fair value under other accounting standards. This election is irrevocable. The company has not applied the fair value option to any eligible assets or liabilities.

 

The following tables present the company’s financial assets and financial liabilities that are measured at fair value on a recurring basis at September 30, 2017 and December 31, 2016.

 

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Notes to Consolidated Financial Statements — (continued)

 

(Dollars in millions)
At September 30, 2017		Level 1			Level 2			Level 3			Total
Assets:
Cash equivalents (1)
Time deposits and certificates of deposit		$	—		$	5,553		$	—		$	5,553
Money market funds		1,375			—			—			1,375
U.S. government securities		—			200			—			200
Canadian government securities		—			460			—			460
Total		1,375			6,214			—			7,589		(6)
Debt securities - current (2)		—			599			—			599		(6)
Debt securities - noncurrent (3)		4			7			—			11
Available-for-sale equity investments (3)		5			—			—			5
Derivative assets (4)
Interest rate contracts		—			517			—			517
Foreign exchange contracts		—			416			—			416
Equity contracts		—			23			—			23
Total		—			957			—			957		(7)
Total assets		$	1,384		$	7,775		$	—		$	9,159	(7)
Liabilities:
Derivative liabilities (5)
Foreign exchange contracts		$	—		$	333		$	—		$	333
Equity contracts		—			4			—			4
Interest rate contracts		—			15			—			15
Total liabilities		$	—		$	352		$	—		$	352	(7)

 

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

(2) U.S. government securities reported as marketable securities in the Consolidated Statement of Financial Position.

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

(4) The gross balances of derivative assets contained within prepaid expenses and other current assets, and investments and sundry assets in the Consolidated Statement of Financial Position at September 30, 2017 were $269 million and $687 million, respectively.

(5) The gross balances of derivative liabilities contained within other accrued expenses and liabilities, and other liabilities in the Consolidated Statement of Financial Position at September 30, 2017 were $332 million and $20 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 $274 million.

 

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Notes to Consolidated Financial Statements — (continued)

 

(Dollars in millions)
At December 31, 2016		Level 1			Level 2			Level 3			Total
Assets:
Cash equivalents (1)
Time deposits and certificates of deposit		$	—		$	3,629		$	—		$	3,629
Money market funds		1,204			—			—			1,204
Total		1,204			3,629			—			4,832		(6)
Debt securities - current (2)		—			699			—			699		(6)
Debt securities - noncurrent (3)		1			6			—			8
Available-for-sale equity investments (3)		7			—			—			7
Derivative assets (4)
Interest rate contracts		—			555			—			555
Foreign exchange contracts		—			560			—			560
Equity contracts		—			11			—			11
Total		—			1,126			—			1,126		(7)
Total assets		$	1,212		$	5,460		$	—		$	6,672	(7)
Liabilities:
Derivative liabilities (5)
Foreign exchange contracts		$	—		$	188		$	—		$	188
Equity contracts		—			10			—			10
Interest rate contracts		—			8			—			8
Total liabilities		$	—		$	206		$	—		$	206	(7)

 

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

(2) U.S government securities reported as marketable securities in the Consolidated Statement of Financial Position.

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

(4) The gross balances of derivative assets contained within prepaid expenses and other current assets, and investments and sundry assets in the Consolidated Statement of Financial Position at December 31, 2016 were $532 million and $594 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, 2016 were $145 million and $61 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 $116 million.

 

There were no transfers between Levels 1 and 2 for the nine months ended September 30, 2017 and the year ended December 31, 2016.

 

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 September 30, 2017 and December 31, 2016, the difference between the carrying amount and estimated fair value for loans and long-term receivables was immaterial. If measured at fair value in the financial statements, these financial instruments would be classified as Level 3 in the fair value hierarchy.

 

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