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EX-32.2 - EX-32.2 - IBM CREDIT LLCibmc-20180930ex3224b16ab.htm
EX-32.1 - EX-32.1 - IBM CREDIT LLCibmc-20180930ex321310bad.htm
EX-31.2 - EX-31.2 - IBM CREDIT LLCibmc-20180930ex312353a32.htm
EX-31.1 - EX-31.1 - IBM CREDIT LLCibmc-20180930ex3110e056f.htm
EX-12 - EX-12 - IBM CREDIT LLCibmc-20180930ex12fd102a1.htm

 

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, 2018

 

000-55786

(Commission file number)

 

IBM CREDIT LLC

(Exact name of registrant as specified in its charter)

 

Delaware

    

22-2351962

(State or Other Jurisdiction of
Incorporation or Organization)

 

(IRS employer identification number)

 

 

Armonk, New York

    

10504

(Address of principal executive offices)

 

(Zip Code)

 

914-765-1900

(Registrant’s telephone number)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(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  ☒    No  ☐

 

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  ☒     No  ☐

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a 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 ☐

    

Accelerated filer  ☐

 

 

 

Non-accelerated filer  ☒

 

Smaller reporting company ☐

 

 

 

 

 

Emerging growth company ☐

 

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

 

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

 

All of the limited liability company interests ("Interests") in the registrant are held by an affiliate of the registrant. None of the Interests are publicly traded.

 

REDUCED DISCLOSURE FORMAT

 

IBM Credit LLC, an indirect, wholly owned subsidiary of International Business Machines Corporation (IBM), meets the conditions set forth in General Instruction H(1)(a) and (b) of Form 10-Q and is therefore filing this form with the reduced disclosure format.

 

 

 

 

 

 


 

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, 2018 and 2017 

 

3

 

 

 

Consolidated Statement of Comprehensive Income for the three and nine months ended September 30, 2018 and 2017 

 

4

 

 

 

Consolidated Statement of Financial Position at September 30, 2018 and December 31, 2017 

 

5

 

 

 

Consolidated Statement of Cash Flows for the nine months ended September 30, 2018 and 2017 

 

6

 

 

 

Consolidated Statement of Changes in Member’s Interest for the nine months ended September 30, 2018 and 2017 

 

7

 

 

 

Notes to Consolidated Financial Statements 

 

8

 

 

 

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

 

33

 

 

 

Item 4. Controls and Procedures 

 

51

 

 

 

Part II - Other Information 

 

 

 

 

 

Item 1. Legal Proceedings 

 

52

 

 

 

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

 

52

 

 

 

Item 6. Exhibits 

 

52

 

 

2


 

Part I— Financial Information

 

Item 1. Consolidated Financial Statements:

 

IBM CREDIT LLC AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF EARNINGS

(UNAUDITED)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30, 

 

Nine Months Ended September 30, 

 

(Dollars in millions)

    

2018

    

2017

    

2018

    

2017

 

Revenue

 

 

  

 

 

  

 

 

  

 

 

  

 

Financing revenue

 

$

367

 

$

321

 

$

1,084

 

$

986

 

Operating lease revenue

 

 

85

 

 

96

 

 

250

 

 

288

 

Total revenue

 

$

452

 

$

418

 

$

1,334

 

$

1,274

 

Financing cost (related party cost for three and nine months: $81 and $215 in 2018, $66 and $201 in 2017)

 

$

135

 

$

95

 

$

362

 

$

267

 

Depreciation of equipment under operating lease

 

 

50

 

 

59

 

 

146

 

 

178

 

Net margin

 

$

268

 

$

264

 

$

827

 

$

829

 

Expense and other (income)

 

 

 

 

 

 

 

 

 

 

 

 

 

Selling, general and administrative

 

$

89

 

$

94

 

$

292

 

$

303

 

Provision for/(benefit from) credit losses

 

 

(10)

 

 

 2

 

 

24

 

 

11

 

Other (income) and expense

 

 

 5

 

 

 3

 

 

(11)

 

 

28

 

Total expense and other (income)

 

$

84

 

$

99

 

$

305

 

$

341

 

Income from before income taxes

 

$

184

 

$

165

 

$

522

 

$

488

 

Provision for income taxes

 

 

39

 

 

38

 

 

112

 

 

112

 

Net income

 

$

144

 

$

127

 

$

410

 

$

376

 

 

(Amounts may not add due to rounding.)

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

 

 

3


 

Table of Contents

Consolidated Financial Statements — (continued)

 

IBM CREDIT LLC AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME

(UNAUDITED)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30, 

 

Nine Months Ended September 30, 

 

(Dollars in millions)

    

2018

    

2017

    

2018

    

2017

 

Net income

 

$

144

 

$

127

 

$

410

 

$

376

 

Other comprehensive income/(loss), before tax:

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign currency translation

 

 

(20)

 

 

151

 

 

(119)

 

 

368

 

Retirement-related benefit plans (1)

 

 

0

 

 

0

 

 

 1

 

 

 2

 

Other comprehensive income/(loss), before tax

 

 

(20)

 

 

151

 

 

(117)

 

 

370

 

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

 

 

(6)

 

 

(8)

 

 

(22)

 

 

(8)

 

Other comprehensive income/(loss), net of tax

 

$

(26)

 

$

143

 

$

(139)

 

$

361

 

Total comprehensive income

 

$

118

 

$

270

 

$

270

 

$

737

 


(1)

Amounts represented relate to multiple-employer plans.

(Amounts may not add due to rounding.)

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

 

4


 

Table of Contents

Consolidated Financial Statements — (continued)

 

IBM CREDIT LLC AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF FINANCIAL POSITION

(UNAUDITED)

 

 

 

 

 

 

 

 

 

 

 

At September 30, 

 

At December 31, 

 

(Dollars in millions)

    

2018

    

2017

 

Assets:

 

 

  

 

 

  

 

Cash and cash equivalents

 

$

1,961

 

$

2,680

 

Financing receivables

 

 

22,653

 

 

26,066

 

(net of allowances of $189 in 2018 and $173 in 2017)

 

 

 

 

 

 

 

Equipment under operating leases

 

 

425

 

 

401

 

(net of accumulated depreciation of $273 in 2018 and $288 in 2017)

 

 

 

 

 

 

 

Financing receivables from IBM

 

 

3,779

 

 

3,743

 

Receivables purchased/participated from IBM

 

 

4,890

 

 

5,239

 

(net of allowances of $33 in 2018 and $39 in 2017)

 

 

 

 

 

 

 

Other receivables from IBM

 

 

2,549

 

 

1,024

 

Other assets

 

 

439

 

 

364

 

Total assets

 

$

36,694

 

$

39,516

 

 

 

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

 

 

Accounts payable

 

$

1,516

 

$

1,776

 

Accounts payable to IBM

 

 

1,142

 

 

2,903

 

Debt

 

 

7,928

 

 

5,779

 

Debt payable to IBM

 

 

21,946

 

 

24,698

 

Taxes

 

 

562

 

 

530

 

Other liabilities

 

 

240

 

 

269

 

Total liabilities

 

$

33,334

 

$

35,954

 

Member’s interest:

 

 

 

 

 

 

 

Member's interest

 

 

3,215

 

 

3,101

 

Retained earnings

 

 

131

 

 

302

 

Accumulated other comprehensive income/(loss)

 

 

13

 

 

158

 

Total member's interest

 

$

3,360

 

$

3,562

 

Total liabilities and member’s interest

 

$

36,694

 

$

39,516

 

 

(Amounts may not add due to rounding.)

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

5


 

Table of Contents

Consolidated Financial Statements — (continued)

 

IBM CREDIT LLC AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF CASH FLOWS

(UNAUDITED)

 

 

 

 

 

 

 

 

 

 

 

Nine Months Ended September 30, 

 

(Dollars in millions)

    

2018

    

2017

 

Cash flows from operating activities:

 

 

  

 

 

  

 

Net income

 

$

410

 

$

376

 

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

 

 

 

 

 

 

 

Provision for credit losses

 

 

24

 

 

11

 

Depreciation

 

 

146

 

 

178

 

Deferred taxes

 

 

(6)

 

 

(35)

 

Net (gain)/loss on asset sales and other

 

 

(67)

 

 

187

 

Change in operating assets and liabilities:

 

 

 

 

 

 

 

Other assets/other liabilities

 

 

306

 

 

(111)

 

Net cash provided by operating activities

 

$

812

 

$

607

 

 

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

  

 

Originations of financing receivables

 

$

(10,978)

 

$

(8,323)

 

Collection of financing receivables

 

 

10,566

 

 

9,097

 

Short-term financing receivables - net (1)

 

 

1,320

 

 

673

 

Purchase of equipment under operating leases

 

 

(221)

 

 

(202)

 

Proceeds from disposition of equipment under operating lease

 

 

53

 

 

79

 

Other receivables from IBM - net

 

 

(1,682)

 

 

(1,287)

 

Other investing activities - net

 

 

90

 

 

(63)

 

Net cash used in investing activities

 

$

(853)

 

$

(26)

 

 

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

  

 

Proceeds from issuance of debt from IBM

 

$

8,696

 

$

5,735

 

Principal payments on debt from IBM

 

 

(8,262)

 

 

(6,234)

 

Proceeds from issuance of debt

 

 

2,581

 

 

3,822

 

Principal payments on debt

 

 

(755)

 

 

(371)

 

Short-term borrowings from/(repayments to) IBM - net (1)

 

 

(2,897)

 

 

(2,206)

 

Short-term borrowings/(repayments) - net (1)

 

 

448

 

 

(32)

 

Net transfers (to)/from IBM

 

 

 —

 

 

(942)

 

Contributions from IBM

 

 

148

 

 

88

 

Distributions to IBM

 

 

(620)

 

 

(365)

 

Net cash used in financing activities

 

$

(661)

 

$

(504)

 

 

 

 

 

 

 

 

 

Effect of exchange rate changes on cash and cash equivalents

 

$

(17)

 

$

43

 

Net change in cash and cash equivalents

 

$

(719)

 

$

120

 

 

 

 

 

 

 

 

 

Cash and cash equivalents at January 1

 

 

2,680

 

 

1,772

 

Cash and cash equivalents at September 30

 

$

1,961

 

$

1,892

 

 

 

 

 

 

 

 

 


(1)

Short-term represents original maturities of 90 days or less.

(Amounts may not add due to rounding.)

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

6


 

Table of Contents

Consolidated Financial Statements — (continued)

 

IBM CREDIT LLC AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF CHANGES IN MEMBER'S INTEREST

(UNAUDITED)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

 

 

 

 

 

Other

 

Total

 

 

 

 

Member's

 

Retained

 

Comprehensive

 

Member’s

(Dollars in millions)

 

 

 

    

Interest

    

Earnings

    

Income/(Loss)

    

Interest

Member’s Interest, January 1, 2018

 

 

 

 

$

3,101

 

$

302

 

$

158

 

$

3,562

Cumulative effect of change in accounting principle*

 

 

 

 

 

 

 

 

 5

 

 

(5)

 

 

 —

Net income plus other comprehensive income/(loss):

 

 

 

 

 

  

 

 

  

 

 

  

 

 

    

Net income

 

 

 

 

 

 

 

 

410

 

 

  

  

 

410

Other comprehensive income/(loss), net of tax

 

 

 

 

 

  

 

 

  

 

 

(139)

  

 

(139)

Total comprehensive income/(loss)

 

 

 

 

 

  

 

 

  

  

$

270

Contributions from IBM

 

 

 

 

 

148

 

 

 

 

 

 

  

 

148

Distributions to IBM

 

 

 

 

 

(34)

 

 

(586)

 

 

 

 

 

(620)

Member’s Interest, September 30, 2018

 

 

 

 

$

3,215

 

$

131

 

$

13

 

$

3,360

 


* Reflects the adoption of the FASB guidance on stranded tax effects. Refer to note 2, "Accounting Changes".

(Amounts may not add due to rounding.)

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

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Prior

 

 

 

 

 

 

 

Accumulated

 

 

 

 

 

Investment

 

 

 

 

 

 

Other

 

Total

 

 

From

 

Member's

 

Retained

 

Comprehensive

 

Member’s

(Dollars in millions)

    

Member

    

Interest

    

Earnings

    

Income/(Loss)

    

Interest

Member’s Interest, January 1, 2017

 

$

3,912

 

$

 —

 

$

 —

 

$

(209)

 

$

3,703

Net income plus other comprehensive income/(loss):

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

Net income

 

 

137

 

 

 

 

 

239

 

 

  

 

 

376

Other comprehensive income/(loss), net of tax

 

 

  

 

 

  

 

 

  

 

 

361

 

 

361

Total comprehensive income/(loss)

 

 

  

 

 

  

 

 

  

 

 

  

 

$

737

Net transfers (to)/from IBM

 

 

(942)

 

 

 

 

 

  

 

 

  

 

 

(942)

Prior investment from member, March 31, 2017

 

 

3,106

 

 

 

 

 

 

 

 

 

 

 

 

Transfer upon consolidation

 

 

(3,106)

 

 

3,106

 

 

 

 

 

 

 

 

 

Contributions from IBM

 

 

 

 

 

88

 

 

 

 

 

 

 

 

88

Distributions to IBM

 

 

 

 

 

(126)

 

 

(239)

 

 

 

 

 

(365)

Member’s Interest, September 30, 2017

 

$

 —

 

$

3,068

 

$

 —

 

$

152

 

$

3,220


(Amounts may not add due to rounding.)

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

 

 

 

7


 

Notes to Consolidated Financial Statements:

1. Basis of Presentation:

The accompanying Consolidated Financial Statements and footnotes of IBM Credit LLC (IBM Credit 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 pages 41 through 43 of the company’s 2017 Form 10-K, filed with the Securities and Exchange Commission (SEC) on March 1, 2018, for a discussion of the company’s critical accounting estimates.

During the second quarter of 2017, certain non-U.S. affiliates of IBM Credit became subsidiaries of the company, which are subsequently reported on a consolidated basis. All prior periods have been recast to reflect the consolidation of the financial statements and conform to the current year presentation as a result of changes to certain financial statement line items. These changes include other receivables from IBM and accounts payable, which are separately reported in the Consolidated Statement of Financial Position and were previously reported within other assets and other liabilities, respectively. Other receivables from IBM are separately reported in the Consolidated Statement of Cash Flows and were previously reported within other investing activities-net. The reporting for accounts payable within the Consolidated Statement of Cash Flows did not change.

Member’s Interest in the Consolidated Statement of Financial Position represents the accumulation of the company’s net income over time and contributions from IBM and distributions to IBM. Prior to the consolidation of the financial statements in the second quarter of 2017, net non-trade intercompany transactions between IBM Credit and IBM (for example, contributions from IBM and distributions to IBM), were reflected as net transfers (to)/from IBM in the financing activities section of the Statement of Cash Flows. Distributions by the company to IBM are considered first to be a return of profit as reflected in the balance of retained earnings in the Consolidated Statement of Financial Position. Any amount distributed to IBM in excess of the company’s available balance in retained earnings is considered a return of a portion of the balance of member’s interest as reflected in the Consolidated Statement of Financial Position.

Income tax expense is based on reported income before income taxes. Whereas the majority of non-U.S. entities are separate legal tax filers, the company’s U.S. federal and certain state and foreign operations will continue to be included in various IBM consolidated tax returns. In such cases, the income taxes for these entities are calculated using a separate return method modified to apply the benefits-for-loss approach, which is consistent with the company’s Tax Sharing Agreement with IBM. Under this approach, the provision for income taxes is computed as if the company filed tax returns on a separate tax return basis and is then adjusted, as necessary, to reflect IBM’s reimbursement for any tax benefits generated by the company.

On December 22, 2017, the U.S. Tax Cuts and Jobs Act (U.S. tax reform) was enacted, resulting in the company recording a provisional net benefit of $162 million to tax expense in the fourth-quarter and year-ended December 31, 2017. An additional provisional charge of $4 million was recorded in the first quarter as a result of Internal Revenue Service (IRS) guidance issued in January 2018 and a provisional benefit of $2 million was recorded in the second quarter as a result of IRS guidance issued in early April 2018. The final impact of U.S. tax reform may differ, possibly materially, due to factors such as changes in interpretations and assumptions that the company has made in its assessment. The company has not completed its assessment and the net tax benefit remains provisional as of September 30, 2018. Any changes to the net tax benefit will be finalized in the fourth quarter of 2018 which is within the 12 month time limit provided by the SEC.

8


 

Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

The amount of restricted cash included in the Consolidated Statement of Financial Position and Consolidated Statement of Cash Flows is immaterial for the periods presented.

All significant intracompany transactions between IBM Credit’s businesses have been eliminated. All significant intercompany transactions between IBM Credit and IBM have been included in these Consolidated Financial Statements.

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 Consolidated Financial Statements included in the Form 10-K.

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 changes the disclosure requirements for fair value measurements. The guidance is effective on January 1, 2020, with early adoption of certain provisions permitted. As a result, the company has removed Level 1/Level 2 transfer disclosures in the third-quarter 2018 in accordance with the fair value guidance. 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 on 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. A cross-functional team has been established which is evaluating the financial instruments portfolio and system, process and policy change requirements. 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 and the company is continuing to evaluate the impact of the new guidance and adoption date.

The FASB issued guidance in February 2016, with amendments in 2018, which changes the accounting for leases. The guidance requires lessees to recognize right-of-use assets and lease liabilities for most leases in the Consolidated Statement of Financial Position. The guidance makes certain changes to lessor accounting, including the elimination of the use of third-party residual value guarantee insurance in the sales-type lease test, initial direct cost capitalization, lease termination guidance and sale-leaseback accounting 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 and will apply the transition option, whereby prior comparative periods will not be retrospectively presented in the consolidated financial statements.

A cross-functional implementation team is evaluating the lease portfolio, system, process, control and policy change requirements. The company will elect the package of practical expedients to not reassess prior conclusions related to contracts containing leases, lease classification and initial direct costs. The company is evaluating the other practical expedients available under the guidance.

As a lessee, the recording of operating lease right-of-use assets and liabilities in the Consolidated Statement of Financial Position is not expected to have a material impact to the company’s consolidated financial results. IBM Credit’s global operations are primarily conducted in IBM leased or owned facilities, whereby IBM charges the company for occupancy expenses based on square footage space usage, with no fixed term commitment. For additional information, see Note 8, “Relationship with IBM and Related Party Transactions”.

9


 

Table of Contents

 

Notes to Consolidated Financial Statements — (continued)

 

As a lessor, under the new capitalization requirements for initial direct costs, the company expects to capitalize lower lease origination expenses than under the previous guidance. However, this change is not expected to have a material impact to the company’s consolidated financial results. 

Due to changes to lease termination guidance, when equipment is returned to the company prior to the end of the lease term, the carrying amounts of lease receivables, which remain outstanding relating to that equipment and still expected to be collected, will be reclassified to loan receivables. The amount of receivables that would have been reclassified from lease to loan in 2017 under the application of this new guidance would have been approximately $450 million.

The company continues to assess the potential impacts of the guidance, including changes to the guidance expected to be issued by the FASB, normal and ongoing business dynamics or potential changes in contracting terms, and as a result, preliminary conclusions are subject to change.

Standards Implemented

In February 2018, the FASB issued guidance that allows entities to elect an option to reclassify the stranded tax effects related to the application of U.S. tax reform from accumulated other comprehensive income/(loss) (“AOCI”) to retained earnings. The guidance is effective January 1, 2019 with early adoption permitted, and can be applied either in the period of adoption or retrospectively to all applicable periods. The company adopted the guidance effective January 1, 2018, and elected not to reclassify prior periods. In accordance with its accounting policy, the company releases income tax effects from AOCI once the reason the tax effects were established ceases to exist. This guidance allows for the reclassification of stranded tax effects as a result of the change in tax rates from U.S. tax reform to be recorded upon adoption of the guidance rather than at an actual cessation date. At adoption, $5 million was reclassified from AOCI to retained earnings.

In August 2017, the FASB issued guidance to simplify the application of current hedge accounting in certain areas, better portray the economic results of an entity’s risk management activities in its financial statements and make targeted improvements to presentation and disclosure requirements. The guidance is effective January 1, 2019 with early adoption permitted. The company adopted the guidance as of January 1, 2018, and it did not have a material impact in the consolidated financial results for the three and nine months ended September 30, 2018.

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 specific disclosures relating to revenue recognition. 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 modified-retrospective transition method).

The company adopted the guidance on January 1, 2018 using the modified-retrospective transition method. The company has concluded that substantially all of its financing and operating lease revenue streams are not within the scope of the guidance, as they are governed by other accounting standards. The guidance did not have an impact on the company’s consolidated financial results for the three and nine months ended September 30, 2018. The company concluded its assessment of the data availability and presentation necessary to meet the additional disclosure requirements of the guidance in the Notes to the Consolidated Financial Statements and there is no material change to disclosures as a result of the adoption of the guidance.

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:

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Notes to Consolidated Financial Statements — (continued)

 

·

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

·

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

·

Level 3—Unobservable inputs for the asset or liability.

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

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

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

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

·

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

·

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

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

Certain assets that are measured at fair value on a recurring basis can be subject to nonrecurring fair value measurements. These assets include available-for-sale debt securities that are deemed to be other-than-temporarily impaired. In the event of an other-than-temporary impairment of a debt security, fair value is measured using a model described above.

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.

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Notes to Consolidated Financial Statements — (continued)

 

The following tables present the company’s financial assets and financial liabilities that are measured at fair value on a recurring basis at September 30, 2018 and December 31, 2017.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(Dollars in millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

At September 30, 2018

    

Level 1

    

Level 2

    

Level 3

    

Total

 

Assets:

 

 

  

 

 

  

 

 

  

 

 

  

 

Cash equivalents (1)

 

 

 

 

 

 

 

 

 

 

 

 

 

Time deposits and certificates of deposit

 

$

 —

 

$

1,314

 

$

 —

 

$

1,314

 

Money market funds

 

 

 —

 

 

 —

 

 

 —

 

 

 —

 

Total

 

 

 —

 

 

1,314

 

 

 —

 

 

1,314

 

Derivative assets (2)

 

 

 —

 

 

27

 

 

 —

 

 

27

(4)

Total assets

 

$

 —

 

$

1,341

 

$

 —

 

$

1,341

 

Liabilities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Derivative liabilities (3)

 

$

 —

 

$

71

 

$

 —

 

$

71

(4)


(1)

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

(2)

Included within other assets in the Consolidated Statement of Financial Position.

(3)

Included within other liabilities in the Consolidated Statement of Financial Position.

(4)

If derivative exposures covered by a qualifying master netting agreement with IBM had been netted in the Consolidated Statement of Financial Position, the total derivative asset and liability positions would each have been reduced by $21 million.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(Dollars in millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

At December 31, 2017

    

Level 1

    

Level 2

    

Level 3

    

Total

 

Assets:

 

 

  

 

 

  

 

 

  

 

 

  

 

Cash equivalents (1)

 

 

  

 

 

  

 

 

  

 

 

  

 

Time deposits and certificates of deposit

 

$

 —

 

$

1,883

 

$

 —

 

$

1,883

 

Money market funds

 

 

 5

 

 

 —

 

 

 —

 

 

 5

 

Total

 

 

 5

 

 

1,883

 

 

 —

 

 

1,888

 

Derivative assets (2)

 

 

 —

 

 

 3

 

 

 —

 

 

 3

 

Total assets

 

$

 5

 

$

1,886

 

$

 —

 

$

1,891

 

Liabilities:

 

 

  

 

 

  

 

 

  

 

 

  

 

Derivative liabilities (3)

 

$

 —

 

$

56

 

$

 —

 

$

56

 


(1)

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

(2)

Included within other assets in the Consolidated Statement of Financial Position.

(3)

Included within other liabilities in the Consolidated Statement of Financial Position. 

Financial Assets and Liabilities Not Measured at Fair Value

Short-Term Receivables and Payables

Short-term financing receivables are financial assets with carrying values that approximate fair value. Accounts payable, other accrued expenses and short-term debt (including debt payable to IBM) 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.

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, 2018 and December 31, 2017, the difference between the carrying amount and estimated fair value for long-term receivables was immaterial. If measured at fair value in the financial statements, these financial instruments would be classified as Level 3 in the fair value hierarchy.

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Notes to Consolidated Financial Statements — (continued)

 

Long-Term Debt

Fair value of publicly traded long-term debt is based on quoted market prices for the identical liability when traded as an asset in an active market. For other long-term debt, which includes debt payable to IBM, 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 (including debt payable to IBM) was $15,389 million and $13,750 million and the estimated fair value was $15,351 million and $13,695 million at September 30, 2018 and December 31, 2017, 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.

Derivative Financial Instruments

The company operates in multiple currencies and is a lender and issuer in the capital markets and a borrower from IBM. In the normal course of business, the company may be exposed to the impact of interest rate changes and foreign currency fluctuations. The company limits its exposure to core market risks by following established risk management policies and procedures, and through the use of match funding with IBM and third parties. Although the company seeks to substantially match fund the terms, currency and interest rate variability of its debt against its underlying financial assets, risks may arise between assets and the related liabilities used for funding. The company may also choose to mitigate any remaining exposure relating to interest rate changes and foreign currency fluctuations through the use of interest rate or foreign exchange derivatives.

Derivative assets and liabilities are recorded in other assets and other liabilities in the Consolidated Statement of Financial Position and are presented on a gross basis. The notional amounts of the derivative instruments do not necessarily represent amounts exchanged by the company with IBM and third parties, and are not necessarily a direct measure of the financial exposure. The company also enters into master netting agreements with certain counterparties that allow for netting of exposures in the event of default or breach. However, in the Consolidated Statement of Financial Position, the company does not offset derivative assets against liabilities in master netting arrangements. At September 30, 2018, the aggregate fair value of derivative contracts with IBM that were in an asset position totaled $27 million and the aggregate fair value of derivative contracts with IBM that were in a liability position totaled $71 million. If derivatives exposures covered by a qualifying master netting agreement with IBM had been netted in the Consolidated Statement of Financial Position, the total derivative asset and liability positions would each have been reduced by $21 million. There were no derivative instruments activity impacted by master netting agreements at December 31, 2017.

Interest Rate Risk

Fixed and Variable Rate Borrowings

The company issues debt in the capital markets to fund its operations. 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 enter into interest-rate swaps with IBM to convert specific fixed-rate debt issuances into variable-rate debt (i.e., fair value hedges) and to convert variable-rate debt issuances into fixed-rate debt (i.e., cash flow hedges). At September 30, 2018 and December 31, 2017, the total notional amount of the company's interest rate swap contracts with IBM was $3,350 million and $1,800 million, respectively. The weighted average remaining maturity of these instruments at September 30, 2018 and December 31, 2017, was approximately 2.7 years and 2.9 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 September 30, 2018 and December 31, 2017.

Foreign Exchange Risk

Long-Term Investments in Foreign Subsidiaries (Net Investment)

The company enters into foreign exchange derivatives with IBM as a hedge of net investment of its foreign subsidiaries to reduce the volatility in member's interest caused by changes in foreign currency exchange rates in the functional currency of major foreign subsidiaries with respect to the U.S. dollar. At September 30, 2018 and December 31, 2017,  the total notional amount of derivative contracts with IBM designated as net investment hedges was $2,066 million and 

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Notes to Consolidated Financial Statements — (continued)

 

$2,331 million, respectively. The weighted average remaining maturity of these instruments was 0.2 years at both periods.

Foreign Currency Asset/Liability Management

The company enters into foreign exchange derivative contracts to manage foreign currency exposures associated with the company’s funding from IBM and third parties. These derivatives are not designated as hedges for accounting purposes. However, these derivatives represent economic hedges which provide an economic offset to the underlying foreign currency exposure. The terms of these derivative contracts are generally less than one year. The gains and losses recognized on economic hedges are recorded in other (income) and expense in the Consolidated Statement of Earnings, and the associated cash flows are included in other investing activities-net, in the Consolidated Statement of Cash Flows.

There were no foreign exchange derivative contracts with third parties outstanding at September 30, 2018. At December 31, 2017, the total notional amount of foreign exchange derivative contracts with third parties was $120 million.

The following tables provide a quantitative summary of the derivative instrument-related risk management activity at September 30, 2018 and December 31, 2017, as well as for the three and nine months ended September 30, 2018 and 2017, respectively.

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

    

9/30/2018

    

12/31/2017

    

Classification

    

9/30/2018

    

12/31/2017

Designated as hedging instruments:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate contracts with IBM

 

Other assets

 

$

 —

 

$

 —

 

Other liabilities

 

$

71

 

$

19

Foreign exchange contracts with IBM

 

Other assets

 

 

27

 

 

 —

 

Other liabilities

 

 

 —

 

 

37

 

 

Fair value of derivative assets

 

$

27

 

$

 —

 

Fair value of derivative liabilities

 

$

71

 

$

56

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Not designated as hedging instruments:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

Other assets

 

 

 —

 

 

 3

 

Other liabilities

 

 

 —

 

 

 —

 

 

Fair value of derivative assets

 

$

 —

 

$

 3

 

Fair value of derivative liabilities

 

$

 —

 

$

 —

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

$

27

 

$

 3

 

 

 

$

71

 

$

56

 

As of September 30, 2018, the following amounts were recorded in the Consolidated Statement of Financial Position related to cumulative basis adjustments for fair value hedges.

 

 

 

 

 

 

 

(Dollars in millions)

 

 

 

 

Cumulative Amount of

Line Item in the

    

Carrying Amount of the

    

Fair Value Hedging Adjustment

Consolidated Statement of Financial Position

 

Hedged Item

 

Included in the Carrying

in which the Hedged Item is Included:

 

Assets/(Liabilities)

 

Amount of Assets/(Liabilities)

Debt 

 

$

(3,273)

 

$

70

 

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Notes to Consolidated Financial Statements — (continued)

 

The Effect of Derivative Instruments in the Consolidated Statement of Earnings

The total amounts of income and expense line items presented in the Consolidated Statement of Earnings in which the effects of fair value hedges, 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:

 

 

 

 

 

 

 

(Dollars in millions)

 

 

 

 

 

 

For the three months ended September 30, 2018:

    

Financing cost

    

Other (income) and expense

Total 

 

$

135

 

$

 5

Gains/(losses) of total hedge activity 

 

 

 6

 

 

 —

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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 September 30:

    

Earnings Line Item

    

2018

    

2017

    

2018

    

2017

Derivative instruments in fair value hedges (1):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate contracts with IBM

 

Financing cost

 

$

(10)

 

$

(14)

 

$

 7

 

$

14

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Derivative instruments not designated as hedging instruments:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts with IBM

 

Other (income) and expense

 

 

 

 

 

 

N/A

 

 

N/A

Foreign exchange contracts

 

Other (income) and expense

 

 

 —

 

 

(4)

 

 

N/A

 

 

N/A

Total 

 

 

 

$

(10)

 

$

(18)

 

$

 7

 

$

14


N/A - Not Applicable

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gain/(Loss) Recognized in Earnings and Other Comprehensive Income

 

 

 

 

 

 

 

 

Consolidated

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Statement of

 

Reclassified

 

Amounts Excluded from

(Dollars in millions)

 

Recognized in OCI

 

Earnings

 

from AOCI

 

Effectiveness Testing (3)

For the three months ended September 30:

    

2018

    

2017

    

Line Item

    

2018

    

2017

    

2018

    

2017

Derivative instruments in net investment hedges:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts with IBM

 

$

23

 

$

20

 

Financing cost

 

$

 

$

 

$

 8

 

$

 0