~~0000051143us-gaap:EmployeeStockOptionMember2019-07-012019-09-30~~0000051143ibm:MoodysCaaToDRatingMembersrt:AsiaPacificMemberus-gaap:FinanceLeasesPortfolioSegmentMember2019-12-31

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM ~~10 - Q~~10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTER ENDED ~~SEPTEMBER~~JUNE 30, ~~2019~~2020

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)

One New Orchard Road Armonk, New York	10504
(Address of principal executive offices)	(Zip Code)

914-499-1900

(Registrant’s telephone number)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class	Trading symbol	Name of each exchange on which registered
Capital stock, par value $.20 per share	IBM	New York Stock Exchange
		NYSE Chicago ~~Stock Exchange~~
~~1.375%~~2.750% Notes due ~~2019~~2020	IBM ~~19B~~20B	New York Stock Exchange
~~2.750%~~1.875% Notes due 2020	IBM ~~20B~~20A	New York Stock Exchange
~~1.875%~~0.500% Notes due ~~2020~~2021	IBM ~~20A~~21B	New York Stock Exchange
~~0.500%~~2.625% Notes due ~~2021~~2022	IBM ~~21B~~22A	New York Stock Exchange
~~2.625%~~1.250% Notes due ~~2022~~2023	IBM ~~22A~~23A	New York Stock Exchange
~~1.25%~~0.375% Notes due 2023	IBM ~~23A~~23B	New York Stock Exchange
~~0.375%~~1.125% Notes due ~~2023~~2024	IBM ~~23B~~24A	New York Stock Exchange
~~1.125%~~2.875% Notes due ~~2024~~2025	IBM ~~24A~~25A	New York Stock Exchange
~~2.875%~~0.950% Notes due 2025	IBM ~~25A~~25B	New York Stock Exchange
~~0.950%~~0.875% Notes due 2025	IBM ~~25B~~25C	New York Stock Exchange
~~0.875%~~0.300% Notes due ~~2025~~2026	IBM ~~25C~~26B	New York Stock Exchange
~~0.300%~~1.250% Notes due ~~2026~~2027	IBM ~~26B~~27B	New York Stock Exchange
~~1.250%~~0.300% Notes due ~~2027~~2028	IBM 28B	New York Stock Exchange
1.750% Notes due 2028	IBM ~~27B~~28A	New York Stock Exchange
~~1.750%~~1.500% Notes due ~~2028~~2029	IBM ~~28A~~29	New York Stock Exchange
~~1.500%~~1.750% Notes due ~~2029~~2031	IBM 2931	New York Stock Exchange
~~1.750%~~0.650% Notes due ~~2031~~2032	IBM 32A	New York Stock Exchange
1.200% Notes due 2040	IBM 40	New York Stock Exchange
7.00% Debentures due 2025	IBM 3125	New York Stock Exchange
~~8.375%~~6.22% Debentures due ~~2019~~2027	IBM 1927	New York Stock Exchange
~~7.00%~~6.50% Debentures due ~~2025~~2028	IBM 2528	New York Stock Exchange
~~6.22%~~7.00% Debentures due ~~2027~~2045	IBM 2745	New York Stock Exchange
~~6.50%~~7.125% Debentures due ~~2028~~2096	IBM 2896	New York Stock Exchange
~~7.00% Debentures due 2045~~	~~IBM 45~~	~~New York Stock Exchange~~
~~7.125% Debentures due 2096~~	~~IBM 96~~	~~New York Stock Exchange~~

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 ☒ 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 ☒

The registrant had ~~885,637,454~~890,578,748 shares of common stock outstanding at ~~September~~June 30, ~~2019.~~2020.

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, 2019 and 2018~~	3

~~Consolidated Statement of Comprehensive Income for the three and nine months ended September 30, 2019 and 2018~~	4

~~Consolidated Statement of Financial Position at September 30, 2019 and December 31, 2018~~	5

~~Consolidated Statement of Cash Flows for the nine months ended September 30, 2019 and 2018~~	7

~~Consolidated Statement of Changes in Equity for the three and nine months ended September 30, 2019 and 2018~~	8

~~Notes to Consolidated Financial Statements~~	10

~~Item 2. Management’s Discussion and Analysis of Results of Operations and Financial Condition~~	64

~~Item 4. Controls and Procedures~~	~~104~~

~~Part II - Other Information~~:

~~Item 1. Legal Proceedings~~	~~105~~

~~Item 2. Unregistered Sales of Equity Securities and Use of Proceeds and Issuer Repurchases of Equity Securities~~	~~105~~

~~Item 5. Other Information~~	~~105~~

~~Item 6. Exhibits~~	~~106~~

~~Table of Contents~~

Part I - Financial Information:

Item 1. Consolidated Financial ~~Statements:~~Statements (Unaudited):

~~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)

2019

2018

2019

2018

Revenue:









Services

$
11,703

$
12,043
*
$
35,454
*
$
36,848
*
Sales

5,981

6,324
*

18,817
*

19,787
*
Financing

343

389

1,099

1,195

Total revenue

18,028

18,756

55,370

57,830

Cost:









Services

7,840

7,951
*

24,293
*

25,238
*
Sales

1,635

1,714
*

4,979
*

5,498
*
Financing

217

287

710

846

Total cost

9,692

9,953

29,982

31,582

Gross profit

8,336

8,803

25,388

26,249

Expense and other (income):









Selling, general and administrative

5,024

4,363

15,171

14,665

Research, development and engineering

1,553

1,252

4,393

4,021

Intellectual property and custom development income

(166)

(275)

(489)

(842)

Other (income) and expense

(31)

275

(850)

968

Interest expense

432

191

990

530

Total expense and other (income)

6,813

5,807

19,215

19,341

Income from continuing operations before income taxes

1,522

2,996

6,173

6,908

Provision for/(benefit from) income taxes

(151)

304

407

138

Income from continuing operations

$
1,673

$
2,692

$
5,766

$
6,770

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

(1)

2

(5)

7

Net income

$
1,672

$
2,694

$
5,761

$
6,777

Earnings/(loss) per share of common stock:









Assuming dilution:









Continuing operations

$
1.87

$
2.94

$
6.46

$
7.36

Discontinued operations

0.00

0.00

(0.01)

0.01

Total

$
1.87

$
2.94

$
6.45

$
7.37

Basic:









Continuing operations

$
1.89

$
2.95

$
6.50

$
7.39

Discontinued operations

0.00

0.00

(0.01)

0.01

Total

$
1.89

$
2.95

$
6.49

$
7.40

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









Assuming dilution

892.8

915.2

892.5

920.0

Basic

886.0

911.2

887.3

915.6

* Reclassified to conform to current period presentation. Refer to note 1, “Basis of Presentation.”

~~(Amounts may not add due~~Consolidated Income Statement for the three and six months ended June 30, 2020 and 2019

Consolidated Statement of Comprehensive Income for the three and six months ended June 30, 2020 and 2019

Consolidated Balance Sheet at June 30, 2020 and December 31, 2019

Consolidated Statement of Cash Flows for the six months ended June 30, 2020 and 2019

Consolidated Statement of Equity for the three and six months ended June 30, 2020 and 2019

Notes to ~~rounding.)~~Consolidated Financial Statements

~~(The accompanying notes are an integral part~~10

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

Item 4. Controls and Procedures

Part II - Other Information:

Item 1. Legal Proceedings

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

Item 6. Exhibits

Table of Contents

Part I - Financial Information

Item 1. Consolidated Financial Statements:

INTERNATIONAL BUSINESS MACHINES CORPORATION

AND SUBSIDIARY COMPANIES

CONSOLIDATED INCOME STATEMENT

(UNAUDITED)


	Three Months Ended June 30,					Six Months Ended June 30,
(Dollars in millions except per share amounts)	2020		2019			2020		2019
Revenue:
Services	$	10,937	$	11,836	*	$	22,311	$	23,751	*
Sales		6,918		6,974	*		12,813		12,836	*
Financing		268		351			570		756
Total revenue		18,123		19,161			35,694		37,342
Cost:
Services		7,520		8,181	*		15,363		16,453	*
Sales		1,739		1,741	*		3,363		3,344	*
Financing		165		228			345		492
Total cost		9,423		10,151			19,071		20,290
Gross profit		8,700		9,010			16,622		17,053
Expense and other (income):
Selling, general and administrative		5,248		5,456			11,203		10,147
Research, development and engineering		1,582		1,407			3,207		2,840
Intellectual property and custom development income		(203)		(222)			(319)		(323)
Other (income) and expense		179		(747)			361		(820)
Interest expense		323		348			649		558
Total expense and other (income)		7,129		6,242			15,101		12,402
Income from continuing operations before income taxes		1,571		2,768			1,522		4,651
Provision for/(benefit from) income taxes		209		269			(1,017)		558
Income from continuing operations	$	1,362	$	2,499		$	2,538	$	4,093
Income/(loss) from discontinued operations, net of tax		(1)		(1)			(2)		(4)
Net income	$	1,361	$	2,498		$	2,536	$	4,089

Earnings/(loss) per share of common stock:
Assuming dilution:
Continuing operations	$	1.52	$	2.81		$	2.83	$	4.58
Discontinued operations		0.00		0.00			0.00		0.00
Total	$	1.52	$	2.81		$	2.83	$	4.58
Basic:
Continuing operations	$	1.53	$	2.82		$	2.85	$	4.61
Discontinued operations		0.00		0.00			0.00		0.00
Total	$	1.53	$	2.82		$	2.85	$	4.61

Weighted-average number of common shares outstanding: (millions)
Assuming dilution		894.9		890.8			895.0		892.4
Basic		889.4		886.3			888.7		887.9

* Reclassified to conform to current period presentation. Refer to note 1, “Basis of Presentation,” for additional information.

(Amounts may not add due to rounding.)

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

Table of Contents

INTERNATIONAL BUSINESS MACHINES CORPORATION

AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME

(UNAUDITED)

Three Months Ended September 30,

Nine Months Ended September 30,
(Dollars in millions)

2019

2018

2019

2018
Net income

$
1,672

$
2,694

$
5,761

$
6,777
Other comprehensive income/(loss), before tax:








Foreign currency translation adjustments

(509)

(22)

(333)

(535)
Net changes related to available-for-sale securities:








Unrealized gains/(losses) arising during the period

3

0

1

(2)
Reclassification of (gains)/losses to net income

—

—

—

—
Total net changes related to available-for-sale securities

3

0

1

(2)
Unrealized gains/(losses) on cash flow hedges:








Unrealized gains/(losses) arising during the period

(439)

(46)

(798)

(134)
Reclassification of (gains)/losses to net income

488

28

418

408
Total unrealized gains/(losses) on cash flow hedges

49

(18)

(380)

274
Retirement-related benefit plans:








Prior service costs/(credits)

—

0

—

(1)
Net (losses)/gains arising during the period

0

(1)

113

83
Curtailments and settlements

3

2

7

7
Amortization of prior service (credits)/costs

(3)

(18)

(9)

(55)
Amortization of net (gains)/losses

461

737

1,385

2,231
Total retirement-related benefit plans

461

719

1,496

2,264
Other comprehensive income/(loss), before tax

4

678

784

2,001
Income tax (expense)/benefit related to items of other comprehensive income

(249)

(209)

(380)

(807)
Other comprehensive income/(loss), net of tax

(245)

470

404

1,194
Total comprehensive income/(loss)

$
1,427

$
3,164

$
6,165

$
7,970


	Three Months Ended June 30,				Six Months Ended June 30,
(Dollars in millions)	2020		2019		2020		2019
Net income	$	1,361	$	2,498	$	2,536	$	4,089
Other comprehensive income/(loss), before tax:
Foreign currency translation adjustments		4		5		(915)		176
Net changes related to available-for-sale securities:
Unrealized gains/(losses) arising during the period		1		(2)		1		(3)
Reclassification of (gains)/losses to net income		—		—		—		—
Total net changes related to available-for-sale securities		1		(2)		1		(3)
Unrealized gains/(losses) on cash flow hedges:
Unrealized gains/(losses) arising during the period		(36)		(6)		(216)		(359)
Reclassification of (gains)/losses to net income		(59)		(168)		32		(70)
Total unrealized gains/(losses) on cash flow hedges		(94)		(175)		(184)		(429)
Retirement-related benefit plans:
Prior service costs/(credits)		—		—		(4)		—
Net (losses)/gains arising during the period		57		116		65		113
Curtailments and settlements		13		3		21		4
Amortization of prior service (credits)/costs		0		(3)		1		(6)
Amortization of net (gains)/losses		566		460		1,136		924
Total retirement-related benefit plans		637		576		1,219		1,035
Other comprehensive income/(loss), before tax		548		405		121		779
Income tax (expense)/benefit related to items of other comprehensive income		(21)		(64)		(281)		(131)
Other comprehensive income/(loss), net of tax		527		340		(160)		649
Total comprehensive income/(loss)	$	1,888	$	2,839	$	2,377	$	4,738

(Amounts may not add due to rounding.)

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

Table of Contents

INTERNATIONAL BUSINESS MACHINES CORPORATION

AND SUBSIDIARY COMPANIES

CONSOLIDATED ~~STATEMENT OF FINANCIAL POSITION~~BALANCE SHEET

(UNAUDITED)

ASSETS

At September 30,

At December 31,
(Dollars in millions)

2019

2018
Assets:




Current assets:




Cash and cash equivalents

$
10,087

$
11,379
Restricted cash

138

225
Marketable securities

733

618
Notes and accounts receivable — trade (net of allowances of $286 in 2019 and $309 in 2018)

6,753

7,432
Short-term financing receivables (net of allowances of $225 in 2019 and $244 in 2018)

12,330

22,388
Other accounts receivable (net of allowances of $35 in 2019 and $38 in 2018)

1,876

743
Inventories, at lower of average cost or net realizable value:


Finished goods

351

266
Work in process and raw materials

1,361

1,415
Total inventories

1,712

1,682
Deferred costs

1,978

2,300
Prepaid expenses and other current assets

2,515

2,378
Total current assets

38,121

49,146
Property, plant and equipment

31,670

32,460
Less: Accumulated depreciation

21,608

21,668
Property, plant and equipment — net

10,063

10,792
Operating right-of-use assets — net*

4,901

—
Long-term financing receivables (net of allowances of $32 in 2019 and $48 in 2018)

7,739

9,148
Prepaid pension assets

5,481

4,666
Deferred costs

2,535

2,676
Deferred taxes

4,994

5,216
Goodwill

57,951

36,265
Intangible assets — net

15,613

3,087
Investments and sundry assets

2,221

2,386
Total assets

$
149,620

$
123,382


	At June 30,		At December 31,
(Dollars in millions)	2020		2019
Assets:
Current assets:
Cash and cash equivalents	$	12,041	$	8,172
Restricted cash		147		141
Marketable securities		2,063		696
Notes and accounts receivable — trade (net of allowances of $369 in 2020 and $299 in 2019)		6,543		7,870
Short-term financing receivables (net of allowances of $206 in 2020 and $188 in 2019)		11,967		14,192
Other accounts receivable (net of allowances of $32 in 2020 and $33 in 2019)		937		1,733
Inventory, at lower of average cost or net realizable value:
Finished goods		288		220
Work in process and raw materials		1,581		1,399
Total inventory		1,869		1,619
Deferred costs		2,127		1,896
Prepaid expenses and other current assets		2,260		2,101
Total current assets		39,953		38,420
Property, plant and equipment		31,666		32,028
Less: Accumulated depreciation		21,957		22,018
Property, plant and equipment — net		9,709		10,010
Operating right-of-use assets — net		4,774		4,996
Long-term financing receivables (net of allowances of $58 in 2020 and $33 in 2019)		7,351		8,712
Prepaid pension assets		7,254		6,865
Deferred costs		2,445		2,472
Deferred taxes		8,689		5,182
Goodwill		57,833		58,222
Intangible assets — net		14,270		15,235
Investments and sundry assets		1,921		2,074
Total assets	$	154,200	$	152,186

* 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.)

Table of Contents

INTERNATIONAL BUSINESS MACHINES CORPORATION

AND SUBSIDIARY COMPANIES

CONSOLIDATED ~~STATEMENT OF FINANCIAL POSITION~~BALANCE SHEET – (CONTINUED)

(UNAUDITED)

LIABILITIES AND EQUITY

At September 30,

At December 31,
(Dollars in millions)

2019

2018
Liabilities:

Current liabilities:




Taxes

$
2,154

$
3,046
Short-term debt

8,530

10,207
Accounts payable

4,042

6,558
Compensation and benefits

3,504

3,310
Deferred income

11,223

11,165
Operating lease liabilities*

1,377

—
Other accrued expenses and liabilities

4,235

3,941
Total current liabilities

35,066

38,227
Long-term debt

57,797

35,605
Retirement and nonpension postretirement benefit obligations

15,925

17,002
Deferred income

3,382

3,445
Operating lease liabilities*

3,790

—
Other liabilities

15,564

12,174
Total liabilities

131,524

106,452
Equity:


IBM stockholders’ equity:


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

55,808

55,151
Shares authorized: 4,687,500,000


Shares issued: 2019 - 2,237,055,309


2018 - 2,233,427,058


Retained earnings

160,709

159,206
Treasury stock - at cost

(169,474)

(168,071)
Shares: 2019 - 1,351,417,855


2018 - 1,340,947,648


Accumulated other comprehensive income/(loss)

(29,086)

(29,490)
Total IBM stockholders’ equity

17,956

16,796
Noncontrolling interests

139

134
Total equity

18,096

16,929
Total liabilities and equity

$
149,620

$
123,382


	At June 30,		At December 31,
(Dollars in millions except per share amount)	2020		2019
Liabilities:
Current liabilities:		��
Taxes	$	2,627	$	2,839
Short-term debt		9,289		8,797
Accounts payable		4,719		4,896
Compensation and benefits		3,486		3,406
Deferred income		12,469		12,026
Operating lease liabilities		1,343		1,380
Other accrued expenses and liabilities		4,509		4,357
Total current liabilities		38,442		37,701
Long-term debt		55,449		54,102
Retirement and nonpension postretirement benefit obligations		16,483		17,142
Deferred income		3,787		3,851
Operating lease liabilities		3,684		3,879
Other liabilities		15,666		14,526
Total liabilities		133,512		131,202
Equity:
IBM stockholders’ equity:
Common stock, par value $0.20 per share, and additional paid-in capital		56,135		55,895
Shares authorized: 4,687,500,000
Shares issued: 2020 - 2,241,228,730
2019 - 2,237,996,975
Retained earnings		162,559		162,954
Treasury stock - at cost		(169,386)		(169,413)
Shares: 2020 - 1,350,649,982
2019 - 1,350,886,521
Accumulated other comprehensive income/(loss)		(28,757)		(28,597)
Total IBM stockholders’ equity		20,551		20,841
Noncontrolling interests		137		144
Total equity		20,688		20,985
Total liabilities and equity	$	154,200	$	152,186

* 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.)

Table of Contents

INTERNATIONAL BUSINESS MACHINES CORPORATION

AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF CASH FLOWS

(UNAUDITED)


	Nine Months Ended September 30,				Six Months Ended June 30,
(Dollars in millions)	2019		2018		2020		2019
Cash flows from operating activities:
Net income	$	5,761	$	6,777	$	2,536	$	4,089
Adjustments to reconcile net income to cash provided by operating activities
Depreciation		3,188		2,337		2,068		2,130
Amortization of intangibles		1,221		1,031		1,245		610
Stock-based compensation		468		371		436		248
Net (gain)/loss on asset sales and other		(828)		(18)		161		(787)
Changes in operating assets and liabilities, net of acquisitions/divestitures		1,509		631		1,606		1,410
Net cash provided by operating activities		11,319		11,128		8,052		7,700

Cash flows from investing activities:
Payments for property, plant and equipment		(1,710)		(2,613)		(1,215)		(1,122)
Proceeds from disposition of property, plant and equipment		452		192		82		383
Investment in software		(468)		(418)		(301)		(305)
Acquisition of businesses, net of cash acquired		(32,630)		(123)		(19)		(43)
Divestitures of businesses, net of cash transferred		927		—		757		888
Non-operating finance receivables — net		6,096		377		95		3,828
Purchases of marketable securities and other investments		(2,813)		(6,024)		(3,478)		(1,803)
Proceeds from disposition of marketable securities and other investments		3,081		3,241		1,942		1,483
Net cash provided by/(used in) investing activities		(27,064)		(5,368)		(2,138)		3,309

Cash flows from financing activities:
Proceeds from new debt		31,496		4,714		10,190		31,249
Payments to settle debt		(8,891)		(4,246)		(8,423)		(3,869)
Short-term borrowings/(repayments) less than 90 days — net		(2,140)		376		(449)		(307)
Common stock repurchases		(1,361)		(2,393)		—		(1,236)
Common stock repurchases for tax withholdings		(186)		(148)		(211)		(152)
Financing — other		68		82		43		41
Cash dividends paid		(4,269)		(4,250)		(2,890)		(2,833)
Net cash provided by/(used in) financing activities		14,717		(5,864)		(1,739)		22,894

Effect of exchange rate changes on cash, cash equivalents and restricted cash		(352)		(399)		(301)		27
Net change in cash, cash equivalents and restricted cash		(1,379)		(503)		3,874		33,930

Cash, cash equivalents and restricted cash at January 1		11,604		12,234		8,314		11,604
Cash, cash equivalents and restricted cash at September 30	$	10,225	$	11,731
Cash, cash equivalents and restricted cash at June 30					$	12,188	$	45,534

(Amounts may not add due to rounding.)

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

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 - July 1, 2019

$
55,404

$
160,467

$
(169,385)

$
(28,841)

$
17,645

$
131

$
17,776
Net income plus other comprehensive income/(loss):














Net income



1,672





1,672



1,672
Other comprehensive income/(loss)







(245)

(245)



(245)
Total comprehensive income/(loss)









$
1,427



$
1,427
Cash dividends paid — common stock ($1.62 per share)



(1,436)





(1,436)



(1,436)
Common stock issued under employee plans (353,035 shares)

404







404



404
Purchases (241,779 shares) and sales (473,196 shares) of treasury stock under employee plans — net



6

27



32



32
Other treasury shares purchased, not retired (822,159 shares)





(115)



(115)



(115)
Changes in noncontrolling interests











8

8
Equity – September 30, 2019

$
55,808

$
160,709

$
(169,474)

$
(29,086)

$
17,956

$
139

$
18,096


	Common
	Stock and						Accumulated
	Additional						Other		Total IBM		Non-
	Paid-in		Retained		Treasury		Comprehensive		Stockholders’		Controlling		Total
(Dollars in millions except per share amounts)	Capital		Earnings		Stock		Income/(Loss)		Equity		Interests		Equity
Equity - April 1, 2020	$	56,092	$	162,626	$	(169,437)	$	(29,283)	$	19,999	$	129	$	20,128
Net income plus other comprehensive income/(loss):
Net income				1,361						1,361				1,361
Other comprehensive income/(loss)								527		527				527
Total comprehensive income/(loss)									$	1,888			$	1,888
Cash dividends paid — common stock ($1.63 per share)				(1,450)						(1,450)				(1,450)
Common stock issued under employee plans (2,296,269 shares)		42								42				42
Purchases (1,311,046 shares) and sales (1,701,568 shares) of treasury stock under employee plans — net				22		50				72				72
Changes in noncontrolling interests												8		8
Equity – June 30, 2020	$	56,135	$	162,559	$	(169,386)	$	(28,757)	$	20,551	$	137	$	20,688


	Common															Common
	Stock and						Accumulated									Stock and						Accumulated
	Additional						Other		Total IBM		Non-					Additional						Other		Total IBM		Non-
	Paid-in		Retained		Treasury		Comprehensive		Stockholders’		Controlling			Total		Paid-in		Retained		Treasury		Comprehensive		Stockholders’		Controlling		Total
(Dollars in millions)	Capital		Earnings		Stock		Income/(Loss)		Equity		Interests			Equity
Equity - July 1, 2018	$	54,827	$	157,349	$	(165,366)	$	(28,290)	$	18,520	$	128		$	18,648
(Dollars in millions except per share amounts)																Capital		Earnings		Stock		Income/(Loss)		Equity		Interests		Equity
Equity - April 1, 2019																$	55,287	$	159,396	$	(169,021)	$	(29,182)	$	16,481	$	126	$	16,607
Net income plus other comprehensive income/(loss):
Net income				2,694						2,694					2,694				2,498						2,498				2,498
Other comprehensive income/(loss)								470		470					470								340		340				340
Total comprehensive income/(loss)									$	3,164				$	3,164									$	2,839			$	2,839
Cash dividends paid — common stock ($1.57 per share)				(1,431)						(1,431)					(1,431)
Common stock issued under employee plans (331,214 shares)		160								160					160
Purchases (31,408 shares) and sales (14,109 shares) of treasury stock under employee plans — net				1		(3)				(2)					(2)
Other treasury shares purchased, not retired (4,288,327 shares)						(627)				(627)			��		(627)
Cash dividends paid — common stock ($1.62 per share)																			(1,435)						(1,435)				(1,435)
Common stock issued under employee plans (1,883,226 shares)																	117								117				117
Purchases (681,109 shares) and sales (330,849 shares) of treasury stock under employee plans — net																			9		(49)				(40)				(40)
Other treasury shares purchased, not retired (2,300,679 shares)																					(316)				(316)				(316)
Changes in noncontrolling interests												6			6												5		5
Equity - September 30, 2018	$	54,987	$	158,612	$	(165,995)	$	(27,820)	$	19,784	$	134		$	19,918
Equity - June 30, 2019																$	55,404	$	160,467	$	(169,385)	$	(28,841)	$	17,645	$	131	$	17,776

(Amounts may not add due to rounding.)

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

Table of Contents

INTERNATIONAL BUSINESS MACHINES CORPORATION

AND SUBSIDIARY COMPANIES

CONSOLIDATED STATEMENT OF ~~CHANGES IN~~ EQUITY – (CONTINUED)

(UNAUDITED)


	Common														Common
	Stock and						Accumulated								Stock and						Accumulated
	Additional						Other		Total IBM		Non-				Additional						Other		Total IBM		Non-
	Paid-in		Retained		Treasury		Comprehensive		Stockholders’		Controlling		Total		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
(Dollars in millions except per share amounts)															Capital		Earnings		Stock		Income/(Loss)		Equity		Interests		Equity
Equity - January 1, 2020															$	55,895	$	162,954	$	(169,413)	$	(28,597)	$	20,841	$	144	$	20,985
Cumulative effect of change in accounting principle*																		(66)						(66)				(66)
Net income plus other comprehensive income/(loss):
Net income				5,761						5,761				5,761				2,536						2,536				2,536
Other comprehensive income/(loss)								404		404				404								(160)		(160)				(160)
Total comprehensive income/(loss)									$	6,165			$	6,165									$	2,377			$	2,377
Cash dividends paid — common stock ($4.81 per share)				(4,269)						(4,269)				(4,269)
Common stock issued under employee plans (3,628,250 shares)		657								657				657
Purchases (1,377,598 shares) and sales (886,907 shares) of treasury stock under employee plans — net				16		(72)				(56)				(56)
Other treasury shares purchased, not retired (9,979,516 shares)						(1,331)				(1,331)				(1,331)
Changes in other equity				(5)						(5)				(5)
Cash dividends paid — common stock ($3.25 per share)																		(2,890)						(2,890)				(2,890)
Common stock issued under employee plans (3,231,755 shares)																239								239				239
Purchases (1,621,500 shares) and sales (1,858,039 shares) of treasury stock under employee plans — net																		24		26				50				50
Changes in noncontrolling interests												6		6												(7)		(7)
Equity - September 30, 2019	$	55,808	$	160,709	$	(169,474)	$	(29,086)	$	17,956	$	139	$	18,096
Equity - June 30, 2020															$	56,135	$	162,559	$	(169,386)	$	(28,757)	$	20,551	$	137	$	20,688

*Reflects the adoption of the FASB guidance on current expected credit losses. Refer to note 2, “Accounting Changes.”

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



6,777





6,777



6,777
Other comprehensive income/(loss)







1,194

1,194



1,194
Total comprehensive income/(loss)









$
7,970



$
7,970
Cash dividends paid — common stock ($4.64 per share)



(4,250)





(4,250)



(4,250)
Common stock issued under employee plans (3,208,989 shares)

421







421



421
Purchases (978,004 shares) and sales (365,600 shares) of treasury stock under employee plans — net



13

(101)



(89)



(89)
Other treasury shares purchased, not retired (15,982,033 shares)





(2,388)



(2,388)



(2,388)
Changes in noncontrolling interests











3

3
Equity - September 30, 2018

$
54,987

$
158,612

$
(165,995)

$
(27,820)

$
19,784

$
134

$
19,918


	Common
	Stock and						Accumulated
	Additional						Other		Total IBM		Non-
	Paid-in		Retained		Treasury		Comprehensive		Stockholders’		Controlling		Total
(Dollars in millions except per share amounts)	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				4,089						4,089				4,089
Other comprehensive income/(loss)								649		649				649
Total comprehensive income/(loss)									$	4,738			$	4,738
Cash dividends paid — common stock ($3.19 per share)				(2,833)						(2,833)				(2,833)
Common stock issued under employee plans (3,275,215 shares)		254								254				254
Purchases (1,135,819 shares) and sales (413,711 shares) of treasury stock under employee plans — net				11		(99)				(88)				(88)
Other treasury shares purchased, not retired (9,157,357 shares)						(1,216)				(1,216)				(1,216)
Changes in other equity				(5)						(5)				(5)
Changes in noncontrolling interests												(3)		(3)
Equity - June 30, 2019	$	55,404	$	160,467	$	(169,385)	$	(28,841)	$	17,645	$	131	$	17,776

* 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.)

Table of Contents

Notes to Consolidated Financial Statements

1. Basis ofof 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,~~2020, the company ~~made a number~~realigned offerings and the related management system to reflect divestitures completed in the second half of ~~changes to its organizational structure~~2019 and ~~management system.~~tighter integration of certain industry-related consulting services. These changes impacted a few of the company’s reportable segments, but did not impact the ~~company’s~~ Consolidated Financial Statements. Refer to note 8,4, “Segments,” for additional information on the company’s reportable segments. The periods presented in this Form 10-Q are reported on a comparable basis. On April 6, 2020, Arvind Krishna became Chief Executive Officer of IBM and announced a number of management changes which did not impact the company’s reportable segments.

For the three months ended June 30, 2020, the company reported a provision for income taxes of $209 million. For the six months ended June 30, 2020, the company reported a benefit from income taxes of $1,017 million. The ~~company provided recast historical segment information reflecting these changes~~tax benefit was primarily related to the tax impacts of an intra-entity sale of certain of the company’s intellectual property in the first quarter, which required the recognition of a $3,442 million deferred tax asset. The recognition of this deferred tax asset and the related impacts resulted in a ~~Form 8-K dated April 4, 2019.~~net one-time benefit in the first quarter of $939 million. For the three and six months ended June 30, 2019, the company reported a provision for income taxes of $269 million and $558 million, respectively.

On July 9, 2019, the company completed the acquisition of all of the outstanding shares of Red ~~Hat.~~Hat, Inc. (Red Hat). Refer to note ~~11, “Acquisitions/~~5, “Acquisitions & Divestitures,” and note ~~12,~~10, “Intangible Assets Including Goodwill,” for additional ~~information on the impacts to the consolidated financial results at and for the three and nine months ended September 30, 2019.~~information.

Noncontrolling interest amounts of ~~$7.1~~$6.8 million and ~~$6.2~~$4.9 million, net of tax, for the three months ended ~~September~~June 30, ~~2019~~2020 and ~~2018,~~2019, respectively, and ~~$19.0~~$11.3 million and ~~$17.9~~$11.9 million, net of tax, for the ~~nine~~six months ended ~~September~~June 30, ~~2019~~2020 and ~~2018,~~2019, respectively, are included as a reduction within other (income) and expense in the Consolidated ~~Statement of Earnings.~~Income Statement.

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~~2019 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 period amounts have been reclassified to conform to the current period presentation. Specifically, beginning in the third-quarter 2019, revenues and related costs for post-contract support provided for perpetual (one-time charge) software licenses ~~were~~have been reclassified from Services Revenue to Sales Revenue and Services ~~Costs~~Cost to Sales ~~Costs~~Cost within the Consolidated ~~Statement of Earnings.~~Income Statement. The revenue and cost amounts reclassified were $0.5 billion ~~$1.0~~and $0.1 billion, ~~and $1.6 billion~~respectively, for the three months ended ~~September~~June 30, ~~2018, nine months ended September 30,~~ 2019. The revenue and ~~nine months ended September 30, 2018, respectively. The~~ cost amounts reclassified were ~~$0.1~~$1.0 billion and $0.2 billion, ~~and $0.3~~respectively, for the ~~billion.~~six months ended June 30, 2019. This reclassification had no impact on total revenue, total cost, net income, financial position or cash flows for any periods presented. Other immaterial reclassifications have been 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

Table of Contents

Notes to Consolidated Financial Statements — (continued)

~~company expects~~2. Accounting Changes:

New Standards to ~~early adopt changes~~be Implemented

Simplifying the Accounting for Income Taxes

Standard/Description–Issuance date: December 2019. This guidance simplifies various aspects of income tax accounting by removing certain exceptions to the ~~disclosure requirements for defined benefit plans in the fourth quarter~~general principle of ~~2019. As~~ the guidance ~~is a change to disclosures only, the company does not expect the~~and also clarifies and amends existing guidance to ~~have a material impact~~improve consistency in ~~the consolidated financial results.~~application.

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 amountsEffective Date and ~~requires additional disclosures for these reporting units.~~ Adoption Considerations–The guidance is effective January 1, ~~2020~~2021 and early adoption is permitted. The company will adopt the guidance ~~on a prospective basis~~ as of the effective date.

Effect on Financial Statements or Other Significant Matters–The guidance is not expected to have a material impact in the consolidated financial results.

Standards Implemented

Reference Rate Reform

Standard/Description–Issuance date: March 2020. This guidance provides optional expedients and exceptions for applying GAAP to contract modifications, hedging relationships, and other transactions that reference London Interbank Offered Rate (LIBOR) or another reference rate expected to be discontinued, subject to meeting certain criteria.

Effective Date and Adoption Considerations–The guidance is effective as of March 12, 2020 through December 31, 2022.

Effect on Financial Statements or Other Significant Matters–The company made a policy election in the first quarter of 2020 to adopt the practical expedient which allows for the continuation of fair value hedge accounting for interest rate derivative contracts upon the transition from LIBOR to Secured Overnight Financing Rate (SOFR) or another reference rate alternative, without any impact to the Consolidated Income Statement. The company is continuing to evaluate the potential impact of the replacement of the LIBOR benchmark on its interest rate risk management activities.

Simplifying the Test for Goodwill Impairment

Standard/Description–Issuance date: January 2017. This guidance simplifies the goodwill impairment test by removing Step 2. It also requires disclosure of any reporting units that have zero or negative carrying amounts if they have goodwill allocated to them.

Effective Date and Adoption Considerations–The guidance was effective January 1, 2020 and early adoption was permitted. The company adopted the guidance on a prospective basis as of the effective date.

Effect on Financial Statements or Other Significant Matters–The guidance did not have a material impact in the consolidated financial results.

Financial Instruments–Credit Losses

Standard/Description–Issuance date: June 2016, with amendments in 2018, 2019 and ~~2019,~~2020. This changes the ~~FASB issued~~ guidance for credit ~~impairment~~losses based on an expected loss model rather than an incurred loss model. ~~The guidance~~It 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 new guidance~~It also expands the scope of financial instruments subject to impairment, including off-balance sheet commitments and residual value.

Effective Date and Adoption Considerations–The guidance iswas effective January 1, 2020 with one-year early adoption permitted. The company ~~will adopt~~adopted the guidance as of the effective ~~date. A cross-functional team was established to evaluate~~date, using the ~~impact of the guidance on the financial instruments portfolio. All of the changes to systems, processes and policies are on track for completion before the effective date. The guidance is~~transition methodology whereby prior comparative periods were not ~~expected to have a material impact~~retrospectively presented in the ~~consolidated financial results.~~Consolidated Financial Statements.

Table of Contents

~~Standards Implemented~~Notes to Consolidated Financial Statements — (continued)

~~The FASB issued guidance~~Effect on Financial Statements or Other Significant Matters–At January 1, 2020, an increase in the allowance for credit losses of $81 million was recorded for accounts receivable–trade and financing receivables (inclusive of its related off-balance sheet commitments). Additionally, net deferred taxes were reduced by $14 million in the Consolidated Balance Sheet, resulting in a cumulative-effect net decrease to retained earnings of $66 million. Refer to note 8, “Financing Receivables,” and note 12, “Commitments,” for additional information.

Leases

Standard/Description–Issuance date: February 2016, with amendments in 2018 and ~~2019, which changed the accounting for leases. The~~2019. This guidance requires lessees to recognize right-of-use (ROU) assets and lease liabilities for most leases in the Consolidated ~~Statement of Financial Position. The guidance~~Balance Sheet. For lessors, it also ~~made some changes to lessor accounting, including elimination of~~eliminated the use of third-party residual value guarantee insurance in the lease classification test, and overall aligns with ~~the new~~ revenue recognition guidance. Due to changes in lease termination guidance, when equipment is returned to the company prior to the end of the lease term, the carrying amounts of lease receivables are reclassified to loan receivables. The guidance also requires qualitative and quantitative disclosures to assess the amount, timing and uncertainty of cash flows arising from leases.

Effective Date and Adoption Considerations–The company adopted the guidance on its effective date of 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 ~~(IDCs)~~ and the lessee practical expedient to combine lease and ~~nonlease~~non-lease components for all asset classes. The company made a policy election to not recognize ROU assets and lease liabilities for short-term leases for all asset classes.

Effect on Financial Statements or Other Significant Matters–The guidance had a material impact on the Consolidated ~~Statement of Financial Position~~Balance Sheet as of the effective date. As a lessee, at adoption, the company recognized operating and financing 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 on 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 termNone of the ~~hosting arrangement. The guidance is effective January 1, 2020 and early adoption is permitted. The company adopted~~other changes to 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

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

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.

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 havehad a material impact in the company’s consolidated financial ~~results. Refer to note 3, “Revenue Recognition,” for additional information.~~results at the effective date.

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

For all other standards that the company ~~on January 1, 2017, and it did not have a~~adopted in 2019, there was no material impact on 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.

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

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.

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 September 30, 2019:

Software

Services

Services

Systems

Financing

Other

Revenue

Cognitive Applications

$
1,383

$
—

$
—

$
—

$
—

$
—

$
1,383
Cloud & Data Platforms

2,308

—

—

—

—

—

2,308
Transaction Processing Platforms

1,589

—

—

—

—

—

1,589

Consulting

—

1,973

—

—

—

—

1,973
Application Management

—

1,897

—

—

—

—

1,897
Global Process Services

—

247

—

—

—

—

247

Infrastructure & Cloud Services

—

—

5,071

—

—

—

5,071
Technology Support Services

—

—

1,629

—

—

—

1,629

Systems Hardware

—

—

—

1,117

—

—

1,117
Operating Systems Software

—

—

—

364

—

—

364

Global Financing*

—

—

—

—

343

—

343

Other Revenue

—

—

—

—

—

107

107
Total

$
5,280

$
4,117

$
6,700

$
1,481

$
343

$
107

$
18,028

* 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)

Total
For the three months ended September 30, 2019:

Revenue

Americas

$
8,514
Europe/Middle East/Africa

5,477
Asia Pacific

4,036
Total

$
18,028

1312

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 September 30, 2018:

Software*

Services*

Services*

Systems

Financing

Other*

Revenue

Cognitive Applications

$
1,324

$
—

$
—

$
—

$
—

$
—

$
1,324
Cloud & Data Platforms

1,968

—

—

—

—

—

1,968
Transaction Processing Platforms

1,669

—

—

—

—

—

1,669

Consulting

—

1,900

—

—

—

—

1,900
Application Management

—

1,915

—

—

—

—

1,915
Global Process Services

—

260

—

—

—

—

260

Infrastructure & Cloud Services

—

—

5,393

—

—

—

5,393
Technology Support Services

—

—

1,707

—

—

—

1,707

Systems Hardware

—

—

—

1,339

—

—

1,339
Operating Systems Software

—

—

—

397

—

—

397

Global Financing**

—

—

—

—

388

—

388

Other Revenue

—

—

—

—

—

493

493
Total

$
4,962

$
4,076

$
7,101

$
1,736

$
388

$
493

$
18,756



	Three Months Ended June 30,					Six Months Ended June 30,
(Dollars in millions)	2020		2019			2020		2019
Cloud & Data Platforms	$	2,797	$	2,173		$	5,333	$	4,090
Cognitive Applications		1,246		1,372	*		2,428		2,609	*
Transaction Processing Platforms		1,706		2,018			3,226		3,830
Total Cloud & Cognitive Software	$	5,748	$	5,563	*	$	10,987	$	10,530	*
Consulting		1,936		2,020	*		4,007		4,021	*
Application Management		1,734		1,919			3,573		3,827
Global Process Services		221		258			447		505
Total Global Business Services	$	3,890	$	4,197	*	$	8,027	$	8,353	*
Infrastructure & Cloud Services		4,813		5,174			9,729		10,383
Technology Support Services		1,503		1,663			3,054		3,328
Total Global Technology Services	$	6,316	$	6,837		$	12,783	$	13,711
Systems Hardware		1,488		1,328			2,484		2,241
Operating Systems Software		365		425			736		840
Total Systems	$	1,852	$	1,753		$	3,220	$	3,081
Global Financing**		265		351			564		757
Other		50		460	*		113		911	*
Total revenue	$	18,123	$	19,161		$	35,694	$	37,342

* Recast to conform to ~~2019~~current period presentation. Refer to note 4, “Segments,” for additional information.

** 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)

Total
For the three months ended September 30, 2018:

Revenue

Americas

$
8,853
Europe/Middle East/Africa

5,827
Asia Pacific

4,076
Total

$
18,756

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

~~Revenue by Major Products/Service Offerings~~

(Dollars in millions)

Cloud &

Global

Global












For the nine months

Cognitive

Business

Technology

Global

Total
ended September 30, 2019:

Software

Services

Services

Systems

Financing

Other

Revenue

Cognitive Applications

$
4,145

$
—

$
—

$
—

$
—

$
—

$
4,145
Cloud & Data Platforms

6,398

—

—

—

—

—

6,398
Transaction Processing Platforms

5,419

—

—

—

—

—

5,419

Consulting

—

5,915

—

—

—

—

5,915
Application Management

—

5,724

—

—

—

—

5,724
Global Process Services

—

752

—

—

—

—

752

Infrastructure & Cloud Services

—

—

15,454

—

—

—

15,454
Technology Support Services

—

—

4,958

—

—

—

4,958

Systems Hardware

—

—

—

3,358

—

—

3,358
Operating Systems Software

—

—

—

1,204

—

—

1,204

Global Financing*

—

—

—

—

1,100

—

1,100

Other Revenue

—

—

—

—

—

944

944
Total

$
15,962

$
12,391

$
20,412

$
4,562

$
1,100

$
944

$
55,370

* 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)

Total
For the nine months ended September 30, 2019:

Revenue

Americas

$
25,813
Europe/Middle East/Africa

17,354
Asia Pacific

12,203
Total

$
55,370

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

~~Revenue by Major Products/Service Offerings~~

(Dollars in millions)

Cloud &

Global

Global












For the nine months

Cognitive

Business

Technology

Global

Total
ended September 30, 2018:

Software*

Services*

Services*

Systems

Financing

Other*

Revenue

Cognitive Applications

$
4,023

$
—

$
—

$
—

$
—

$
—

$
4,023
Cloud & Data Platforms

5,997

—

—

—

—

—

5,997
Transaction Processing Platforms

5,528

—

—

—

—

—

5,528

Consulting

—

5,698

—

—

—

—

5,698
Application Management

—

5,863

—

—

—

—

5,863
Global Process Services

—

765

—

—

—

—

765

Infrastructure & Cloud Services

—

—

16,608

—

—

—

16,608
Technology Support Services

—

—

5,239

—

—

—

5,239

Systems Hardware

—

—

—

4,187

—

—

4,187
Operating Systems Software

—

—

—

1,225

—

—

1,225

Global Financing**

—

—

—

—

1,188

—

1,188

Other Revenue

—

—

—

—

—

1,511

1,511
Total

$
15,548

$
12,326

$
21,846

$
5,412

$
1,188

$
1,511

$
57,830

* 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


			Three Months Ended June 30,				Six Months Ended June 30,
(Dollars in millions)	Total		2020		2019		2020		2019
For the nine months ended September 30, 2018:	Revenue

Americas	$	26,772	$	8,450	$	8,806	$	16,617	$	17,299
Europe/Middle East/Africa		18,410		5,695		6,149		11,212		11,876
Asia Pacific		12,648		3,977		4,205		7,865		8,167
Total	$	57,830	$	18,123	$	19,161	$	35,694	$	37,342

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~~RPO 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 June 30, 2020, the aggregate amount of the transaction price allocated to RPO related to customer contracts that are unsatisfied or partially unsatisfied was $117 billion. Given the profile of contract terms, approximately 60 percent of

Table of Contents

Notes to Consolidated Financial Statements — (continued)

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.

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

For the three and six months ended June 30, 2020, revenue was reduced by $56 million and $54 million, respectively, for performance obligations satisfied (or partially satisfied) in previous periods mainly due to changes in estimates on percentage-of-completion based contracts.

Contract Balances

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


	At June 30,		At December 31,
(Dollars in millions)	2020		2019
Notes and accounts receivable — trade (net of allowances of $369 and $299 at June 30, 2020 and December 31, 2019, respectively)	$	6,543	$	7,870
Contract assets (1)		505		492
Deferred income (current)		12,469		12,026
Deferred income (noncurrent)		3,787		3,851

(1)	Included within prepaid expenses and other current assets in the Consolidated Balance Sheet.

The amount of revenue recognized during the three and six months ended June 30, 2020 that was included within the deferred income balance at March 31, 2020 and December 31, 2019 was $4.5 billion and $6.5 billion, respectively, and was primarily related to services and software.

The following table provides roll forwards of the notes and accounts receivable – trade allowance for credit losses for the six months ended June 30, 2020 and the year ended December 31, 2019:


(Dollars in millions)
January 1, 2020*		Additions / (Releases)		Write-offs		Other**		June 30, 2020
$	316	$	87	$	(26)	$	(8)	$	369


January 1, 2019		Additions / (Releases)		Write-offs		Other**		December 31, 2019
$	309	$	98	$	(113)	$	5	$	299

*	Opening balance does not equal the allowance at December 31, 2019 due to the adoption of the guidance for current expected credit losses. Refer to note 2, “Accounting Changes,” for additional information.

**	Primarily represents translation adjustments.

The contract assets allowance for credit losses was not material in any of the periods presented.

Table of Contents

Notes to Consolidated Financial Statements — (continued)

4.Segments:

During the first quarter of 2020, the company realigned offerings and the related management system to reflect divestitures completed in the second half of 2019 and tighter integration of certain industry-related consulting services. Accordingly, the company updated its Cloud & Cognitive Software segment, Global Business Services segment and the Other – divested businesses category in the first quarter of 2020 and recast the related historical information for consistency with the go-forward performance. Total recast revenue for full-year 2019 was approximately $0.3 billion of IBM’s total $77 billion. There was no change to the Global Technology Services, Systems or Global Financing segments, and there was no impact to IBM’s consolidated results. The following table displays the segment updates:


Management System Change		Resulting Segment Implications
Divestitures of IBM's Risk Analytics and Regulatory Offerings and Sales Performance Management Offerings		- Cloud & Cognitive Software (Cognitive Applications)
		+ Other Divested Business

Realignment of certain industry-related consulting offerings to the Global Business Services segment		- Cloud & Cognitive Software (Cognitive Applications)
		+ Global Business Services (Consulting)

Table of Contents

Notes to Consolidated Financial Statements — (continued)

SEGMENT INFORMATION


	Cloud &			Global			Global
	Cognitive			Business			Technology						Global			Total
(Dollars in millions)	Software			Services			Services			Systems			Financing			Segments
For the three months ended June 30, 2020:
External revenue	$	5,748		$	3,890		$	6,316		$	1,852		$	265		$	18,072
Internal revenue		743			55			304			240			241			1,582
Total revenue	$	6,491		$	3,945		$	6,621		$	2,092		$	506		$	19,655
Pre-tax income from continuing operations	$	1,708		$	362		$	250		$	248		$	176		$	2,744
Revenue year-to-year change		5.2	%		(7.5)	%		(7.3)	%		8.7	%		(20.0)	%		(2.4)	%
Pre-tax income year-to-year change		(14.9)	%		25.1	%		6.4	%		304.8	%		(26.2)	%		(3.1)	%
Pre-tax income margin		26.3	%		9.2	%		3.8	%		11.8	%		34.9	%		14.0	%

For the three months ended June 30, 2019:
External revenue	$	5,563	*	$	4,197	*	$	6,837		$	1,753		$	351		$	18,701	*
Internal revenue		607			69			302			171			281			1,430
Total revenue	$	6,170	*	$	4,266	*	$	7,139		$	1,924		$	632		$	20,131	*
Pre-tax income from continuing operations	$	2,007	*	$	290	*	$	235		$	61		$	239		$	2,832	*
Pre-tax income margin		32.5	%*		6.8	%*		3.3	%		3.2	%		37.8	%		14.1	%*

Reconciliations to IBM as Reported:


(Dollars in millions)
For the three months ended June 30:	2020		2019
Revenue:
Total reportable segments	$	19,655	$	20,131	*
Other—divested businesses		13		403	*
Other revenue		37		57
Eliminations of internal transactions		(1,582)		(1,430)
Total consolidated revenue	$	18,123	$	19,161

Pre-tax income from continuing operations:
Total reportable segments	$	2,744	$	2,832	*
Amortization of acquired intangible assets		(472)		(169)
Acquisition-related (charges)/income		(1)		(102)
Non-operating retirement-related (costs)/income		(273)		(136)
Eliminations of internal transactions		(121)		(60)
Other—divested businesses		(22)		561	*
Unallocated corporate amounts		(283)		(156)
Total pre-tax income from continuing operations	$	1,571	$	2,768

* Recast to conform to current period presentation.

Table of Contents

Notes to Consolidated Financial Statements — (continued)

At September 30, 2019, the aggregate amount of the transaction price allocated to RPO related to customer contracts that are unsatisfied or partially unsatisfied was $115 billion. Given the profile of contract terms, approximately 58 percent of this amount is expected to be recognized as revenue over the next two years, approximately 34 percent between three and five years and the balance (mostly Infrastructure & Cloud Services) thereafter.

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~~SEGMENT INFORMATION

For the three and nine months ending September 30, 2019, revenue was reduced by $42 million and $33 million, respectively, for performance obligations satisfied (or partially satisfied) in previous periods mainly due to changes in estimates on percentage-of-completion based contracts.

For the three and nine months ending September 30, 2018, revenue was reduced by $25 million and $50 million, respectively, for performance obligations satisfied (or partially satisfied) in previous periods mainly due to changes in estimates on percentage-of-completion based contracts.


	Cloud &			Global			Global
	Cognitive			Business			Technology						Global			Total
(Dollars in millions)	Software			Services			Services			Systems			Financing			Segments
For the six months ended June 30, 2020:
External revenue	$	10,987		$	8,027		$	12,783		$	3,220		$	564		$	35,581
Internal revenue		1,556			101			599			388			453			3,096
Total revenue	$	12,543		$	8,128		$	13,382		$	3,608		$	1,017		$	38,677
Pre-tax income from continuing operations	$	2,641		$	633		$	72		$	31		$	370		$	3,747
Revenue year-to-year change		4.7	%		(4.3)	%		(6.4)	%		5.7	%		(24.0)	%		(2.2)	%
Pre-tax income year-to-year change		(30.4)	%		7.8	%		(85.9)	%		nm			(29.8)	%		(29.0)	%
Pre-tax income margin		21.1	%		7.8	%		0.5	%		0.9	%		36.4	%		9.7	%

For the six months ended June 30, 2019:
External revenue	$	10,530	*	$	8,353	*	$	13,711		$	3,081		$	757		$	36,432	*
Internal revenue		1,448			143			591			334			581			3,097
Total revenue	$	11,978	*	$	8,495	*	$	14,303		$	3,415		$	1,338		$	39,529	*
Pre-tax income/(loss) from continuing operations	$	3,792	*	$	587	*	$	510		$	(141)		$	527		$	5,276	*
Pre-tax income/(loss) margin		31.7	%*		6.9	%*		3.6	%		(4.1)	%		39.4	%		13.3	%*

~~Reconciliation of Contract Balances~~Reconciliations to IBM as Reported:

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


(Dollars in millions)
For the six months ended June 30:	2020		2019
Revenue:
Total reportable segments	$	38,677	$	39,529	*
Other—divested businesses		32		780	*
Other revenue		81		131
Eliminations of internal transactions		(3,096)		(3,097)
Total consolidated revenue	$	35,694	$	37,342

Pre-tax income from continuing operations:
Total reportable segments	$	3,747	$	5,276	*
Amortization of acquired intangible assets		(945)		(343)
Acquisition-related (charges)/income		(2)		(141)
Non-operating retirement-related (costs)/income		(538)		(274)
Eliminations of internal transactions		(176)		(149)
Other—divested businesses		3		505	*
Unallocated corporate amounts		(568)		(224)
Total pre-tax income from continuing operations	$	1,522	$	4,651

* Recast to conform to current period presentation.

nm - not meaningful

At September 30,

At December 31,
(Dollars in millions)

2019

2018
Notes and accounts receivable — trade (net of allowances of $286 and $309 at September 30, 2019 and December 31, 2018, respectively)

$
6,753

$
7,432
Contract assets (1)

513

470
Deferred income (current)

11,223

11,165
Deferred income (noncurrent)

3,382

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 and nine months ended September 30, 2019 that was included within the deferred income balance at June 30, 2019 and December 31, 2018 was $3.6 billion and $7.7 billion, respectively, and was primarily related to services and software.

The amount of revenue recognized during the three and nine months ended September 30, 2018 that was included within the deferred income balance at June 30, 2018 and January 1, 2018 was $3.8 billion and $8.0 billion, respectively, and was primarily related to services and software.

Table of Contents

Notes to Consolidated Financial Statements — (continued)

4.5. Acquisitions & Divestitures:

Acquisitions

Purchase price consideration for all acquisitions was paid primarily in cash. All acquisitions, except otherwise stated were for 100 percent of the acquired business and are reported in the Consolidated Statement of Cash Flows, net of acquired cash and cash equivalents.

During the six months ended June 30, 2020, the company completed 2 acquisitions in the Cloud & Cognitive Software segment. NaN acquisition was completed in the second quarter of 2020, and 1 acquisition was completed in the first quarter of 2020. These acquisitions did not have a material impact in the Consolidated Financial Statements.

On July 9, 2019, the company completed the acquisition of all of the outstanding shares of Red Hat at an aggregate cost of $35 billion. Red Hat’s portfolio of open-source and cloud technologies combined with IBM’s innovative hybrid cloud technology and industry expertise are delivering the hybrid multi-cloud capabilities required to address the next chapter of cloud implementations.

On the acquisition date, Red Hat shareholders received $190 per share in cash, representing a total equity value of approximately $34 billion. The company funded the transaction through a combination of cash on hand and proceeds from debt issuances.

The following table reflects the purchase price and the resulting purchase price allocation as of June 30, 2020. The net purchase price adjustment recorded in the second-quarter 2020 was related to noncurrent tax assets and liabilities.


	Amortization	Allocated
(Dollars in millions)	Life (in years)	Amount
Current assets*		$	3,186
Property, plant and equipment/noncurrent assets			948
Intangible assets:
Goodwill	N/A		22,986
Client relationships	10		7,215
Completed technology	9		4,571
Trademarks	20		1,686
Total assets acquired		$	40,592
Current liabilities**			1,395
Noncurrent liabilities			4,117
Total liabilities assumed		$	5,513
Total purchase price		$	35,080

*	Includes $2.2 billion of cash and cash equivalents.

**	Includes $485 million of short-term debt related to the convertible notes acquired from Red Hat that were recognized at their fair value on the acquisition date, which was fully settled as of October 1, 2019.

N/A – not applicable

The goodwill generated is primarily attributable to the assembled workforce of Red Hat and the increased synergies expected to be achieved from the integration of Red Hat products into the company’s various integrated solutions neither of which qualify as an amortizable intangible asset.

The overall weighted-average useful life of the identified amortizable intangible assets acquired was 10.9 years. These identified intangible assets will be amortized on a straight-line basis over their useful lives, which approximates the pattern that the assets’ economic benefits are expected to be consumed over time. The following table presents the goodwill allocated to the segments as of June 30, 2020.

Table of Contents

Notes to Consolidated Financial Statements — (continued)


(Dollars in billions)	Goodwill
Segment	Allocated*
Cloud & Cognitive Software	$	18.4
Global Technology Services		3.1
Global Business Services		1.1
Systems		0.4
Total	$	23.0

*	It is expected that approximately 6 percent of the goodwill will be deductible for tax purposes.

Divestitures

Select IBM Software Products – On June 30, 2019, HCL Technologies Limited (HCL) acquired select standalone Cloud & Cognitive Software products from IBM for $1,775 million, inclusive of $150 million of contingent consideration. The transaction included commercial software, intellectual property and services offerings in addition to transition services for IT and other services. The total pre-tax gain recognized on this transaction as of June 30, 2020 was $637 million. The total gain on sale may change in the future due to contingent consideration or changes in other transaction estimates, however, material changes are not expected.

The company received cash of $812 million at closing and $40 million of contingent consideration in the third quarter of 2019. In the second quarter of 2020, HCL remitted $812 million of cash to the company, of which receivables of $165 million had been previously transferred as a participating interest to a third-party bank in the first quarter of 2020. Any earned outstanding contingent consideration is expected to be paid to IBM within 27 months of the closing. In addition, IBM remits payment to HCL predominantly for servicing certain customer contracts until such contracts are terminated or entitlements are assumed by HCL, related to deferred revenue that existed prior to closing. IBM made cash payments to HCL of $81 million and $219 million during the three and six months ended June 30, 2020, respectively.

Select IBM Marketing Platform and Commerce Offerings – On April 4, 2019, IBM and Centerbridge Partners, L.P. (Centerbridge) announced a definitive agreement, in which Centerbridge would acquire select marketing platform and commerce offerings from IBM.The transaction included commercial software and services offerings. In addition, IBM is providing Centerbridge with IT transition services. All other contracted transition services have concluded as of June 30, 2020. Upon closing, Centerbridge announced that this business would be re-branded under the name Acoustic. The closing completed for the U.S. on June 30, 2019. The company received a net cash payment of $240 million and expects to receive an additional $150 million of cash within 36 months of the U.S. closing.

A subsequent closing occurred in most other countries on March 31, 2020. The closing of all remaining countries occurred as of June 30, 2020. The pre-tax gain recognized on this transaction as of June 30, 2020 was $75 million, and was not material to the consolidated financial results in any quarter. The pre-tax gain is subject to adjustment in the future due to changes in transaction-related estimates which are not expected to be material.

IBM Risk Analytics and Regulatory Offerings – On September 24, 2019, IBM and SS&C Technologies Holdings, Inc. (SS&C) entered into a definitive agreement in which SS&C would acquire certain Algorithmics and related assets from IBM. The transaction closed in the fourth quarter of 2019. The company recognized an immaterial pre-tax gain on the sale for the year ended December31, 2019.

Sales Performance Management Offerings – On November 20, 2019, IBM and Varicent Parent Holdings Corporation (Varicent) entered into a definitive agreement in which Varicent would acquire certain sales performance management assets from IBM. The initial closing of certain countries was completed on December 31, 2019. The company received a net cash payment of $230 million and recognized a pre-tax gain on the sale of $136 million for the year ended December 31, 2019. A subsequent closing for the remaining countries occurred on March 31, 2020 and the company recognized an immaterial pre-tax gain.

Table of Contents

Notes to Consolidated Financial Statements — (continued)

The above divested businesses are reported in Other–divested businesses as described in note 4, "Segments."

The pre-tax gains recognized on the divestitures above were recorded in other (income) and expense in the Consolidated Income Statement.

6. Earnings Per Share of Common Stock:

The following tables provide the computation of basic and diluted earnings per share of common stock for the three and six months ended June 30, 2020 and 2019.


	For the Three Months Ended
	June 30, 2020		June 30, 2019
Number of shares on which basic earnings per share is calculated:
Weighted-average shares outstanding during period		889,435,166		886,273,682
Add — Incremental shares under stock-based compensation plans		4,290,365		3,281,570
Add — Incremental shares associated with contingently issuable shares		1,213,549		1,276,549
Number of shares on which diluted earnings per share is calculated		894,939,080		890,831,801

Income from continuing operations (millions)	$	1,362	$	2,499
Income/(loss) from discontinued operations, net of tax (millions)		(1)		(1)
Net income on which basic earnings per share is calculated (millions)	$	1,361	$	2,498

Income from continuing operations (millions)	$	1,362	$	2,499
Net income applicable to contingently issuable shares (millions)		—		0
Income from continuing operations on which diluted earnings per share is calculated (millions)	$	1,362	$	2,500
Income/(loss) from discontinued operations, net of tax, on which basic and diluted earnings per share is calculated (millions)		(1)		(1)
Net income on which diluted earnings per share is calculated (millions)	$	1,361	$	2,499

Earnings/(loss) per share of common stock:
Assuming dilution
Continuing operations	$	1.52	$	2.81
Discontinued operations		0.00		0.00
Total	$	1.52	$	2.81
Basic
Continuing operations	$	1.53	$	2.82
Discontinued operations		0.00		0.00
Total	$	1.53	$	2.82

Stock options to purchase 1,511,989 shares and 762,019 shares were outstanding as of June 30, 2020 and 2019, respectively, but were not included in the computation of diluted earnings per share because the options' exercise price during the respective period was greater than the average market price of the common shares, and, therefore, the effect would have been antidilutive.

Table of Contents

Notes to Consolidated Financial Statements — (continued)


	For the Six Months Ended
	June 30, 2020		June 30, 2019
Number of shares on which basic earnings per share is calculated:
Weighted-average shares outstanding during period		888,702,256		887,927,612
Add — Incremental shares under stock-based compensation plans		5,015,390		3,327,015
Add — Incremental shares associated with contingently issuable shares		1,271,513		1,116,537
Number of shares on which diluted earnings per share is calculated		894,989,159		892,371,164

Income from continuing operations (millions)	$	2,538	$	4,093
Income/(loss) from discontinued operations, net of tax (millions)		(2)		(4)
Net income on which basic earnings per share is calculated (millions)	$	2,536	$	4,089

Income from continuing operations (millions)	$	2,538	$	4,093
Net income applicable to contingently issuable shares (millions)		(2)		0
Income from continuing operations on which diluted earnings per share is calculated (millions)	$	2,536	$	4,093
Income/(loss) from discontinued operations, net of tax, on which basic and diluted earnings per share is calculated (millions)		(2)		(4)
Net income on which diluted earnings per share is calculated (millions)	$	2,534	$	4,090

Earnings/(loss) per share of common stock:
Assuming dilution
Continuing operations	$	2.83	$	4.58
Discontinued operations		0.00		0.00
Total	$	2.83	$	4.58
Basic
Continuing operations	$	2.85	$	4.61
Discontinued operations		0.00		0.00
Total	$	2.85	$	4.61

Stock options to purchase 1,324,444 shares and 949,519 shares (average of first and second quarter share amounts) were outstanding as of June 30, 2020 and 2019, respectively, but were not included in the computation of diluted earnings per share because the options' exercise price during the respective period was greater than the average market price of the common shares, and, therefore, the effect would have been antidilutive.

7. Financial ~~Instruments:~~Assets & Liabilities:

Fair Value Measurements

~~Accounting guidance defines fair~~Fair value is defined 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~~The company ~~is required to classify~~classifies 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~~21

Table of ~~observable market data if such data is available without undue cost and effort.~~Contents

Notes to Consolidated Financial Statements — (continued)

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 company holds investments primarily in time deposits, certificates of deposit, and U.S. government debt that are designated as available-for-sale. The primary objective of the company’s cash and debt investment portfolio is to maintain principal by investing in very liquid and highly rated investment grade securities.

Available-for-sale securities are measured for impairment on a recurring basis by comparing the security’s fair value with its amortized cost basis. Effective January 1, 2020 with the adoption of the new standard on credit losses, if the fair value of ~~derivatives~~the security falls below its amortized cost basis, the change in fair value is ~~derived utilizing a discounted cash flow model that uses observable market inputs~~recognized in the period the impairment is identified when the loss is due to credit factors. The change in fair value due to non-credit factors is recorded in other comprehensive income when the company does not intend to sell and has the ability to hold the investment. The company’s standard practice is to hold all of its debt security investments classified as available-for-sale until maturity. There were 0 impairments for credit losses or non-credit impairments for the three and six months ended June 30, 2020. Prior to the adoption of the new standard, available-for-sale securities were measured for impairment using an other-than-temporary impairment model. NaN impairment was recorded for the three and six months ended June 30, 2019.

Certain nonfinancial assets such as ~~known notional value amounts, yield curves, spot~~property, plant and ~~forward exchange rates as well as discount rates. These inputs relate to liquid, heavily traded currencies with active markets which~~equipment, operating right-of-use assets, land, goodwill and intangible assets are ~~available for the full term of the derivative.~~

~~Certain assets that are measured at fair value on a recurring basis can be~~also subject to nonrecurring fair value ~~measurements. These assets include available-for-sale debt securities that~~measurements if they are deemed to be ~~other-than-temporarily~~ impaired. InThe impairment models used for nonfinancial assets depend on the ~~event~~type of ~~an other-than-temporary impairment~~asset. There were no material impairments of ~~a debt security, fair value is measured using a model described above.~~nonfinancial assets for the six months ended June 30, 2020 and 2019, respectively.

1822

Table of Contents

Notes to Consolidated Financial Statements — (continued)

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 nine months ended September 30, 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.

The following ~~tables present~~table presents the company’s financial assets and financial liabilities that are measured at fair value on a recurring basis at ~~September~~June 30, ~~2019~~2020 and December 31, ~~2018.~~2019.

(Dollars in millions)












At September 30, 2019

Level 1

Level 2

Level 3

Total

Assets:









Cash equivalents (1)









Time deposits and certificates of deposit

$
—

$
6,251

$
—

$
6,251
(6)
Money market funds

597

—

—

597

Total

$
597

$
6,251

$
—

$
6,848

Equity investments (2)

0

—

—

0

Debt securities – current (3)

—

733

—

733
(6)
Debt securities – noncurrent (2)

—

111

—

111
(6)
Derivative assets (4)

4

533

—

536

Total assets

$
601

$
7,628

$
—

$
8,229

Liabilities:









Derivative liabilities (5)

$
—

$
1,074

$
—

$
1,074


	Fair Value
	Hierarchy	At June 30, 2020				At December 31, 2019
(Dollars in millions)	Level	Assets (7)		Liabilities (8)		Assets (7)		Liabilities (8)
Cash equivalents (1)
Time deposits and certificates of deposit (2)	2	$	7,785	$	N/A	$	4,392	$	N/A
Money market funds	1		926		N/A		427		N/A
Total cash equivalents		$	8,712	$	N/A	$	4,819	$	N/A
Equity investments (3)	1		0		N/A		0		N/A
Debt securities-current (2)(4)	2		2,063		N/A		696		N/A
Debt securities-noncurrent (2)(5)	2		22		N/A		65		N/A
Derivatives designated as hedging instruments
Interest rate contracts	2		126		—		56		—
Foreign exchange contracts	2		161		468		175		635
Derivatives not designated as hedging instruments
Foreign exchange contracts	2		8		18		10		33
Equity contracts (6)	1,2		11		4		1		4
Total		$	11,104	$	491	$	5,823	$	673

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

(2)	Available-for-sale securities with an amortized cost basis that approximates fair value.

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

~~(3)~~(4)

~~Included~~Primarily includes time deposits and U.S. treasury bills that are reported within marketable securities in the Consolidated ~~Statement of Financial Position.~~Balance Sheet.

~~(4)~~(5)

Primarily includes corporate debt securities with a maximum maturity of two years that are reported within investments and sundry assets in the Consolidated Balance Sheet.

(6)	Level 1 includes immaterial amounts related to equity futures contracts.

(7)

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~~Balance Sheet at ~~September~~June 30, 2020 were $195 million and $112 million, respectively, and at December 31, 2019 were ~~$395~~$149 million and ~~$141~~$94 million, respectively.

~~(5)~~(8)

The gross balances of derivative liabilities contained within other accrued expenses and liabilities, and other liabilities in the Consolidated ~~Statement of Financial Position~~Balance Sheet at ~~September~~June 30, 2020 were $289 million and $202 million, respectively, and at December 31, 2019 were ~~$203~~$167 million and ~~$870~~$506 million, respectively.

~~(6)~~

~~Available-for-sale debt securities with carrying values that approximate fair value.~~

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

(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

Total assets

$
26

$
9,028

$
—

$
9,053

Liabilities:









Derivative liabilities (5)

$
40

$
343

$
—

$
383

~~(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.~~

N/A – not applicable

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 ~~September~~June 30, ~~2019~~2020 and December 31, ~~2018,~~2019, 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.

Table of Contents

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 (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 ~~$57,797~~$55,449 million and ~~$35,605~~$54,102 million, and the estimated fair value was ~~$62,398~~$61,600 million and ~~$36,599~~$58,431 million at ~~September~~June 30, ~~2019~~2020 and December 31, ~~2018,~~2019, 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.

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

~~Available-for-Sale Debt Securities~~8. Financing Receivables:

~~There~~Financing receivables primarily consist of client loan and installment payment receivables (loans) and investment in sales-type and direct financing leases (collectively referred to as client financing receivables) and commercial financing receivables. Loans are provided primarily to clients to finance the purchase of hardware, software and services. Payment terms on these financing arrangements are generally for terms up to seven years. Investment in sales-type and direct financing leases relate principally to the company’s Systems products and are for terms ranging generally from two to six years. Commercial financing receivables relate primarily to working capital financing for dealers and remarketers of IBM products. Payment terms for working capital financing generally range from 30 to 90 days.

Effective January 1, 2020, the company adopted the new accounting standard related to credit losses, using the transition methodology whereby prior comparative periods were 0 gross realized gains/losses from the sale of available-for-sale debt securities during the three and nine month periods ended September 30, 2019 and gross realized gains/losses for the three and nine months ended September 30, 2018 were immaterial. After-tax net unrealized holding gains/losses on available-for-sale debt securities that have been included in other comprehensive income/loss for the three and nine months ended September 30, 2019 and 2018 were immaterial.

~~The contractual maturities of substantially all available-for-sale debt securities are less than one year at September 30, 2019.~~

~~Derivative Financial Instruments~~

~~The company operates in multiple functional currencies and is a significant lender and borrower~~not retrospectively presented in the ~~global markets. In~~Consolidated Financial Statements. Refer to note 2, “Accounting Changes,” for additional information. Under this new guidance, the ~~normal course~~amortized cost basis of ~~business,~~a financial asset represents the ~~company is exposed~~original amount of the financing receivable (including residual value) adjusted for unearned income, deferred initial direct costs, cash collected, write-offs and any foreign exchange adjustments. The allowance for credit losses represents future expected credit losses over the life of the receivables based on past experience, current information and forward-looking economic considerations. Prior to the ~~impact of interest rate changes and foreign currency fluctuations, and~~effective date, financing receivables were measured at recorded investment, which does not include residual value. As a result, all prior periods are presented at recorded investment, while current period information is presented at amortized cost. Additionally, current period information reflects updates 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 leaseportfolio segments, and other ~~financial assets and~~presentation changes within 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.

Asfollowing tables, as a result of the ~~use~~adoption 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 entitiesthis new guidance.

A summary of the ~~company subject to the arrangement to net amounts due to and from the counterparty reducing the maximum loss from credit risk in the event of counterparty default.~~

The company is also a party to collateral security arrangements with most of its major derivative counterparties. These arrangements require the company to hold or post collateral (cash or U.S. Treasury securities) when the derivative fair values exceed contractually established thresholds. Posting thresholds can be fixed or can vary based on credit default swap pricing or credit ratings received from the major credit agencies. The aggregate fair value of all derivative instruments under these collateralized arrangements that were in a liability position at September 30, 2019 and December 31, 2018 was $737 million and $74 million, respectively, for which $116 million of collateral was posted by the company and reduced the position at September 30, 2019, and for which 0 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 September 30, 2019 and December 31, 2018 was $536 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 $316 million and $267 million at September 30, 2019 and December 31, 2018, respectively, of liabilities included in master netting arrangements with those counterparties. Additionally, at December 31, 2018, this exposure was reduced by $70 million of cash collateral received from counterparties. NaN collateral was received at September 30, 2019. There were 0 non-cash collateral balances received from counterparties in U.S. Treasury securities at September 30, 2019 and December 31, 2018. At September 30, 2019 and December 31, 2018, the net exposure related to derivative assets recorded in the Consolidated Statement of Financial Position was $220 million and $395 million, respectively. At September 30, 2019 and December 31, 2018, the net position related to derivative liabilities recorded in the Consolidated Statement of Financial Position was $641 million and $116 million, respectively.

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

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 $116 million at September 30, 2019. NaN 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 $70 million at December 31, 2018. NaN amount was recognized in accounts payable for the obligation to return cash collateral at September 30, 2019. 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. NaN amount was rehypothecated at September 30, 2019 and 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 September 30, 2019 and December 31, 2018, the total notional amountcomponents of the company’s ~~interest-rate swaps was $4.7 billion~~financing receivables is presented as follows:


	Client Financing Receivables
	Client Loan and		Investment in
	Installment Payment		Sales-Type and		Commercial
(Dollars in millions)	Receivables		Direct Financing		Financing
At June 30, 2020:	(Loans)		Leases		Receivables		Total
Financing receivables, gross	$	12,539	$	4,967	$	2,393	$	19,898
Unearned income		(506)		(393)		(3)		(903)
Residual value*		—		586		—		586
Amortized cost	$	12,033	$	5,160	$	2,389	$	19,582
Allowance for credit losses		(164)		(89)		(11)		(264)
Total financing receivables, net	$	11,869	$	5,070	$	2,379	$	19,318
Current portion	$	7,501	$	2,087	$	2,379	$	11,967
Noncurrent portion	$	4,368	$	2,983	$	—	$	7,351

* Includes guaranteed and $7.6 billion, respectively. The weighted-average remaining maturity of these instruments at September 30, 2019 and December 31, 2018 was approximately 2.7 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 September 30, 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. On May 15, 2019, the company issued an aggregate of $20 billion of indebtedness (see note 13, “Borrowings,” for additional information). Following the receipt of the net proceeds from this debt offering, the company terminated $5.5 billion of forward starting interest-rate swaps. These instruments were designated and accounted for as cash flow hedges for a portion of this issuance and hedged exposure to the variability in future cash flows over a maximum of 30 years. These swaps were the only instruments outstanding under this program at December 31, 2018, and there were 0 instruments outstanding at September 30, 2019.

In connection with cash flow hedges of forecasted interest payments related to the company's borrowings, the company recorded net losses of $196 million and net losses of $35 million (before taxes) at September 30, 2019 and

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

December 31, 2018, respectively, in AOCI. The company estimates that $18 million (before taxes) of the deferred net losses on derivatives in AOCI at September 30, 2019 will be reclassified to net income within the next 12 months, providing an offsetting economic impact against the underlying interest payments.

~~Foreign Exchange Risk~~

~~Long-Term Investments in Foreign Subsidiaries (Net Investment)~~

A large portion of the company’s foreign currency denominated debt portfolio is designated as a hedge of net investment in foreign subsidiaries to reduce the volatility in stockholders’ equity caused by changes in foreign currency exchange rates in the functional currency of major foreign subsidiaries with respect to the U.S. dollar. The company also uses cross-currency swaps and foreign exchange forward contracts for this risk management purpose. At September 30, 2019 and December 31, 2018, the total notional amount of derivative instruments designated as net investment hedges was $11.4 billion and $6.4 billion, respectively. At September 30, 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 September 30, 2019 and December 31, 2018, the total notional amount of forward contracts designated as cash flow hedges of forecasted royalty and cost transactions was $9.9 billion and $9.8 billion, respectively. At September 30, 2019 and December 31, 2018, the weighted-average remaining maturity of these instruments was approximately 0.7 years and 0.8 years, respectively.

At September 30, 2019 and December 31, 2018, in connection with cash flow hedges of anticipated royalties and cost transactions, the company recorded net gains of $337 million and net gains of $342 million (before taxes), respectively, in AOCI. The company estimates that $266 million (before taxes) of deferred net gains on derivatives in AOCI at September 30, 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 September 30, 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 September 30, 2019 and December 31, 2018, in connection with cash flow hedges of foreign currency denominated borrowings, the company recorded net losses of $138 million and net gains of $75 million (before taxes), respectively, in AOCI. The company estimates that $278 million (before taxes) of deferred net gains on derivatives in AOCI at September 30, 2019 will be reclassified to net income within the next 12 months, providing an offsetting economic impact against the underlying exposure.

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

~~Subsidiary Cash and Foreign Currency Asset/Liability Management~~

The company uses its Global Treasury Centers to manage the cash of its subsidiaries. These centers principally use currency swaps to convert cash flows in a cost-effective manner. In addition, the company uses foreign exchange forward contracts to economically hedge, on a net basis, the foreign currency exposure of a portion of the company’s nonfunctional currency assets and liabilities. The terms of these forward and swap contracts are generally less than one year. The changes in the fair values of these contracts and of the underlying hedged exposures are generally offsetting and are recorded in other (income) and expense in the Consolidated Statement of Earnings. At September 30, 2019 and December 31, 2018, the total notional amount of derivative instruments in economic hedges of foreign currency exposure was $8.2 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 September 30, 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 September 30, 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 September 30, 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 September 30, 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 September 30, 2019 and December 31, 2018, as well as for the three and nine months ended September 30, 2019 and 2018, respectively.unguaranteed residual value.

Table of Contents

Notes to Consolidated Financial Statements — (continued)


	Client Financing Receivables
	Client Loan and		Investment in
	Installment Payment		Sales-Type and		Commercial
(Dollars in millions)	Receivables		Direct Financing		Financing
At December 31, 2019:	(Loans)		Leases		Receivables		Total
Financing receivables, gross	$	13,592	$	6,077	$	3,836	$	23,504
Unearned income		(570)		(509)		(4)		(1,083)
Recorded investment	$	13,022	$	5,567	$	3,831	$	22,421
Allowance for credit losses		(138)		(72)		(11)		(221)
Unguaranteed residual value		—		652		—		652
Guaranteed residual value		—		53		—		53
Total financing receivables, net	$	12,884	$	6,199	$	3,820	$	22,904
Current portion	$	8,037	$	2,334	$	3,820	$	14,192
Noncurrent portion	$	4,847	$	3,865	$	—	$	8,712

~~Fair Values~~

The company has a long-standing practice of ~~Derivative Instruments~~taking mitigation actions, in certain circumstances, to transfer credit risk to third parties. These actions may include credit insurance, financial guarantees, nonrecourse borrowings, transfers of receivables recorded as true sales in accordance with accounting guidance or sales of equipment under operating lease.

Financing receivables pledged as collateral for borrowings were $758 million and $1,062 million at June 30, 2020 and December 31, 2019, respectively.

In the second quarter of 2020, the company sold $711 million of financing receivables, consisting of lease and loan receivables of $417 million and $294 million, respectively, approximately half of which were scheduled to be due within the next 12 months. The transfer of these receivables qualified as true sales and therefore reduced Global Financing receivables and resulted in a benefit to cash flows from operating activities. The impact to the Consolidated Income Statement, including fees and net gain associated with the transfer of ~~Financial Position~~these receivables was not material.

The company did not have any financing receivables held for sale as of June 30, 2020 and December 31, 2019.

Allowance for Credit Losses – Financing Receivables

Fair Value of Derivative Assets

Fair Value of Derivative Liabilities


Balance Sheet





Balance Sheet




(Dollars in millions)

Classification

9/30/2019

12/31/2018

Classification

9/30/2019

12/31/2018
Designated as hedging instruments:












Interest rate contracts

Prepaid expenses and other current assets

$
9

$
9

Other accrued expenses and liabilities

$
—

$
4

Investments and sundry assets

106

212

Other liabilities

2

76
Foreign exchange contracts

Prepaid expenses and other current assets

368

348

Other accrued expenses and liabilities

165

110

Investments and sundry assets

35

135

Other liabilities

869

129

Fair value of derivative assets

$
518

$
704

Fair value of derivative liabilities

$
1,035

$
320
Not designated as hedging instruments:












Foreign exchange contracts

Prepaid expenses and other current assets

$
12

$
26

Other accrued expenses and liabilities

$
36

$
13
Equity contracts

Prepaid expenses and other current assets

6

2

Other accrued expenses and liabilities

2

51

Fair value of derivative assets

$
18

$
28

Fair value of derivative liabilities

$
38

$
63
Total derivatives



$
536

$
731



$
1,074

$
383
Total debt designated as hedging instruments (1):












Short-term debt



N/A

N/A



$
—

$
—
Long-term debt



N/A

N/A



6,061

6,261

N/A

N/A

$
6,061

$
6,261
Total



$
536

$
731



$
7,134

$
6,644
~~(1)~~ ~~Debt designated as hedging instruments are reported at carrying value.~~
N/Refer to note A, ~~- not applicable~~
~~At September 30, 2019 and December 31, 2018, the following amounts were recorded~~“Significant Accounting Policies,” in the ~~Consolidated Statement~~company’s 2019 Annual Report for a full description of ~~Financial Position~~its accounting policies for trade and financing receivables, contract assets and related allowances. The descriptions below include any changes to ~~cumulative basis adjustments for fair value hedges:~~those policies due to the new standard.


September 30,

December 31,

(Dollars in millions)

2019

2018

Short-term debt:





Carrying amount of the hedged item

$
(326)

$
(1,878)

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

(1)
(1)

(4)
(1)
Long-term debt:





Carrying amount of the hedged item

$
(4,834)

$
(6,004)

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

(469)
(2)

(333)
(2)
~~(1)~~ ~~Includes ($1) million and ($6) million of hedging adjustments on discontinued hedging relationships at September 30, 2019 and December 31, 2018, respectively.~~
~~(2)~~ ~~Includes ($378) million and ($213) million of hedging adjustments on discontinued hedging relationships at September 30, 2019 and December 31, 2018, respectively.~~
Effective with the adoption of the new credit losses standard, the company’s estimates of its allowances for expected credit losses include consideration of: past events, including any historical default, historical concessions and resulting troubled debt restructurings, current economic conditions, taking into account any non-freestanding mitigating credit enhancements and certain forward-looking information, including reasonable and supportable forecasts.
Collectively Evaluated Financing Receivables

The company determines its allowance for credit losses based on 2 portfolio segments: client financing receivables and commercial financing receivables, and further segments the portfolio into 3 classes: Americas, Europe/Middle East/Africa (EMEA) and Asia Pacific.

For client financing receivables, the company uses a credit loss model to calculate allowances based on its internal loss experience and current conditions and forecasts, by class of financing receivable. The company records an unallocated reserve that is calculated by applying a reserve rate to its portfolio, excluding accounts that have been individually evaluated and specifically reserved. This reserve rate is based upon credit rating, probability of default, term and loss history. The allowance is adjusted quarterly for expected recoveries of amounts that were previously written off

Table of Contents

Notes to Consolidated Financial Statements — (continued)

~~The Effect~~or are expected to be written off. Recoveries cannot exceed the aggregated amount 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:previous write-off or expected write-off.

Gains/(Losses) of

(Dollars in millions)

Total

Total Hedge Activity

For the three months ended September 30:

2019

2018

2019

2018

Cost of services

$
7,840

$
7,951
*
$
22

$
1

Cost of sales

1,635

1,714
*

10

8

Cost of financing

217

287

(11)

(3)
*
SG&A expense

5,024

4,363

20

47

Other (income) and expense

(31)

275

(561)

(63)

Interest expense

432

191

(35)

(3)
*
Macroeconomic variables attributed to the expected credit losses for client financing receivables may vary by class of financing receivables based on historical experiences, portfolio composition and current environment. In addition to a qualitative review of credit risk factors across the portfolio, the company considers forward-looking macroeconomic variables such as gross domestic product, unemployment rates, equity prices and corporate profits when quantifying the impact of economic forecasts on its client financing receivables allowance for expected credit losses. The company also considers the impact of current conditions and economic forecasts relating to specific industries, geographical areas, and client-specific exposures on the portfolio. Under this approach, forecasts of these variables over two years are considered reasonable and supportable. Beyond two years, the company reverts to long-term average loss experience. Forward-looking estimates require the use of judgment, particularly in times of economic uncertainty. Consistent with the first quarter of 2020, with evolving global impacts from the COVID-19 pandemic, external economic models have been revised with increased frequency and with alternative scenarios. The company’s allowances at June 30, 2020, reflect the qualitative process described above. Any changes to economic models that occurred after the balance sheet date will be reflected in future periods.

The allowance for commercial financing receivables is estimated based on a combination of write-off history and current economic conditions, excluding any individually evaluated accounts. The commercial financing receivables portfolio segment is excluded from the tables in the sections below as the receivables are short term in nature and the current estimated risk of loss and resulting impact to the company’s financial results are not material.

At January 1, 2020, upon adoption of the new standard, the company recorded an additional allowance for client and commercial financing receivables (including related off-balance sheet commitments) of $64 million. This was primarily driven by an increase in the client financing receivables allowance. Refer to note 12, “Commitments,” for additional information regarding off-balance sheet commitments.

Client Financing Receivables
The following tables present the amortized cost basis or recorded investment for client financing receivables at June 30, 2020 and December 31, 2019, further segmented by 3 classes: Americas, Europe/Middle East/Africa (EMEA) and Asia Pacific.

(Dollars in millions)












At June 30, 2020:

Americas

EMEA

Asia Pacific

Total
Amortized cost

$
9,060

$
4,932

$
3,201

$
17,192

Allowance for credit losses








Beginning balance at December 31, 2019

$
120

$
54

$
36

$
210
Adjustment for adoption of new standard

21

15

5

41
Beginning balance at January 1, 2020

$
142

$
69

$
41

$
252
Write-offs

$
(17)

$
(1)

$
(2)

$
(21)
Recoveries

0

0

2

2
Additions/(releases)

28

9

(2)

34
Other*

(13)

0

(1)

(14)
Ending balance at June 30, 2020

$
140

$
76

$
37

$
253
* ~~Reclassified to conform to current period presentation.~~Primarily represents translation adjustments.

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 September 30:

Earnings Line Item

2019

2018

2019

2018
Derivative instruments in fair value hedges (1):










Interest rate contracts

Cost of financing

$
3

$
(27)

$
0

$
33

Interest expense

9

(26)

0

33
Derivative instruments not designated as hedging instruments:










Foreign exchange contracts

Other (income) and expense

(114)

(55)

N/A

N/A
Equity contracts

SG&A expense

9

40

N/A

N/A
Total



$
(94)

$
(69)

$
0

$
66

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 September 30:

2019

2018

Earnings Line Item

2019

2018

2019

2018

Derivative instruments in cash flow hedges:















Interest rate contracts

$
—

$
—

Cost of financing

$
(1)

$
—

$
—

$
—

Interest expense

(3)

—

—

—

Foreign exchange contracts

(439)

(46)

Cost of services

22

1

—

—

Cost of sales

10

8

—

—

Cost of financing

(20)

(18)
*

—

—

SG&A expense

11

7

—

—

Other (income) and expense

(447)

(8)

—

—

Interest expense

(61)

(18)
*

—

—

Instruments in net investment hedges (4):















Foreign exchange contracts

435

86

Cost of financing

—

—

7

9
*

Interest expense

—

—

20

9
*
Total

$
(4)

$
40



$
(488)

$
(28)

$
27

$
18

* Reclassified to conform to current period presentation.
~~(1)~~ The amount includes changes in clean fair values of the derivative instruments in fair value hedging relationships and the periodic accrual for coupon payments required under these derivative contracts.
~~(2)~~ The amount includes basis adjustments to the carrying value of the hedged item recorded during the period and amortization of basis adjustments recorded on de-designated hedging relationships during the period.
~~(3)~~ ~~The company’s policy is to recognize all fair value changes in amounts excluded from effectiveness testing in net income each period.~~
~~(4)~~ ~~Instruments in net investment hedges include derivative and non-derivative instruments.~~
~~N/A - not applicable~~

Gains/(Losses) of

(Dollars in millions)

Total

Total Hedge Activity

For the nine months ended September 30:

2019

2018

2019

2018

Cost of services

$
24,293
*
$
25,238
*
$
52

$
29

Cost of sales

4,979
*

5,498
*

40

(15)

Cost of financing

710

846

(47)

1
*
SG&A expense

15,171

14,665

199

24

Other (income) and expense

(850)

968

(358)

(449)

Interest expense

990

530

(96)

1
*
* Reclassified to conform to current period presentation.

~~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 nine months ended September 30:

Earnings Line Item

2019

2018

2019

2018
Derivative instruments in fair value hedges (1):














Interest rate contracts

Cost of financing

$
51

$
(138)

$
(44)

$
170

Interest expense

105

(128)

(89)

157
Derivative instruments not designated as hedging instruments:










Foreign exchange contracts

Other (income) and expense

(27)

(148)

N/A

N/A
Equity contracts

SG&A expense

153

38

N/A

N/A
Total



$
283

$
(377)

$
(133)

$
327

Gain (Loss) Recognized in Earnings and Other Comprehensive Income

(Dollars in millions)

Consolidated

Reclassified

Amounts Excluded from

For the nine months

Recognized in OCI

Statement of

from AOCI

Effectiveness Testing(3)

ended September 30:

2019

2018

Earnings Line Item

2019

2018

2019

2018

Derivative instruments in cash flow hedges:















Interest rate contracts

$
(168)

$
—

Cost of financing

$
(2)

$
—

$
—

$
—

Interest expense

(5)

—

—

—

Foreign exchange contracts

(630)

(134)

Cost of services

52

29

—

—

Cost of sales

40

(15)

—

—

Cost of financing

(71)

(56)
*

—

—

SG&A expense

45

(14)

—

—

Other (income) and expense

(331)

(301)

—

—

Interest expense

(146)

(52)
*

—

—

Instruments in net investment hedges (4):















Foreign exchange contracts

306

509

Cost of financing

—

—

19

26
*

Interest expense

—

—

38

24
*
Total

$
(491)

$
375



$
(418)

$
(408)

$
57

$
49

* Reclassified to conform to current period presentation.
~~(1)~~ The amount includes changes in clean fair values of the derivative instruments in fair value hedging relationships and the periodic accrual for coupon payments required under these derivative contracts.
~~(2)~~ The amount includes basis adjustments to the carrying value of the hedged item recorded during the period and amortization of basis adjustments recorded on de-designated hedging relationships during the period.
~~(3)~~ ~~The company’s policy is to recognize all fair value changes in amounts excluded from effectiveness testing in net income each period.~~
~~(4)~~ ~~Instruments in net investment hedges include derivative and non-derivative instruments.~~
~~N/A - not applicable~~

For the three and nine months ending September 30, 2019 and 2018, there were no material gains or losses excluded from the assessment of hedge effectiveness (for fair value or cash flow hedges), or associated with an underlying exposure that did not or was not expected to occur (for cash flow hedges); nor are there any anticipated in the normal course of business.
5. ~~Leases:~~
The company conducts business as both a lessee and a lessor. In its ordinary course of business, the company enters into leases as a lessee for property, plant and equipment. The company is also the lessor of certain equipment, mainly through its Global Financing segment.

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

When procuring goods or services, or upon entering into a contract with its clients, the company determines whether an arrangement contains a lease at its inception. As part of that evaluation, the company considers whether there is an implicitly or explicitly identified asset in the arrangement and whether the company, as the lessee, or the client, if the company is the lessor, has the right to control that asset.
The company determines whether there is a right to control the use of the asset by assessing its rights, as the lessee, or the client’s rights, if the company is the lessor, to obtain substantially all of the economic benefits from the use of the identified asset and the right to direct the use of the identified asset. If there is either an explicit or embedded lease within a contract, the company determines the classification of the lease (e.g., finance, operating, sales-type lease) at the lease commencement date.
~~Accounting for leases as a lessee~~
Effective January 1, 2019, when the company is the lessee, all leases with a term of more than 12 months are recognized as ROU assets and associated lease liabilities in the Consolidated Statement of Financial Position. The lease liabilities are measured at the lease commencement date and determined using the present value of the lease payments not yet paid and the company's incremental borrowing rate, which approximates the rate at which the company would borrow, on a secured basis, in the country where the lease was executed. The interest rate implicit in the lease is generally not determinable in transactions where the company is the lessee. The ROU asset equals the lease liability adjusted for any IDCs, prepaid rent and lease incentives. Fixed and in-substance fixed payments are included in the recognition of ROU assets and lease liabilities, however, variable lease payments, other than those based on a rate or index, are recognized in the Consolidated Statement of Earnings in the period in which the obligation for those payments is incurred. The company’s variable lease payments generally relate to payments tied to various indexes, non-lease components and payments above a contractual minimum fixed payment.
ROU assets represent the company’s right to control the underlying assets under lease, and the lease liability is the obligation to make the lease payments related to the underlying assets under lease. Operating leases are included in operating right-of-use assets – net, current operating lease liabilities and operating lease liabilities in the Consolidated Statement of Financial Position. Finance leases are included in property, plant and equipment, short-term debt and long-term debt in the Consolidated Statement of Financial Position. At September 30, 2019, the total amount of ROU assets and lease liabilities for finance leases recognized in the Consolidated Statement of Financial Position in property, plant and equipment, short-term debt and long-term debt was $140 million, $34 million and $121 million, respectively.
Finance lease ROU assets are generally amortized on a straight-line basis over the lease term with the interest expense on the lease liability recorded using the interest method. The amortization and interest expense are recorded separately in the Consolidated Statement of Earnings. For operating leases, the amortization of the ROU asset and the interest expense on the lease liability are not separately recorded; rather, the lease cost is recognized on a straight-line basis over the lease term as a single-line item in the Consolidated Statement of Earnings, unless the ROU asset is impaired. The company has elected to not recognize leases with a lease term of less than 12 months in the Consolidated Statement of Financial Position, including those acquired in a business combination, and lease costs for those short-term leases are recognized on a straight-line basis over the lease term in the Consolidated Statement of Earnings.
For all asset classes, the company has elected the lessee practical expedient to combine lease and non-lease components (e.g., maintenance services) and account for the combined unit as a single lease component. A significant portion of the company’s lease portfolio is real estate, which are mainly accounted for as operating leases, and are primarily used for corporate offices and data centers. The average term of the real estate leases is approximately five years. Certain real estate leases have renewal and/or termination options, which are assessed to determine if those options would affect the duration of the lease term. The company also has equipment leases, such as IT equipment and vehicles, which have lease terms that range from two to five years. For certain equipment leases, the company applies a portfolio approach to account for the operating lease ROU assets and lease liabilities.

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

~~The following tables present the various components of lease costs:~~

(Dollars in millions)



For the three months ended September 30:

2019
Finance lease cost

$
7
Operating lease cost

423
Short-term lease cost

11
Variable lease cost

90
Sublease income

(7)
Total lease cost

$
523

(Dollars in millions)



For the nine months ended September 30:

2019
Finance lease cost

$
14
Operating lease cost

1,243
Short-term lease cost

26
Variable lease cost

345
Sublease income

(16)
Total lease cost

$
1,613

There were 0 net gains recorded on sale and leaseback transactions for the three months ended September 30, 2019 and the company recorded $41 million of net gains for the nine months ended September 30, 2019.
The following tables present supplemental information relating to the cash flows arising from lease transactions. Cash payments related to variable lease costs and short-term leases are not included in the measurement of operating and finance lease liabilities, and, as such, are excluded from the amounts below:

(Dollars in millions)



For the nine months ended September 30:

2019

Cash paid for amounts included in the measurement of lease liabilities:



Operating cash outflows from finance leases

$
7

Financing cash outflows from finance leases

$
6

Operating cash outflows from operating leases

$
1,154

ROU assets obtained in exchange for new finance lease liabilities

$
149
*
ROU assets obtained in exchange for new operating lease liabilities

$
6,023
*
* Includes opening balance additions as a result of the adoption of the new lease guidance effective January 1, 2019. The post adoption addition of leases for the nine months ended September 30, 2019 was $1,221 million for operating leases and immaterial for finance leases.
~~The following table presents the weighted-average lease terms and discount rates for both finance and operating leases:~~

~~At September 30:~~

~~2019~~

~~Weighted-average remaining lease term — finance leases~~

~~5.9~~
~~yrs.~~
~~Weighted-average remaining lease term — operating leases~~

~~5.3~~
~~yrs.~~
~~Weighted-average discount rate — finance leases~~

~~1.73~~
%
~~Weighted-average discount rate — operating leases~~

~~3.10~~
%

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

The following table presents a maturity analysis of the expected undiscounted cash out flows for operating and finance leases on an annual basis for the next five years and thereafter, at September 30, 2019:


Remainder of













Beyond

Imputed



(Dollars in millions)

2019

2020

2021

2022

2023

2023

Interest*

Total
Finance leases

$
10

$
42

$
43

$
36

$
24

$
53

$
(54)

$
155
Operating leases

$
402

$
1,419

$
1,123

$
847

$
604

$
1,160

$
(388)

$
5,167
* Imputed interest represents the difference between undiscounted cash flows and discounted cash flows.
Prior to the adoption of the new lease guidance on January 1, 2019, ROU assets and lease liabilities for operating leases were not recognized in the Consolidated Statement of Financial Position. The company elected the practical expedient to not provide comparable presentation in the Consolidated Statement of Financial Position for periods prior to adoption. Rental expense, including amounts charged to inventories and fixed assets, and excluding amounts previously reserved, was $1,944 million for the year ended December 31, 2018. Rental expense in agreements with rent holidays and scheduled rent increases was previously recognized on a straight-line basis over the lease term. Contingent rentals were included in the determination of rental expense as accruable.
The following table, which was included in the company’s 2018 Annual Report, depicts gross minimum rental commitments under noncancelable leases, amounts related to vacant space associated with workforce transformation, sublease income commitments and capital lease commitments at December 31, 2018.

















Beyond
(Dollars in millions)

2019

2020

2021

2022

2023

2023
Operating lease commitments












Gross minimum rental commitments












(including vacant space below)

$
1,581

$
1,233

$
914

$
640

$
445

$
815
Vacant space

$
29

$
23

$
14

$
9

$
5

$
8
Sublease income commitments

$
11

$
7

$
5

$
4

$
4

$
2
Capital lease commitments

$
3

$
3

$
3

$
3

$
2

$
28

The difference between the company’s total lease commitments as reported at December 31, 2018 compared to the January 1, 2019 ROU asset balance in the Consolidated Statement of Financial Position is primarily due to the required use of a discount factor (imputed interest) under the new lease guidance and certain amounts that are not included in the ROU asset under the new lease guidance (e.g., tenant incentives and vacant space).
~~Accounting for leases as a lessor~~
The company typically enters into leases as an alternative means of realizing value from equipment that it would otherwise sell. Assets under lease include new and used IBM equipment and certain OEM products. IBM equipment generally consists of IBM Z, Power Systems and Storage Systems products.
Lease payments due to IBM are typically fixed and paid in equal installments over the lease term. The majority of the company’s leases do not contain variable payments that are dependent on an index or a rate. Variable lease payments that do not depend on an index or a rate (e.g., property taxes), that are paid directly by the company and are reimbursed by the client, are recorded as revenue, along with the related cost, in the period in which collection of these payments is probable. Payments that are made directly by the client to a third party, including certain property taxes and insurance, are not considered part of variable payments and therefore are not recorded by the company. The company has made a policy election to exclude from consideration in contracts all collections from sales and other similar taxes.

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

The company’s payment terms for leases are typically unconditional. Therefore, in an instance when the client requests to terminate the lease prior to the end of the lease term, the client would typically be required to pay the remaining lease payments in full. At the end of the lease term, the company allows the client to either return the equipment, purchase the equipment at the then-current fair market value or at a pre-stated purchase price or renew the lease based on mutually agreed upon terms.
When lease arrangements include multiple performance obligations, the company allocates the consideration in the contract between the lease components and the non-lease components on a relative standalone selling price basis.
~~The following tables present amounts included in the Consolidated Statement of Earnings related to lessor activity:~~

(Dollars in millions)



For the three months ended September 30:

2019
Lease income — sales-type and direct financing leases


Sales-type lease selling price

$
188
Less: Carrying value of underlying assets, excluding unguaranteed residual value

75
Gross profit

113
Interest income on lease receivables

71
Total sales-type and direct financing lease income

$
184
Lease income — operating leases

80
Variable lease income

12
Total lease income

$
276

(Dollars in millions)



For the nine months ended September 30:

2019
Lease income — sales-type and direct financing leases


Sales-type lease selling price

$
516
Less: Carrying value of underlying assets, excluding unguaranteed residual value

204
Gross profit

312
Interest income on lease receivables

222
Total sales-type and direct financing lease income

$
534
Lease income — operating leases

252
Variable lease income

38
Total lease income

$
824

~~Sales-Type and Direct Financing Leases~~
If a lease is classified as a sales-type or direct financing lease, the carrying amount of the asset is derecognized from inventory and a net investment in the lease is recorded. For a sales-type lease, the net investment in the lease is measured at commencement date as the sum of the lease receivable and the estimated residual value of the equipment less unearned income and allowance for credit losses. At September 30, 2019, the unguaranteed residual value of sales-type and direct financing leases was $565 million. For further information on the company’s net investment in leases, including residual values, refer to note 6, “Financing Receivables.” Any selling profit or loss arising from a sales-type lease is recorded at lease commencement. Selling profit or loss is presented on a gross basis when the company enters into a lease to realize value from a product that it would otherwise sell in its ordinary course of business, whereas in transactions where the company enters into a lease for the purpose of generating revenue by providing financing, the selling profit or loss is presented on a net basis. Under a sales-type lease, initial direct costs are expensed at lease commencement. Over the term of the lease, the company recognizes finance income on the net investment in the lease and any variable lease payments, which are not included in the net investment in the lease.

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

For a direct financing lease, the investment in the lease is measured similarly to a sales-type lease, however, the net investment in the lease is reduced by any selling profit. In a direct financing lease, the selling profit and initial direct costs are deferred at commencement and recognized over the lease term. The company rarely enters into direct financing leases.
The estimated residual value represents the estimated fair value of the equipment under lease at the end of the lease. Estimating residual value is a risk unique to financing activities, and management of this risk is dependent upon the ability to accurately project future equipment values. The company has insight into product plans and cycles for the IBM products under lease. The company estimates the future fair value of leased equipment by using historical models, analyzing the current market for new and used equipment and obtaining forward-looking product information such as marketing plans and technology innovations.
The company optimizes the recovery of residual values by extending lease arrangements with, or selling leased equipment to existing clients. The company has historically managed residual value risk both through insight into its own product cycles and monitoring of OEM IT product announcements. The company periodically reassesses the realizable value of its lease residual values. Anticipated decreases in specific future residual values that are considered to be other-than-temporary are recognized immediately upon identification and are recorded as an adjustment to the residual value estimate. For sales-type and direct financing leases, this reduction lowers the recorded net investment and is recognized as a loss charged to finance income in the period in which the estimate is changed, as well as an adjustment to unearned income to reduce future-period financing income. For the three and nine months ended September 30, 2019 and September 30, 2018, respectively, impairment of residual values was immaterial.
The following table presents a maturity analysis of the lease payments due to IBM on sales-type and direct financing leases over the next five years and thereafter, as well as a reconciliation of the undiscounted cash flows to the financing receivables recognized in the Consolidated Statement of Financial Position at September 30, 2019:

(Dollars in millions)

Total

Remainder of 2019

$
847

2020

2,344

2021

1,571

2022

759

2023

216

Thereafter

43

Total undiscounted cash flows

$
5,781

Present value of lease payments (recognized as financing receivables)

5,337
*
Difference between undiscounted cash flows and discounted cash flows

$
444

* The present value of the lease payments will not equal the financing receivables balances in the Statement of Financial Position, due to certain items including IDC's, allowance for credit losses and residual values, which are included in the financing receivables balance, but are not included in the future lease payments.
~~Operating Leases~~
Equipment provided to clients under an operating lease is carried at cost within property, plant and equipment in the Consolidated Statement of Financial Position and depreciated over the lease term using the straight-line method, generally ranging from one to six years. The depreciable basis is the original cost of the equipment less the estimated residual value of the equipment at the end of the lease term. At September 30, 2019, the unguaranteed residual value of operating leases was $88 million.
At commencement of an operating lease, IDCs are deferred. As lease payments are made, the company records sales revenue over the lease term. IDCs are amortized over the lease term on the same basis as lease income is recorded.

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

~~The following table presents a maturity analysis of the undiscounted lease payments due to IBM on operating leases over the next five years and thereafter, at September 30, 2019:~~

(Dollars in millions)

Total
Remainder of 2019

$
90
2020

119
2021

33
2022

3
2023

0
Thereafter

0
Total undiscounted cash flows

$
245

Assets under operating leases are tested for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. The impairment test is based on undiscounted cash flows, and, if impaired, the asset is written down to fair value based on either discounted cash flows or appraised values. There were no material impairment losses incurred during the three and nine months ended September 30, 2019 for assets under operating leases. These assets are included in property, plant and equipment ꟷ ~~net in the Consolidated Statement of Financial Position.~~
6. ~~Financing Receivables:~~
Financing receivables primarily consist of client loan and installment payment receivables (loans), investment in sales-type and direct financing leases and commercial financing receivables. Client loan and installment payment receivables (loans) are provided primarily to clients to finance the purchase of hardware, software and services. Payment terms on these financing arrangements are generally for terms up to seven years. Client loans and installment payment financing contracts are priced independently at competitive market rates. Investment in sales-type and direct financing leases relates principally to the company’s Systems products and are for terms ranging generally from two to six years. Commercial financing receivables relate primarily to inventory and accounts receivable financing for dealers and remarketers of IBM and OEM products. Payment terms for inventory and accounts receivable financing generally range from 30 to 90 days.
Beginning in the second quarter of 2019 and continuing throughout the year, the company is winding down the portion of its commercial financing operations which provides short-term working capital solutions for OEM information technology suppliers, distributors and resellers, which has resulted in a significant reduction of commercial financing receivables. This wind down is consistent with IBM’s capital allocation strategy and high-value focus. IBM Global Financing will continue to provide differentiated end-to-end financing solutions, including commercial financing in support of IBM partner relationships.

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

~~A summary of the components of the company’s financing receivables is presented as follows:~~


Investment in




Client Loan and



Sales-Type and

Commercial

Installment Payment

(Dollars in millions)

Direct Financing

Financing

Receivables/

At September 30, 2019:

Leases

Receivables

(Loans)

Total
Financing receivables, gross

$
5,781

$
2,953

$
11,958

$
20,692
Unearned income

(444)

(5)

(543)

(992)
Recorded investment

$
5,337

$
2,948

$
11,415

$
19,700
Allowance for credit losses

(81)

(11)

(165)

(257)
Unguaranteed residual value

565

—

—

565
Guaranteed residual value

61

—

—

61
Total financing receivables, net

$
5,882

$
2,937

$
11,250

$
20,069
Current portion

$
2,433

$
2,937

$
6,960

$
12,330
Noncurrent portion

$
3,449

$
—

$
4,290

$
7,739


Investment in




Client Loan and



Sales-Type and

Commercial

Installment Payment

(Dollars in millions)

Direct Financing

Financing

Receivables/

At December 31, 2018:

Leases

Receivables

(Loans)

Total
Financing receivables, gross

$
6,846

$
11,889

$
13,614

$
32,348
Unearned income

(526)

(37)

(632)

(1,195)
Recorded investment

$
6,320

$
11,852

$
12,981

$
31,153
Allowance for credit losses

(99)

(13)

(179)

(292)
Unguaranteed residual value

589

—

—

589
Guaranteed residual value

85

—

—

85
Total financing receivables, net

$
6,895

$
11,838

$
12,802

$
31,536
Current portion

$
2,834

$
11,838

$
7,716

$
22,388
Noncurrent portion

$
4,061

$
—

$
5,086

$
9,148

The company utilizes certain of its financing receivables as collateral for nonrecourse borrowings. Financing receivables pledged as collateral for borrowings were $939 million and $710 million at September 30, 2019 and December 31, 2018, respectively.
~~The company did not have any financing receivables held for sale as of September 30, 2019 and December 31, 2018.~~

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

~~Financing Receivables by Portfolio Segment~~
The following tables present the recorded investment by portfolio segment and by class, excluding commercial financing receivables and other miscellaneous financing receivables at September 30, 2019 and December 31, 2018. Commercial financing receivables are excluded from the presentation of financing receivables by portfolio segment, as they are short term in nature and the current estimated risk of loss and resulting impact to the company’s financing results are not material. The company determines its allowance for credit losses based on 2 portfolio segments: lease receivables and loan receivables, and further segments the portfolio into 3 classes: Americas, Europe/Middle East/Africa (EMEA) and Asia Pacific.

(Dollars in millions)
























At September 30, 2019:

Americas

EMEA

Asia Pacific

Total
At December 31, 2019:

Americas

EMEA

Asia Pacific

Total
Recorded investment
















Lease receivables

$
3,279

$
1,096

$
961

$
5,337

$
3,419

$
1,186

$
963

$
5,567
Loan receivables

5,899

3,161

2,356

11,415

6,726

3,901

2,395

13,022
Ending balance

$
9,178

$
4,257

$
3,317

$
16,752

$
10,144

$
5,087

$
3,359

$
18,590
Recorded investment collectively evaluated for impairment

$
9,039

$
4,209

$
3,275

$
16,523

$
10,032

$
5,040

$
3,326

$
18,399
Recorded investment individually evaluated for impairment

$
139

$
48

$
43

$
229

$
112

$
47

$
32

$
191

Allowance for credit losses
















Beginning balance at January 1, 2019
















Lease receivables

$
53

$
22

$
24

$
99

$
53

$
22

$
24

$
99
Loan receivables

105

43

32

179

105

43

32

179
Total

$
158

$
65

$
56

$
279

$
158

$
65

$
56

$
279
Write-offs

$
(14)

$
(3)

$
(6)

$
(23)

$
(42)

$
(3)

$
(18)

$
(63)
Recoveries

0

0

0

1

1

0

1

2
Provision / (benefit)

4

(6)

(1)

(4)
Additions/(releases)

5

(7)

(3)

(5)
Other*

(3)

(2)

(1)

(6)

(1)

0

(1)

(2)
Ending balance at September 30, 2019

$
144

$
54

$
48

$
246
Ending balance at December 31, 2019

$
120

$
54

$
36

$
210
Lease receivables

$
35

$
23

$
22

$
81

$
33

$
23

$
16

$
72
Loan receivables

$
109

$
31

$
26

$
165

$
88

$
31

$
20

$
138

Related allowance, collectively evaluated for impairment

$
29

$
11

$
4

$
44

$
25

$
11

$
4

$
39
Related allowance, individually evaluated for impairment

$
115

$
43

$
43

$
202

$
96

$
43

$
32

$
171
* Primarily represents translation adjustments.
Write-offs of lease receivables and loan receivables were ~~$11~~$16 million and ~~$12~~$47 million, respectively, for the ~~nine months~~year ended ~~September 30,~~December 31, 2019. ~~Provision~~Provisions for credit losses recorded for lease receivables and loan receivables were a release of $3$6 million and ~~$2 million, respectively, for the nine months ended September 30, 2019.~~
~~The average recorded investment~~an addition of impaired leases and loans for Americas, EMEA and Asia Pacific were $141 million, $48 million and $46 million, respectively, for the three months ended September 30, 2019 and $143 million, $56 million and $76 million, respectively, for the three months ended September 30, 2018. Both interest income recognized and interest income recognized on a cash basis on impaired leases and loans were immaterial for the three months ended September 30, 2019 and 2018.
The average recorded investment of impaired leases and loans for Americas, EMEA and Asia Pacific were $144 million, $49 million and $48 million, respectively, for the nine months ended September 30, 2019 and $136 million, $56 million and $79 ~~million, respectively, for the nine months ended September 30, 2018. Both interest income recognized~~

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

~~and interest income recognized on a cash basis on impaired leases and loans were immaterial for the nine months ended September 30, 2019 and 2018.~~

(Dollars in millions)












At December 31, 2018:

Americas

EMEA

Asia Pacific

Total
Recorded investment








Lease receivables

$
3,827

$
1,341

$
1,152

$
6,320
Loan receivables

6,817

3,675

2,489

12,981
Ending balance

$
10,644

$
5,016

$
3,641

$
19,301
Recorded investment collectively evaluated for impairment

$
10,498

$
4,964

$
3,590

$
19,052
Recorded investment individually evaluated for impairment

$
146

$
52

$
51

$
249

Allowance for credit losses








Beginning balance at January 1, 2018








Lease receivables

$
63

$
9

$
31

$
103
Loan receivables

108

52

51

211
Total

$
172

$
61

$
82

$
314
Write-offs

$
(10)

$
(2)

$
(23)

$
(35)
Recoveries

0

0

2

2
Provision

7

9

0

16
Other*

(11)

(3)

(4)

(19)
Ending balance at December 31, 2018

$
158

$
65

$
56

$
279
Lease receivables

$
53

$
22

$
24

$
99
Loan receivables

$
105

$
43

$
32

$
179

Related allowance, collectively evaluated for impairment

$
39

$
16

$
5

$
59
Related allowance, individually evaluated for impairment

$
119

$
49

$
51

$
219
* Primarily represents translation adjustments.
Write-offs of lease receivables and loan receivables were $15 million and $20 million, respectively, for the year ended December 31, 2018. Provisions for credit losses recorded for lease receivables and loan receivables were $14 million and $2 million, respectively, for the year ended December 31, ~~2018.~~2019.
When determining the allowances, financing receivables are evaluated either on an individual or a collective basis. For individually evaluated receivables, the company determines the expected cash flow for the receivable and calculates an estimate of the potential loss and the probability of loss. For those accounts in which the loss is probable, the company records a specific reserve. The company considers any receivable with an individually evaluated reserve as an impaired receivable.
In addition, the company records an unallocated reserve that is determined by applying a reserve rate to its different portfolios, excluding accounts that have been specifically reserved. This reserve rate is based upon credit rating, probability of default, term, characteristics (lease/loan) and loss history.
Past Due Financing Receivables
The company considers a client’s financing receivable balance past due when any installment is aged over 90 days. The following ~~table summarizes~~tables summarize information about the amortized cost basis or recorded investment in ~~lease and loan~~client financing receivables, including amortized cost or recorded investment aged over 90 days and still accruing, billed invoices aged over 90 days and still accruing, and amortized cost or recorded investment not accruing.








Amortized

Billed


Total

Amortized

Cost

Invoices

Amortized
(Dollars in millions)

Amortized

Cost

> 90 Days and

> 90 Days and

Cost Not
At June 30, 2020:

Cost

> 90 Days (1)

Accruing (1)

Accruing

Accruing (2)
Americas

$
9,060

$
323

$
231

$
30

$
111
EMEA

4,932

115

31

5

89
Asia Pacific

3,201

48

20

4

29
Total client financing receivables

$
17,192

$
486

$
283

$
38

$
229
(1) At a contract level, which includes total billed and unbilled amounts for financing receivables aged greater than 90 days.
(2) Of the amortized cost not accruing, there is a related allowance of $171 million. Financing income recognized on these receivables was immaterial for the three and six months ended June 30, 2020, respectively.

Table of Contents

Notes to Consolidated Financial Statements — (continued)

Recorded

Billed

Recorded

Total

Recorded

Investment

Invoices

Investment
(Dollars in millions)

Recorded

Investment

> 90 Days and

> 90 Days and

Not
At December 31, 2019:

Investment

> 90 Days (1)

Accruing (1)

Accruing

Accruing (2)
Americas

$
3,419

$
187

$
147

$
11

$
41
EMEA

1,186

28

13

2

17
Asia Pacific

963

19

7

1

11
Total lease receivables

$
5,567

$
234

$
168

$
14

$
69

Americas

$
6,726

$
127

$
71

$
11

$
72
EMEA

3,901

77

8

3

72
Asia Pacific

2,395

26

6

2

21
Total loan receivables

$
13,022

$
231

$
85

$
15

$
166

Total

$
18,590

$
465

$
253

$
29

$
235
(1) At a contract level, which includes total billed and unbilled amounts for financing receivables aged greater than 90 days.
(2) Of the recorded investment not accruing, $191 million is individually evaluated for impairment with a related allowance of $171 million. Financing income recognized on these receivables was immaterial for the three and six months ended June 30, 2019, respectively.

Credit Quality Indicators
The company’s credit quality indicators, which are based on rating agency data, publicly available information and information provided by customers, are reviewed periodically based on the relative level of risk. The resulting indicators are a numerical rating system that maps to Moody’s Investors Service credit ratings as shown below. The company uses information provided by Moody’s, where available, as one of many inputs in its determination of customer credit ratings. The credit quality of the customer is evaluated based on these indicators and is assigned the same risk rating whether the receivable is a lease or a loan.
The following tables present the amortized cost basis or recorded investment for client financing receivables by credit quality indicator at June 30, 2020 and December 31, 2019, respectively. Receivables with a credit quality indicator ranging from Aaa to Baa3 are considered investment grade. All others are considered non-investment grade. Effective January 1, 2020, under the new guidance for credit losses, the company discloses its credit quality by year of origination. Additionally, under the new guidance, the amortized cost is presented on a gross basis, whereas under the prior guidance, the company presented the recorded investment net of the allowance for credit losses. At June 30, 2020, the credit quality indicators reflect mitigating credit enhancement actions taken by customers which reduces the risk to IBM.

(Dollars in millions)

Americas

EMEA

Asia Pacific
At June 30, 2020:

Aaa – Baa3

Ba1 – D

Aaa – Baa3

Ba1 – D

Aaa – Baa3

Ba1 – D
Vintage year:












2020

$
1,556

$
1,185

$
925

$
1,062

$
548

$
273
2019

2,076

1,187

922

836

719

271
2018

1,173

608

403

328

498

221
2017

582

257

107

170

266

77
2016

144

95

52

65

176

48
2015 and prior

57

140

37

27

80

24
Total

$
5,588

$
3,472

$
2,444

$
2,487

$
2,287

$
914

Table of Contents

Notes to Consolidated Financial Statements — (continued)

(Dollars in millions)

Lease Receivables

Loan Receivables
At December 31, 2019:

Americas

EMEA

Asia Pacific

Americas

EMEA

Asia Pacific
Credit rating:












Aaa – Aa3

$
465

$
54

$
43

$
1,028

$
193

$
189
A1 – A3

750

181

454

1,186

395

892
Baa1 – Baa3

955

409

147

1,882

1,527

619
Ba1 – Ba2

746

326

154

1,513

921

388
Ba3 – B1

215

140

101

471

564

205
B2 – B3

242

50

47

522

253

72
Caa – D

13

2

2

36

18

10
Total

$
3,385

$
1,162

$
947

$
6,638

$
3,871

$
2,376

Troubled Debt Restructurings
The company did not have any significant troubled debt restructurings during the six months ended June 30, 2020 or for the year ended December 31, 2019.
9. Leases:
Accounting for leases as a lessor
The following table presents amounts included in the Consolidated Income Statement related to lessor activity:


Three Months Ended June 30,

Six Months Ended June 30,
(Dollars in millions)

2020

2019

2020

2019
Lease income — sales-type and direct financing leases








Sales-type lease selling price

$
368

$
179

$
579

$
328
Less: Carrying value of underlying assets*

117

74

194

129
Gross profit

$
251

$
105

$
385

$
199
Interest income on lease receivables

65

73

139

151
Total sales-type and direct financing lease income

$
316

$
178

$
524

$
350
Lease income — operating leases

68

82

139

172
Variable lease income

27

9

58

27
Total lease income

$
411

$
269

$
721

$
548
* Excludes unguaranteed residual value.

Table of Contents

Notes to Consolidated Financial Statements — (continued)

10. Intangible Assets Including Goodwill:
Intangible Assets
The following table presents the company's intangible asset balances by major asset class:

At June 30, 2020


Gross Carrying

Accumulated

Net Carrying
(Dollars in millions)

Amount

Amortization

Amount*
Intangible asset class

Capitalized software

$
1,759

$
(776)

$
983
Client relationships

8,665

(1,665)

7,000
Completed technology

5,964

(1,466)

4,498
Patents/trademarks

2,213

(445)

1,768
Other**

56

(35)

20
Total

$
18,656

$
(4,387)

$
14,270

At December 31, 2019


Gross Carrying

Accumulated

Net Carrying
(Dollars in millions)

Amount

Amortization

Amount*
Intangible asset class

Capitalized software

$
1,749

$
(743)

$
1,006
Client relationships

8,921

(1,433)

7,488
Completed technology

6,261

(1,400)

4,861
Patents/trademarks

2,301

(445)

1,856
Other**

56

(31)

24
Total

$
19,287

$
(4,052)

$
15,235
*  Amounts as of June 30, 2020 and December 31, 2019 include a decrease in net intangible asset balances of $6 million and $42 million, respectively, due to foreign currency translation.
**
Other intangibles are primarily acquired proprietary and non-proprietary business processes, methodologies and systems.

The net carrying amount of intangible assets decreased $965 million during the first six months of 2020, primarily due to intangible asset amortization, partially offset by additions of capitalized software. The aggregate intangible amortization expense was $623 million and $1,245 million for the second quarter and first six months of 2020, respectively, versus $307 million and $610 million for the second quarter and first six months of 2019, respectively. The increase in intangible amortization expense was primarily due to an increase in the gross carrying amount of intangible assets from the Red Hat acquisition which closed in the third quarter of 2019. In addition, in the first six months of 2020, the company retired $913 million of fully amortized intangible assets, impacting both the gross carrying amount and accumulated amortization by this amount.
The future amortization expense relating to intangible assets currently recorded in the Consolidated Balance Sheet is estimated to be the following at June 30, 2020:


Capitalized

Acquired



(Dollars in millions)

Software

Intangibles

Total
Remainder of 2020

$
288

$
905

$
1,193
2021

445

1,748

2,193
2022

215

1,686

1,901
2023

35

1,373

1,407
2024

0

1,323

1,323
Thereafter

—

6,251

6,251

Table of Contents

Notes to Consolidated Financial Statements — (continued)

Goodwill
The changes in the goodwill balances by segment for the six months ended June 30, 2020 and for the year ended December 31, 2019 are as follows:














Foreign



Currency

Purchase

Translation

(Dollars in millions)

Balance

Goodwill

Price

And Other

Balance
Segment

1/1/2020

Additions

Adjustments

Divestitures

Adjustments**

6/30/2020
Cloud & Cognitive Software

$
43,037

$
11

$
(139)

$
—

$
(147)

$
42,762
Global Business Services

5,775

—

—

—

(45)

5,730
Global Technology Services

7,141

—

—

—

(61)

7,080
Systems

2,270

—

—

—

(8)

2,261
Other—divested businesses

—

—

—

—

—

—
Total

$
58,222

$
11

$
(139)

$
—

$
(260)

$
57,833














Foreign



Currency

Purchase

Translation

(Dollars in millions)

Balance

Goodwill

Price

And Other

Balance
Segment

1/1/2019

Additions

Adjustments

Divestitures

Adjustments**

12/31/2019
Cloud & Cognitive Software*

$
24,463

$
18,399

$
133

$
—

$
41

$
43,037
Global Business Services

4,711

1,059

1

(1)

5

5,775
Global Technology Services

3,988

3,119

—

—

34

7,141
Systems

1,847

525

(110)

—

7

2,270
Other—divested businesses*

1,256

—

—

(1,256)

—

—
Total

$
36,265

$
23,102

$
24

$
(1,257)

$
87

$
58,222
* Recast to conform to 2020 presentation.
** Primarily driven by foreign currency translation.
There were 0 goodwill impairment losses recorded during the first six months of 2020 or full year 2019 and the company has 0 accumulated impairment losses.

Purchase price adjustments recorded in the first six months of 2020 and full year 2019 were related to acquisitions that were still subject to the measurement period that ends at the earlier of 12 months from the acquisition date or when information becomes available. During the first six months of 2020, net purchase price adjustments recorded to noncurrent tax assets and liabilities were related to the Red Hat acquisition. Net purchase price adjustments recorded in full-year 2019 were not material.
11. Borrowings:
Short-Term Debt


At June 30,

At December 31,
(Dollars in millions)

2020

2019
Commercial paper

$
115

$
304
Short-term loans

730

971
Long-term debt—current maturities

8,444

7,522
Total

$
9,289

$
8,797

The weighted-average interest rate for commercial paper at June 30, 2020 and December 31, 2019 was 1.4 percent and 1.6 percent, respectively. The weighted-average interest rate for short-term loans was 5.0 percent and 6.1 percent at June 30, 2020 and December 31, 2019, respectively.

Table of Contents

Notes to Consolidated Financial Statements — (continued)

Long-Term Debt

Pre-Swap Borrowing

Pre-Swap Borrowing




Balance

Balance
(Dollars in millions)

Maturities

6/30/2020

12/31/2019
U.S. dollar debt (weighted-average interest rate at June 30, 2020):*






2.2%

2020

$
1,513

$
4,326
1.6%

2021

5,536

8,498
2.6%

2022

6,246

6,289
3.3%

2023

2,403

2,388
3.3%

2024

5,041

5,045
6.6%

2025

654

636
3.3%

2026

4,350

4,350
3.0%

2027

2,219

969
6.5%

2028

313

313
3.5%

2029

3,250

3,250
2.0%

2030

1,350

—
5.9%

2032

600

600
8.0%

2038

83

83
4.5%

2039

2,745

2,745
2.9%

2040

650

—
4.0%

2042

1,107

1,107
7.0%

2045

27

27
4.7%

2046

650

650
4.3%

2049

3,000

3,000
3.0%

2050

750

—
7.1%

2096

316

316

$
42,804

$
44,594
Other currencies (weighted-average interest rate at June 30, 2020, in parentheses):*






Euro (1.1%)

2020–2040

$
18,545

$
14,306
Pound sterling (2.7%)

2020–2022

1,301

1,390
Japanese yen (0.3%)

2022–2026

1,349

1,339
Other (3.1%)

2020–2022

203

375

$
64,203

$
62,003
Finance lease obligations (1.8%)

2021–2030

268

204

$
64,470

$
62,207
Less: net unamortized discount



892

881
Less: net unamortized debt issuance costs



165

142
Add: fair value adjustment**



480

440

$
63,893

$
61,624
Less: current maturities



8,444

7,522
Total



$
55,449

$
54,102
*   Includes notes, debentures, bank loans and secured borrowings.
**
The portion of the company’s fixed-rate debt obligations that was hedged was reflected in the Consolidated Balance Sheet as an amount equal to the sum of the debt’s carrying value and a fair value adjustment representing changes in the fair value of the hedged debt obligations attributable to movements in benchmark interest rates.

The company’s indenture governing its debt securities and its various credit facilities each contain significant covenants which obligate the company to promptly pay principal and interest, limit the aggregate amount of secured

Table of Contents

Notes to Consolidated Financial Statements — (continued)

indebtedness and sale and leaseback transactions to 10 percent of the company’s consolidated net tangible assets, and restrict the company’s ability to merge or consolidate unless certain conditions are met. The credit facilities also include a covenant on the company’s consolidated net interest expense ratio, which cannot be less than 2.20 to 1.0, as well as a cross default provision with respect to other defaulted indebtedness of at least $500 million.
The company is in compliance with its debt covenants and provides periodic certifications to its lenders. The failure to comply with its debt covenants could constitute an event of default with respect to the debt to which such provisions apply. If certain events of default were to occur, the principal and interest on the debt to which such event of default applied would become immediately due and payable.
In the first half of 2019, the company issued an aggregate of $20 billion of U.S. dollar fixed- and floating-rate notes and $5.7 billion of Euro fixed-rate notes. The proceeds were primarily used for the acquisition of Red Hat. For additional information on this transaction, refer to note 5, “Acquisitions & Divestitures.” In the first half of 2020, the company issued an aggregate of $4.1 billion of Euro fixed-rate notes and $4.0 billion of U.S. dollar fixed-rate notes. The proceeds from the Euro issuance were primarily used to early redeem outstanding fixed-rate notes which were due in 2021 in the aggregate amount of $2.9 billion. The company incurred a loss of $49 million in the first quarter of 2020 upon redemption, which was recorded in other (income) and expense in the Consolidated Income Statement.
Pre-swap annual contractual obligations of long-term debt outstanding at June 30, 2020, are as follows:

(Dollars in millions)

Total
Remainder of 2020

$
4,366
2021

6,937
2022

7,194
2023

5,417
2024

6,324
Thereafter

34,232
Total

$
64,470

Interest on Debt

(Dollars in millions)






For the six months ended June 30:

2020

2019
Cost of financing

$
237

$
343
Interest expense

649

558
Interest capitalized

5

3
Total interest paid and accrued

$
891

$
904

Lines of Credit
On July 2, 2020, the company and IBM Credit LLC entered into a new $2.5 billion 364-day Credit Agreement to replace the existing $2.5 billion 364-day Credit Agreement, and also extended the maturity date of the existing $2.5 billion Three-Year Credit Agreement. The new maturity dates for the 364-day and Three-Year Credit Agreements are July 1, 2021 and July 20, 2023, respectively. The company also amended its $10.25 billion Five-Year Credit Agreement to include an option exercisable in 2021 to extend the current maturity date of July 20, 2024 by an additional two years.

At June 30, 2020, there were 0 borrowings by the company, or its subsidiaries, under these credit facilities.

12. Commitments:
The company’s extended lines of credit to third-party entities include unused amounts of $1.9 billion and $1.8 billion at June 30, 2020 and December 31, 2019, respectively. A portion of these amounts was available to the

Table of Contents

Notes to Consolidated Financial Statements — (continued)

company’s business partners to support their working capital needs. In addition, the company has committed to provide future financing to its clients in connection with client purchase agreements for $5.7 billion and $6.3 billion at June 30, 2020 and December 31, 2019, respectively. Effective January 1, 2020, the company adopted the new standard on credit losses, which resulted in the recognition of a related allowance for non-cancellable off-balance sheet commitments. Refer to note 2, “Accounting Changes,” for additional information. The allowance for these commitments is recorded in other liabilities in the Consolidated Balance Sheet and was not material at June 30, 2020. The company collectively evaluates the allowance for these arrangements using a provision methodology consistent with the portfolio of the commitments. Refer to note 8, “Financing Receivables,” for additional information.
The company has applied the guidance requiring a guarantor to disclose certain types of guarantees, even if the likelihood of requiring the guarantor’s performance is remote. The following is a description of arrangements in which the company is the guarantor.
The company is a party to a variety of agreements pursuant to which it may be obligated to indemnify the other party with respect to certain matters. Typically, these obligations arise in the context of contracts entered into by the company, under which the company customarily agrees to hold the party harmless against losses arising from a breach of representations and covenants related to such matters as title to the assets sold, certain intellectual property rights, specified environmental matters, third-party performance of nonfinancial contractual obligations and certain income taxes. In each of these circumstances, payment by the company is conditioned on the other party making a claim pursuant to the procedures specified in the particular contract, the procedures of which typically allow the company to challenge the other party’s claims. While typically indemnification provisions do not include a contractual maximum on the company’s payment, the company’s obligations under these agreements may be limited in terms of time and/or nature of claim, and in some instances, the company may have recourse against third parties for certain payments made by the company.
It is not possible to predict the maximum potential amount of future payments under these or similar agreements due to the conditional nature of the company’s obligations and the unique facts and circumstances involved in each particular agreement. Historically, payments made by the company under these agreements have not had a material effect on the company’s business, financial condition or results of operations.
In addition, the company guarantees certain loans and financial commitments. The maximum potential future payment under these financial guarantees and the fair value of these guarantees recognized in the Consolidated Balance Sheet at June 30, 2020 and December 31, 2019 was not material.
Changes in the company’s warranty liability for standard warranties, which are included in other accrued expenses and liabilities and other liabilities in the Consolidated Balance Sheet, and for extended warranty contracts, which are included in deferred income in the Consolidated Balance Sheet, are presented in the following tables.
Standard Warranty Liability

(Dollars in millions)

2020

2019
Balance at January 1

$
113

$
118
Current period accruals

43

45
Accrual adjustments to reflect actual experience

(14)

(1)
Charges incurred

(49)

(59)
Balance at June 30

$
93

$
103

Table of Contents

Notes to Consolidated Financial Statements — (continued)

Extended Warranty Liability

(Dollars in millions)

2020

2019
Balance at January 1

$
477

$
533
Revenue deferred for new extended warranty contracts

93

81
Amortization of deferred revenue

(115)

(128)
Other*

(9)

0
Balance at June 30

$
445

$
486
Current portion

$
216

$
225
Noncurrent portion

$
228

$
260
* Other primarily consists of foreign currency translation adjustments.
13.Contingencies:
As a company with a substantial employee population and with clients in more than 175 countries, IBM is involved, either as plaintiff or defendant, in a variety of ongoing claims, demands, suits, investigations, tax matters and proceedings that arise from time to time in the ordinary course of its business. The company is a leader in the information technology industry and, as such, has been and will continue to be subject to claims challenging its IP rights and associated products and offerings, including claims of copyright and patent infringement and violations of trade secrets and other IP rights. In addition, the company enforces its own IP against infringement, through license negotiations, lawsuits or otherwise. Also, as is typical for companies of IBM’s scope and scale, the company is party to actions and proceedings in various jurisdictions involving a wide range of labor and employment issues (including matters related to contested employment decisions, country-specific labor and employment laws, and the company’s pension, retirement and other benefit plans), as well as actions with respect to contracts, product liability, securities, foreign operations, competition law and environmental matters. These actions may be commenced by a number of different parties, including competitors, clients, current or former employees, government and regulatory agencies, stockholders and representatives of the locations in which the company does business. Some of the actions to which the company is party may involve particularly complex technical issues, and some actions may raise novel questions under the laws of the various jurisdictions in which these matters arise.
The company records a provision with respect to a claim, suit, investigation or proceeding when it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. Any recorded liabilities, including any changes to such liabilities for the quarter ended June 30, 2020 were not material to the Consolidated Financial Statements.
In accordance with the relevant accounting guidance, the company provides disclosures of matters for which the likelihood of material loss is at least reasonably possible. In addition, the company also discloses matters based on its consideration of other matters and qualitative factors, including the experience of other companies in the industry, and investor, customer and employee relations considerations.
With respect to certain of the claims, suits, investigations and proceedings discussed herein, the company believes at this time that the likelihood of any material loss is remote, given, for example, the procedural status, court rulings, and/or the strength of the company’s defenses in those matters. With respect to the remaining claims, suits, investigations and proceedings discussed in this note, except as specifically discussed herein, the company is unable to provide estimates of reasonably possible losses or range of losses, including losses in excess of amounts accrued, if any, for the following reasons. Claims, suits, investigations and proceedings are inherently uncertain, and it is not possible to predict the ultimate outcome of these matters. It is the company’s experience that damage amounts claimed in litigation against it are unreliable and unrelated to possible outcomes, and as such are not meaningful indicators of the company’s potential liability. Further, the company is unable to provide such an estimate due to a number of other factors with respect to these claims, suits, investigations and proceedings, including considerations of the procedural status of the matter in question, the presence of complex or novel legal theories, and/or the ongoing discovery and development of information

Table of Contents

Notes to Consolidated Financial Statements — (continued)

important to the matters. The company reviews claims, suits, investigations and proceedings at least quarterly, and decisions are made with respect to recording or adjusting provisions and disclosing reasonably possible losses or range of losses (individually or in the aggregate), to reflect the impact and status of settlement discussions, discovery, procedural and substantive rulings, reviews by counsel and other information pertinent to a particular matter.

Whether any losses, damages or remedies finally determined in any claim, suit, investigation or proceeding could reasonably have a material effect on the company’s business, financial condition, results of operations or cash flows will depend on a number of variables, including: the timing and amount of such losses or damages; the structure and type of any such remedies; the significance of the impact any such losses, damages or remedies may have in the Consolidated Financial Statements; and the unique facts and circumstances of the particular matter that may give rise to additional factors. While the company will continue to defend itself vigorously, it is possible that the company’s business, financial condition, results of operations or cash flows could be affected in any particular period by the resolution of one or more of these matters.

The following is a summary of the more significant legal matters involving the company.

The company is a defendant in an action filed on March 6, 2003 in state court in Salt Lake City, Utah by the SCO Group (SCO v. IBM). The company removed the case to Federal Court in Utah. Plaintiff is an alleged successor in interest to some of AT&T’s UNIX IP rights, and alleges copyright infringement, unfair competition, interference with contract and breach of contract with regard to the company’s distribution of AIX and Dynix and contribution of code to Linux and the company has asserted counterclaims. On September 14, 2007, plaintiff filed for bankruptcy protection, and all proceedings in this case were stayed. The court in another suit, the SCO Group, Inc. v. Novell, Inc., held a trial in March 2010. The jury found that Novell is the owner of UNIX and UnixWare copyrights; the judge subsequently ruled that SCO is obligated to recognize Novell’s waiver of SCO’s claims against IBM and Sequent for breach of UNIX license agreements. On August 30, 2011, the Tenth Circuit Court of Appeals affirmed the district court’s ruling and denied SCO’s appeal of this matter. In June 2013, the Federal Court in Utah granted SCO’s motion to reopen the SCO v. IBM case. In February 2016, the Federal Court ruled in favor of IBM on all of SCO’s remaining claims, and SCO appealed. On October 30, 2017, the Tenth Circuit Court of Appeals affirmed the dismissal of all but 1 of SCO’s remaining claims, which was remanded to the Federal Court in Utah.

On March 9, 2017, the Commonwealth of Pennsylvania’s Department of Labor and Industry sued IBM in Pennsylvania state court regarding a 2006 contract for the development of a custom software system to manage the Commonwealth’s unemployment insurance benefits programs. The matter is pending in a Pennsylvania court.

In December 2017, CIS General Insurance Limited (CISGIL) sued IBM UK regarding a contract entered into by IBM UK and CISGIL in 2015 to implement and operate an IT insurance platform. The contract was terminated by IBM UK in July 2017 for non-payment by CISGIL. CISGIL alleges wrongful termination, breach of contract and breach of warranty. The matter is pending in the London High Court with trial beginning in January 2020.

In May 2015, a putative class action was commenced in the United States District Court for the Southern District of New York related to the company’s October 2014 announcement that it was divesting its global commercial semiconductor technology business, alleging violations of the Employee Retirement Income Security Act (ERISA). Management’s Retirement Plans Committee and 3 current or former IBM executives are named as defendants. On September 29, 2017, the Court granted the defendants’ motion to dismiss the first amended complaint. On December 10, 2018, the Second Circuit Court of Appeals reversed the District Court order. On January 14, 2020, the Supreme Court of the United States vacated the decision and remanded the case to the Second Circuit. On June 22, 2020, the Second Circuit reinstated its prior decision and remanded the case to the District Court.

Table of Contents

Notes to Consolidated Financial Statements — (continued)

investigations, assessments or remediations at or in the vicinity of several current or former operating sites globally pursuant to permits, administrative orders or agreements with country, state or local environmental agencies, and is involved in lawsuits and claims concerning certain current or former operating sites.

The company is also subject to ongoing tax examinations and governmental assessments in various jurisdictions. Along with many other U.S. companies doing business in Brazil, the company is involved in various challenges with Brazilian tax authorities regarding non-income tax assessments and non-income tax litigation matters. The total potential amount related to all these matters for all applicable years is approximately $700 million. The company believes it will prevail on these matters and that this amount is not a meaningful indicator of liability.

14. Equity Activity:
Reclassifications and Taxes Related to Items of Other Comprehensive Income

(Dollars in millions)

Before Tax

Tax (Expense)/

Net of Tax
For the three months ended June 30, 2020:

Amount

Benefit

Amount
Other comprehensive income/(loss):






Foreign currency translation adjustments

$
4

$
135

$
139
Net changes related to available-for-sale securities:






Unrealized gains/(losses) arising during the period

$
1

$
0

$
1
Reclassification of (gains)/losses to other (income) and expense

—

—

—
Total net changes related to available-for-sale securities

$
1

$
0

$
1
Unrealized gains/(losses) on cash flow hedges:






Unrealized gains/(losses) arising during the period

$
(36)

$
9

$
(26)
Reclassification of (gains)/losses to:






Cost of services

1

0

1
Cost of sales

(9)

3

(7)
Cost of financing

7

(2)

5
SG&A expense

(7)

2

(5)
Other (income) and expense

(70)

18

(52)
Interest expense

19

(5)

15
Total unrealized gains/(losses) on cash flow hedges

$
(94)

$
25

$
(70)
Retirement-related benefit plans (1):






Prior service costs/(credits)

$
—

$
0

$
0
Net (losses)/gains arising during the period

57

(22)

35
Curtailments and settlements

13

(4)

9
Amortization of prior service (credits)/costs

0

1

1
Amortization of net (gains)/losses

566

(155)

411
Total retirement-related benefit plans

$
637

$
(180)

$
457
Other comprehensive income/(loss)

$
548

$
(21)

$
527
(1) These accumulated other comprehensive income (AOCI) components are included in the computation of net periodic pension cost. Refer to note 17, “Retirement-Related Benefits,” for additional information.

Table of Contents

Notes to Consolidated Financial Statements — (continued)

Reclassifications and Taxes Related to Items of Other Comprehensive Income

(Dollars in millions)

Before Tax

Tax (Expense)/

Net of Tax
For the three months ended June 30, 2019:

Amount

Benefit

Amount
Other comprehensive income/(loss):






Foreign currency translation adjustments

$
5

$
37

$
42
Net changes related to available-for-sale securities:






Unrealized gains/(losses) arising during the period

$
(2)

$
0

$
(1)
Reclassification of (gains)/losses to other (income) and expense

—

—

—
Total net changes related to available-for-sale securities

$
(2)

$
0

$
(1)
Unrealized gains/(losses) on cash flow hedges:






Unrealized gains/(losses) arising during the period

$
(6)

$
2

$
(4)
Reclassification of (gains)/losses to:

Cost of services

(20)

5

(15)
Cost of sales

(11)

3

(8)
Cost of financing

25

(6)

18
SG&A expense

(12)

3

(9)
Other (income) and expense

(202)

51

(151)
Interest expense

52

(13)

39
Total unrealized gains/(losses) on cash flow hedges

$
(175)

$
45

$
(129)
Retirement-related benefit plans (1):






Net (losses)/gains arising during the period

$
116

$
(25)

$
92
Curtailments and settlements

3

0

3
Amortization of prior service (credits)/costs

(3)

0

(3)
Amortization of net (gains)/losses

460

(123)

337
Total retirement-related benefit plans

$
576

$
(147)

$
430
Other comprehensive income/(loss)

$
405

$
(64)

$
340
(1) These AOCI components are included in the computation of net periodic pension cost. Refer to note 17, “Retirement-Related Benefits,” for additional information.

Table of Contents

Notes to Consolidated Financial Statements — (continued)

Reclassifications and Taxes Related to Items of Other Comprehensive Income

(Dollars in millions)

Before Tax

Tax (Expense)/

Net of Tax
For the six months ended June 30, 2020:

Amount

Benefit

Amount
Other comprehensive income/(loss):






Foreign currency translation adjustments

$
(915)

$
13

$
(902)
Net changes related to available-for-sale securities:






Unrealized gains/(losses) arising during the period

$
1

$
0

$
1
Reclassification of (gains)/losses to other (income) and expense

—

—

—
Total net changes related to available-for-sale securities

$
1

$
0

$
1
Unrealized gains/(losses) on cash flow hedges:






Unrealized gains/(losses) arising during the period

$
(216)

$
55

$
(162)
Reclassification of (gains)/losses to:






Cost of services

(9)

2

(6)
Cost of sales

(18)

5

(13)
Cost of financing

15

(4)

11
SG&A expense

(17)

4

(13)
Other (income) and expense

19

(5)

15
Interest expense

41

(10)

31
Total unrealized gains/(losses) on cash flow hedges

$
(184)

$
47

$
(137)
Retirement-related benefit plans (1):






Prior service costs/(credits)

$
(4)

$
1

$
(3)
Net (losses)/gains arising during the period

65

(24)

41
Curtailments and settlements

21

(6)

15
Amortization of prior service (credits)/costs

1

1

2
Amortization of net (gains)/losses

1,136

(312)

824
Total retirement-related benefit plans

$
1,219

$
(341)

$
879
Other comprehensive income/(loss)

$
121

$
(281)

$
(160)
(1) These AOCI components are included in the computation of net periodic pension cost. Refer to note 17, “Retirement-Related Benefits,” for additional information.

Table of Contents

Notes to Consolidated Financial Statements — (continued)

~~including recorded investments aged over 90 days~~Reclassifications and ~~still accruing, billed invoices aged over 90 days and still accruing, and recorded investment not accruing.~~Taxes Related to Items of Other Comprehensive Income








Recorded

Billed

Recorded

Total

Recorded

Investment

Invoices

Investment
(Dollars in millions)

Recorded

Investment

> 90 Days and

> 90 Days and

Not
At September 30, 2019:

Investment

> 90 Days(1)

Accruing(1)

Accruing

Accruing(2)
Americas

$
3,279

$
213

$
179

$
13

$
37
EMEA

1,096

34

17

3

19
Asia Pacific

961

37

19

2

18
Total lease receivables

$
5,337

$
284

$
215

$
18

$
74

Americas

$
5,899

$
155

$
64

$
10

$
108
EMEA

3,161

93

28

15

67
Asia Pacific

2,356

41

16

6

26
Total loan receivables

$
11,415

$
288

$
108

$
31

$
200

Total

$
16,752

$
572

$
323

$
50

$
274

(Dollars in millions)

Before Tax

Tax (Expense)/

Net of Tax
For the six months ended June 30, 2019:

Amount

Benefit

Amount
Other comprehensive income/(loss):






Foreign currency translation adjustments

$
176

$
38

$
214
Net changes related to available-for-sale securities:




Unrealized gains/(losses) arising during the period

$
(3)

$
1

$
(2)
Reclassification of (gains)/losses to other (income) and expense

—

—

—
Total net changes related to available-for-sale securities

$
(3)

$
1

$
(2)
Unrealized gains/(losses) on cash flow hedges:






Unrealized gains/(losses) arising during the period

$
(359)

$
87

$
(272)
Reclassification of (gains)/losses to:

Cost of services

(29)

8

(22)
Cost of sales

(30)

8

(21)
Cost of financing

53

(13)

40
SG&A expense

(34)

9

(25)
Other (income) and expense

(115)

29

(86)
Interest expense

86

(22)

64
Total unrealized gains/(losses) on cash flow hedges

$
(429)

$
106

$
(323)
Retirement-related benefit plans (1):






Net (losses)/gains arising during the period

$
113

$
(24)

$
89
Curtailments and settlements

4

0

4
Amortization of prior service (credits)/costs

(6)

1

(5)
Amortization of net (gains)/losses

924

(252)

671
Total retirement-related benefit plans

$
1,035

$
(275)

$
760
Other comprehensive income/(loss)

$
779

$
(131)

$
649
(1) ~~At a contract level, which includes total billed and unbilled amounts~~These AOCI components are included in the computation of net periodic pension cost. Refer to note 17, “Retirement-Related Benefits,” for ~~financing receivables aged greater than 90 days.~~
~~(2)~~ ~~Of the recorded investment not accruing, $229 million is individually evaluated for impairment with a related allowance of $202 million.~~








Recorded

Billed

Recorded

Total

Recorded

Investment

Invoices

Investment
(Dollars in millions)

Recorded

Investment

> 90 Days and

> 90 Days and

Not
At December 31, 2018:

Investment

> 90 Days(1)

Accruing(1)

Accruing

Accruing(2)
Americas

$
3,827

$
310

$
256

$
19

$
57
EMEA

1,341

25

9

1

16
Asia Pacific

1,152

49

27

3

24
Total lease receivables

$
6,320

$
385

$
292

$
24

$
97

Americas

$
6,817

$
259

$
166

$
24

$
99
EMEA

3,675

98

25

3

73
Asia Pacific

2,489

40

11

1

31
Total loan receivables

$
12,981

$
397

$
202

$
29

$
203

Total

$
19,301

$
782

$
494

$
52

$
300
~~(1)~~ ~~At a contract level, which includes total billed and unbilled amounts for financing receivables aged greater than 90 days.~~
~~(2)~~ ~~Of the recorded investment not accruing, $249 million is individually evaluated for impairment with a related allowance of $219 million.~~additional information.

~~Credit Quality Indicators~~Accumulated Other Comprehensive Income/(Loss) (net of tax)
~~The company’s credit quality indicators,~~








Net Change

Net Unrealized



Net Unrealized

Foreign

Retirement-

Gains/(Losses)

Accumulated

Gains/(Losses)

Currency

Related

on Available-

Other

on Cash Flow

Translation

Benefit

For-Sale

Comprehensive
(Dollars in millions)

Hedges

Adjustments*

Plans

Securities

Income/(Loss)
January 1, 2020

$
(179)

$
(3,700)

$
(24,718)

$
0

$
(28,597)
Other comprehensive income before reclassifications

(162)

(902)

38

1

(1,025)
Amount reclassified from accumulated other comprehensive income

25

—

841

—

866
Total change for the period

$
(137)

$
(902)

$
879

$
1

$
(160)
June 30, 2020

$
(316)

$
(4,602)

$
(23,839)

$
1

$
(28,757)
*  Foreign currency translation adjustments are presented gross except for any associated hedges which are based on rating agency data, publicly available information and information provided by customers, are reviewed periodically based on the relative level of risk. The resulting indicators are a numerical rating system that maps to Moody’s Investors Service credit ratings as shown below. The company uses information provided by Moody’s, where available, as one of many inputs in its determination of customer credit ratings.
~~The following tables present the recorded investment~~presented net of ~~allowance for credit losses for each class of receivables, by credit quality indicator, at September 30, 2019 and December 31, 2018. Receivables with a credit quality indicator~~tax.

3840

Table of Contents

Notes to Consolidated Financial Statements — (continued)

Net Change

Net Unrealized



Net Unrealized

Foreign

Retirement-

Gains/(Losses)

Accumulated

Gains/(Losses)

Currency

Related

on Available-

Other

on Cash Flow

Translation

Benefit

For-Sale

Comprehensive
(Dollars in millions)

Hedges

Adjustments*

Plans

Securities

Income/(Loss)
January 1, 2019

$
284

$
(3,690)

$
(26,083)

$
0

$
(29,490)
Other comprehensive income before reclassifications

(272)

214

89

(2)

29
Amount reclassified from accumulated other comprehensive income

(51)

—

671

—

620
Total change for the period

$
(323)

$
214

$
760

$
(2)

$
649
June 30, 2019

$
(39)

$
(3,477)

$
(25,323)

$
(2)

$
(28,841)
*Foreign currency translation adjustments are presented gross except for any associated hedges which are presented net of tax.

15. 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.
In the Consolidated Balance Sheet, 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 accounts payable for the obligation to return cash collateral at June 30, 2020 was $2 million and 0 amount was recognized at December 31, 2019. NaN amount was recognized in other accounts receivable for the right to reclaim cash collateral at June 30, 2020 and $26 million was recognized at December 31, 2019. The company restricts the use of cash collateral received to rehypothecation, and therefore reports it in restricted cash in the Consolidated Balance Sheet. NaN amount was rehypothecated at June 30, 2020 and December 31, 2019. Additionally, if derivative exposures covered by a qualifying master netting agreement had been netted in the Consolidated Balance Sheet at June 30, 2020 and December 31, 2019, the total derivative asset and liability positions each would have been reduced by $220 million and $194 million, respectively.
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 June 30, 2020 and December 31, 2019, the total notional amount of the company’s interest-rate

Table of Contents

Notes to Consolidated Financial Statements — (continued)

swaps was $3.0 billion at both periods. The weighted-average remaining maturity of these instruments at June 30, 2020 and December 31, 2019 was approximately 1.7 years and 2.2 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 June 30, 2020 and December 31, 2019.
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. In the second quarter of 2019, the company issued an aggregate of $20 billion of indebtedness (refer to note 11, “Borrowings,” for additional information). Following the receipt of the net proceeds from this debt offering, the company terminated $5.5 billion of forward starting interest-rate swaps. There were 0 instruments outstanding at June 30, 2020 and December 31, 2019.
In connection with cash flow hedges of forecasted interest payments related to the company's borrowings, the company recorded net losses of $183 million and net losses of $192 million (before taxes) at June 30, 2020 and December 31, 2019, respectively, in AOCI. The company estimates that $18 million (before taxes) of the deferred net losses on derivatives in AOCI at June 30, 2020 will be reclassified to net income within the next 12 months, providing an offsetting economic impact against the underlying interest payments.
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. At June 30, 2020 and December 31, 2019, the carrying value of debt designated as hedging instruments was $17.1 billion and $7.3 billion, respectively. The $9.8 billion increase is part of the company’s risk management strategy and is primarily for the designation of new issuances and previously hedged Euro denominated debt. The company also uses cross-currency swaps and foreign exchange forward contracts for risk management purposes. At June 30, 2020 and December 31, 2019, the total notional amount of derivative instruments designated as net investment hedges was $8.8 billion and $7.9 billion, respectively. At June 30, 2020 and December 31, 2019, the weighted-average remaining maturity of these instruments was approximately 0.3 years and 0.1 years, respectively.
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 remaining length of time over which the company hedged its exposure is approximately four years. At June 30, 2020 and December 31, 2019, the total notional amount of forward contracts designated as cash flow hedges of forecasted royalty and cost transactions was $9.4 billion and $9.7 billion, respectively. At June 30, 2020 and December 31, 2019, the weighted-average remaining maturity of these instruments was approximately 0.7 years and 0.8 years, respectively.
At June 30, 2020 and December 31, 2019, in connection with cash flow hedges of anticipated royalties and cost transactions, the company recorded net gains of $58 million and net gains of $145 million (before taxes), respectively, in AOCI. The company estimates that $28 million (before taxes) of deferred net gains on derivatives in AOCI at June 30, 2020 will be reclassified to net income within the next 12 months, providing an offsetting economic impact against the underlying anticipated transactions.

Table of Contents

Notes to Consolidated Financial Statements — (continued)

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. At June 30, 2020, the maximum length of time remaining over which the company hedged its exposure was approximately eight years. At June 30, 2020 and December 31, 2019, the total notional amount of cross-currency swaps designated as cash flow hedges of foreign currency denominated debt was $2.4 billion and $8.2 billion, respectively. The $5.7 billion decrease in cross-currency swaps is part of the company’s risk management strategy and the previously hedged foreign currency denominated debt has been designated as a hedge of net investment in foreign subsidiaries.

At June 30, 2020 and December 31, 2019, in connection with cash flow hedges of foreign currency denominated borrowings, the company recorded net losses of $291 million and net losses of $185 million (before taxes), respectively, in AOCI. The company estimates that $25 million (before taxes) of deferred net losses on derivatives in AOCI at June 30, 2020 will be reclassified to net income within the next 12 months, providing an offsetting economic impact against the underlying exposure.

Subsidiary Cash and Foreign Currency Asset/Liability Management

The company uses its Global Treasury Centers to manage the cash of its subsidiaries. These centers principally use currency swaps to convert cash flows in a cost-effective manner. In addition, the company uses foreign exchange forward contracts to economically hedge, on a net basis, the foreign currency exposure of a portion of the company’s nonfunctional currency assets and liabilities. The terms of these forward and swap contracts are generally less than one year. The changes in the fair values of these contracts and of the underlying hedged exposures are generally offsetting and are recorded in other (income) and expense in the Consolidated Income Statement. At June 30, 2020 and December 31, 2019, the total notional amount of derivative instruments in economic hedges of foreign currency exposure was $4.3 billion and $7.1 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 Income Statement. 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 Income Statement. At June 30, 2020 and December 31, 2019, the total notional amount of derivative instruments in economic hedges of these compensation obligations was $1.2 billion and $1.3 billion, respectively.

Table of Contents

Notes to Consolidated Financial Statements — (continued)

ranging from Aaa to Baa3 are considered investment grade. All others are considered non-investment grade. The credit quality indicators do not reflect mitigation actions that the company takes to transfer credit risk to third parties.

(Dollars in millions)

Lease Receivables

Loan Receivables
At September 30, 2019:

Americas

EMEA

Asia Pacific

Americas

EMEA

Asia Pacific
Credit ratings:












Aaa – Aa3

$
443

$
11

$
44

$
1,006

$
167

$
160
A1 – A3

727

201

441

855

308

874
Baa1 – Baa3

843

380

153

1,560

1,120

617
Ba1 – Ba2

697

311

149

1,380

830

396
Ba3 – B1

259

123

104

444

476

208
B2 – B3

258

46

44

499

222

62
Caa – D

16

1

5

47

7

14
Total

$
3,245

$
1,073

$
939

$
5,789

$
3,130

$
2,330

(Dollars in millions)

Lease Receivables

Loan Receivables
At December 31, 2018:

Americas

EMEA

Asia Pacific

Americas

EMEA

Asia Pacific
Credit ratings:












Aaa – Aa3

$
593

$
45

$
85

$
1,055

$
125

$
185
A1 – A3

678

158

413

1,206

436

901
Baa1 – Baa3

892

417

297

1,587

1,148

648
Ba1 – Ba2

852

426

191

1,516

1,175

417
Ba3 – B1

433

171

84

770

472

184
B2 – B3

299

90

50

531

249

109
Caa – D

26

10

7

47

28

15
Total

$
3,774

$
1,319

$
1,128

$
6,712

$
3,633

$
2,457

~~Troubled Debt Restructurings~~
~~The company did not have any significant troubled debt restructurings during the nine months ended September 30, 2019 or for the year ended December 31, 2018.~~
7. ~~Stock-Based Compensation:~~Cumulative Basis Adjustments for Fair Value Hedges
~~Stock-based compensation cost is measured at grant date, based on~~At June 30, 2020 and December 31, 2019, the following amounts were recorded in the Consolidated Balance Sheet related to cumulative basis adjustments for fair value ~~of the award, and is recognized over the employee requisite service period. The following table presents total stock-based compensation cost included in income from continuing operations.~~hedges:

Three Months Ended September 30,

Nine Months Ended September 30,
(Dollars in millions)

2019

2018

2019

2018
Cost

$
29

$
19

$
71

$
60
Selling, general and administrative

147

95


313


264
Research, development and engineering

44

15


84


47
Pre-tax stock-based compensation cost

$
220

$
129

$
468

$
371
Income tax benefits

(50)

(29)


(104)


(88)
Total net stock-based compensation cost

$
170

$
100

$
364

$
283


June 30,

December 31,

(Dollars in millions)

2020

2019

Short-term debt:





Carrying amount of the hedged item

$
(1,313)

$
—

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

(14)

—

Long-term debt:





Carrying amount of the hedged item

$
(2,138)

$
(3,411)

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

(466)
(1)

(440)
(1)
(1) Includes ($378) million and ($404) million of hedging adjustments on discontinued hedging relationships at June 30, 2020 and December 31, 2019, respectively.

~~Table~~The Effect of ~~Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

~~Pre-tax stock-based compensation cost for the three months ended September 30, 2019 increased $91 million compared to the corresponding period~~Derivative Instruments in the ~~prior year. This was primarily due to increases related to issuances~~Consolidated Income Statement

The total amounts of income and ~~conversions of stock-based compensation for Red Hat ($79 million) and restricted stock units ($10 million).~~

~~Pre-tax stock-based compensation cost for the nine months ended September 30, 2019 increased $98 million compared to the corresponding period~~expense line items presented in the ~~prior year. This was primarily due to increases related to issuances~~Consolidated Income Statement in which the effects of fair value hedges, cash flow hedges, net investment hedges and ~~conversions of stock-based compensation for Red Hat ($79 million)~~derivatives not designated as hedging instruments are recorded and ~~restricted stock units ($25 million).~~

~~As of September 30, 2019,~~ the total ~~unrecognized compensation cost~~effect of ~~$1.4 billion related to non-vested awards was expected to be recognized over a weighted-average period of approximately 2.5 years.~~

~~There was no significant capitalized stock-based compensation cost at September 30, 2019~~hedge activity on these income and ~~2018.~~

8.~~Segments:~~

The following tables reflect the continuing operations results of the company’s segments consistent with the management and measurement system utilized within the company. Effective with the closing of the transaction in July, Red Hat is included in the Cloud & Cognitive Software segment. The “Other” segment includes the divested mortgage servicing and select software businesses. Performance measurement is based on operating pre-tax income from continuing operations. The segments represent components of the company for which separate financial information is available that is utilized on a regular basis by the chief operating decision maker (the chief executive officer) in determining how to allocate resources and evaluate performance. The tables reflect the segments recast for the prior-year period due to the company’s segment changes effective January 2019.expense line items are as follows:

Gains/(Losses) of

(Dollars in millions)

Total

Total Hedge Activity

For the three months ended June 30:

2020

2019

2020

2019

Cost of services

$
7,520

$
8,181
*
$
(1)

$
20

Cost of sales

1,739

1,741
*

9

11

Cost of financing

165

228

2

(18)

SG&A expense

5,248

5,456

157

38

Other (income) and expense

179

(747)

92

271

Interest expense

323

348

7

(39)

* Reclassified to conform to current period presentation.

4044

Table of Contents

Notes to Consolidated Financial Statements — (continued)

Gain (Loss) Recognized in Consolidated Income Statement

Consolidated

Recognized on

Attributable to Risk
(Dollars in millions)

Income Statement

Derivatives

Being Hedged (2)
For the three months ended June 30:

Line Item

2020

2019

2020

2019
Derivative instruments in fair value hedges (1):










Interest rate contracts

Cost of financing

$
3

$
23

$
3

$
(20)

Interest expense

8

48

8

(43)
Derivative instruments not designated as hedging instruments:










Foreign exchange contracts

Other (income) and expense

22

69

N/A

N/A
Equity contracts

SG&A expense

150

26

N/A

N/A
Total



$
183

$
165

$
11

$
(64)
~~SEGMENT INFORMATION~~

Gain (Loss) Recognized in Consolidated Income Statement and Other Comprehensive Income

(Dollars in millions)

Consolidated

Reclassified

Amounts Excluded from

For the three months

Recognized in OCI

Income Statement

from AOCI

Effectiveness Testing (3)

ended June 30:

2020

2019

Line Item

2020

2019

2020

2019

Derivative instruments in cash flow hedges:















Interest rate contracts

$
—

$
3

Cost of financing

$
(1)

$
(1)

$
—

$
—

Interest expense

(3)

(2)

—

—

Foreign exchange contracts

(36)

(10)

Cost of services

(1)

20

—

—

Cost of sales

9

11

—

—

Cost of financing

(6)

(24)

—

—

SG&A expense

7

12

—

—

Other (income) and expense

70

202

—

—

Interest expense

(16)

(51)

—

—

Instruments in net investment hedges (4):















Foreign exchange contracts

(535)

(148)

Cost of financing

—

—

4

4

Interest expense

—

—

10

9

Total

$
(571)

$
(154)



$
59

$
168

$
14

$
13

(1) The amount includes changes in clean fair values of the derivative instruments in fair value hedging relationships and the periodic accrual for coupon payments required under these derivative contracts.
(2) The amount includes basis adjustments to the carrying value of the hedged item recorded during the period and amortization of basis adjustments recorded on de-designated hedging relationships during the period.
(3) The company’s policy is to recognize all fair value changes in amounts excluded from effectiveness testing in net income each period.
(4) Instruments in net investment hedges include derivative and non-derivative instruments.

N/A - not applicable


Cloud &

Global

Global









Cognitive

Business

Technology

Global

Total

(Dollars in millions)

Software

Services

Services

Systems

Financing

Segments

For the three months ended September 30, 2019:













External revenue

$
5,280

$
4,117

$
6,700

$
1,481

$
343

$
17,921

Internal revenue

686

70

287

195

302

1,541

Total revenue

$
5,966

$
4,187

$
6,988

$
1,676

$
645

$
19,462

Pre-tax income/(loss) from continuing operations

$
1,283

$
573

$
490

$
39

$
275

$
2,661

Revenue year-to-year change

4.0
%

0.8
%

(5.3)
%

(12.6)
%

(11.2)
%

(2.3)
%
Pre-tax income year-to-year change

(37.4)
%

1.2
%

(19.2)
%

(81.3)
%

(10.8)
%

(28.9)
%
Pre-tax income/(loss) margin

21.5
%

13.7
%

7.0
%

2.3
%

42.6
%

13.7
%

For the three months ended September 30, 2018:













External revenue

$
4,962
*
$
4,076
*
$
7,101
*
$
1,736

$
388

$
18,262
*
Internal revenue

777
*

77

279
*

181

338

1,652
*
Total revenue

$
5,738
*
$
4,153
*
$
7,380
*
$
1,917

$
726

$
19,914
*
Pre-tax income/(loss) from continuing operations

$
2,050
*
$
566
*
$
607
*
$
209

$
308

$
3,741
*
Pre-tax income/(loss) margin

35.7
%*

13.6
%*

8.2
%*

10.9
%

42.5
%

18.8
%*

Gains/(Losses) of

(Dollars in millions)

Total

Total Hedge Activity

For the six months ended June 30:

2020

2019

2020

2019

Cost of services

$
15,363

$
16,453
*
$
9

$
29

Cost of sales

3,363

3,344
*

18

30

Cost of financing

345

492

6

(36)

SG&A expense

11,203

10,147

(34)

179

Other (income) and expense

361

(820)

(9)

202

Interest expense

649

558

16

(59)

* ~~Recast~~Reclassified to conform to ~~2019~~current period presentation.
~~Reconciliations to IBM as Reported:~~

(Dollars in millions)






For the three months ended September 30:

2019

2018

Revenue:





Total reportable segments

$
19,462

$
19,914
*
Other — divested businesses

48

432
*
Other revenue

59

62

Eliminations of internal transactions

(1,541)

(1,652)
*
Total consolidated revenue

$
18,028

$
18,756

Pre-tax income from continuing operations:





Total reportable segments

$
2,661

$
3,741
*
Amortization of acquired intangible assets

(473)

(207)

Acquisition-related (charges)/income

(255)

(2)

Non-operating retirement-related (costs)/income

(145)

(389)

Eliminations of internal transactions

(84)

(118)
*
Other — divested businesses

(25)

62
*
Unallocated corporate amounts

(157)

(91)

Total pre-tax income from continuing operations

$
1,522

$
2,996

* Recast to conform to 2019 presentation.

4145

Table of Contents

Notes to Consolidated Financial Statements — (continued)

Gain (Loss) Recognized in Consolidated Income Statement

Consolidated

Recognized on

Attributable to Risk
(Dollars in millions)

Income Statement

Derivatives

Being Hedged (2)
For the six months ended June 30:

Line Item

2020

2019

2020

2019
Derivative instruments in fair value hedges (1):














Interest rate contracts

Cost of financing

$
21

$
55

$
(11)

$
(50)

Interest expense

56

90

(29)

(82)
Derivative instruments not designated as hedging instruments:










Foreign exchange contracts

Other (income) and expense

10

87

N/A

N/A
Equity contracts

SG&A expense

(51)

145

N/A

N/A
Total



$
37

$
377

$
(39)

$
(132)
~~SEGMENT INFORMATION~~

Gain (Loss) Recognized in Consolidated Income Statement and Other Comprehensive Income

(Dollars in millions)

Consolidated

Reclassified

Amounts Excluded from

For the six months

Recognized in OCI

Income Statement

from AOCI

Effectiveness Testing (3)

ended June 30:

2020

2019

Line Item

2020

2019

2020

2019

Derivative instruments in cash flow hedges:















Interest rate contracts

$
—

$
(168)

Cost of financing

$
(2)

$
(1)

$
—

$
—

Interest expense

(6)

(1)

—

—

Foreign exchange contracts

(216)

(191)

Cost of services

9

29

—

—

Cost of sales

18

30

—

—

Cost of financing

(13)

(52)

—

—

SG&A expense

17

34

—

—

Other (income) and expense

(19)

115

—

—

Interest expense

(35)

(85)

—

—

Instruments in net investment hedges (4):















Foreign exchange contracts

(50)

(128)

Cost of financing

—

—

11

12

Interest expense

—

—

30

19

Total

$
(266)

$
(487)



$
(32)

$
70

$
41

$
30

(1) The amount includes changes in clean fair values of the derivative instruments in fair value hedging relationships and the periodic accrual for coupon payments required under these derivative contracts.
(2) The amount includes basis adjustments to the carrying value of the hedged item recorded during the period and amortization of basis adjustments recorded on de-designated hedging relationships during the period.
(3) The company’s policy is to recognize all fair value changes in amounts excluded from effectiveness testing in net income each period.
(4) Instruments in net investment hedges include derivative and non-derivative instruments.

N/A - not applicable


Cloud &

Global

Global









Cognitive

Business

Technology

Global

Total

(Dollars in millions)

Software

Services

Services

Systems

Financing

Segments

For the nine months ended September 30, 2019:













External revenue

$
15,962

$
12,391

$
20,412

$
4,562

$
1,100

$
54,426

Internal revenue

2,135

213

879

528

884

4,638

Total revenue

$
18,097

$
12,604

$
21,291

$
5,091

$
1,983

$
59,065

Pre-tax income/(loss) from continuing operations

$
5,052

$
1,188

$
1,000

$
(101)

$
803

$
7,941

Revenue year-to-year change

0.2
%

0.2
%

(5.1)
%

(15.0)
%

(18.3)
%

(3.9)
%
Pre-tax income year-to-year change

(12.3)
%

11.7
%

(11.0)
%

(128.8)
%

(23.0)
%

(15.0)
%
Pre-tax income/(loss) margin

27.9
%

9.4
%

4.7
%

(2.0)
%

40.5
%

13.4
%

For the nine months ended September 30, 2018:













External revenue

$
15,548
*
$
12,326
*
$
21,846
*
$
5,412

$
1,188

$
56,319
*
Internal revenue

2,518
*

249

589
*

576

1,240

5,173
*
Total revenue

$
18,066
*
$
12,575
*
$
22,435
*
$
5,989

$
2,428

$
61,492
*
Pre-tax income/(loss) from continuing operations

$
5,760
*
$
1,063
*
$
1,124
*
$
352

$
1,042

$
9,342
*
Pre-tax income/(loss) margin

31.9
%*

8.5
%*

5.0
%*

5.9
%

42.9
%

15.2
%*
* RecastFor the three and six months ended June 30, 2020 and 2019, there were no material gains or losses excluded from the assessment of hedge effectiveness (for fair value or cash flow hedges), or associated with an underlying exposure that did not or was not expected to ~~conform to 2019 presentation.~~

~~Reconciliations to IBM as Reported:~~

(Dollars in millions)






For the nine months ended September 30:

2019

2018

Revenue:





Total reportable segments

$
59,065

$
61,492
*
Other — divested businesses

754

1,335
*
Other revenue

190

176

Eliminations of internal transactions

(4,638)

(5,173)
*
Total consolidated revenue

$
55,370

$
57,830

Pre-tax income from continuing operations:





Total reportable segments

$
7,941

$
9,342
*
Amortization of acquired intangible assets

(816)

(613)

Acquisition-related (charges)/income

(396)

(3)

Non-operating retirement-related (costs)/income

(419)

(1,185)

Eliminations of internal transactions

(233)

(615)
*
Other — divested businesses

477

265
*
Unallocated corporate amounts

(380)

(283)

Total pre-tax income from continuing operations

$
6,173

$
6,908

*~~Recast to conform to 2019 presentation.~~occur (for cash flow hedges); nor are there any anticipated in the normal course of business.

4246

Table of Contents

Notes to Consolidated Financial Statements — (continued)

9.16. ~~Equity Activity:~~Stock-Based Compensation:
~~Reclassifications~~Stock-based compensation cost is measured at grant date, based on the fair value of the award, and ~~Taxes Related to Items of Other Comprehensive Income~~is recognized over the employee requisite service period. The following table presents total stock-based compensation cost included in income from continuing operations.

(Dollars in millions)

Before Tax

Tax (Expense)/

Net of Tax
For the three months ended September 30, 2019:

Amount

Benefit

Amount
Other comprehensive income/(loss):






Foreign currency translation adjustments

$
(509)

$
(109)

$
(618)
Net changes related to available-for-sale securities:






Unrealized gains/(losses) arising during the period

$
3

$
(1)

$
2
Reclassification of (gains)/losses to other (income) and expense

—

—

—
Total net changes related to available-for-sale securities

$
3

$
(1)

$
2
Unrealized gains/(losses) on cash flow hedges:






Unrealized gains/(losses) arising during the period

$
(439)

$
110

$
(329)
Reclassification of (gains)/losses to:






Cost of services

(22)

6

(17)
Cost of sales

(10)

3

(7)
Cost of financing

21

(5)

15
SG&A expense

(11)

3

(8)
Other (income) and expense

447

(112)

334
Interest expense

64

(16)

48
Total unrealized gains/(losses) on cash flow hedges

$
49

$
(12)

$
36
Retirement-related benefit plans (1):






Net (losses)/gains arising during the period

$
0

$
0

$
0
Curtailments and settlements

3

(1)

2
Amortization of prior service (credits)/costs

(3)

3

(1)
Amortization of net (gains)/losses

461

(128)

333
Total retirement-related benefit plans

$
461

$
(127)

$
335
Other comprehensive income/(loss)

$
4

$
(249)

$
(245)
~~(1)~~ ~~These AOCI components are included in the computation of net periodic pension cost. Refer to note 10, “Retirement-Related Benefits,” for additional information.~~

Three Months Ended June 30,

Six Months Ended June 30,
(Dollars in millions)

2020

2019

2020

2019
Cost

$
40

$
22

$
67

$
42
Selling, general and administrative

155

93


272


167
Research, development and engineering

52

21


97


39
Pre-tax stock-based compensation cost

$
247

$
135

$
436

$
248
Income tax benefits

(52)

(29)


(96)


(54)
Total net stock-based compensation cost

$
196

$
106

$
340

$
194
43

~~Table~~Pre-tax stock-based compensation cost for the three months ended June 30, 2020 increased $112 million compared to the corresponding period in the prior year. This was primarily due to increases related to the conversion of ~~Contents~~stock-based compensation previously issued by Red Hat ($62 million), restricted stock units ($45 million) and performance share units ($5 million).

~~Notes~~Pre-tax stock-based compensation cost for the six months ended June 30, 2020 increased $188 million compared to ~~Consolidated Financial Statements — (continued)~~the corresponding period in the prior year. This was primarily due to increases related to the conversion of stock-based compensation previously issued by Red Hat ($127 million) and restricted stock units ($63 million), partially offset by decreases in performance share units ($2 million).

Total unrecognized compensation cost related to non-vested awards at June 30, 2020 was $1.6 billion and is expected to be recognized over a weighted-average period of approximately 2.6 years.
Capitalized stock-based compensation cost was not material at June 30, 2020 and 2019.
~~Reclassifications and Taxes Related to Items~~17. Retirement-Related Benefits:

The company offers defined benefit pension plans, defined contribution pension plans, as well as nonpension postretirement plans primarily consisting of ~~Other Comprehensive Income~~

(Dollars in millions)

Before Tax

Tax (Expense)/

Net of Tax
For the three months ended September 30, 2018:

Amount

Benefit

Amount
Other comprehensive income/(loss):






Foreign currency translation adjustments

$
(22)

$
(22)

$
(44)
Net changes related to available-for-sale securities:






Unrealized gains/(losses) arising during the period

$
0

$
0

$
0
Reclassification of (gains)/losses to other (income) and expense

—

—

—
Total net changes related to available-for-sale securities

$
0

$
0

$
0
Unrealized gains/(losses) on cash flow hedges:






Unrealized gains/(losses) arising during the period

$
(46)

$
11

$
(35)
Reclassification of (gains)/losses to:

Cost of services

(1)

0

(1)
Cost of sales

(8)

3

(6)
Cost of financing*

18

(5)

14
SG&A expense

(7)

2

(5)
Other (income) and expense

8

(2)

6
Interest expense*

18

(5)

14
Total unrealized gains/(losses) on cash flow hedges

$
(18)

$
4

$
(14)
Retirement-related benefit plans (1):






Prior service costs/(credits)

$
0

$
0

$
0
Net (losses)/gains arising during the period

(1)

1

(1)
Curtailments and settlements

2

0

1
Amortization of prior service (credits)/costs

(18)

5

(13)
Amortization of net (gains)/losses

737

(196)

540
Total retirement-related benefit plans

$
719

$
(191)

$
527
Other comprehensive income/(loss)

$
678

$
(209)

$
470

* Reclassified to conform to current period presentation.

~~(1)~~

~~These AOCI components are included in the computation of net periodic pension cost. Refer to note 10, “Retirement-Related Benefits,” for additional information.~~

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

~~Reclassifications and Taxes Related to Items of Other Comprehensive Income~~retiree medical benefits. The following tables provide the pre-tax cost for all retirement-related plans.

(Dollars in millions)

Before Tax

Tax (Expense)/

Net of Tax
For the nine months ended September 30, 2019:

Amount

Benefit

Amount
Other comprehensive income/(loss):






Foreign currency translation adjustments

$
(333)

$
(72)

$
(405)
Net changes related to available-for-sale securities:






Unrealized gains/(losses) arising during the period

$
1

$
0

$
1
Reclassification of (gains)/losses to other (income) and expense

—

—

—
Total net changes related to available-for-sale securities

$
1

$
0

$
1
Unrealized gains/(losses) on cash flow hedges:






Unrealized gains/(losses) arising during the period

$
(798)

$
196

$
(601)
Reclassification of (gains)/losses to:






Cost of services

(52)

13

(38)
Cost of sales

(40)

11

(29)
Cost of financing

73

(18)

55
SG&A expense

(45)

12

(33)
Other (income) and expense

331

(83)

248
Interest expense

150

(38)

112
Total unrealized gains/(losses) on cash flow hedges

$
(380)

$
93

$
(287)
Retirement-related benefit plans (1):






Net (losses)/gains arising during the period

$
113

$
(23)

$
90
Curtailments and settlements

7

(1)

6
Amortization of prior service (credits)/costs

(9)

4

(5)
Amortization of net (gains)/losses

1,385

(380)

1,005
Total retirement-related benefit plans

$
1,496

$
(401)

$
1,095
Other comprehensive income/(loss)

$
784

$
(380)

$
404

~~(1)~~

~~These AOCI components are included in the computation of net periodic pension cost. Refer to note 10, “Retirement-Related Benefits,” for additional information.~~


					Yr. to Yr.
(Dollars in millions)					Percent
For the three months ended June 30:	2020		2019		Change
Retirement-related plans — cost
Defined benefit and contribution pension plans — cost	$	596	$	441	34.9	%
Nonpension postretirement plans — cost		50		53	(5.6)
Total	$	645	$	494	30.6	%


					Yr. to Yr.
(Dollars in millions)					Percent
For the six months ended June 30:	2020		2019		Change
Retirement-related plans — cost
Defined benefit and contribution pension plans — cost	$	1,179	$	878	34.3	%
Nonpension postretirement plans — cost		102		107	(4.8)
Total	$	1,281	$	985	30.0	%

4547

Table of Contents

Notes to Consolidated Financial Statements — (continued)

~~Reclassifications and Taxes Related to Items of Other Comprehensive Income~~

(Dollars in millions)

Before Tax

Tax (Expense)/

Net of Tax
For the nine months ended September 30, 2018:

Amount

Benefit

Amount
Other comprehensive income/(loss):






Foreign currency translation adjustments

$
(535)

$
(128)

$
(663)
Net changes related to available-for-sale securities:






Unrealized gains/(losses) arising during the period

$
(2)

$
1

$
(1)
Reclassification of (gains)/losses to other (income) and expense

—

—

—
Total net changes related to available-for-sale securities

$
(2)

$
1

$
(1)
Unrealized gains/(losses) on cash flow hedges:






Unrealized gains/(losses) arising during the period

$
(134)

$
39

$
(95)
Reclassification of (gains)/losses to:

Cost of services

(29)

7

(22)
Cost of sales

15

(4)

11
Cost of financing*

56

(14)

42
SG&A expense

14

(4)

10
Other (income) and expense

301

(76)

225
Interest expense*

52

(13)

39
Total unrealized gains/(losses) on cash flow hedges

$
274

$
(63)

$
210
Retirement-related benefit plans (1):






Prior service costs/(credits)

$
(1)

$
0

$
(1)
Net (losses)/gains arising during the period

83

(22)

60
Curtailments and settlements

7

(2)

5
Amortization of prior service (credits)/costs

(55)

15

(40)
Amortization of net (gains)/losses

2,231

(607)

1,624
Total retirement-related benefit plans

$
2,264

$
(616)

$
1,648
Other comprehensive income/(loss)

$
2,001

$
(807)

$
1,194

* Reclassified to conform to current period presentation.

~~(1)~~

~~These AOCI components are included in the computation of net periodic pension cost. Refer to note 10, “Retirement-Related Benefits,” for additional information.~~

~~Accumulated Other Comprehensive Income/(Loss) (net of tax)~~

* Foreign currency translation adjustments are presented gross except for any associated hedges which are presented net of tax.

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

*~~Foreign currency translation adjustments are presented gross except for any associated hedges which are presented net of tax.~~

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

~~Stock Repurchases~~

~~The Board of Directors authorizes the company to repurchase IBM common stock. At September 30, 2019,~~ $2,008 million of Board common stock repurchase authorization was available. The company suspended its share repurchase program effective with the close of the Red Hat acquisition in order to focus on reducing debt related to the acquisition.

~~10.~~ ~~Retirement-Related Benefits:~~

The company offers defined benefit pension plans, defined contribution pension plans, as well as nonpension postretirement plans primarily consisting of retiree medical benefits. The following tables provide the pre-tax cost for all retirement-related plans.

Yr. to Yr.

(Dollars in millions)

Percent

For the three months ended September 30:

2019

2018

Change

Retirement-related plans — cost







Defined benefit and contribution pension plans — cost

$
459

$
705

(34.9)
%
Nonpension postretirement plans — cost

53

49

8.6

Total

$
512

$
754

(32.1)
%

Yr. to Yr.

(Dollars in millions)

Percent

For the nine months ended September 30:

2019

2018

Change

Retirement-related plans — cost







Defined benefit and contribution pension plans — cost

$
1,337

$
2,152

(37.8)
%
Nonpension postretirement plans — cost

160

149

7.4

Total

$
1,497

$
2,300

(34.9)
%

The following tables provide the components of the cost/(income) for the company’s pension plans.

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

Cost/(Income) of Pension Plans


(Dollars in millions)	U.S. Plans				Non-U.S. Plans				U.S. Plans				Non-U.S. Plans
For the three months ended September 30:	2019		2018		2019		2018
For the three months ended June 30:									2020		2019		2020		2019
Service cost	$	—	$	—	$	93	$	104	$	—	$	—	$	95	$	93
Interest cost (1)		470		430		202		204		375		469		137		206
Expected return on plan assets (1)		(650)		(675)		(391)		(330)		(542)		(650)		(311)		(396)
Amortization of prior service costs/(credits) (1)		4		4		(7)		(20)		4		4		(5)		(7)
Recognized actuarial losses (1)		140		381		313		346		207		139		340		312
Curtailments and settlements (1)		—		—		3		2		—		—		13		3
Multi-employer plans		—		—		10		9		—		—		7		8
Other costs/(credits) (1)		—		—		11		5		—		—		9		6
Total net periodic pension (income)/cost of defined benefit plans	$	(36)	$	140	$	235	$	318	$	44	$	(37)	$	284	$	225
Cost of defined contribution plans		151		152		109		95		154		140		113		114
Total defined benefit and contribution pension plans cost recognized in the Consolidated Statement of Earnings	$	115	$	292	$	344	$	413
Total defined benefit and contribution pension plans cost recognized in the Consolidated Income Statement									$	198	$	103	$	397	$	339


(Dollars in millions)	U.S. Plans				Non-U.S. Plans
For the six months ended June 30:	2020		2019		2020		2019
Service cost	$	—	$	—	$	190	$	185
Interest cost (1)		750		941		266		413
Expected return on plan assets (1)		(1,084)		(1,300)		(620)		(795)
Amortization of prior service costs/(credits) (1)		8		8		(9)		(13)
Recognized actuarial losses (1)		415		279		682		626
Curtailments and settlements (1)		—		—		21		4
Multi-employer plans		—		—		14		17
Other costs/(credits) (1)		—		—		14		11
Total net periodic pension (income)/cost of defined benefit plans	$	89	$	(71)	$	559	$	449
Cost of defined contribution plans		309		289		223		212
Total defined benefit and contribution pension plans cost recognized in the Consolidated Income Statement	$	398	$	218	$	782	$	661

(1)	These components of net periodic pension cost are included in other (income) and expense in the Consolidated ~~Statement of Earnings.~~Income Statement.

(Dollars in millions)

U.S. Plans

Non-U.S. Plans
For the nine months ended September 30:

2019

2018

2019

2018
Service cost

$
—

$
—

$
279

$
309
Interest cost (1)

1,411

1,289

616

630
Expected return on plan assets (1)

(1,949)

(2,026)

(1,186)

(1,017)
Amortization of prior service costs/(credits) (1)

12

12

(20)

(62)
Recognized actuarial losses (1)

419

1,144

939

1,057
Curtailments and settlements (1)

—

—

7

7
Multi-employer plans

—

—

26

29
Other costs/(credits) (1)

—

—

22

16
Total net periodic pension (income)/cost of defined benefit plans

$
(107)

$
419

$
683

$
969
Cost of defined contribution plans

440

457

321

306
Total defined benefit and contribution pension plans cost recognized in the Consolidated Statement of Earnings

$
333

$
876

$
1,004

$
1,276

~~(1)~~

~~These components of net periodic pension cost are included in other (income) and expense in the Consolidated Statement of Earnings.~~

As of 2019, substantially all the plan participants in the U.S. Qualified IBM Personal Pension Plan (PPP) are considered inactive. As required by U.S. GAAP, this resulted in a change in the amortization period of unrecognized actuarial losses to the average remaining life expectancy of inactive plan participants, which was 18 years as of December 31, 2018. Recognized actuarial losses decreased $242 million and $725 million for the three and nine months ended September 30, 2019, respectively, compared to the corresponding periods in the prior year, primarily driven by the change in the amortization period. There was no impact to funded status, retiree benefit payments or funding requirements of the U.S. Qualified PPP as a result of this change.

In 2019, the company expects to contribute approximately $300 million to its non-U.S. defined benefit and multi-employer plans, the largest of which will be contributed to the defined benefit pension plans in Japan, Spain and Belgium. This amount generally represents the legally mandated minimum contribution. Total net contributions to the non-U.S. plans in the first nine months of 2019 were $159 million, of which $95 million was in cash and $65 million in U.S. Treasury securities. Total contributions to the non-U.S. plans in the first nine months of 2018 were $275 million, of which $117 million was in cash and $157 million in U.S. Treasury securities. The contribution of U.S. Treasury securities is considered a non-cash transaction in the Consolidated Statement of Cash Flows.

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

The following tables provide the components of the cost for the company’s nonpension postretirement plans.

Cost of Nonpension Postretirement Plans

(Dollars in millions)

U.S. Plan

Non-U.S. Plans
For the three months ended September 30:

2019

2018

2019

2018
Service cost

$
3

$
3

$
1

$
1
Interest cost (1)

36

33

12

11
Expected return on plan assets (1)

—

—

(1)

(1)
Amortization of prior service costs/(credits) (1)

(1)

(2)

0

0
Recognized actuarial losses (1)

0

2

3

1
Curtailments and settlements (1)

—

—

—

0
Total nonpension postretirement plans cost recognized in Consolidated Statement of Earnings

$
38

$
37

$
15

$
12

~~(1)~~

~~These components of net periodic pension cost are included in other (income) and expense in the Consolidated Statement of Earnings~~.

(Dollars in millions)

U.S. Plan

Non-U.S. Plans
For the nine months ended September 30:

2019

2018

2019

2018
Service cost

$
8

$
10

$
4

$
4
Interest cost (1)

109

99

37

34
Expected return on plan assets (1)

—

—

(4)

(4)
Amortization of prior service costs/(credits) (1)

(2)

(6)

0

0
Recognized actuarial losses (1)

0

7

8

4
Curtailments and settlements (1)

—

—

0

0
Total nonpension postretirement plans cost recognized in Consolidated Statement of Earnings

$
115

$
111

$
45

$
38

~~(1)~~

~~These components of net periodic pension cost are included in other (income) and expense in the Consolidated Statement of Earnings.~~

The company contributed $357 million in U.S. Treasury securities to the U.S. nonpension postretirement benefit and active employee medical trusts during the nine months ended September 30, 2019, and $275 million in U.S. Treasury securities during the nine months ended September 30, 2018. The contribution of U.S. Treasury securities is considered a non-cash transaction in the Consolidated Statement of Cash Flows.

~~11.~~ ~~Acquisitions/Divestitures:~~

~~Acquisitions~~

The company accounts for business combinations using the acquisition method and accordingly, the identifiable assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree are recorded at their acquisition date fair values. Significant judgments and use of estimates are required when performing valuations. For example, the company uses judgments when estimating the fair value of intangible assets using a discounted cash flow model; which involves the use of significant estimates and assumptions with respect to revenue growth rates, customer attrition rate and discount rates.


(Dollars in millions)	U.S. Plan				Non-U.S. Plans
For the three months ended June 30:	2020		2019		2020		2019
Service cost	$	2	$	3	$	1	$	1
Interest cost (1)		26		36		8		12
Expected return on plan assets (1)		—		—		(1)		(1)
Amortization of prior service costs/(credits) (1)		1		(1)		0		0
Recognized actuarial losses (1)		7		0		5		3
Curtailments and settlements (1)		—		—		—		—
Total nonpension postretirement plans cost recognized in Consolidated Income Statement	$	36	$	38	$	14	$	15

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

~~Red Hat~~ - On July 9, 2019, the company completed the acquisition of all of the outstanding shares of Red Hat. Red Hat’s portfolio of open-source technologies, innovative cloud development platform and developer community, combined with IBM’s innovative hybrid cloud technology, industry expertise and commitment to data, trust and security, will deliver the hybrid multicloud capabilities required to address the next chapter of cloud implementations as well as accelerate the company’s growth. Red Hat’s business model is based upon open-source software, which is an alternative to proprietary software in relation to the development and licensing of commercial software code. For Red Hat’s open-source software subscriptions, 0 revenue is recognized upfront from the licensing of the code itself, but rather, is recognized over time throughout the contract term as control of the promised product or service is transferred to the customer.

Total
(Dollars in millions)

Consideration
Cash paid for outstanding Red Hat common stock

$
33,769
Cash paid for Red Hat equity awards

24
Cash paid to settle warrants

1,008
Cash consideration

$
34,801
Fair value of stock-based compensation awards attributable to pre-combination services

174
Stock issued to holders of vested performance share units

45
Settlement of pre-existing relationships

60
Total consideration

$
35,079

~~The following table reflects the preliminary purchase price allocation as of the acquisition date.~~

(Dollars in millions)

Life (in years)

Amount
Current assets*

$
3,190
Property, plant and equipment/noncurrent assets

955
Intangible assets:

Goodwill

N/A

23,102
Client relationships

10

7,215
Completed technology

9

4,571
Trademarks

20

1,686
Total assets acquired

$
40,719
Current liabilities**

1,378
Noncurrent liabilities

4,262
Total liabilities assumed

$
5,640
Total purchase price

$
35,079

*	~~Includes $2.2 billion of cash and cash equivalents.~~

Includes $485 million of short-term debt related to the convertible notes acquired from Red Hat that were recognized at their fair value on the acquisition date, of which $50 million is included in the company’s Consolidated Statement of Financial Position as of September 30, 2019. This remaining balance was settled on October 1, 2019.

~~N/A – Not applicable~~

The goodwill generated is primarily attributable to the assembled workforce of Red Hat and the increased synergies expected to be achieved from the integration of Red Hat products into the company’s various integrated solutions, neither of which qualify as an amortizable intangible asset.

The overall weighted-average useful life of the identified amortizable intangible assets acquired is 10.9 years. These identified intangible assets will be amortized on a straight-line basis over their useful lives, which approximates the

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

pattern that the assets’ economic benefits are expected to be consumed over time. Goodwill of $23.1 billion has been assigned to the segments as follows: Cloud & Cognitive Software $18.4 billion, Global Technology Services $3.1 billion, Global Business Services $1.1 billion, and Systems $0.5 billion. It is expected that 6 percent of the goodwill will be deductible for tax purposes.

The valuation of the assets acquired and liabilities assumed is preliminary and subject to revision as more detailed analyses are completed. If additional information about the fair value of assets acquired and liabilities assumed becomes available, the company may further revise the preliminary purchase price allocation as soon as practical, but no later than one year from the acquisition date. Any such revisions or changes may be material.

The company recognized acquisition-related costs, such as legal and advisory fees, related to the acquisition within SG&A in the Consolidated Statement of Earnings of $98 million and $171 million for the three and nine months ending September 30, 2019, respectively. Within the amounts recognized in SG&A, $55 million represents amortized costs related to bridge term loan facility fees for the nine months ended September 30, 2019. There were 0 ~~bridge loan fees for the three months ended September 30, 2019. In addition, for the period beginning on the acquisition date through September 30, 2019, the company recognized~~ $16 million, $101 million and $68 million of compensation expense, within cost, SG&A and RD&E, respectively in the Consolidated Statement of Earnings, related to employee retention plans. The remaining compensation expense of approximately $230 million associated with the retention plans will be recognized over the remaining requisite service periods, which range from six months to three years from the acquisition date.

The acquisition of Red Hat settled a pre-existing vendor/customer relationship in which the company had historically paid in advance for purchases of Red Hat products. Because the terms of the agreements were determined to approximate fair value as of the acquisition date, the company did not recognize any gain or loss separately from the acquisition, and $60 million was included as part of the fair value of consideration transferred on the acquisition date.

The Consolidated Statement of Earnings includes revenue and a pre-tax loss attributable to Red Hat since the date of acquisition for both the three and nine months ended September 30, 2019 of $371 million and $981 million, respectively. The pre-tax loss is primarily driven by the deferred revenue fair value adjustment, retention expenses, intangible asset amortization and deal fees. It excludes interest expense.

The following table presents the supplemental consolidated financial results of the company on an unaudited pro forma basis, as if the acquisition had been consummated on January 1, 2018 through the periods shown below. The primary adjustments reflected in the pro forma results relate to: (1) the debt used to fund the acquisition, (2) changes driven by acquisition accounting, including amortization of intangible assets and the deferred revenue fair value adjustment, (3) employee retention plans, (4) elimination of intercompany transactions between IBM and Red Hat, and (5) the presentation of acquisition-related costs. Acquisition-related costs are non-recurring in nature and the pro forma net income amounts shown below include $356 million of these costs.

The unaudited pro forma financial information presented below does not purport to represent the actual results of operations that IBM and Red Hat would have achieved had the companies been combined during the periods presented and is not intended to project the future results of operations that the combined company may achieve after the acquisition. Historical fiscal periods are not aligned under this presentation. The unaudited pro forma financial information does not reflect any potential cost savings, operating efficiencies, long-term debt pay down estimates, suspension of IBM’s share repurchase program, financial synergies or other strategic benefits that may be realized as a result of the acquisition and also does not reflect any restructuring costs to achieve those benefits.

(Unaudited)

Three Months Ended September 30,

Nine Months Ended September 30,
(Dollars in millions)

2019

2018

2019

2018
Revenue

$
18,567

$
19,236

$
57,424

$
58,987
Net income

$
2,249

$
2,079

$
5,664

$
4,278

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

~~Divestitures~~

~~Select IBM Software Products~~ – On December 6, 2018, IBM and HCL Technologies Limited (HCL) announced a definitive agreement, in which HCL would acquire select standalone Cloud & Cognitive Software products for $1,775 million, inclusive of $150 million of contingent consideration. The software products in-scope included AppScan, BigFix, Unica, Commerce, Portal, Notes, Domino and Connections. The transaction included commercial software, intellectual property and services offerings. In addition, the transaction includes transition services for IT and other services. The initial terms of the transition services are generally less than one year, however, HCL can renew certain services up to an additional year.

~~The transaction closed on June 30, 2019. The company received cash of~~ $812 million at closing and $40 million of the contingent consideration in the third quarter of 2019. The company expects to receive an additional $813 million (net of any additional contingent consideration) within 12 months of closing. The outstanding contingent consideration is expected to be earned within 24 months of the closing. The company recognized a pre-tax gain on the sale of $556 million on June 30, 2019, which was recorded in other (income) and expense in the Consolidated Statement of Earnings. Due to changes in transaction estimates, the company recognized an additional pre-tax gain of $72 million in the third quarter of 2019. The total gain on sale may change in the future due to contingent consideration or changes in other transaction estimates, however, material changes are not expected.

~~Select IBM Marketing Platform and Commerce Offerings~~ – On April 4, 2019, IBM and Centerbridge Partners, L.P. (Centerbridge) announced a definitive agreement, in which Centerbridge would acquire select marketing platform and commerce offerings from IBM, including Customer Experience Analytics, Content Hub and Marketing Assistant, among others.The transaction included commercial software and services offerings. In addition, the company started providing Centerbridge with transition services including IT, supply chain management, and other services. Upon closing, Centerbridge announced that this business would be re-branded under the name Acoustic. The closing completed for the U.S. on June 30, 2019. The company expects a subsequent closing for the remaining countries to occur within 12 months of the U.S. closing. The timing of the subsequent closing is subject to change as more information becomes available. The company received a net cash payment of $240 million on June 30, 2019 and expects to receive an additional $150 million within 36 months of the U.S. closing.

The company recognized an immaterial pre-tax gain on the sale on June 30, 2019. The amount of the pre-tax gain for the remaining countries will not be determinable until the valuation of the final balance sheet transferred is completed, however, it is not expected to be material.

~~Seterus~~ – On January 3, 2019, IBM and Mr. Cooper Group announced a definitive agreement, in which Mr. Cooper Group acquired IBM’s Seterus home mortgage servicing platform business. The transaction closed in the first quarter of 2019. The financial terms related to this transaction were not material.

~~The above 3 divested businesses are reported in other – divested businesses. Refer to note 8, “Segments,” for additional information.~~

~~Others~~ ‒ ~~In addition to the above, the company completed or signed the following divestitures:~~

~~2019~~ – In the first quarter of 2019, the Global Financing segment sold certain commercial financing capabilities and assigned a number of its commercial financing contracts, excluding related receivables which will be collected as they become due in the normal course of business. In the third quarter of 2019, IBM completed 1 divestiture in the Global Business Services segment and entered into a definitive agreement to sell select assets reported in the Cloud & Cognitive Software segment. The financial terms related to each of these transactions were not material.

5248

Table of Contents

Notes to Consolidated Financial Statements — (continued)

~~12.~~ ~~Intangible Assets Including Goodwill:~~

~~Intangible Assets~~

~~The following table details the company's intangible asset balances by major asset class.~~

At September 30, 2019
(Dollars in millions)

Gross Carrying

Accumulated

Net Carrying
Intangible asset class

Amount

Amortization

Amount
Capitalized software

$
1,686

$
(702)

$
985
Client relationships

8,996

(1,312)

7,684
Completed technology

6,413

(1,386)

5,027
Patents/trademarks

2,291

(401)

1,890
Other*

56

(29)

26
Total

$
19,443

$
(3,830)

$
15,613


(Dollars in millions)	U.S. Plan				Non-U.S. Plans
For the six months ended June 30:	2020		2019		2020		2019
Service cost	$	4	$	5	$	3	$	3
Interest cost (1)		51		73		18		25
Expected return on plan assets (1)		—		—		(2)		(3)
Amortization of prior service costs/(credits) (1)		2		(1)		0		0
Recognized actuarial losses (1)		15		0		11		5
Curtailments and settlements (1)		—		—		0		0
Total nonpension postretirement plans cost recognized in Consolidated Income Statement	$	72	$	77	$	29	$	30

* Other intangibles are primarily acquired proprietary and non-proprietary business processes, methodologies and systems.

At December 31, 2018
(Dollars in millions)

Gross Carrying

Accumulated

Net Carrying
Intangible asset class

Amount

Amortization

Amount
Capitalized software

$
1,568

$
(629)

$
939
Client relationships

2,068

(1,123)

945
Completed technology

2,156

(1,296)

860
Patents/trademarks

641

(330)

311
Other*

56

(23)

32
Total

$
6,489

$
(3,402)

$
3,087

* Other intangibles are primarily acquired proprietary and non-proprietary business processes, methodologies and systems.

The net carrying amount of intangible assets increased $12,526 million during the first nine months of 2019, primarily due to the acquisition of Red Hat, partially offset by intangible asset amortization. Intangible assets of $13,472 million generated from the acquisition of Red Hat have been assigned to the segments as follows: Cloud & Cognitive Software $10,729 million, Global Technology Services $1,819 million, Global Business Services $617 million and Systems $306 million. For additional information on the acquisition of Red Hat, see note 11, “Acquisitions/Divestitures.”

The aggregate intangible amortization expense was $614 million and $1,224 million for the third quarter and first nine months of 2019, respectively, versus $348 million and $1,031 million for the third quarter and first nine months of 2018, respectively. In the first nine months of 2019, the company retired $543 million of fully amortized intangible assets, impacting both the gross carrying amount and accumulated amortization by this amount. In addition, in the first nine months of 2019, the company divested select intangible assets with a gross carrying amount of $317 million and $253 million of accumulated amortization.

(1)	These components of net periodic pension cost are included in other (income) and expense in the Consolidated Income Statement.

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

The amortization expense for each of the five succeeding years relating to intangible assets currently recorded in the Consolidated Statement of Financial Position is estimated to be the following at September 30, 2019:

Capitalized

Acquired



(Dollars in millions)

Software

Intangibles

Total
2019 (for Q4)

$
149

$
473

$
623
2020

471

1,850

2,321
2021

296

1,745

2,041
2022

66

1,681

1,748
2023

1

1,367

1,368

~~Goodwill~~

~~The change in the goodwill balances by segment, for the nine months ended September 30, 2019 and for the year ended December 31, 2018 are as follows:~~

Foreign



Currency

Purchase

Translation

(Dollars in millions)

Balance

Goodwill

Price

And Other

Balance
Segment

1/1/2019

Additions

Adjustments

Divestitures

Adjustments*

9/30/2019
Cloud & Cognitive Software

$
24,594

$
18,399

$
0

$
—

$
(174)

$
42,819
Global Business Services

4,711

1,059

1

(1)

(76)

5,694
Global Technology Services

3,988

3,119

—

—

(41)

7,066
Systems

1,847

525

—

—

(1)

2,372
Other — divested businesses

1,126

—

—

(1,126)

—

—
Total

$
36,265

$
23,102

$
1

$
(1,126)

$
(291)

$
57,951

* Primarily driven by foreign currency translation.

Foreign



Currency

Purchase

Translation

(Dollars in millions)

Balance

Goodwill

Price

And Other

Balance
Segment

1/1/2018

Additions

Adjustments

Divestitures

Adjustments**

12/31/2018
Cloud & Cognitive Software*

$
24,973

$
9

$
0

$
(1)

$
(388)

$
24,594
Global Business Services*

4,782

24

(3)

—

(92)

4,711
Global Technology Services*

4,044

—

0

—

(56)

3,988
Systems

1,862

—

0

—

(15)

1,847
Other — divested businesses*

1,127

1

0

0

(2)

1,126
Total

$
36,788

$
34

$
(3)

$
(1)

$
(553)

$
36,265

* Recast to conform to 2019 presentation.

** Primarily driven by foreign currency translation.

Goodwill additions recorded in the first nine months of 2019 are related to the acquisition of Red Hat during the third quarter of 2019. For additional information on this transaction, see note 11, “Acquisitions/Divestitures.”

~~There were 0 goodwill impairment losses recorded during the first nine months of 2019 or full year 2018 and the company has 0 accumulated impairment losses.~~

Purchase price adjustments recorded in the first nine months of 2019 and full year 2018 were related to acquisitions that were still subject to the measurement period that ends at the earlier of 12 months from the acquisition date or when

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

~~information becomes available. Net purchase price adjustments recorded during the first nine months of 2019 and full year 2018 were not material.~~

~~13.~~ ~~Borrowings:~~

~~Short-Term Debt~~

At September 30,

At December 31,
(Dollars in millions)

2019

2018
Commercial paper

$
2,988

$
2,995
Short-term loans

395

161
Long-term debt — current maturities

5,147

7,051
Total

$
8,530

$
10,207

The weighted-average interest rate for commercial paper at September 30, 2019 and December 31, 2018 was 1.9 percent and 2.5 percent, respectively. The weighted-average interest rate for short-term loans was 2.5 percent and 4.3 percent at September 30, 2019 and December 31, 2018, respectively.

~~Table of Contents~~

~~Notes~~company does not anticipate any significant changes to ~~Consolidated Financial Statements — (continued)~~

~~Long-Term Debt~~

~~Pre-Swap Borrowing~~

Balance

Balance
(Dollars in millions)

Maturities

9/30/2019

12/31/2018
U.S. dollar debt (weighted-average interest rate at September 30, 2019):*






8.4%

2019

$
752

$
5,465
2.4%

2020

4,333

4,344
2.7%

2021

8,527

5,529
2.7%

2022

6,305

3,536
3.2%

2023

2,391

2,428
3.2%

2024

5,061

2,037
6.8%

2025

624

600
3.3%

2026

4,350

1,350
4.7%

2027

969

969
6.5%

2028

313

313
3.5%

2029

3,250

—
3.7%

2030

33

32
5.9%

2032

600

600
8.0%

2038

83

83
4.5%

2039

2,745

745
4.0%

2042

1,107

1,107
7.0%

2045

27

27
4.7%

2046

650

650
4.3%

2049

3,000

—
7.1%

2096

316

316

$
45,438

$
30,131
Other currencies (weighted-average interest rate at September 30, 2019, in parentheses):*






Euros (1.3%)

2019–2031

$
15,022

$
10,011
Pound sterling (2.7%)

2020–2025

1,346

1,338
Japanese yen (0.2%)

2022–2026

1,347

1,325
Other (6.2%)

2020–2022

360

391

$
63,512

$
43,196
Less: net unamortized discount



890

802
Less: net unamortized debt issuance costs



148

76
Add: fair value adjustment**



470

337

$
62,944

$
42,656
Less: current maturities



5,147

7,051
Total



$
57,797

$
35,605

* Includes notes, debentures, bank loans, secured borrowings and finance lease obligations.

** The portion of the ~~company’s fixed-rate debt obligations that is hedged is reflected~~expected plan contributions in 2020 from the amounts disclosed in the ~~Consolidated Statement of Financial Position as an amount equal~~2019 Annual Report.

The table below includes contributions to the ~~sum~~following plans:

-
	Plan Contributions
	Three Months Ended June 30,				Six Months Ended June 30,
(Dollars in millions)	2020		2019		2020		2019
U.S. nonpension postretirement benefit plan	$	65	$	33	$	200	$	227
Non-U.S. DB and multi-employer plans		29		34		111		128
Total plan contributions	$	94	$	66	$	311	$	355

During the three months ended June 30, 2020 and 2019, $155 million and $101 million, respectively, was contributed in U.S. Treasury securities (includes the Active Medical Trust). During the six months ended June 30, 2020 and 2019, $410 million and $357 million, respectively, was contributed in U.S. Treasury securities (includes the Active Medical Trust). The contribution of ~~the debt’s carrying value and~~U.S. Treasury securities is considered a ~~fair value adjustment representing changes in the fair value of the hedged debt obligations attributable to movements in benchmark interest rates.~~

There are 0 debt securities issued and outstanding by IBM International Group Capital LLC, which is an indirect, 100 percent owned finance subsidiary of IBM, the parent. Any debt securities issued by IBM International Group Capital LLC would be fully and unconditionally guaranteed by the parent.

The company’s indenture governing its debt securities and its various credit facilities each contain significant covenants which obligate the company to promptly pay principal and interest, limit the aggregate amount of secured indebtedness and sale and leaseback transactions to 10 percent of the company’s consolidated net tangible assets, and

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

restrict the company’s ability to merge or consolidate unless certain conditions are met. The credit facilities also include a covenant on the company’s consolidated net interest expense ratio, which cannot be less than 2.20 to 1.0, as well as a cross default provision with respect to other defaulted indebtedness of at least $500 million.

The company is in compliance with all of its significant debt covenants and provides periodic certifications to its lenders. The failure to comply with its debt covenants could constitute an event of default with respect to the debt to which such provisions apply. If certain events of default were to occur, the principal and interest on the debt to which such event of default applied would become immediately due and payable.

On May 15, 2019, the company issued an aggregate of $20 billion of indebtedness in the following 8 tranches: $1.5 billion of 2-year floating rate notes priced at 3 month LIBOR plus 40 basis points, $1.5 billion of 2-year fixed rate notes with a 2.8 percent coupon, $2.75 billion of 3-year fixed rate notes with a 2.85 percent coupon, $3.0 billion of 5-year fixed rate notes with a 3.0 percent coupon, $3.0 billion of 7-year fixed rate notes with a 3.3 percent coupon, $3.25 billion of 10-year fixed rate notes with a 3.5 percent coupon, $2.0 billion of 20-year fixed rate notes with a 4.15 percent coupon and $3.0 billion of 30-year fixed rate notes with a 4.25 percent coupon. The proceeds from these debt issuances were primarily used for the acquisition of Red Hat. For additional information on this transaction, see note 11, “Acquisitions/Divestitures.”non-cash transaction.

~~Additionally, the long-term debt table above includes Euro bonds that were issued in the first quarter of 2019 to partially finance the acquisition of Red Hat upon closing.~~

~~Pre-swap annual contractual obligations of long-term debt outstanding at September 30, 2019, are as follows:~~

(Dollars in millions)

Total
2019 (for Q4)

$
1,949
2020

7,352
2021

9,741
2022

7,121
2023

5,278
2024 and beyond

32,071
Total

$
63,512

~~Interest on Debt~~18.

(Dollars in millions)






For the nine months ended September 30:

2019

2018
Cost of financing

$
483

$
568
Interest expense

990

530
Interest capitalized

5

3
Total interest paid and accrued

$
1,478

$
1,101

~~Lines of Credit~~

On July 18, 2019, the company extended the maturity date of its existing $10.25 billion Five-Year Credit Agreement. In addition, the company and IBM Credit LLC entered into a new $2.5 billion 364-day Credit Agreement to replace the existing $2.5 billion 364-day Credit Agreement, and also extended the maturity date of the existing $2.5 billion Three-Year Credit Agreement. The new maturity dates for the Three-Year and Five-Year Credit Agreements are July 20, 2022 and July 20, 2024, respectively. Each of the facility sizes remain unchanged. ~~As of September 30, 2019, there were 0 borrowings by the company, or its subsidiaries, under the Credit Facilities.~~

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

~~14.~~~~Contingencies:~~

As a company with a substantial employee population and with clients in more than 175 countries, IBM is involved, either as plaintiff or defendant, in a variety of ongoing claims, demands, suits, investigations, tax matters and proceedings that arise from time to time in the ordinary course of its business. The company is a leader in the information technology industry and, as such, has been and will continue to be subject to claims challenging its IP rights and associated products and offerings, including claims of copyright and patent infringement and violations of trade secrets and other IP rights. In addition, the company enforces its own IP against infringement, through license negotiations, lawsuits or otherwise. Also, as is typical for companies of IBM’s scope and scale, the company is party to actions and proceedings in various jurisdictions involving a wide range of labor and employment issues (including matters related to contested employment decisions, country-specific labor and employment laws, and the company’s pension, retirement and other benefit plans), as well as actions with respect to contracts, product liability, securities, foreign operations, competition law and environmental matters. These actions may be commenced by a number of different parties, including competitors, clients, current or former employees, government and regulatory agencies, stockholders and representatives of the locations in which the company does business. Some of the actions to which the company is party may involve particularly complex technical issues, and some actions may raise novel questions under the laws of the various jurisdictions in which these matters arise.

The company records a provision with respect to a claim, suit, investigation or proceeding when it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. Any recorded liabilities, including any changes to such liabilities for the quarter ended September 30, 2019 were not material to the Consolidated Financial Statements.

In accordance with the relevant accounting guidance, the company provides disclosures of matters for which the likelihood of material loss is at least reasonably possible. In addition, the company also discloses matters based on its consideration of other matters and qualitative factors, including the experience of other companies in the industry, and investor, customer and employee relations considerations.

With respect to certain of the claims, suits, investigations and proceedings discussed herein, the company believes at this time that the likelihood of any material loss is remote, given, for example, the procedural status, court rulings, and/or the strength of the company’s defenses in those matters. With respect to the remaining claims, suits, investigations and proceedings discussed in this note, except as specifically discussed herein, the company is unable to provide estimates of reasonably possible losses or range of losses, including losses in excess of amounts accrued, if any, for the following reasons. Claims, suits, investigations and proceedings are inherently uncertain, and it is not possible to predict the ultimate outcome of these matters. It is the company’s experience that damage amounts claimed in litigation against it are unreliable and unrelated to possible outcomes, and as such are not meaningful indicators of the company’s potential liability. Further, the company is unable to provide such an estimate due to a number of other factors with respect to these claims, suits, investigations and proceedings, including considerations of the procedural status of the matter in question, the presence of complex or novel legal theories, and/or the ongoing discovery and development of information important to the matters. The company reviews claims, suits, investigations and proceedings at least quarterly, and decisions are made with respect to recording or adjusting provisions and disclosing reasonably possible losses or range of losses (individually or in the aggregate), to reflect the impact and status of settlement discussions, discovery, procedural and substantive rulings, reviews by counsel and other information pertinent to a particular matter.

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

~~The following is a summary of the more significant legal matters involving the company.~~

The company is a defendant in an action filed on March 6, 2003 in state court in Salt Lake City, Utah by the SCO Group (SCO v. IBM). The company removed the case to Federal Court in Utah. Plaintiff is an alleged successor in interest to some of AT&T’s UNIX IP rights, and alleges copyright infringement, unfair competition, interference with contract and breach of contract with regard to the company’s distribution of AIX and Dynix and contribution of code to Linux and the company has asserted counterclaims. On September 14, 2007, plaintiff filed for bankruptcy protection, and all proceedings in this case were stayed. The court in another suit, the SCO Group, Inc. v. Novell, Inc., held a trial in March 2010. The jury found that Novell is the owner of UNIX and UnixWare copyrights; the judge subsequently ruled that SCO is obligated to recognize Novell’s waiver of SCO’s claims against IBM and Sequent for breach of UNIX license agreements. On August 30, 2011, the Tenth Circuit Court of Appeals affirmed the district court’s ruling and denied SCO’s appeal of this matter. In June 2013, the Federal Court in Utah granted SCO’s motion to reopen the SCO v. IBM case. In February ~~2016, the Federal Court ruled in favor of IBM on all of SCO’s remaining claims, and SCO appealed. On October 30, 2017, the Tenth Circuit Court of Appeals affirmed the dismissal of all but~~ ~~1 of SCO’s remaining claims, which was remanded to the Federal Court in Utah.~~

On May 13, 2010, IBM and the State of Indiana (acting on behalf of the Indiana Family and Social Services Administration) sued one another in a dispute over a 2006 contract regarding the modernization of social service program processing in Indiana. After six weeks of trial, on July 18, 2012, the Indiana Superior Court in Marion County rejected the State’s claims in their entirety and awarded IBM $52 million plus interest and costs. On February 13, 2014, the Indiana Court of Appeals reversed portions of the trial judge’s findings, found IBM in material breach, and ordered the case remanded to the trial judge to determine the State’s damages, if any. The Indiana Court of Appeals also affirmed approximately $50 million of the trial court’s award of damages to IBM. On March 22, 2016, the Indiana Supreme Court affirmed the outcome of the Indiana Court of Appeals and remanded the case to the Indiana Superior Court. On August 7, 2017, the Indiana Superior Court awarded the State $128 million, which it then offset against IBM’s previously affirmed award of $50 million, resulting in a $78 million award to the State, plus interest. On September 28, 2018, the Indiana Court of Appeals affirmed the Superior Court’s $78 million award to the State, but reversed the Superior Court by awarding IBM interest on its previously affirmed $50 million award. On June 26, 2019, the Indiana Supreme Court reversed the Court of Appeals regarding the time at which the award of interest to IBM began to run, but otherwise affirmed the Superior Court’s and the Court of Appeals’ awards. The sole matter remaining is the determination of the parties’ respective interest awards.

Following the 2017 final judgment of the Appeal Court in London holding that IBM UK acted lawfully in 2010 in closing its UK defined benefit plans to future accruals for most participants and in implementing a new retirement policy, the Employment Tribunal in Southampton UK is expected to address approximately 290 individual actions alleging constructive dismissal and age discrimination brought against IBM UK in 2010 by employees who left the company at that time. The individual actions were previously stayed. The parties have an agreement to settle substantially all of the cases.

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

September 29, 2017, the Court granted the defendants’ motion to dismiss the first amended complaint. On December 10, 2018, the Second Circuit Court of Appeals reversed the District Court order. On June 3, 2019, the Supreme Court of the United States granted defendants’ request to hear the case.

The company is party to, or otherwise involved in, proceedings brought by U.S. federal or state environmental agencies under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), known as “Superfund,” or laws similar to CERCLA. Such statutes require potentially responsible parties to participate in remediation activities regardless of fault or ownership of sites. The company is also conducting environmental investigations, assessments or remediations at or in the vicinity of several current or former operating sites globally pursuant to permits, administrative orders or agreements with country, state or local environmental agencies, and is involved in lawsuits and claims concerning certain current or former operating sites.

The company is also subject to ongoing tax examinations and governmental assessments in various jurisdictions. Along with many other U.S. companies doing business in Brazil, the company is involved in various challenges with Brazilian tax authorities regarding non-income tax assessments and non-income tax litigation matters. The total potential amount related to all these matters for all applicable years is approximately $900 million. The company believes it will prevail on these matters and that this amount is not a meaningful indicator of liability.

~~15.~~ ~~Commitments:~~

The company’s extended lines of credit to third-party entities include unused amounts of $3,060 million and $7,368 million at September 30, 2019 and December 31, 2018, respectively. A portion of these amounts was available to the company’s business partners to support their working capital needs. The decrease reflects the company’s wind down of its OEM IT commercial financing operations. In addition, the company has committed to provide future financing to its clients in connection with client purchase agreements for approximately $5,003 million and $4,432 million at September 30, 2019 and December 31, 2018, respectively.

The company has applied the guidance requiring a guarantor to disclose certain types of guarantees, even if the likelihood of requiring the guarantor’s performance is remote. The following is a description of arrangements in which the company is the guarantor.

The company is a party to a variety of agreements pursuant to which it may be obligated to indemnify the other party with respect to certain matters. Typically, these obligations arise in the context of contracts entered into by the company, under which the company customarily agrees to hold the party harmless against losses arising from a breach of representations and covenants related to such matters as title to the assets sold, certain intellectual property rights, specified environmental matters, third-party performance of nonfinancial contractual obligations and certain income taxes. In each of these circumstances, payment by the company is conditioned on the other party making a claim pursuant to the procedures specified in the particular contract, the procedures of which typically allow the company to challenge the other party’s claims. While typically indemnification provisions do not include a contractual maximum on the company’s payment, the company’s obligations under these agreements may be limited in terms of time and/or nature of claim, and in some instances, the company may have recourse against third parties for certain payments made by the company.

It is not possible to predict the maximum potential amount of future payments under these or similar agreements due to the conditional nature of the company’s obligations and the unique facts and circumstances involved in each particular agreement. Historically, payments made by the company under these agreements have not had a material effect on the company’s business, financial condition or results of operations.

In addition, the company guarantees certain loans and financial commitments. The maximum potential future payment under these financial guarantees was $23 million and $26 million at September 30, 2019 and December 31, 2018, respectively. The fair value of the guarantees recognized in the Consolidated Statement of Financial Position is not material.

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

~~Changes in the company’s warranty liability for standard warranties and deferred income for extended warranty are presented in the following tables.~~

~~Standard Warranty Liability~~

(Dollars in millions)

2019

2018
Balance at January 1

$
118

$
152
Current period accruals

66

84
Accrual adjustments to reflect actual experience

(1)

(31)
Charges incurred

(86)

(93)
Balance at September 30

$
98

$
112

~~Extended Warranty Liability~~

(Dollars in millions)

2019

2018
Aggregate deferred revenue at January 1

$
533

$
566
Revenue deferred for new extended warranty contracts

124

138
Amortization of deferred revenue

(194)

(178)
Other*

(8)

(12)
Aggregate deferred revenue at September 30

$
455

$
514
Current portion

$
226

$
242
Noncurrent portion

$
230

$
273

* Other primarily consists of foreign currency translation adjustments.

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

~~16.~~ ~~Earnings Per Share of Common Stock~~:

~~The following tables provide the computation of basic and diluted earnings per share of common stock for the three and nine months ended September 30, 2019 and 2018.~~

For the Three Months Ended


September 30, 2019

September 30, 2018
Number of shares on which basic earnings per share is calculated:




Weighted-average shares outstanding during period

886,018,372

911,152,848
Add — Incremental shares under stock-based compensation plans

5,368,268

2,566,139
Add — Incremental shares associated with contingently issuable shares

1,453,105

1,493,644
Number of shares on which diluted earnings per share is calculated

892,839,745

915,212,631

Income from continuing operations (millions)

$
1,673

$
2,692
Income/(loss) from discontinued operations, net of tax (millions)

(1)

2
Net income on which basic earnings per share is calculated (millions)

$
1,672

$
2,694

Income from continuing operations (millions)

$
1,673

$
2,692
Net income applicable to contingently issuable shares (millions)

—

—
Income from continuing operations on which diluted earnings per share is calculated (millions)

$
1,673

$
2,692
Income/(loss) from discontinued operations, net of tax, on which basic and diluted earnings per share is calculated (millions)

(1)

2
Net income on which diluted earnings per share is calculated (millions)

$
1,672

$
2,694

Earnings/(loss) per share of common stock:




Assuming dilution




Continuing operations

$
1.87

$
2.94
Discontinued operations

0.00

0.00
Total

$
1.87

$
2.94
Basic




Continuing operations

$
1.89

$
2.95
Discontinued operations

0.00

0.00
Total

$
1.89

$
2.95

Stock options to purchase 761,659 shares and 388,335 shares were outstanding as of September 30, 2019 and 2018, respectively, but were not included in the computation of diluted earnings per share because the options' exercise price during the respective period was greater than the average market price of the common shares, and, therefore, the effect would have been antidilutive.

~~Table of Contents~~

~~Notes to Consolidated Financial Statements — (continued)~~

For the Nine Months Ended


September 30, 2019

September 30, 2018
Number of shares on which basic earnings per share is calculated:




Weighted-average shares outstanding during period

887,291,199

915,632,501
Add — Incremental shares under stock-based compensation plans

4,007,433

3,000,429
Add — Incremental shares associated with contingently issuable shares

1,228,726

1,373,960
Number of shares on which diluted earnings per share is calculated

892,527,357

920,006,890

Income from continuing operations (millions)

$
5,766

$
6,770
Income/(loss) from discontinued operations, net of tax (millions)

(5)

7
Net income on which basic earnings per share is calculated (millions)

$
5,761

$
6,777

Income from continuing operations (millions)

$
5,766

$
6,770
Net income applicable to contingently issuable shares (millions)

0

(1)
Income from continuing operations on which diluted earnings per share is calculated (millions)

$
5,766

$
6,769
Income/(loss) from discontinued operations, net of tax, on which basic and diluted earnings per share is calculated (millions)

(5)

7
Net income on which diluted earnings per share is calculated (millions)

$
5,762

$
6,776

Earnings/(loss) per share of common stock:




Assuming dilution




Continuing operations

$
6.46

$
7.36
Discontinued operations

(0.01)

0.01
Total

$
6.45

$
7.37
Basic




Continuing operations

$
6.50

$
7.39
Discontinued operations

(0.01)

0.01
Total

$
6.49

$
7.40

Stock options to purchase 886,899 shares and 264,628 shares (average of first, second and third quarter share amounts) were outstanding as of September 30, 2019 and 2018, respectively, but were not included in the computation of diluted earnings per share because the options' exercise price during the respective period was greater than the average market price of the common shares, and, therefore, the effect would have been antidilutive.

~~17.~~ Subsequent Events:

On ~~October 29, 2019,~~July 28, 2020, the company announced that the Board of Directors approved a quarterly dividend of ~~$1.62~~$1.63 per common share. The dividend is payable ~~December~~September 10, ~~2019~~2020 to shareholders of record on ~~November 8, 2019.~~

August 10, 2020.

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Table of Contents

Item 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS

OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION

FOR THE THREE AND ~~NINE~~SIX MONTHS ENDED ~~SEPTEMBER~~JUNE 30, ~~2019~~2020

Snapshot

Financial Results Summary — Three Months Ended ~~September~~June 30:


							Yr. to Yr.								Yr. to Yr.
							Percent/								Percent/
(Dollars and shares in millions except per share amounts)							Margin								Margin
For the three months ended September 30:	2019			2018			Change**
For the three months ended June 30:									2020			2019			Change*
Revenue	$	18,028		$	18,756		(3.9)	%*	$	18,123		$	19,161		(5.4)	%**
Gross profit margin		46.2	%		46.9	%	(0.7)	pts.		48.0	%		47.0	%	1.0	pts.
Total expense and other (income)	$	6,813		$	5,807		17.3	%	$	7,129		$	6,242		14.2	%
Income from continuing operations before income taxes	$	1,522		$	2,996		(49.2)	%	$	1,571		$	2,768		(43.2)	%
Provision for/(benefit from) income taxes from continuing operations	$	(151)		$	304		nm
Provision for income taxes from continuing operations									$	209		$	269		(22.2)	%
Income from continuing operations	$	1,673		$	2,692		(37.8)	%	$	1,362		$	2,499		(45.5)	%
Income from continuing operations margin		9.3	%		14.4	%	(5.1)	pts.		7.5	%		13.0	%	(5.5)	pts.
Net income	$	1,672		$	2,694		(37.9)	%	$	1,361		$	2,498		(45.5)	%
Earnings per share from continuing operations - assuming dilution	$	1.87		$	2.94		(36.4)	%	$	1.52		$	2.81		(45.9)	%
Weighted-average shares outstanding - assuming dilution		892.8			915.2		(2.4)	%		894.9			890.8		0.5	%

*	~~(2.6) percent adjusted for currency.~~2020 results were impacted by Red Hat acquisition-related activity.

** ~~2019 results were impacted by Red Hat purchase accounting~~(3.9) percent adjusted for currency; (1.9) percent excluding divested businesses and ~~acquisition-related activity.~~adjusted for currency.

~~nm - not meaningful~~

Organization of Information:

In the first quarter of 2020, we realigned offerings and the related management system to reflect divestitures completed in the second half of 2019 and tighter integration of certain industry-specific consulting services. These changes impacted Cloud & Cognitive Software and Global Business Services but did not impact the Consolidated Financial Statements. Total recast revenue for full-year 2019 was approximately $0.3 billion of IBM’s total $77 billion. Refer to note 4, “Segments,” for additional information on our reportable segments. The periods presented in this Form 10-Q are reported on a comparable basis. We provided recast historical segment information reflecting these changes in a Form 8-K dated April 21, 2020.

On July 9, 2019, ~~the company~~IBM acquired 100 percent of the outstanding shares of Red Hat, Inc. (Red Hat). Red Hat is reported within the Cloud & Cognitive Software segment, in Cloud & Data Platforms. ~~The consolidated financial results at and as of~~Compared to the ~~three and nine months ended September 30, 2019 reflect~~prior-year period, the impacts of the acquisition on IBM; including: recognition of goodwill, intangible assets and related amortization and deferred tax liabilities, along with other purchase accounting adjustments including a deferred revenue fair value adjustment. The Consolidated Income Statement ~~of Earnings~~ for the three and ~~nine~~six months ended ~~September~~June 30, ~~2019~~2020 includes impacts from ~~these~~ purchase accounting adjustments, higher ~~interest expense, transaction-related costs~~intangible asset amortization and other acquisition-related activities. Refer to note ~~11, “Acquisitions/Divestitures”~~5, “Acquisitions & Divestitures,” for additional information.

Effective with the first quarter of 2019, the company made a number of changes to its organizational structure and management system. As a result of these changes, the company revised its reportable segments. There was no change to the company’s Consolidated Financial Statements. Refer to note 8, “Segments” for additional information on the company’s 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.

Currency:

The references to “adjusted for currency” or “at constant currency” in the Management Discussion do not include operational impacts that could result from fluctuations in foreign currency rates. When the company refers to growth rates at constant currency or adjusts such growth rates for currency, it is done so that certain financial results can be viewed without the impact of fluctuations in foreign currency exchange rates, thereby facilitating period-to-period comparisons of its business performance. Financial results adjusted for currency are calculated by translating current period activity in local currency using the comparable ~~prior year~~prior-year period’s currency conversion rate. This approach is

~~Table of Contents~~

~~Management Discussion – (continued)~~

used for countries where the functional currency is the local currency. Generally, when the dollar either strengthens or

Table of Contents

Management Discussion – (continued)

weakens against other currencies, the growth at constant currency rates or adjusting for currency will be higher or lower than growth reported at actual exchange rates. Refer to “Currency Rate Fluctuations” for additional information.

Revenue Adjusted for Divested Businesses and Constant Currency:

To provide better transparency on the recurring performance of the ongoing business, the company provides total revenue, geographic revenue and cloud revenue growth rates excluding divested businesses and at constant currency. These divested businesses are included in the ~~company’s Other segment.~~category “Other–divested businesses.”

Operating (non-GAAP) Earnings:

In an effort to provide better transparency into the operational results of the business, supplementally, the company separates business results into operating and non-operating categories. Operating earnings from continuing operations is a non-GAAP measure that excludes the effects of certain acquisition-related charges, intangible asset amortization, expense resulting from basis differences on equity method investments, retirement-related costs and discontinued operations and their related tax impacts. Due to the unique, non-recurring nature of the enactment of the U.S. Tax Cuts and Jobs Act (U.S. tax reform), ~~the company~~management characterizes the one-time provisional charge recorded in the fourth quarter of 2017 and adjustments to that charge as non-operating. Adjustments include true-ups, accounting elections, any changes to regulations, laws, audit adjustments, etc. that affect the recorded one-time charge. For acquisitions, operating (non-GAAP) earnings exclude the amortization of purchased intangible assets and acquisition-related charges such as in-process research and development, transaction costs, applicable retention, restructuring and related expenses, tax charges related to acquisition integration and pre-closing charges, such as financing costs. These charges are excluded as they may be inconsistent in amount and timing from period to period and are significantly impacted by the size, type and frequency of the company’s acquisitions. All other spending for acquired companies is included in both earnings from continuing operations and in operating (non-GAAP) earnings. Throughout the Management Discussion, the impact of acquisitions over the prior 12-month period may be a driver of higher expense year to year. For retirement-related costs, ~~the company~~management characterizes certain items as operating and others as non-operating, consistent with GAAP. The company includes defined benefit plan and nonpension postretirement benefit plan service costs, multi-employer plan costs and the cost of defined contribution plans in operating earnings. Non-operating retirement-related costs include defined benefit plan and nonpension postretirement benefit plan amortization of prior service costs, interest cost, expected return on plan assets, amortized actuarial gains/losses, the impacts of any plan curtailments/settlements and pension insolvency costs and other costs. Non-operating retirement-related costs are primarily related to changes in pension plan assets and liabilities which are tied to financial market performance, and the company considers these costs to be outside of the operational performance of the business.

Overall, ~~the company~~management believes that supplementally providing investors with a view of operating earnings as described above provides increased transparency and clarity into both the operational results of the business and the performance of the company’s pension plans; improves visibility to management decisions and their impacts on operational performance; enables better comparison to peer companies; and allows the company to provide a long-term strategic view of the business going forward. ~~The company’s~~Our reportable segment financial results reflect pre-tax operating earnings from continuing operations, consistent with ~~the company’s~~our management and measurement system. In addition, these non-GAAP measures provide a perspective consistent with areas of interest ~~the~~ ~~company~~we routinely ~~receives~~receive from investors and analysts.

6551

Table of Contents

Management Discussion – (continued)

The following table provides the company’s operating (non-GAAP) earnings for the ~~third~~second quarter of ~~2019~~2020 and ~~2018.~~2019.


					Yr. to Yr.						Yr. to Yr.
(Dollars in millions except per share amounts)					Percent						Percent
For the three months ended September 30:	2019		2018		Change**
For the three months ended June 30:							2020		2019		Change*
Net income as reported	$	1,672	$	2,694	(37.9)	%	$	1,361	$	2,498	(45.5)	%
Income/(loss) from discontinued operations, net of tax		(1)		2	nm			(1)		(1)	(26.6)
Income from continuing operations	$	1,673	$	2,692	(37.8)	%	$	1,362	$	2,499	(45.5)	%
Non-operating adjustments (net of tax):
Acquisition-related charges		586		153	281.9			365		217	68.3
Non-operating retirement-related costs/(income)		130		289	(55.1)			222		97	129.9
U.S. tax reform charges		5		—	nm			—		14	(100.0)
Operating (non-GAAP) earnings*	$	2,394	$	3,134	(23.6)	%
Diluted operating (non-GAAP) earnings per share	$	2.68	$	3.42	(21.6)	%
Operating (non-GAAP) earnings**							$	1,949	$	2,827	(31.0)	%
Diluted operating (non-GAAP) earnings per share**							$	2.18	$	3.17	(31.2)	%

*	~~Refer to page 102 for a more detailed reconciliation of net income to operating earnings.~~2020 results were impacted by Red Hat acquisition-related activity.

** ~~2019 results were impacted~~Refer to page 90 for a more detailed reconciliation of net income to operating earnings and operating earnings per share.

Environmental Dynamics

On March 11, 2020, the World Health Organization (WHO) declared the novel coronavirus (COVID-19) a global pandemic. This resulted in significant governmental measures being initiated around the globe, including travel bans and border closings, shelter-in-place orders, closures of non-essential businesses and social distancing requirements in efforts to slow down and control the spread of the virus.

The health of IBM employees, our clients, business partners and community remain our primary focus. We are actively engaged to ensure our plans and response activities continue to be aligned with recommendations of the WHO, the U.S. Centers for Disease Control and Prevention and governmental regulations.

IBM's technical and industry leaders continue to provide help to government and health agencies as they monitor and manage the outbreak. IBM's Summit supercomputer is helping researchers at the U.S. Department of Energy identify drug compounds that could disable the coronavirus. IBM's Watson Health unit is working directly with health organizations around the world to better understand the nature of COVID-19. The IBM Clinical Development system has been made available, without charge, to national health agencies to reduce the time and cost of clinical trials by ~~Red Hat purchase accounting~~providing data and ~~acquisition-related activity.~~analysis from web-enabled devices. Our cognitive Operational Risk Insight tool has also been made available to not-for-profit organizations. IBM extended its online education resources for teachers, students and parents on IBM Skills, offering them the ability to tap into new knowledge, skills and online credentials, anytime, anywhere and for free. We worked with the City of New York through delivery of 300,000 tablets with educational software and free cellular data connections to help students learn remotely.

~~nm -~~The COVID-19 pandemic is an unprecedented, global challenge and it has placed every company in uncharted waters. In this current environment, the underlying fundamentals of our business continue to remain sound:

●

IBM has always focused on the enterprise space, and within that our business is more concentrated in large enterprises, which in total have been relatively more stable throughout the pandemic;

●

Our diversification and mix by industry, geography and client segment provides some stability during these times;

●

From an industry perspective, the majority of our revenue comes from clients in financial services, telecom, and the public sector – including government and healthcare;

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Management Discussion – (continued)

●

Approximately 70 percent of our revenue comes from industries that run the world’s most critical processes, such as core banking systems, supply chains, and claims processing, and those industries have been less impacted;

●

From a geographic perspective, we are continuing to see markets experience different impacts from the pandemic over time. Our global footprint of more than 170 countries provides some natural hedge.

●

Approximately 60 percent of our annual revenue is in recurring revenue streams;

●

Our innovative technology and our industry-specific expertise are assets to our clients; and,

●

Our balance sheet remains strong with ample liquidity and access to capital, and we remain committed to our dividend to provide value to shareholders.

Our industry, geographic and client profile and our annuity base provide some level of stability, not ~~meaningful~~only in our revenue, but also in profit and cash, as we manage through these challenging times. However, while we have adapted quickly to conduct business virtually around the world, with the current macroeconomic environment, we have experienced disruptions in transactional performance and volume reductions.

The long-term economic effects of the pandemic remain unknown. However, this environment has only reinforced the need for clients to accelerate their digital transformations, with hybrid cloud and AI at the core of their reinventions. While the current environment poses certain short-term challenges, it also presents long-term opportunities that IBM will seize as our hybrid cloud and AI platforms, together with our expertise in running critical processes, ideally position us to guide clients on their journeys.

Financial Performance Summary — Three Months Ended ~~September~~June 30:

In the ~~third~~second quarter of ~~2019, the company~~2020, we reported ~~$18.0~~$18.1 billion in revenue, ~~$1.7~~$1.4 billion in income from continuing operations and operating (non-GAAP) earnings of ~~$2.4~~$1.9 billion, resulting in diluted earnings per share from continuing operations of ~~$1.87~~$1.52 as reported and ~~$2.68~~$2.18 on an operating (non-GAAP) basis. ~~The company~~We also generated $3.6 billion in cash from operations, ~~$1.8~~$2.3 billion in free cash flow and delivered shareholder returns of ~~$1.6~~$1.5 billion ~~in dividends and gross common stock repurchases. These~~through dividends. Although the external dynamics associated with the pandemic continued into the second quarter, these results reflect ~~solid~~strong performance in ~~the key high-value areas of data and AI, security,~~hybrid cloud, ~~and digital. The company continued to bring new innovations to the market, launching the new z15 mainframe and containerizing its software portfolio. The combination of IBM and~~momentum in Red Hat, ~~will help accelerate clients’ cloud journeys~~gross margin expansion and ~~Red Hat contributed to strong third-quarter revenue performance within the Cloud & Cognitive Software segment.~~solid cash generation.

Total consolidated revenue decreased 3.9 percent as reported and 3 percent adjusted for currency compared to the prior year; excluding divested businesses, revenue declined 1.9 percent as reported and 1 percent adjusted for currency. Cloud & Cognitive Software increased 6.4 percent as reported and 8 percent adjusted for currency. Cloud & Data Platforms including Red Hat grew 17.2 percent (19 percent adjusted for currency) and Cognitive Applications grew 4.5 percent (6 percent adjusted for currency); partially offset by a decline in Transaction Processing Platforms of 4.8 percent (4 percent adjusted for currency). ~~Global Business Services (GBS) increased 1.0~~5.4 percent as reported and 2 percent excluding divested businesses and adjusted for currency. Across our segments, there were impacts from transactional performance and volume reductions as clients continued to delay projects, defer purchases and favor operational expenditures over capital spending in the current environment. This slowdown in large purchases and discretionary spending was most evident in our transactional software and project-oriented services. On a segment basis, Cloud & Cognitive Software increased 3.3 percent as reported and 5 percent adjusted for ~~currency led by Consulting which~~currency. Within this segment, Cloud & Data Platforms grew ~~3.8~~28.7 percent (5(30 percent adjusted for currency) ~~driven~~as a result of the Red Hat acquisition and continued momentum, but this growth was partially offset by ~~next generation application offerings.~~declines in Cognitive Applications and Transaction Processing Platforms. We had a significant increase in the number of Red Hat large deals in the quarter and expanded Red Hat’s presence in certain underpenetrated markets. Global Business Services (GBS) decreased 7.3 percent as reported (6 percent adjusted for currency) with declines across all lines of business. Clients’ shift to focus on their operational stability and cash preservation delayed both existing projects and new commitments. Global Technology Services (GTS) decreased ~~5.6~~7.6 percent as reported (4(5 percent adjusted for currency), with declines in Infrastructure & Cloud Services and Technology Support Services. ~~While there was continued growth in services that help clients move and manage cloud workloads, overall performance~~In this segment, revenue was impacted by lower ~~in-period revenue from client business volumes.~~volumes in more challenged industries including retail, automotive, consumer goods, and travel and transportation. Systems ~~decreased 14.7~~grew 5.7 percent as reported ~~(14~~(6 percent adjusted for currency) ~~primarily reflecting the back end of the z14 product cycle.~~driven by continued strong performance in IBM Z ~~declined 20.6~~and good growth in Storage Systems.

Total cloud revenue of $6.3 billion in the second quarter of 2020 grew 30 percent ~~(20 percent adjusted for currency) year to year due to the z14 cycle with the new z15 shipments beginning the last week of September. Storage Systems decreased 5.5 percent (4~~as reported (32 percent adjusted for currency) and ~~Power Systems declined 27.5~~34 percent ~~(27 percent~~excluding divested businesses and adjusted for ~~currency) compared with strong performance in the prior year.~~

~~Total cloud revenue~~currency, an increase of ~~$5.0 billion in the third quarter~~over 10 points of ~~2019 grew 11 percent as reported and 12 percent adjusted for currency. Over the trailing 12 months, total cloud revenue was $20.0 billion, up 5 percent (8 percent adjusted for currency) year to year.~~

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Management Discussion – (continued)

growth compared to the last quarter. Over the trailing 12 months, total cloud revenue was $23.5 billion, up 20 percent as reported (22 percent adjusted for currency) and 23 percent excluding divested businesses and adjusted for currency.

From a geographic perspective, Americas revenue declined ~~3.8~~4.0 percent year to year as reported ~~(3 percent~~but was flat excluding divested businesses and adjusted for ~~currency).~~currency. Europe/Middle East/Africa (EMEA) decreased ~~6.0~~7.4 percent (2as reported (3 percent excluding divested businesses and adjusted for currency) ~~and~~. Asia Pacific declined ~~1.0~~5.4 percent year to year as reported (2(4 percent excluding divested businesses and adjusted for currency).

Total consolidated gross margin of ~~46.2~~48.0 percent ~~decreased 0.7~~increased 1.0 points year to year ~~primarily due to acquisition- related activity for~~reflecting the combination of Red Hat, ~~(including the deferred revenue adjustment, amortization of intangibles~~our focus on productivity and ~~retention costs)~~operational efficiencies and ~~from the businesses divested in the second quarter, partially offset by improvements in operating leverage.~~cloud scale-out. Operating (non-GAAP) gross margin of ~~47.4~~49.0 percent ~~was flat~~increased 1.6 points versus the prior year, primarily driven by the same ~~factors as above, excluding the amortization of intangibles.~~factors.

Total expense and other (income) increased ~~17.3~~14.2 percent in the ~~third~~second quarter of ~~2019~~2020 versus the ~~prior year primarily~~prior-year period driven by higher spending ~~including~~primarily from the addition of Red Hat, ~~investments in software~~lower gains from divestitures, higher amortization of intangible assets due to the Red Hat acquisition and ~~systems innovation, and lower intellectual income (IP) income,~~non-operating retirement-related costs, partially offset by lower ~~non-operating retirement-related costs~~workforce rebalancing charges and lower expense from divested businesses. Total operating (non-GAAP) expense and other (income) increased ~~15.9~~11.2 percent year to year, driven primarily by the factors above excluding the higher ~~spending described above.~~amortization of intangible assets and non-operating retirement-related costs.

The ~~Pre-tax~~pre-tax income from continuing operations in the second quarter of ~~$1.5~~2020 was $1.6 billion, ~~decreased 49.2 percent and~~compared to $2.8 billion in the second quarter of 2019. The pre-tax margin was ~~8.4~~8.7 percent, a decrease of ~~7.5~~5.8 points versus the prior-year period. ~~This decline~~The current year was ~~primarily driven~~impacted by ~~the purchase accounting~~Red Hat acquisition-related spending and deferred revenue ~~adjustment (lower revenue without an equivalent adjustment to cost and expense) and the acquisition-related activity.~~purchase price adjustment. The continuing operations ~~effective tax rate for~~provision from income taxes in the ~~third~~second quarter of ~~2019~~2020 was ~~(9.9) percent, a decrease of 20.1 points~~$0.2 billion compared to $0.3 billion in the ~~third~~second quarter of 2018. The year-to-year decrease was primarily driven by a benefit from the realization of a tax only capital loss in a subsidiary (10.7 points), an increase in tax benefits attributable to audit activity (4.3 points), as well as a benefit due to the mix of geographic income year to year (5.0 points), primarily driven by Red Hat.2019. Net income of ~~$1.7~~$1.4 billion decreased ~~37.9~~45.5 percent and the net income margin was ~~9.3~~7.5 percent, a decrease of ~~5.1~~5.5 points year to year.

Operating (non-GAAP) pre-tax income from continuing operations of ~~$2.4~~$2.3 billion decreased ~~33.4~~27.0 percent year to year and the operating (non-GAAP) pre-tax margin from continuing operations decreased ~~5.9~~3.8 points to ~~13.3~~12.8 percent. The operating (non-GAAP) ~~tax rate~~provision for income taxes was $0.4 billion in the ~~third~~second quarter of ~~2019 was 0.1 percent, a decrease of 12.7 points~~2020 compared to $0.3 billion in the ~~third~~second quarter of ~~2018.~~ ~~The change in the operating (non-GAAP) tax rate was primarily driven by the same factors mentioned above.~~2019. Operating (non-GAAP) income from continuing operations of ~~$2.4~~$1.9 billion decreased ~~23.6~~31.0 percent with an operating (non-GAAP) income margin from continuing operations of ~~13.3~~10.8 percent, down ~~3.4~~4.0 points year to year.

Diluted earnings per share from continuing operations of ~~$1.87~~$1.52 in the ~~third~~second quarter of ~~2019~~2020 decreased ~~36.4~~45.9 percent and operating (non-GAAP) diluted earnings per share of ~~$2.68~~$2.18 decreased ~~21.6~~31.2 percent versus the ~~third~~second quarter of 2018. In the third quarter of 2019, the company repurchased 0.8 million shares of its common stock at a cost of $0.1 billion and had $2.0 billion remaining in the current share repurchase authorization at September 30, 2019. ~~The company suspended its share repurchase program at the time of the Red Hat closing.~~

~~The company~~We generated $3.6 billion in cash flow provided by operating activities, ~~a decrease~~an increase of $0.6 billion compared to the ~~third~~second quarter of ~~2018.~~2019. In the ~~third~~second quarter of ~~2019,~~2020, investing activities were a net use of cash of ~~$30.4~~$1.2 billion compared to ~~$3.0~~a source of cash of $4.2 billion in the prior year. The $5.4 billion change year ~~primarily~~to year was driven by a decrease in cash provided by non-operating finance receivables primarily related to the wind down of the OEM IT commercial financing operations and an increase in cash used for ~~the Red Hat acquisition.~~net purchases of marketable securities. Financing activities were a use of cash of ~~$8.2~~$1.6 billion in the ~~third~~second quarter of ~~2019~~2020 compared to ~~$0.4~~a source of cash of $21.0 billion in the ~~prior year.~~prior-year period. The ~~$7.7~~$22.7 billion ~~increase in financing cash outflows~~change year to year was driven by a decrease in net cash ~~related~~sourced from debt transactions, primarily due to ~~debt transactions. In the third quarter of 2019, there was a net payment of debt of $6.6 billion versus $1.6 billion of net~~ issuances in the prior ~~year.~~

year to fund the Red Hat acquisition.

~~The company expects GAAP earnings per share from continuing operations of at least $10.58~~Given the uncertainty in the environment, and ~~continues to expect operating (non-GAAP) earnings of at least $12.80 per diluted share for 2019. The company continues to expect free cash flow to be approximately $12 billion~~consistent with our direction in ~~2019. Refer to~~ the ~~Liquidity and Capital Resources section for additional information on this non-GAAP measure.~~first quarter, we are not providing 2020 expectations. Refer to the Looking Forward section for additional ~~information on the company’s expectations.~~information.

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Management Discussion – (continued)

Financial Results Summary ~~—Nine~~—Six Months Ended ~~September~~June 30:


							Yr. to Yr.								Yr. to Yr.
							Percent/								Percent/
(Dollars and shares in millions except per share amounts)							Margin								Margin
For the nine months ended September 30:	2019			2018			Change**
For the six months ended June 30:									2020			2019			Change*
Revenue	$	55,370		$	57,830		(4.3)	%*	$	35,694		$	37,342		(4.4)	%**
Gross profit margin		45.9	%		45.4	%	0.5	pts.		46.6	%		45.7	%	0.9	pts.
Total expense and other (income)	$	19,215		$	19,341		(0.7)	%	$	15,101		$	12,402		21.8	%
Income from continuing operations before income taxes	$	6,173		$	6,908		(10.6)	%	$	1,522		$	4,651		(67.3)	%
Provision for/(benefit from) income taxes from continuing operations	$	407		$	138		195.0	%	$	(1,017)		$	558		(282.1)	%
Income from continuing operations	$	5,766		$	6,770		(14.8)	%	$	2,538		$	4,093		(38.0)	%
Income from continuing operations margin		10.4	%		11.7	%	(1.3)	pts.		7.1	%		11.0	%	(3.8)	pts.
Net income	$	5,761		$	6,777		(15.0)	%	$	2,536		$	4,089		(38.0)	%
Earnings per share from continuing operations - assuming dilution	$	6.46		$	7.36		(12.2)	%	$	2.83		$	4.58		(38.2)	%
Weighted-average shares outstanding - assuming dilution		892.5			920.0		(3.0)	%		895.0			892.4		0.3	%

	At 9/30/2019			At 12/31/2018					At 6/30/2020			At 12/31/2019
Assets	$	149,620		$	123,382		21.3	%	$	154,200		$	152,186		1.3	%
Liabilities	$	131,524		$	106,452		23.6	%	$	133,512		$	131,202		1.8	%
Equity	$	18,096		$	16,929		6.9	%	$	20,688		$	20,985		(1.4)	%

*	~~(1.7) percent adjusted for currency.~~2020 results were impacted by Red Hat acquisition-related activity.

**	~~2019 results were impacted by Red Hat purchase accounting~~(2.9) percent adjusted for currency; (0.9) percent excluding divested businesses and ~~acquisition-related activity.~~adjusted for currency.

The following table provides the company’s operating (non-GAAP) earnings for the first ~~nine~~six months of ~~2019~~2020 and ~~2018.~~2019.


					Yr. to Yr.						Yr. to Yr.
(Dollars in millions except per share amounts)					Percent						Percent
For the nine months ended September 30:	2019		2018		Change**
For the six months ended June 30:							2020		2019		Change*
Net income as reported	$	5,761	$	6,777	(15.0)	%	$	2,536	$	4,089	(38.0)	%
Income/(loss) from discontinued operations, net of tax		(5)		7	nm			(2)		(4)	(48.9)
Income from continuing operations	$	5,766	$	6,770	(14.8)	%	$	2,538	$	4,093	(38.0)	%
Non-operating adjustments (net of tax):
Acquisition-related charges		967		478	102.4			736		381	93.4
Non-operating retirement-related costs/(income)		338		900	(62.5)			472		208	127.2
U.S. tax reform charges		160		93	71.5			(149)		155	nm
Operating (non-GAAP) earnings*	$	7,230	$	8,241	(12.3)	%
Diluted operating (non-GAAP) earnings per share	$	8.10	$	8.96	(9.6)	%
Operating (non-GAAP) earnings**							$	3,598	$	4,836	(25.6)	%
Diluted operating (non-GAAP) earnings per share**							$	4.02	$	5.42	(25.8)	%

*	2020 results were impacted by Red Hat acquisition-related activity.

**	Refer to page ~~103~~91 for a more detailed reconciliation of net income to operating ~~earnings.~~

**	~~2019 results were impacted by Red Hat purchase accounting~~earnings and ~~acquisition-related activity.~~operating earnings per share.

nm - not meaningful

Financial Performance Summary ~~—Nine~~—Six Months Ended ~~September~~June 30:

In the first ~~nine~~six months of ~~2019, the company~~2020, we reported ~~$55.4~~$35.7 billion in revenue, ~~$5.8~~$2.5 billion in income from continuing operations and operating (non-GAAP) earnings of ~~$7.2~~$3.6 billion, resulting in diluted earnings per share from continuing operations of ~~$6.46~~$2.83 as reported and ~~$8.10~~$4.02 on an operating (non-GAAP) basis. ~~The company also~~We generated ~~$11.3~~$8.1 billion in cash from operations, ~~$5.9~~$3.6 billion in free cash flow and delivered shareholder returns of ~~$5.6~~$2.9 billion ~~in dividends and gross common stock repurchases.~~through dividends.

Total consolidated revenue decreased 4.4 percent as reported (1 percent excluding divested businesses and adjusted for currency). Revenue dynamics were impacted by the global pandemic beginning in March. Cloud & Cognitive

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Management Discussion – (continued)

~~Total consolidated revenue decreased~~Software increased 4.3 percent as reported ~~and 2~~(6 percent adjusted for currency compared to the prior year; excluding divested businesses, revenue declined 3.3 percent and 1 percent adjusted for currency. Cloud & Cognitive Software increased 2.7 percent as reported and 5 percent adjusted for currency.currency). Within this segment, Cloud & Data Platforms grew ~~6.7~~30.4 percent (32 percent adjusted for currency) as a result of the Red Hat acquisition and momentum, however, this growth was partially offset by declines in Cognitive Applications and Transaction Processing Platforms. GBS decreased 3.9 percent as reported and 9 percent adjusted for currency, Cognitive Applications increased 3.0 percent as reported and 5 percent adjusted for currency, while Transaction Processing Platforms declined 2.0 percent as reported but was flat adjusted for currency. GBS grew 0.5 percent as reported and 3 percent adjusted for currency led by Consulting which grew 3.8 percent (6(3 percent adjusted for currency). Within this segment Consulting was flat as reported but grew 1 percent adjusted for currencywith continued strong performance in cloud services. GTS decreased ~~6.6~~6.8 percent as reported (4(5 percent adjusted for currency), with declines in Infrastructure & Cloud Services and Technology Support Services. Systems ~~decreased 15.7~~increased 4.5 percent ~~year to year~~ as reported ~~(14~~(5 percent adjusted for currency)~~, with declines across all major business lines within the segment including~~ driven by growth in IBM Z ~~which decreased 34.7 percent (34 percent adjusted for currency) reflecting product cycle dynamics.~~ and Storage Systems.

Total cloud revenue ~~of $14.3~~was $11.6 billion in the first ~~nine~~six months of ~~2019 grew 6~~2020 with strong growth of 25 percent as reported, ~~and 9~~26 percent adjusted for currency and 29 percent excluding divested businesses and adjusted for currency.

From a geographic perspective, Americas revenue declined ~~3.6~~3.9 percent year to year as reported ~~(3 percent~~but was flat excluding divested businesses and adjusted for ~~currency).~~currency. Europe/Middle East/Africa (EMEA) decreased ~~5.7~~5.6 percent ~~(flat~~as reported (1 percent excluding divested businesses and adjusted for currency). Asia Pacific declined ~~3.5~~3.7 percent year to year as reported (2 percent excluding divested businesses and adjusted for currency).

~~The~~Total consolidated gross margin of ~~45.9~~46.6 percent increased ~~0.5~~0.9 points year to year, reflecting strong margin performance in GBS and Systems and the ~~operating~~contribution of Red Hat. Operating (non-GAAP) gross margin of ~~46.5~~47.6 percent increased ~~0.6~~1.6 points versus the prior year,. ~~The improved margins in~~ primarily driven by the first nine months of 2019 reflect the actions the company has taken to focus on higher value and portfolio optimization while also driving productivity and operational efficiency, partially offset by impacts from the Red Hat acquisition.same factors.

Total expense and other (income) ~~decreased 0.7~~increased 21.8 percent in the first ~~nine~~six months of ~~2019 compared~~2020 versus the prior-year period primarily driven by higher spending due to the ~~prior year. The year-to-year performance was driven by~~addition of Red Hat, lower gains from divestitures, amortization of intangible assets associated with the acquisition of Red Hat, higher workforce rebalancing charges, and non-operating retirement-related costs, ~~(4 points), the impact of currency (4 points) and gains from divestitures (3 points),~~ partially offset by higher spending including Red Hat (6 points), amortization of acquired intangible assets and other non-operating activity related to the Red Hat acquisition (3 points) and a decrease in IP income (2 points).lower expense from divested businesses. Total operating (non-GAAP) expense and other (income) increased ~~0.7~~18.6 percent year to year, driven primarily by the ~~same~~ factors above excluding the ~~non-operating retirement-related costs and the~~higher amortization of ~~acquired~~ intangible assets and ~~other~~ non-operating ~~activity related to the Red Hat acquisition.~~retirement-related costs.

~~Pre-tax~~The pre-tax income from continuing operations in the first six months of ~~$6.2~~2020 was $1.5 billion, ~~decreased 10.6 percent and~~compared to $4.7 billion in the first six months of 2019. The pre-tax margin was ~~11.1~~4.3 percent, a decrease of ~~0.8~~8.2 points versus ~~2018. Similar to~~ the ~~three months ended September 30, 2019, the nine month~~prior-year period. The current period was ~~also~~ impacted by ~~the deferred revenue purchase accounting adjustment and~~ Red Hat acquisition-related ~~activity.~~spending, lower gains on divestitures and also included higher workforce rebalancing charges. The continuing operations ~~effective tax rate for~~benefit from income taxes in the first ~~nine~~six months of ~~2019~~2020 was ~~6.6 percent, an increase of 4.6 points~~$1.0 billion compared to a tax provision of $0.6 billion in the first ~~nine~~six months of ~~2018.~~2019. The ~~year-to-year change~~current year benefit from income taxes was primarily driven by a ~~reduced~~net tax benefit in the first quarter of 2020 related to ~~audit activitycompared to~~an intra-entity sale of certain of the ~~prior year.~~company’s intellectual property and the related impacts. Net income of ~~$5.8~~$2.5 billion decreased ~~15.0~~38.0 percent and the net income margin was ~~10.4~~7.1 percent, ~~down 1.3~~a decrease of 3.8 points year to year.

Operating (non-GAAP) pre-tax income from continuing operations of ~~$7.8~~$3.0 billion decreased ~~10.4~~44.4 percent year to year and the operating (non-GAAP) pre-tax margin from continuing operations decreased ~~1.0 point~~6.1 points to ~~14.1~~8.4 percent. The operating (non-GAAP) ~~tax rate for~~benefit from income taxes was $0.6 billion in the first ~~nine~~six months of ~~2019 was 7.4 percent, an increase of 2.0 points~~2020, compared to a tax provision of $0.6 billion in the first ~~nine~~six months of ~~2018.~~2019. The ~~change in the~~current year operating (non-GAAP) ~~tax rate~~benefit from income taxes was primarily driven by the same ~~factors mentioned~~factor described above. Operating (non-GAAP) income from continuing operations of ~~$7.2~~$3.6 billion decreased ~~12.3~~25.6 percent with an operating (non-GAAP) income margin from continuing operations of ~~13.1~~10.1 percent, down ~~1.2~~2.9 points year to year.

Diluted earnings per share from continuing operations of ~~$6.46~~$2.83 in the first ~~nine~~six months of ~~2019~~2020 decreased ~~12.2~~38.2 percent and operating (non-GAAP) diluted earnings per share of ~~$8.10~~$4.02 decreased ~~9.6~~25.8 percent versus the first ~~nine~~six months of ~~2018. In the first nine months of 2019, the company repurchased 10.0 million shares of its common stock at a cost of $1.3 billion.~~2019.

In the second quarter, we continued to take actions to further enhance our balance sheet and liquidity position. At ~~September~~June 30, ~~2019,~~2020, the balance sheet remained strong with the flexibility to support and invest in the ~~business. Cash, restricted cash and marketable securities at quarter end were $11.0 billion,~~business, with a ~~decrease of $1.3 billion from December 31,~~strong

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Management Discussion – (continued)

~~2018. Although debt balances have increased since year-end 2018 driven by new issuances to finance the acquisition of Red Hat, the company reduced debt by $6.7 billion since~~cash position and ample credit available during these uncertain times. Cash and cash equivalents, restricted cash and marketable securities at June 30, 2020 were $14.3 billion, an increase of $5.2 billion from December 31, 2019.

Key drivers in the balance sheet and total cash flows were:

Total assets increased ~~$26.2~~$2.0 billion ($~~28.1~~4.1 billion adjusted for currency) from December 31, ~~2018~~2019 driven by:

●

~~Increases~~An increase in ~~goodwill~~cash and cash equivalents, restricted cash and marketable securities of ~~$21.7 billion and intangible assets of $12.5 billion primarily associated with the acquisition of Red Hat;~~$5.2 billion; and

●

An increase in ~~operating right-of-use~~deferred tax assets of ~~$4.9~~$3.5 billion ~~resulting from~~primarily due to an intra-entity sale of IP in the ~~adoption of the new leasing standard on January 1, 2019;~~first quarter; partially offset by

●

A decrease in ~~financing~~ receivables of ~~$11.5~~$5.7 billion primarily ~~due to the wind down~~as a result of ~~OEM IT commercial financing operations.~~collections of seasonally higher year-end balances and divestiture-related receivables, as well as sales of receivables.

Total liabilities increased ~~$25.1~~$2.3 billion ($~~26.5~~3.4 billion adjusted for currency) from December 31, ~~2018~~2019 driven by:

●

An increase in total debt of ~~$20.5~~$1.8 billion primarily driven by new debt issuances ~~to finance the Red Hat acquisition;~~of $8.6 billion, partially offset by debt maturities and early retirements of $6.4 billion; and

●

An increase in ~~operating lease~~other liabilities of ~~$5.2~~$1.1 billion ~~resulting from~~primarily driven by an increase in deferred tax liabilities related to the ~~adoption of the new leasing standard.~~first-quarter intra-entity IP sale.

Total equity of ~~$18.1~~$20.7 billion ~~increased $1.2~~decreased $0.3 billion from December 31, ~~2018~~2019 as a result of:

●

~~Increases from net income~~Dividends of ~~$5.8 billion and retirement related plans of $1.1~~$2.9 billion; partially offset by

●

~~Decreases from dividends~~Net income of ~~$4.3 billion and gross share repurchases of $1.3~~$2.5 billion.

~~The company~~We generated ~~$11.3~~$8.1 billion in cash flow provided by operating activities, an increase of ~~$0.2~~$0.4 billion compared to the first ~~nine~~six months of ~~2018, driven primarily by an increase in~~2019. This included a number of strategic actions taken to preserve cash ~~provided by financing receivables ($0.8 billion).~~and maintain a strong balance sheet and liquidity position. In the first ~~nine~~six months of ~~2019,~~2020, investing activities were a net use of cash of ~~$27.1~~$2.1 billion compared to ~~$5.4~~a source of cash of $3.3 billion in the prior year. The ~~year-to-year increase~~$5.4 billion change year to year was driven by ~~an increase in cash used for acquisitions ($32.5 billion); partially offset by an increase~~a decrease in cash provided by non-operating finance receivables ~~($5.7 billion)~~primarily related to the wind down of the OEM IT commercial financing operations and ~~a decrease~~an increase in cash used for net purchases of marketable securities and other ~~investments ($3.1 billion). In~~investments. Financing activities were a use of cash of $1.7 billion in the first ~~nine~~six months of ~~2019, financing activities were~~2020 compared to a source of cash of ~~$14.7 billion compared to a use of cash of $5.9~~$22.9 billion in the ~~first nine months of 2018.~~prior year. The ~~$20.6~~$24.6 billion ~~increase in financing cash flows~~change year to year was ~~driven by an increase in net cash sourced from debt transactions ($19.6 billion)~~ primarily driven by a decrease in net cash provided by debt transactions, with a higher level of ~~issuances~~net additions in the prior year to ~~finance~~fund the Red Hat acquisition.

Table of Contents

~~Third~~Management Discussion – (continued)

Second Quarter and First ~~Nine~~Six Months in Review

Results of Continuing Operations

Segment Details

The following is an analysis of the ~~third~~second quarter and first ~~nine~~six months of ~~2019~~2020 versus the ~~third~~second quarter and first ~~nine~~six months of ~~2018~~2019 reportable segment external revenue and gross margin results. Segment pre-tax income includes

~~Table of Contents~~

~~Management Discussion – (continued)~~

transactions between segments that are intended to reflect an arm’s-length transfer price and excludes certain unallocated corporate items.


									Yr. to Yr.										Yr. to Yr.
									Percent										Percent
							Yr. to Yr.		Change								Yr. to Yr.		Change
(Dollars in millions)							Percent/Margin		Adjusted For								Percent/Margin		Adjusted For
For the three months ended September 30:	2019			2018			Change		Currency
For the three months ended June 30:											2020			2019			Change		Currency
Revenue:
Cloud & Cognitive Software	$	5,280		$	4,962	*	6.4	%	7.8	%	$	5,748		$	5,563	*	3.3	%**	4.6	%
Gross margin		74.1	%		76.1	%*	(2.1)	pts.**				77.1	%		77.7	%*	(0.6)	pts.**
Global Business Services		4,117			4,076	*	1.0	%	2.2	%		3,890			4,197	*	(7.3)	%	(6.0)	%
Gross margin		31.1	%		30.0	%*	1.1	pts.				28.4	%		26.0	%*	2.4	pts.
Global Technology Services		6,700			7,101	*	(5.6)	%	(4.1)	%		6,316			6,837		(7.6)	%	(5.4)	%
Gross margin		35.8	%		37.0	%*	(1.2)	pts.				34.2	%		34.4	%	(0.3)	pts.
Systems		1,481			1,736		(14.7)	%	(13.8)	%		1,852			1,753		5.7	%	6.3	%
Gross margin		52.6	%		52.7	%	(0.0)	pts.				57.8	%		53.5	%	4.3	pts.
Global Financing		343			388		(11.7)	%	(10.7)	%		265			351		(24.5)	%	(22.7)	%
Gross margin		36.9	%		26.3	%	10.6	pts.				38.6	%		35.0	%	3.6	pts.
Other		107			493	*	(78.3)	%	(78.0)	%		50			460	*	(89.1)	%	(88.8)	%
Gross margin		(152.2)	%		31.8	%*	(184.0)	pts.				(338.2)	%		38.8	%*	(377.0)	pts.
Total consolidated revenue	$	18,028		$	18,756		(3.9)	%	(2.6)	%	$	18,123		$	19,161		(5.4)	%***	(3.9)	%
Total consolidated gross profit	$	8,336		$	8,803		(5.3)	%**			$	8,700		$	9,010		(3.4)	%**
Total consolidated gross margin		46.2	%		46.9	%	(0.7)	pts.				48.0	%		47.0	%	1.0	pts.**
Non-operating adjustments:
Amortization of acquired intangible assets		196			96		105.3	%				187			73		155.2	%
Acquisition-related charges		13			—		nm
Operating (non-GAAP) gross profit	$	8,545		$	8,899		(4.0)	%**			$	8,887		$	9,083		(2.2)	%**
Operating (non-GAAP) gross margin		47.4	%		47.4	%	(0.0)	pts.				49.0	%		47.4	%	1.6	pts.**

*	Recast to reflect segment changes.

**	~~2019 results were impacted by Red Hat purchase accounting and acquisition-related activity.~~

~~nm - not meaningful~~** 2020 results were impacted by Red Hat purchase accounting and acquisition-related activity.

***(1.9) percent excluding divested businesses and adjusted for currency.

7158

Table of Contents

Management Discussion – (continued)


									Yr. to Yr.										Yr. to Yr.
									Percent										Percent
							Yr. to Yr.		Change								Yr. to Yr.		Change
(Dollars in millions)							Percent/Margin		Adjusted For								Percent/Margin		Adjusted For
For the nine months ended September 30:	2019			2018			Change		Currency
For the six months ended June 30:											2020			2019			Change		Currency
Revenue:
Cloud & Cognitive Software	$	15,962		$	15,548	*	2.7	%	4.9	%	$	10,987		$	10,530	*	4.3	%**	5.6	%
Gross margin		75.5	%		76.8	%*	(1.2)	pts.				76.3	%		76.7	%*	(0.4)	pts.**
Global Business Services		12,391			12,326	*	0.5	%	3.3	%		8,027			8,353	*	(3.9)	%	(2.6)	%
Gross margin		27.8	%		26.5	%*	1.3	pts.				27.8	%		26.1	%*	1.7	pts.
Global Technology Services		20,412			21,846	*	(6.6)	%	(3.6)	%		12,783			13,711		(6.8)	%	(4.7)	%
Gross margin		34.6	%		34.3	%*	0.4	pts.				34.1	%		34.1	%	0.0	pts.
Systems		4,562			5,412		(15.7)	%	(14.1)	%		3,220			3,081		4.5	%	5.4	%
Gross margin		51.1	%		49.3	%	1.7	pts.				54.6	%		50.3	%	4.3	pts.
Global Financing		1,100			1,188		(7.4)	%	(5.0)	%		564			757		(25.4)	%	(23.9)	%
Gross margin		35.6	%		29.1	%	6.4	pts.				39.7	%		34.9	%	4.8	pts.
Other		944			1,511	*	(37.5)	%	(35.8)	%		113			911	*	(87.6)	%	(87.4)	%
Gross margin		10.8	%		36.4	%*	(25.6)	pts.				(291.7)	%		34.0	%*	(325.7)	pts.
Total consolidated revenue	$	55,370		$	57,830		(4.3)	%	(1.7)	%	$	35,694		$	37,342		(4.4)	%***	(2.9)	%
Total consolidated gross profit	$	25,388		$	26,249		(3.3)	%			$	16,622		$	17,053		(2.5)	%**
Total consolidated gross margin		45.9	%		45.4	%	0.5	pts.				46.6	%		45.7	%	0.9	pts.**
Non-operating adjustments:
Amortization of acquired intangible assets		346			283		22.2	%				375			149		151.4	%
Acquisition-related charges		13			—		nm
Operating (non-GAAP) gross profit	$	25,747		$	26,531		(3.0)	%			$	16,998		$	17,202		(1.2)	%**
Operating (non-GAAP) gross margin		46.5	%		45.9	%	0.6	pts.				47.6	%		46.1	%	1.6	pts.**

*	Recast to reflect segment changes.

** 2020 results were impacted by Red Hat purchase accounting and acquisition-related activity.

* ~~Recast to reflect segment changes.~~

~~nm - not meaningful~~**(0.9) percent excluding divested businesses and adjusted for currency.

Cloud & Cognitive Software


							Yr. to Yr.									Yr. to Yr.
							Percent									Percent
					Yr. to Yr.		Change							Yr. to Yr.		Change
(Dollars in millions)					Percent		Adjusted For							Percent		Adjusted For
For the three months ended September 30:	2019		2018*		Change		Currency**
For the three months ended June 30:									2020		2019			Change		Currency
Cloud & Cognitive Software external revenue:	$	5,280	$	4,962	6.4	%	7.8	%	$	5,748	$	5,563	*	3.3	%**	4.6	%
Cloud & Data Platforms									$	2,797	$	2,173		28.7	%**	30.3	%
Cognitive Applications	$	1,383	$	1,324	4.5	%	5.6	%		1,246		1,372	*	(9.2)		(8.0)
Cloud & Data Platforms		2,308		1,968	17.2		18.8
Transaction Processing Platforms		1,589		1,669	(4.8)		(3.5)			1,706		2,018		(15.5)		(14.4)

* Recast to reflect segment changes.

**	~~2019~~2020 results were impacted by Red Hat purchase accounting.


							Yr. to Yr.									Yr. to Yr.
							Percent									Percent
					Yr. to Yr.		Change							Yr. to Yr.		Change
(Dollars in millions)					Percent		Adjusted For							Percent		Adjusted For
For the nine months ended September 30:	2019		2018*		Change		Currency**
For the six months ended June 30:									2020		2019			Change		Currency
Cloud & Cognitive Software external revenue:	$	15,962	$	15,548	2.7	%	4.9	%	$	10,987	$	10,530	*	4.3	%**	5.6	%
Cloud & Data Platforms									$	5,333	$	4,090		30.4	%**	31.9	%
Cognitive Applications	$	4,145	$	4,023	3.0	%	4.9	%		2,428		2,609	*	(6.9)		(5.8)
Cloud & Data Platforms		6,398		5,997	6.7		9.0
Transaction Processing Platforms		5,419		5,528	(2.0)		0.4			3,226		3,830		(15.8)		(14.6)

* Recast to reflect segment changes.

** ~~2019~~2020 results were impacted by Red Hat purchase accounting.

7259

Table of Contents

Management Discussion – (continued)

Cloud & Cognitive Software revenue of ~~$5,280~~$5,748 million increased ~~6.4~~3.3 percent as reported (8(5 percent adjusted for currency) in the ~~third~~second quarter of ~~2019~~2020 compared to the prior ~~year. This growth was~~year, driven by ~~Cognitive Applications and~~growth in Cloud & Data Platforms with continued momentum in Red Hat. With the pandemic’s economic impacts beginning in March, clients began to shift their focus to their own resiliency efforts, which ~~includes Red Hat, partially offset by~~impacted our software performance. This client focus continued into the second quarter which impacted transactional revenue in the first part of the quarter. Later in the quarter, demand improved for critical priority areas such as hybrid cloud solutions and some AI applications. We had a ~~decline~~sequential quarter-to-quarter improvement in ~~Transaction Processing Platforms, as reported~~software subscription and ~~adjusted for currency.~~support renewal rates. Transactional software revenue continued to be adversely impacted, particularly in some of the more troubled industries. For the first ~~nine~~six months of the year, Cloud & Cognitive Software revenue of ~~$15,962~~$10,987 million ~~grew 2.7~~increased 4.3 percent as reported (5(6 percent adjusted for ~~currency.) There was year-to-year~~currency), with strong growth in Cloud & Data Platforms ~~driven~~ primarily byfrom the contribution ~~from~~of Red ~~Hat in~~Hat.

In the ~~third~~second quarter, ~~and Cognitive Applications, as reported and adjusted for currency. Transaction Processing~~Cloud & Data Platforms ~~decreased 2.0~~revenue of $2,797 million increased 28.7 percent as reported ~~but grew slightly adjusted for currency.~~

Cognitive Applications includes software that addresses vertical and domain-specific solutions, increasingly infused with AI. This includes areas such as health, financial services, Internet of Things (IoT) solutions, The Weather Company and security software and services. In the third quarter, Cognitive Applications revenue of $1,383 million grew 4.5 percent as reported (6(30 percent adjusted for currency) compared to the prior year, ~~driven by double-digit growth~~reflecting the synergy of bringing IBM and Red Hat together, and our continued momentum in ~~Security~~Red Hat in the quarter. We have standardized on Red Hat OpenShift as our hybrid cloud platform and modernized our software and services, and in industry verticals such as the Internet of Things (IoT). The Security performance included continued strong results in threat management software and services offerings. Within IoT, there wasportfolio to run on this platform. We had good performance across Red Hat, including improved bookings growth in countries where IBM has helped Red Hat expand go-to-market efforts over the ~~portfolio~~last year. We had further traction in Cloud Paks this quarter as clients embrace a hybrid cloud strategy and increasingly leverage the ~~business~~OpenShift container platform. The number of clients using our container platform continued to ~~invest in new offerings~~grow to over 2,400 and ~~industry-specifc solutions.~~

~~Cloud & Data Platforms includes distributed middleware and data platform software critical for orchestration and integration~~nearly 600 of ~~multicloud environments, inclusive of public and private clouds, including~~our IBM Services clients are utilizing Red Hat Enterprise Linux (RHEL) and OpenShift running on open source hybrid, multicloud platforms. This business also includes product areas such as WebSphere distributed, analytics platform software (e.g., DB2 distributed, information integration, and enterprise content management) and IoT, Blockchain and AI platforms. The company has innovated in containerizing its software and introduced CloudPaks standardizing on OpenShift as the container platform. Cloud & Data Platforms third-quartertechnology.

Cognitive Applications second-quarter revenue of ~~$2,308~~$1,246 million ~~increased 17.2~~decreased 9.2 percent as reported ~~(19 percent adjusted for currency) compared to the prior year as the company began to execute on the combined Red Hat and IBM hybrid cloud strategy.~~

Transaction Processing Platforms includes software that supports client mission critical on-premise workloads, including transaction processing software as well as analytics and integration software running on IBM operating systems. In the third quarter, Transaction Processing Platforms revenue of $1,589 million decreased 4.8 percent as reported (4(8 percent adjusted for currency) compared to the prior year. ~~Although much~~In the current economic environment, clients in some of ~~this business is annuity-based,~~ the ~~year-to-year decline~~more impacted industries, such as automotive, electronics and aerospace, deferred transformational purchases or discretionary spending to remain focused on their core operations. Our weather applications were impacted by general weakness in the ~~third~~advertising market.

Transaction Processing Platforms revenue of $1,706 million decreased 15.5 percent as reported (14 percent adjusted for currency) in the second quarter ~~revenue reflects~~compared to the ~~timing of larger~~prior year. Clients’ continued focus on operating expenditures versus new capital expenditures impacted transactions ~~that are tied to client buying cycles.~~this quarter.

Within Cloud & Cognitive Software, cloud revenue of ~~$1.1~~$1.6 billion grew 61114 percent as reported ~~(63~~(116 percent adjusted for currency) in the ~~third~~second quarter of ~~2019.~~2020. For the first ~~nine~~six months of ~~2019,~~2020, cloud revenue of ~~$2.6~~$3.0 billion grew 24100 percent as reported ~~(26~~(102 percent adjusted for currency). With Red Hat, we have developed the most secure, open hybrid cloud platform, underpinned by OpenShift, and we have modernized our Cloud Paks software solutions by bringing Red Hat and IBM technology together, providing the leading hybrid cloud platform.


							Yr. to Yr.								Yr. to Yr.
							Percent/								Percent/
(Dollars in millions)							Margin								Margin
For the three months ended September 30:	2019			2018*			Change**
For the three months ended June 30:									2020			2019*			Change**
Cloud & Cognitive Software:
External gross profit	$	3,910		$	3,778		3.5	%	$	4,432		$	4,325		2.5	%
External gross profit margin		74.1	%		76.1	%	(2.1)	pts.		77.1	%		77.7	%	(0.6)	pts.
Pre-tax income	$	1,283		$	2,050		(37.4)	%	$	1,708		$	2,007		(14.9)	%
Pre-tax margin		21.5	%		35.7	%	(14.2)	pts.		26.3	%		32.5	%	(6.2)	pts.

*	Recast to reflect segment changes.

** ~~2019~~2020 results were impacted by Red Hat purchase accounting and acquisition-related activity.

7360

Table of Contents

Management Discussion – (continued)



							Yr. to Yr.								Yr. to Yr.
							Percent/								Percent/
(Dollars in millions)							Margin								Margin
For the nine months ended September 30:	2019			2018*			Change**
For the six months ended June 30:									2020			2019*			Change**
Cloud & Cognitive Software:
External gross profit	$	12,056		$	11,936		1.0	%	$	8,384		$	8,078		3.8	%
External gross profit margin		75.5	%		76.8	%	(1.2)	pts.		76.3	%		76.7	%	(0.4)	pts.
Pre-tax income	$	5,052		$	5,760		(12.3)	%	$	2,641		$	3,792		(30.4)	%
Pre-tax margin		27.9	%		31.9	%	(4.0)	pts.		21.1	%		31.7	%	(10.6)	pts.

* Recast to reflect segment changes.

** ~~2019~~2020 results were impacted by Red Hat purchase accounting and acquisition-related activity.

Cloud & Cognitive Software gross profit margin decreased ~~2.1~~0.6 points to ~~74.1~~77.1 percent in the ~~third~~second quarter of ~~2019~~2020 compared to the prior year, driven primarily by ~~portfolio mix and~~ margin declines in software and ~~services.~~services, partially offset by portfolio mix including the addition of Red Hat software. For the first ~~nine~~six months of ~~2019,~~2020, gross profit margin decreased ~~1.2~~0.4 points to ~~75.5~~76.3 percent, primarily driven by the same factors.

In the ~~third~~second quarter, pre-tax income of ~~$1,283~~$1,708 million decreased ~~37.4~~14.9 percent compared to the prior year. The pre-tax margin decreased ~~14.2~~6.2 points to ~~21.5~~26.3 percent in the ~~third~~second quarter, driven primarily by the purchase accounting impacts from the Red Hat acquisition. For the first ~~nine~~six months of the year, pre-tax income of ~~$5,052~~$2,641 million decreased ~~12.3~~30.4 percent compared to the prior year and the pre-tax margin decreased ~~4.0~~10.6 points to ~~27.9~~21.1 percent. The year-to-year margin decline in the first ~~nine~~six months of ~~2019 as compared to the same period in 2018 reflects the acquisition of~~2020 was primarily driven by Red Hat ~~ongoing investments in key strategic areas~~acquisition-related activity and a ~~lower impact~~higher level of ~~IP partnership agreements in the first nine months of 2019.~~charges for workforce rebalancing actions.

Global Business Services


								Yr. to Yr.									Yr. to Yr.
								Percent									Percent
						Yr. to Yr.		Change							Yr. to Yr.		Change
(Dollars in millions)						Percent		Adjusted For							Percent		Adjusted For
For the three months ended September 30:	2019		2018			Change		Currency
For the three months ended June 30:										2020		2019			Change		Currency
Global Business Services external revenue:	$	4,117	$	4,076	*	1.0	%	2.2	%	$	3,890	$	4,197	*	(7.3)	%	(6.0)	%
Consulting	$	1,973	$	1,900		3.8	%	4.9	%	$	1,936	$	2,020	*	(4.2)	%	(3.1)	%
Application Management		1,897		1,915		(1.0)		0.2			1,734		1,919		(9.7)		(8.3)
Global Process Services		247		260	*	(5.1)		(3.2)			221		258		(14.1)		(12.4)

* Recast to reflect segment changes.


								Yr. to Yr.									Yr. to Yr.
								Percent									Percent
						Yr. to Yr.		Change							Yr. to Yr.		Change
(Dollars in millions)						Percent		Adjusted For							Percent		Adjusted For
For the nine months ended September 30:	2019		2018			Change		Currency
For the six months ended June 30:										2020		2019			Change		Currency
Global Business Services external revenue:	$	12,391	$	12,326	*	0.5	%	3.3	%	$	8,027	$	8,353	*	(3.9)	%	(2.6)	%
Consulting	$	5,915	$	5,698		3.8	%	6.3	%	$	4,007	$	4,021	*	(0.3)	%	0.8	%
Application Management		5,724		5,863		(2.4)		0.6			3,573		3,827		(6.6)		(5.2)
Global Process Services		752		765	*	(1.7)		1.7			447		505		(11.5)		(9.7)

* Recast to reflect segment changes.

Global Business Services revenue of ~~$4,117~~$3,890 million ~~increased 1.0~~decreased 7.3 percent as reported and 26 percent adjusted for currency in the ~~third~~second quarter of ~~2019~~2020 compared to the prior ~~year, driven primarily by strong performance in Consulting. For~~year. In the ~~first nine months of~~second quarter, as the ~~year, Global Business Services revenue of $12,391 million increased 0.5 percent as reported~~macroeconomic climate worsened, clients shifted their focus to operational stability and ~~3 percent adjusted for currency. This growth demonstrates GBS’ ability~~cash preservation. These actions delayed both the existing projects and new commitments, particularly those projects deemed discretionary or with a longer time to ~~bring together deep industry~~value.

7461

Table of Contents

Management Discussion – (continued)

~~expertise~~These delays are reflected in the decline in revenue from backlog, which represents about 80 percent of GBS quarterly revenue, and ~~technology~~smaller in-period signings. Offerings such as cloud strategy consulting, application development and modernization continued to ~~provide~~grow revenue in the second quarter. These offerings, standardized on Red Hat’s OpenShift platform, enable clients ~~a holistic approach to de-risk and orchestrate~~in their ~~digital transformation journey.~~

Incloud journeys. For the ~~third quarter, Consulting~~first six months of the year, Global Business Services revenue of $1,973 million grew 3.8 percent as reported and 5 percent adjusted for currency, driven primarily by growth in offerings that address cognitive technology, application modernization, and next-generation enterprise applications, such as S4/Hana, and Salesforce.

Application Management revenue of $1,897 million declined 1.0 percent as reported, but was flat adjusted for currency compared to the third-quarter 2018, driven primarily by growth in application modernization offerings. Cloud application offerings help clients to implement cloud-centric architectures to modernize and automate their application portfolio. As the company has been standardizing on Red Hat OpenShift as the preferred development platform, there was early progress in synergies in the quarter.

~~Global Process Services third-quarter revenue of $247~~$8,027 million decreased ~~5.1~~3.9 percent as reported and 3 percent adjusted for currency. While we are managing through the near-term macroeconomic challenges, GBS’s deep industry expertise combined with IBM and Red Hat’s innovative technology continue to play a critical role in the acceleration of clients’ digital transformations.

In the second quarter, Consulting revenue of $1,936 million declined 4.2 percent as reported and 3 percent adjusted for currency. During the second quarter, given the economic environment, clients continued to deprioritize certain projects, but we had continued strong performance in cloud services. We continued to invest in offerings and capabilities to help advise clients and move their applications to a hybrid cloud environment.

Application Management revenue of $1,734 million declined 9.7 percent as reported and 8 percent adjusted for currency compared to the second quarter of 2019. We had continued growth in offerings that assist clients as they invest in building and managing cloud applications, which was offset by a decline in the more traditional on-premise services.

Global Process Services second-quarter revenue of $221 million decreased 14.1 percent as reported and 12 percent adjusted for currency, reflecting the dynamics of the macroeconomic climate. We had continued growth in certain cognitive process automation offerings which was offset by a decline in traditional business process outsourcing.

Within GBS, cloud revenue of ~~$1.3~~$1.4 billion grew 812 percent as reported ~~(10~~(13 percent adjusted for currency) in the ~~third~~second quarter of ~~2019.~~2020. For the first ~~nine~~six months of the year, cloud revenue of ~~$3.8~~$2.7 billion grew 139 percent as reported ~~(17~~(11 percent adjusted for currency).

Yr. to Yr.

Percent/

(Dollars in millions)





Margin

For the three months ended September 30:

2019

2018*

Change

Global Business Services:







External gross profit

$
1,282

$
1,224

4.8
%
External gross profit margin

31.1
%

30.0
%
1.1
pts.
Pre-tax income

$
573

$
566

1.2
%
Pre-tax margin

13.7
%

13.6
%
0.1
pts.


							Yr. to Yr.
							Percent/
(Dollars in millions)							Margin
For the three months ended June 30:	2020			2019*			Change
Global Business Services:
External gross profit	$	1,107		$	1,093		1.3	%
External gross profit margin		28.4	%		26.0	%	2.4	pts.
Pre-tax income	$	362		$	290		25.1	%
Pre-tax margin		9.2	%		6.8	%	2.4	pts.

* Recast to reflect segment changes.


							Yr. to Yr.								Yr. to Yr.
							Percent/								Percent/
(Dollars in millions)							Margin								Margin
For the nine months ended September 30:	2019			2018*			Change
For the six months ended June 30:									2020			2019*			Change
Global Business Services:
External gross profit	$	3,439		$	3,263		5.4	%	$	2,231		$	2,180		2.4	%
External gross profit margin		27.8	%		26.5	%	1.3	pts.		27.8	%		26.1	%	1.7	pts.
Pre-tax income	$	1,188		$	1,063		11.7	%	$	633		$	587		7.8	%
Pre-tax margin		9.4	%		8.5	%	1.0	pts.		7.8	%		6.9	%	0.9	pts.

* Recast to reflect segment changes.

GBS ~~third-quarter~~second-quarter gross profit margin of ~~31.1~~28.4 percent grew ~~1.1~~2.4 points on a year-to-year basis, primarily driven by the ~~continued mix shift to higher-value offerings,~~margin expansion in Consulting. To effectively manage the ~~yield from delivery improvement, productivity,~~business in the current environment, we leveraged our variable and ~~utilization initiatives and a currency benefit from leveraging the~~ global delivery resource ~~model. Pre-tax income increased~~model, which improved price-margin realization, and optimized utilization. We also had a benefit to ~~$573 million and pre-tax~~gross margin ~~of 13.7 percent was flat year to year~~from currency in the ~~third~~second quarter, ~~of 2019 compared~~relatively consistent with recent quarters. At the same time, we continued to ~~the prior year. For the first nine months of the year, pre-tax income of $1,188 million increased 11.7 percent~~invest in building skills and ~~the pre-tax margin increased 1.0 points to 9.4 percent. The pre-tax margin for the first nine months of 2019 included a lower level of workforce rebalancing charges year to year.~~practices through education and hiring.

7562

Table of Contents

Management Discussion – (continued)

Pre-tax income of $362 million increased 25.1 percent and pre-tax margin increased 2.4 points to 9.2 percent in the second quarter of 2020 compared to the prior year, primarily driven by the margin expansion in Consulting and a lower level of charges for workforce rebalancing actions in 2020. For the first six months of the year, pre-tax income of $633 million increased 7.8 percent and the pre-tax margin increased 0.9 points to 7.8 percent, primarily driven by the gross profit margin expansion, partially offset by a higher level of charges year to year for workforce rebalancing actions which had 0.7 points of impact on the pre-tax margin.

Global Technology Services

Yr. to Yr.

Percent

Yr. to Yr.

Change

(Dollars in millions)

Percent

Adjusted For

For the three months ended September 30:

2019

2018

Change

Currency

Global Technology Services external revenue:

$
6,700

$
7,101
*
(5.6)
%
(4.1)
%
Infrastructure & Cloud Services

$
5,071

$
5,393
*
(6.0)
%
(4.5)
%
Technology Support Services

1,629

1,707

(4.6)

(3.1)


							Yr. to Yr.
							Percent
					Yr. to Yr.		Change
(Dollars in millions)					Percent		Adjusted For
For the three months ended June 30:	2020		2019		Change		Currency
Global Technology Services external revenue:	$	6,316	$	6,837	(7.6)	%	(5.4)	%
Infrastructure & Cloud Services	$	4,813	$	5,174	(7.0)	%	(5.1)	%
Technology Support Services		1,503		1,663	(9.6)		(6.4)

* Recast to reflect segment changes.

Yr. to Yr.

Percent

Yr. to Yr.

Change

(Dollars in millions)

Percent

Adjusted For

For the nine months ended September 30:

2019

2018

Change

Currency

Global Technology Services external revenue:

$
20,412

$
21,846
*
(6.6)
%
(3.6)
%
Infrastructure & Cloud Services

$
15,454

$
16,608
*
(6.9)
%
(4.0)
%
Technology Support Services

4,958

5,239

(5.4)

(2.2)


							Yr. to Yr.
							Percent
					Yr. to Yr.		Change
(Dollars in millions)					Percent		Adjusted For
For the six months ended June 30:	2020		2019		Change		Currency
Global Technology Services external revenue:	$	12,783	$	13,711	(6.8)	%	(4.7)	%
Infrastructure & Cloud Services	$	9,729	$	10,383	(6.3)	%	(4.5)	%
Technology Support Services		3,054		3,328	(8.3)		(5.5)

* Recast to reflect segment changes.

Global Technology Services revenue of ~~$6,700~~$6,316 million declined ~~5.6~~7.6 percent as reported (4(5 percent adjusted for currency) in the ~~third~~second quarter of ~~2019~~2020 compared to the prior year. ~~There was continued~~Our GTS signings in the second quarter declined 1 percent as reported, but grew 2 percent adjusted for currency. We had strong growth in ~~services that help clients move and manage workloads. However, performance~~cloud revenue which was offset by a continued decline in ~~the segment reflects lower in-period revenue from~~ client business ~~volumes~~volumes. This business has a high mix of recurring revenue streams and there is variability as we provide clients with flexibility in ~~certain markets~~their capacity to deal with volume changes due to their business needs and some multi-national clients. Although these lower volumes impact near-term revenue and profit, the business had good long-term signings and a solid pipeline of future deals that will deliver productivity to clients.macroeconomic environment. For the first ~~nine~~six months of the year, ~~Global Technology Services~~GTS revenue of ~~$20,412~~$12,783 million declined ~~6.6~~6.8 percent as reported (4(5 percent adjusted for currency). as compared to the prior-year period.

In the ~~third~~second quarter, Infrastructure & Cloud Services revenue of ~~$5,071~~$4,813 million decreased ~~6.0~~7.0 percent as reported (4(5 percent adjusted for currency) compared to the prior-year period. ~~Revenue was impacted by certain contracts that are tied to customers’ own~~As the pandemic intensified into the second quarter, we experienced lower client-based business volumes ~~which were lower year to year in certain markets~~reflecting challenges across several industries, including retail, automotive, consumer goods and some multi-national clients. Enterprises are in the initial phases of modernizing their core infrastructures to hybrid multicloud infrastructures. GTS is continuing to shift its portfolio to capture this opportunitytravel and investing in cloud capabilities, while de-emphasizing and exiting certain lower value offerings. Growth in cloud signings reflects the business’s re-alignment of its offerings across the clients’ cloud lifecycle journey of Advise, Move, Build and Manage, infusing offerings with IP and leveraging Red Hat’s capabilities. The business continues to expand its cloud availability zones and data centers. Cloud now comprises over 40 percent of the GTS outsourcing backlog. transportation.

Technology Support Services ~~third-quarter~~(TSS) second-quarter revenue of ~~$1,629~~$1,503 million decreased ~~4.6~~9.6 percent as reported (3(6 percent adjusted for currency) ~~due~~, primarily ~~to hardware cycle dynamics.~~driven by a shift away from low-margin businesses and current IBM product cycles.

7663

Table of Contents

Management Discussion – (continued)

Within GTS, cloud revenue of ~~$2.1~~$2.4 billion grew 818 percent as reported ~~(10~~(20 percent adjusted for currency) in the ~~third~~second quarter of ~~2019.~~2020. For the first ~~nine~~six months of the year, cloud revenue of ~~$6.2~~$4.7 billion grew 614 percent as reported (9(16 percent adjusted for currency).


							Yr. to Yr.
							Percent/
(Dollars in millions)							Margin
For the three months ended June 30:	2020			2019			Change
Global Technology Services:
External gross profit	$	2,158		$	2,353		(8.3)	%
External gross profit margin		34.2	%		34.4	%	(0.3)	pts.
Pre-tax income/(loss)	$	250		$	235		6.4	%
Pre-tax margin		3.8	%		3.3	%	0.5	pts.

Yr. to Yr.

Percent/

(Dollars in millions)

Margin

For the three months ended September 30:

2019

2018*

Change

Global Technology Services:








External gross profit

$
2,400

$
2,629

(8.7)
%
External gross profit margin

35.8
%

37.0
%
(1.2)
pts.
Pre-tax income

$
490

$
607

(19.2)
%
Pre-tax margin

7.0
%

8.2
%
(1.2)
pts.


							Yr. to Yr.
							Percent/
(Dollars in millions)							Margin
For the six months ended June 30:	2020			2019			Change
Global Technology Services:
External gross profit	$	4,354		$	4,670		(6.8)	%
External gross profit margin		34.1	%		34.1	%	0.0	pts.
Pre-tax income	$	72		$	510		(85.9)	%
Pre-tax margin		0.5	%		3.6	%	(3.0)	pts.

* Recast to reflect segment changes.

Yr. to Yr.

Percent/

(Dollars in millions)

Margin

For the nine months ended September 30:

2019

2018*

Change

Global Technology Services:








External gross profit

$
7,069

$
7,484

(5.5)
%
External gross profit margin

34.6
%

34.3
%
0.4
pts.
Pre-tax income

$
1,000

$
1,124

(11.0)
%
Pre-tax margin

4.7
%

5.0
%
(0.3)
pts.

* Recast to reflect segment changes.

Global Technology Services gross profit margin decreased ~~1.2~~0.3 points to ~~35.8~~34.2 percent in the ~~third~~second quarter of ~~2019. Margin decline was~~2020 as compared to the prior year, primarily driven by portfolio mix, as the ~~lower in-period client~~high-value TSS business ~~volumes in~~was impacted by the ~~quarter.~~current IBM product cycles. The ~~business has~~benefits from the first-quarter structural actions have not yet ~~realized the cost benefits~~been realized.

Pre-tax income of workforce actions taken in the second-quarter 2019, but continues to scale its Agile services delivery model and is accelerating its use of AI and automation in delivery operations, including leveraging Red Hat’s Ansible platform, which is expected to increase delivery productivity. Third-quarter pre-tax income decreased to $490$250 million increased 6.4 percent and pre-tax margin ~~decreased 1.2~~increased 0.5 points to ~~7.0~~3.8 percent in the second quarter compared to the prior year, reflecting a lower level of charges from workforce rebalancing actions in the ~~decline in gross profit margin.~~second quarter of 2020. For the first ~~nine~~six months of the year, pre-tax income ~~of $1,000~~declined to $72 million ~~decreased 11.0 percent~~ and pre-tax margin ~~of 4.7~~declined 3.0 points to 0.5 percent ~~declined 0.3 points year~~compared to ~~year,~~the same prior-year period, reflecting a higher level of charges for workforce rebalancing ~~charges year to year.~~actions in 2020, which had 2.0 points of impact on pre-tax margin.

Services Backlog and Signings

Yr. to Yr.

Percent

Yr. to Yr.

Change

Yr. to Yr.

Change

At September 30,

Percent

Adjusted For

At June 30,

Percent

Adjusted For

(Dollars in billions)

2019

2018

Change

Currency

2020

2019

Change

Currency

Total backlog

107.6

112.8

(4.7)

(2.3)

107.1

111.2

(3.7)

(0.9)

The estimated total services backlog at ~~September~~June 30, ~~2019~~2020 was ~~$107.6~~$107.1 billion, a decrease of ~~4.7~~3.7 percent as reported (2(1 percent adjusted for currency).

Total services backlog includes Infrastructure & Cloud Services, Security Services, Consulting, Global Process Services, Application Management and ~~Technology Support Services.~~TSS. Total backlog is intended to be a statement of overall work under contract which is either non-cancellable, or which historically has very low likelihood of termination, given the criticality of certain services to the company’s clients. Total backlog does not include as-a-Service arrangements that allow for termination under contractual commitment terms. Backlog estimates are subject to change

~~Table of Contents~~

~~Management Discussion – (continued)~~

and are affected by several factors, including terminations, changes in the scope of contracts, periodic revalidations, adjustments for revenue not materialized and adjustments for currency.

Table of Contents

Management Discussion – (continued)

Services signings are management’s initial estimate of the value of a client’s commitment under a services contract. There are no third-party standards or requirements governing the calculation of signings. The calculation used by management involves estimates and judgments to gauge the extent of a client’s commitment, including the type and duration of the agreement, and the presence of termination charges or wind-down costs.

Signings include Infrastructure & Cloud Services, Security Services, Consulting, Global Process Services and Application Management contracts. Contract extensions and increases in scope are treated as signings only to the extent of the incremental new value. ~~Technology Support~~Total services signings can vary over time due to a variety of factors including, but not limited to, the timing of signing a small number of larger contracts, such as in Infrastructure & Cloud Services ~~(TSS) are~~or Global Process Services. TSS is generally not included in signings as the maintenance contracts tend to be more steady state, where revenues equal renewals. Certain longer-term TSS contracts that have characteristics similar to outsourcing contracts are included in signings.

Contract portfolios purchased in an acquisition are treated as positive backlog adjustments provided those contracts meet the company’s requirements for initial signings. A new signing will be recognized if a new services agreement is signed incidental or coincidental to an acquisition or divestiture.

Management believes that the estimated values of services backlog and signings disclosed herein provide insight into our potential future revenue, which is used by management as a tool to monitor the performance of the business and viewed as useful decision-making information for investors. The conversion of signings and backlog into revenue may vary based on the types of services and solutions, customer decisions, and as well as other factors, which may include, but are not limited to, macroeconomic environment or external events.


							Yr. to Yr.
							Percent
					Yr. to Yr.		Change
(Dollars in millions)					Percent		Adjusted For
For the three months ended June 30:	2020		2019		Change		Currency
Total signings	$	8,204	$	9,687	(15.3)	%	(13.7)	%


							Yr. to Yr.								Yr. to Yr.
							Percent								Percent
					Yr. to Yr.		Change						Yr. to Yr.		Change
(Dollars in millions)					Percent		Adjusted For						Percent		Adjusted For
For the nine months ended September 30:	2019		2018		Change		Currency
For the six months ended June 30:									2020		2019		Change		Currency
Total signings	$	26,371	$	28,865	(8.6)	%	(6.0)	%	$	17,132	$	17,324	(1.1)	%	0.6	%

In the second quarter, clients continued to delay both existing projects and new commitments as the macroeconomic climate worsened. These delays were reflected in a continued decline in the smaller signings within GBS through May, however, the trajectory improved with a return to modest growth in June. In addition, GBS cloud signings grew at a double-digit rate year to year as clients prioritized their digital transformations.

~~Systems~~

Yr. to Yr.

Percent

Yr. to Yr.

Change

(Dollars in millions)

Percent

Adjusted For

For the three months ended September 30:

2019

2018

Change

Currency

Systems external revenue:

$
1,481

$
1,736

(14.7)
%
(13.8)
%
Systems Hardware

$
1,117

$
1,339

(16.6)
%
(15.8)
%
IBM Z





(20.6)

(19.9)

Power Systems





(27.5)

(26.7)

Storage Systems





(5.5)

(4.5)

Operating Systems Software

364

397

(8.1)

(7.1)

Within GTS, despite the current environment, clients continued their infrastructure transformations to hybrid multi-cloud environments, which is reflected in the double-digit signings growth in GTS in the first half of 2020 compared to the prior-year period.

7865

Table of Contents

Management Discussion – (continued)

Yr. to Yr.

Percent

Yr. to Yr.

Change

(Dollars in millions)

Percent

Adjusted For

For the nine months ended September 30:

2019

2018

Change

Currency

Systems external revenue:

$
4,562

$
5,412

(15.7)
%
(14.1)
%
Systems Hardware

$
3,358

$
4,187

(19.8)
%
(18.4)
%
IBM Z





(34.7)

(33.8)

Power Systems





(7.7)

(5.8)

Storage Systems





(14.5)

(12.9)

Operating Systems Software

1,204

1,225

(1.7)

0.5

Systems


							Yr. to Yr.
							Percent
					Yr. to Yr.		Change
(Dollars in millions)					Percent		Adjusted For
For the three months ended June 30:	2020		2019		Change		Currency
Systems external revenue:	$	1,852	$	1,753	5.7	%	6.3	%
Systems Hardware	$	1,488	$	1,328	12.0	%	12.5	%
IBM Z					68.7		68.5
Power Systems					(28.9)		(28.3)
Storage Systems					1.7		2.7
Operating Systems Software		365		425	(14.2)		(13.0)


							Yr. to Yr.
							Percent
					Yr. to Yr.		Change
(Dollars in millions)					Percent		Adjusted For
For the six months ended June 30:	2020		2019		Change		Currency
Systems external revenue:	$	3,220	$	3,081	4.5	%	5.4	%
Systems Hardware	$	2,484	$	2,241	10.8	%	11.6	%
IBM Z					65.4		65.8
Power Systems					(30.6)		(29.8)
Storage Systems					8.5		9.5
Operating Systems Software		736		840	(12.4)		(11.2)

Systems revenue of ~~$1,481~~$1,852 million ~~decreased 14.7~~increased 5.7 percent as reported ~~(14~~and 6 percent adjusted for ~~currency)~~currency in the ~~third~~second quarter of ~~2019~~2020 compared to the prior year. Systems Hardware revenue of ~~$1,117~~$1,488 million ~~decreased 16.6~~grew 12.0 percent as reported ~~(16~~and 13 percent adjusted for currency). The decline was across the product portfolio, but primarily reflects the back end of the z14 mainframe product cycle. The business continues to invest to bring new innovation across the platforms, and introduced the next generation ofcurrency, driven by continued strong performance in IBM Z and good growth in Storage Systems, partially offset by a decline in Power Systems. Clients continued to value the new innovation of the z15 mainframe and high-end storage ~~in mid-September.~~systems. Operating Systems Software revenue of ~~$364~~$365 million decreased ~~8.1~~14.2 percent as reported (7and 13 percent adjusted for ~~currency)~~currency compared to the prior year. For the first ~~nine~~six months of ~~2019,~~2020, Systems revenue of ~~$4,562~~$3,220 million ~~decreased 15.7~~increased 4.5 percent as reported ~~(14~~and 5 percent adjusted for ~~currency)~~currency compared to the ~~first nine months of 2018,~~same prior-year period, driven ~~primarily~~ by ~~IBM Z and Storage Systems. Operating Systems Software revenue decreased 1.7 percent~~the same factors as ~~reported, but increased 1 percent adjusted for currency.~~the quarter.

IBM Z revenue ~~declined 20.6~~grew 68.7 percent as reported ~~(20~~and 68 percent adjusted for ~~currency) year~~currency in the second quarter compared to the prior year, reflecting the ~~end~~continued strong performance of the ~~z14 product cycle~~z15 mainframe. The z15 offers enterprises valuable capabilities, including remote management, security and scalability. Clients increasingly turned to IBM Z for resiliency and business continuity to keep their mission-critical workloads operating smoothly. We continue to offer additional hybrid cloud capabilities on the z15 with new offerings released in the current period compared to solid growth in the third-quarter 2018. The new z15 mainframe began to ship in the last week of the quarter with a good start to the cycle. The z15 mainframe’s capabilities extend the platform’s differentiation with encryption everywhere, cloud native (with the introduction of Red Hat OpenShift) and instant recovery. The z15 will offer clients improved productivity, security and efficiency.quarter.

Power Systems revenue decreased ~~27.5~~28.9 percent as reported ~~(27~~and 28 percent adjusted for ~~currency)~~currency year to ~~year, as a result~~year. This decline reflects the product cycle, and Power Systems’ client base of ~~strong performance in~~smaller enterprises which were more severely impacted by the ~~third-quarter 2018 due to the introduction of mid-range and high-end POWER9 products and the roll-out of supercomputers to the U.S. Department of Energy labs.~~macroeconomic environment.

Storage Systems revenue ~~decreased 5.5~~grew 1.7 percent as reported (4and 3 percent adjusted for ~~currency), reflecting improvement in year-to-year performance compared to recent quarters,~~currency, primarily driven by ~~the high-end products and growth in All Flash Array. In mid-September 2019, the company introduced the next generation,~~ high-end storage ~~system DS8900 which delivers~~systems. These systems provide comprehensive ~~next-level cyber security,~~cybersecurity, data availability and ~~system~~ resiliency ~~specifically designed for~~in support of our clients’ mission-critical ~~hybrid multicloud environments.~~

In the third quarter, Operating Systems Software revenue of $364 million decreased 8.1 percent as reported (7 percent adjusted for currency) compared to the prior year. The decline was driven by a decrease in Power Systems and IBM Z operating system software.applications.

7966

Table of Contents

Management Discussion – (continued)

Within Systems, cloud revenue of ~~$0.5~~$0.8 billion ~~declined 20~~increased 22 percent as reported ~~(19 percent~~and adjusted for ~~currency)~~currency in the ~~third~~second quarter of ~~2019.~~2020. For the first ~~nine~~six months of the year, cloud revenue of ~~$1.6~~$1.3 billion ~~declined 18~~increased 17 percent as reported ~~(17~~(18 percent adjusted for currency).


							Yr. to Yr.								Yr. to Yr.
							Percent/								Percent/
(Dollars in millions)							Margin								Margin
For the three months ended September 30:	2019			2018			Change
For the three months ended June 30:									2020			2019			Change
Systems:
External Systems Hardware gross profit	$	478		$	577		(17.1)	%	$	772		$	579		33.3	%
External Systems Hardware gross profit margin		42.8	%		43.1	%	(0.2)	pts.		51.9	%		43.6	%	8.3	pts.
External Operating Systems Software gross profit	$	301		$	337		(10.7)	%	$	299		$	359		(16.5)	%
External Operating Systems Software gross profit margin		82.6	%		85.0	%	(2.4)	pts.		82.0	%		84.3	%	(2.3)	pts.
External total gross profit	$	779		$	914		(14.7)	%	$	1,071		$	937		14.2	%
External total gross profit margin		52.6	%		52.7	%	0.0	pts.		57.8	%		53.5	%	4.3	pts.
Pre-tax income	$	39		$	209		(81.3)	%	$	248		$	61		304.8	%
Pre-tax margin		2.3	%		10.9	%	(8.6)	pts.		11.8	%		3.2	%	8.7	pts.


							Yr. to Yr.								Yr. to Yr.
							Percent/								Percent/
(Dollars in millions)							Margin								Margin
For the nine months ended September 30:	2019			2018			Change
For the six months ended June 30:									2020			2019			Change
Systems:
External Systems Hardware gross profit	$	1,322		$	1,642		(19.5)	%	$	1,151		$	843		36.5	%
External Systems Hardware gross profit margin		39.4	%		39.2	%	0.1	pts.		46.3	%		37.6	%	8.7	pts.
External Operating Systems Software gross profit	$	1,008		$	1,027		(1.8)	%	$	607		$	707		(14.2)	%
External Operating Systems Software gross profit margin		83.7	%		83.9	%	(0.1)	pts.		82.5	%		84.2	%	(1.8)	pts.
External total gross profit	$	2,330		$	2,670		(12.7)	%	$	1,758		$	1,551		13.4	%
External total gross profit margin		51.1	%		49.3	%	1.7	pts.		54.6	%		50.3	%	4.3	pts.
Pre-tax income	$	(101)		$	352		nm
Pre-tax income/(loss)									$	31		$	(141)		nm
Pre-tax margin		(2.0)	%		5.9	%	(7.9)	pts.		0.9	%		(4.1)	%	5.0	pts.

nm - not meaningful

Systems gross profit margin ~~of 52.6~~increased 4.3 points to 57.8 percent ~~was flat~~ in the ~~third~~second quarter of ~~2019~~2020 compared to the prior year, ~~with~~primarily driven by a mix to IBM Z and margin expansion in ~~Power Systems~~IBM Z and Storage Systems. ~~Systems Hardware margin of 42.8 percent was flat year to year.~~ For the first ~~nine~~six months of ~~2019,~~2020, Systems gross profit margin of 54.6 percent increased ~~1.7~~4.3 points ~~to 51.1 percent~~ compared to the prior year, primarily driven by actions taken in 2018 to better position the systems cost structure over the longer term. Systems Hardware gross profit margin was flat year to year, with margin improvement in Storage Systems, offset by declines in IBM Z and Power Systems.

In the third quarter of 2019, pre-tax income of $39 million declined 81.3 percent and pre-tax margin decreased 8.6 points year to year to 2.3 percent. The pre-tax margin was impacted by portfolio mix, the z14 product cycle and investments made to bring new hardware innovation to market. For the first nine months of 2019, Systems had a pre-tax loss of $101 million compared to pre-tax income of $352 million in the first nine months of the prior year. Pre-tax margin decreased 7.9 points year to year to (2.0) percent, primarily due to the same factors as the ~~third~~ quarter.

~~Global Financing~~

Global Financing is a reportable segment that is measured as a stand-alone entity. Global Financing facilitates IBM clients’ acquisition of information technology systems, software and services by providing financing solutionsPre-tax income in the ~~areas where~~second quarter of 2020 was $248 million compared to $61 million in the ~~company has~~prior-year period and pre-tax margin of 11.8 percent increased 8.7 points year to year, primarily driven by the ~~expertise, while generating strong returns on equity. Global Financing also optimizes~~portfolio mix, the ~~recovery~~z15 product cycle and a lower level of ~~residual values~~charges for workforce rebalancing actions. For the first six months of 2020, Systems had pre-tax income of $31 million compared to a pre-tax loss of $141 million in the prior-year period. Pre-tax margin of 0.9 percent increased 5.0 points year to year. The year-to-year growth was primarily driven by ~~selling assets sourced from end~~the portfolio mix to IBM Z, partially offset by a higher level of ~~lease, leasing used equipment to new clients, or extending lease arrangements with current clients. Sales of equipment include equipment returned at the end of a lease,~~charges for workforce rebalancing actions.

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Management Discussion – (continued)

surplus internal equipment and used equipment purchased externally. Residual value is a risk unique to the financing business and management of this risk is dependent upon the ability to accurately project future equipment values at lease inception. Global Financing has insight into product plans and cycles for the IBM products under lease. Based upon this product information, Global Financing continually monitors projections of future equipment values and compares them with the residual values reflected in the portfolio.

~~Results of Operations~~


					Yr. to Yr.						Yr. to Yr.
					Percent/						Percent/
(Dollars in millions)					Margin						Margin
For the three months ended September 30:	2019		2018		Change
For the three months ended June 30:							2020		2019		Change
External revenue	$	343	$	388	(11.7)	%	$	265	$	351	(24.5)	%
Internal revenue		302		338	(10.6)			241		281	(14.3)
Total revenue	$	645	$	726	(11.2)	%	$	506	$	632	(20.0)	%
Pre-tax income	$	275	$	308	(10.8)	%	$	176	$	239	(26.2)	%


					Yr. to Yr.						Yr. to Yr.
					Percent/						Percent/
(Dollars in millions)					Margin						Margin
For the nine months ended September 30:	2019		2018		Change
For the six months ended June 30:							2020		2019		Change
External revenue	$	1,100	$	1,188	(7.4)	%	$	564	$	757	(25.4)	%
Internal revenue		884		1,240	(28.7)			452		581	(22.1)
Total revenue	$	1,983	$	2,428	(18.3)	%	$	1,017	$	1,338	(24.0)	%
Pre-tax income	$	803	$	1,042	(23.0)	%	$	370	$	527	(29.8)	%

In the ~~third~~second quarter, Global Financing total revenue of ~~$645~~$506 million declined ~~11.2~~20.0 percent compared to the prior year. ~~Internal revenue decreased 10.6 percent, driven by a decrease in internal financing (down 21.7 percent to $86 million) and internal used equipment sales (down 5.2 percent to $216 million).~~ External revenue decreased ~~11.7~~24.5 percent ~~(11~~(23 percent adjusted for currency), due to a decrease in external financing (down ~~14.6~~27.5 percent to ~~$261~~$208 million) and external used equipment sales (down ~~1.0~~11.3 percent to ~~$81~~$57 million).

The ~~decrease~~decline in ~~total revenue in the first nine months of 2019 compared~~external financing was primarily due to the ~~same period~~company’s wind down of ~~2018 was due to a decrease~~OEM IT commercial financing operations in ~~internal~~2019. Internal revenue ~~of 28.7~~decreased 14.3 percent, driven by a decrease in internal financing (down 41.1 percent to $54 million) and internal used equipment sales (down ~~36.0~~1.3 percent to ~~$593 million) and internal financing (down 7.4 percent to $291~~$186 million). ~~External~~Internal financing was down due to lower average asset balances and yields.

The decrease in total revenue ~~decreased 7.4~~of 24.0 percent (5in the first six months of 2020 compared to the same period in 2019 was due to a decrease in external revenue of 25.4 percent (24 percent adjusted for currency), driven by a decline in external financing (down 28.9 percent to $443 million) and external used equipment sales (down ~~19.9~~9.4 percent to ~~$216~~$122 million) ~~and~~. The decline in external financing ~~(down 3.7~~was primarily due to the company’s wind down of OEM IT commercial financing operations in 2019. Internal revenue decreased 22.1 percent, ~~to $884 million).~~

~~The decrease~~driven by a decline in internal financing ~~revenue in the third quarter~~(down 33.1 percent to $137 million) and ~~the first nine months of 2019 compared~~internal used equipment sales (down 16.2 percent to ~~the same periods in 2018~~$316 million). Internal financing was ~~primarily~~down due to lower average asset balances ~~partially offset by higher asset~~and yields. The decrease in external financing revenue in the third quarter and the first nine months of 2019 compared to the same periods in 2018 reflects the company’s wind down of the OEM IT commercial financing operations.

Total sales of used equipment represented 46.1 percent of Global Financing’s revenue in the third quarter of 2019 compared to 42.7 percent in the third quarter of 2018. The increase was due to declines in internal and external financing revenue. Total sales of used equipment represented 40.8 percent of Global Financing’s revenue in the first nine months of 2019 compared to 49.2 percent in the first nine months of 2018. The decrease was due to lower volumes of both internal and external used equipment sales. The gross profit margin on used sales was 56.6 percent and 50.9 percent in the third quarter of 2019 and 2018, respectively, and 54.4 percent and 56.6 percent in the first nine months of 2019 and 2018, respectively.

Global Financing pre-tax income decreased ~~10.8~~26.2 percent to ~~$275~~$176 million in the ~~third~~second quarter of ~~2019~~2020 compared to the same period in ~~2018,~~2019, primarily due to lower gross profit of ~~$45~~$68 million. Pre-tax income decreased 29.8 percent to $370 million in the first six months of 2020, compared to the same period in 2019, due to lower gross profit of $183 million, partially offset by a decrease in expense of ~~$12~~$26 million. The decline in pre-tax income in both periods was primarily driven by lower financing revenue, partially offset by a decrease in expense, which was in line with the segment’s performance.

Global Financing return on equity was 24.0 percent for the three months ended June 30, 2020, compared to 24.9 percent for the three months ended June 30, 2019. The decrease was due to a decline in net income. Return on equity was 26.5 percent for the six months ended June 30, 2020, compared to 19.2 percent for the six months ended June 30, 2019. The increase was driven by a lower average equity balance and an increase in net income, which included additional tax expense in the first quarter of 2019 related to U.S. tax reform. Refer to page 89 for the details of the after-tax income and return on equity calculation.

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Management Discussion – (continued)

million. Pre-tax income decreased 23.0 percent to $803 million in the first nine months of 2019, compared to the same period in 2018, due to lower gross profit of $344 million, partially offset by a decrease in expense of $104 million, which was driven by a decline in IBM shared expenses in line with the segment’s performance, a lower provision for credit losses and a gain from the sale of certain commercial financing capabilities in the first quarter of 2019.

Global Financing return on equity was 32.4 percent for the three months ended September 30, 2019, compared to 27.5 percent for the three months ended September 30, 2018. The increase was due to a lower average equity balance. Return on equity was 23.0 percent for the nine months ended September 30, 2019, compared to 30.5 percent for the nine months ended September 30, 2018. The decrease was driven by a decline in net income, which included higher tax expense in the first quarter of 2019 due to additional guidance issued by the U.S. Treasury regarding the U.S. tax reform repatriation tax. Refer to page 101 for the details of the after-tax income and return on equity calculation.

Geographic Revenue

In addition to the revenue presentation by reportable segment, ~~the company~~we also ~~measures~~measure revenue performance on a geographic basis.


																	Yr. to Yr.
							Yr. to Yr.								Yr. to Yr.		Percent Change
							Percent								Percent		Excluding Divested
					Yr. to Yr.		Change						Yr. to Yr.		Change		Businesses And
(Dollars in millions)					Percent		Adjusted For						Percent		Adjusted For		Adjusted For
For the three months ended September 30:	2019		2018		Change		Currency
For the three months ended June 30:									2020		2019		Change		Currency		Currency
Total Revenue	$	18,028	$	18,756	(3.9)	%	(2.6)	%	$	18,123	$	19,161	(5.4)	%	(3.9)	%	(1.9)	%
Americas	$	8,514	$	8,853	(3.8)	%	(3.4)	%	$	8,450	$	8,806	(4.0)	%	(2.4)	%	(0.1)	%
Europe/Middle East/Africa (EMEA)		5,477		5,827	(6.0)		(1.8)			5,695		6,149	(7.4)		(5.4)		(3.2)
Asia Pacific		4,036		4,076	(1.0)		(1.9)			3,977		4,205	(5.4)		(4.9)		(3.7)


																	Yr. to Yr.
							Yr. to Yr.								Yr. to Yr.		Percent Change
							Percent								Percent		Excluding Divested
					Yr. to Yr.		Change						Yr. to Yr.		Change		Businesses And
(Dollars in millions)					Percent		Adjusted For						Percent		Adjusted For		Adjusted For
For the nine months ended September 30:	2019		2018		Change		Currency
For the six months ended June 30:									2020		2019		Change		Currency		Currency
Total Revenue	$	55,370	$	57,830	(4.3)	%	(1.7)	%	$	35,694	$	37,342	(4.4)	%	(2.9)	%	(0.9)	%
Americas	$	25,813	$	26,772	(3.6)	%	(2.6)	%	$	16,617	$	17,299	(3.9)	%	(2.5)	%	(0.2)	%
Europe/Middle East/Africa (EMEA)		17,354		18,410	(5.7)		(0.3)			11,212		11,876	(5.6)		(3.3)		(1.3)
Asia Pacific		12,203		12,648	(3.5)		(1.8)			7,865		8,167	(3.7)		(3.0)		(1.8)

Total revenue of ~~$18,028~~$18,123 million decreased ~~3.9~~5.4 percent as reported (4 percent adjusted for currency) and 3decreased 2 percent excluding divested businesses and adjusted for currency in the ~~third~~second quarter compared to the prior year. Americas revenue of $8,514 million decreased 3.8 percent as reported and 3 percent adjusted for currency. EMEA revenue of $5,477 million decreased 6.0 percent as reported and 2 percent adjusted for currency. Asia Pacific revenue of $4,036 million decreased 1.0 percent as reported and 2 percent adjusted for currency.prior-year period.

Americas revenue of $8,450 million decreased 4.0 percent as reported (2 percent adjusted for currency), but was flat excluding divested businesses and adjusted for currency. Within Americas, the U.S. decreased ~~5.6~~2.8 percent as reported compared to the prior year. Canada ~~increased 7.7~~decreased 11.8 percent as reported and 9 percent adjusted for currency. Latin America decreased ~~1.2~~6.1 percent as reported, but increased 27 percent adjusted for currency, with Brazil flat as reported and up 121 percent adjusted for currency.

In EMEA, ~~Germany~~total revenue of $5,695 million decreased ~~11.9~~7.4 percent as reported (8(5 percent adjusted for currency), and decreased 3 percent excluding divested businesses and adjusted for currency. Within EMEA, the ~~U.K.~~UK decreased 21.9 percent as reported (19 percent adjusted for currency) and Germany declined ~~8.7~~10.9 percent as reported (9 percent adjusted for currency). Italy decreased 6.7 percent as reported and 5 percent adjusted for currency. France declined 0.8 percent as reported, but grew 1 percent adjusted for currency.

Asia Pacific revenue of $3,977 million decreased 5.4 percent as reported (5 percent adjusted for currency) and decreased 4 percent excluding divested businesses and adjusted for currency. Within Asia Pacific, Japan revenue was flat as reported and decreased 2 percent adjusted for currency compared to the prior year. China declined 25.9 percent as reported and 24 percent adjusted for currency. Australia decreased 8.0 percent as reported (3 percent adjusted for currency) and ~~France~~India decreased ~~7.8~~9 percent as reported (1 percent adjusted for currency).

Total revenue of $35,694 million decreased 4.4 percent as reported (3 percent adjusted for currency)~~. Italy~~ and decreased ~~3.1~~1 percent ~~as reported, but increased 2 percent~~excluding divested businesses and adjusted for ~~currency. The Middle East and Africa region decreased 6.0 percent as reported (5 percent adjusted for currency).~~currency in the first six months of 2020 compared to the prior-year period.

~~Within Asia Pacific, Japan increased 6.4 percent as reported (2 percent adjusted for currency) compared to the prior year. China~~Americas revenue of $16,617 million decreased ~~17.0 percent as reported (15 percent adjusted for currency), Australia decreased 14.2 percent as reported (8 percent adjusted for currency), and India decreased 2.9~~3.9 percent as reported (3 percent adjusted for currency).

, but was flat excluding divested businesses and adjusted for currency. Within Americas, the U.S. decreased 3.0 percent as reported compared to the prior year. Canada decreased 5.6 percent as reported and 3 percent adjusted for currency. Latin

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Management Discussion – (continued)

Total revenue of $55,370 million decreased 4.3 percent as reported and 2 percent adjusted for currency in the first nine months of 2019 compared to the prior year. Americas revenue of $25,813 million decreased 3.6 percent as reported and 3 percent adjusted for currency. EMEA revenue of $17,354 million decreased 5.7 percent as reported and was flat adjusted for currency. Asia Pacific revenue of $12,203 million decreased 3.5 percent as reported and 2 percent adjusted for currency.

~~Within Americas, the U.S. decreased 4.4 percent compared to the prior year. Canada increased 4.0 percent as reported and 7 percent adjusted for currency. Latin~~ America decreased ~~4.8~~9.0 percent as reported, but increased 12 percent adjusted for currency, with Brazil ~~down 10.0~~declining 8.0 percent as reported, ~~and 5~~but growing 8 percent adjusted for currency.

In EMEA, ~~Germany declined 9.6 percent as reported (4 percent adjusted for currency) and France~~total revenue of $11,212 million decreased ~~8.9~~5.6 percent as reported (3 percent adjusted for currency) and decreased 1 percent excluding divested businesses and adjusted for currency. Within EMEA, the UK decreased 17.1 percent as reported (15 percent adjusted for currency) and Germany declined 10.8 percent as reported (9 percent adjusted for currency). ~~The U.K.~~Italy decreased ~~3.1~~3.7 percent as reported and 1 percent adjusted for currency. France declined 0.8 percent as reported, but increased 3 percent adjusted for currency. Italy declined 2.8 percent as reported, but increased 3 percent adjusted for currency. The Middle East and Africa region decreased 5.5 percent as reported and 3grew 1 percent adjusted for currency.

~~Within~~ Asia Pacific ~~Japan increased 3.4~~revenue of $7,865 million decreased 3.7 percent as reported (3 percent adjusted for currency) and decreased 2 percent excluding divested businesses and adjusted for currency. Within Asia Pacific, Japan increased 1.1 percent as reported, but decreased 1 percent adjusted for currency compared to the prior year. China decreased ~~14.1~~15.8 percent as reported ~~(11~~(14 percent adjusted for currency), and Australia ~~declined 15.7~~decreased 11.9 percent as reported ~~(9 percent adjusted for currency), and India decreased 9.1 percent as reported (5~~(6 percent adjusted for currency). India declined 1.8 percent as reported, but grew 4 percent adjusted for currency.

Expense

Total Expense and Other (Income)


							Yr. to Yr.								Yr. to Yr.
(Dollars in millions)							Percent								Percent
For the three months ended September 30:	2019			2018			Change*
For the three months ended June 30:									2020			2019			Change*
Total consolidated expense and other (income)	$	6,813		$	5,807		17.3	%	$	7,129		$	6,242		14.2	%
Non-operating adjustments:
Amortization of acquired intangible assets	$	(277)		$	(112)		147.9	%	$	(284)		$	(96)		196.3	%
Acquisition-related charges		(241)			(2)		nm			(1)			(102)		(98.7)
Non-operating retirement-related (costs)/income		(145)			(389)		(62.6)			(273)			(136)		100.6
Operating (non-GAAP) expense and other (income)	$	6,150		$	5,304		15.9	%	$	6,570		$	5,907		11.2	%
Total consolidated expense-to-revenue ratio		37.8	%		31.0	%	6.8	pts.		39.3	%		32.6	%	6.8	pts.
Operating (non-GAAP) expense-to-revenue ratio		34.1	%		28.3	%	5.8	pts.		36.3	%		30.8	%	5.4	pts.

* ~~2019~~2020 results were impacted by Red Hat ~~purchase accounting and~~ acquisition-related activity.

~~nm - not meaningful~~


							Yr. to Yr.								Yr. to Yr.
(Dollars in millions)							Percent								Percent
For the nine months ended September 30:	2019			2018			Change*
For the six months ended June 30:									2020			2019			Change*
Total consolidated expense and other (income)	$	19,215		$	19,341		(0.7)	%	$	15,101		$	12,402		21.8	%
Non-operating adjustments:
Amortization of acquired intangible assets	$	(470)		$	(331)		42.2	%	$	(569)		$	(194)		194.2	%
Acquisition-related charges		(383)			(3)		nm			(2)			(141)		(98.8)
Non-operating retirement-related (costs)/income		(419)			(1,185)		(64.6)			(538)			(274)		96.3
Operating (non-GAAP) expense and other (income)	$	17,942		$	17,822		0.7	%	$	13,992		$	11,793		18.6	%
Total consolidated expense-to-revenue ratio		34.7	%		33.4	%	1.3	pts.		42.3	%		33.2	%	9.1	pts.
Operating (non-GAAP) expense-to-revenue ratio		32.4	%		30.8	%	1.6	pts.		39.2	%		31.6	%	7.6	pts.

* ~~2019~~2020 results were impacted by Red Hat ~~purchase accounting and~~ acquisition-related activity.

~~nm - not meaningful~~

The ~~following~~ current-year periods included Red ~~Hat-related expenses are included in~~Hat operational spending and amortization of acquired intangible assets associated with the ~~current period,~~acquisition with no corresponding expense in the prior-year ~~periods:~~periods. The current-year periods also included higher interest expense associated with the funding of the Red Hat ~~operational~~acquisition.

Total expense and other (income) increased 14.2 percent in the second quarter of 2020 versus the prior year primarily driven by higher spending ~~interest~~including Red Hat, lower gains from divestitures, higher amortization of acquired intangible assets associated with the Red Hat transaction and higher non-operating retirement-related costs, partially offset by lower workforce rebalancing charges and lower expense from ~~debt issuances to fund the acquisition and other~~divested businesses. Total operating (non-

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Management Discussion – (continued)

~~acquisition-related activity, including: amortization of acquired intangible assets, retention and legal and advisory fees associated with the transaction.~~

~~Total~~GAAP) expense and other (income) increased 17.3 percent in the third quarter of 2019 versus the prior year primarily driven by higher spending including Red Hat, investments in software and systems innovation, and lower IP income, partially offset by lower non-operating retirement-related costs and divested businesses. ~~Total operating (non-GAAP) expense and other (income) increased 15.9~~11.2 percent year to year, driven primarily by the factors described above excluding the higher ~~spending described above.~~amortization of acquired intangible assets and higher non-operating retirement-related costs.

For additional information regarding total expense and other (income) for both expense presentations, see the following analyses by category.

Selling, General and Administrative Expense

Yr. to Yr.

(Dollars in millions)

Percent

For the three months ended September 30:

2019

2018

Change

Selling, general and administrative expense:







Selling, general and administrative — other

$
4,183

$
3,805

9.9
%
Advertising and promotional expense

381

323

18.1

Workforce rebalancing charges

24

26

(8.8)

Amortization of acquired intangible assets

276

110

150.0

Stock-based compensation

147

95

54.0

Bad debt expense

14

4

273.0

Total consolidated selling, general and administrative expense

$
5,024

$
4,363

15.1
%
Non-operating adjustments:







Amortization of acquired intangible assets

$
(276)

$
(110)

150.0
%
Acquisition-related charges

(175)

(2)

nm

Operating (non-GAAP) selling, general and administrative expense

$
4,573

$
4,251

7.6
%


					Yr. to Yr.
(Dollars in millions)					Percent
For the three months ended June 30:	2020		2019		Change
Selling, general and administrative expense:
Selling, general and administrative — other	$	4,239	$	4,335	(2.2)	%
Advertising and promotional expense		363		421	(13.8)
Workforce rebalancing charges		137		495	(72.4)
Amortization of acquired intangible assets		284		95	197.6
Stock-based compensation		155		93	67.5
Expected credit loss expense		70		17	303.6
Total consolidated selling, general and administrative expense	$	5,248	$	5,456	(3.8)	%
Non-operating adjustments:
Amortization of acquired intangible assets	$	(284)	$	(95)	197.6	%
Acquisition-related charges		(1)		(54)	(97.5)
Operating (non-GAAP) selling, general and administrative expense	$	4,962	$	5,307	(6.5)	%

~~nm — not meaningful~~

Yr. to Yr.

(Dollars in millions)

Percent

For the nine months ended September 30:

2019

2018

Change

Selling, general and administrative expense:







Selling, general and administrative — other

$
12,566

$
12,295

2.2
%
Advertising and promotional expense

1,234

1,131

9.1

Workforce rebalancing charges

538

590

(8.7)

Amortization of acquired intangible assets

468

329

42.2

Stock-based compensation

313

264

18.8

Bad debt expense

51

56

(10.0)

Total consolidated selling, general and administrative expense

$
15,171

$
14,665

3.5
%
Non-operating adjustments:







Amortization of acquired intangible assets

$
(468)

$
(329)

42.2
%
Acquisition-related charges

(256)

(3)

nm

Operating (non-GAAP) selling, general and administrative expense

$
14,447

$
14,333

0.8
%


					Yr. to Yr.
(Dollars in millions)					Percent
For the six months ended June 30:	2020		2019		Change
Selling, general and administrative expense:
Selling, general and administrative — other	$	8,580	$	8,383	2.3	%
Advertising and promotional expense		791		853	(7.3)
Workforce rebalancing charges		865		514	68.2
Amortization of acquired intangible assets		568		192	195.4
Stock-based compensation		272		167	63.0
Expected credit loss expense		126		37	242.8
Total consolidated selling, general and administrative expense	$	11,203	$	10,147	10.4	%
Non-operating adjustments:
Amortization of acquired intangible assets	$	(568)	$	(192)	195.4	%
Acquisition-related charges		(2)		(81)	(97.9)
Operating (non-GAAP) selling, general and administrative expense	$	10,633	$	9,873	7.7	%

~~nm — not meaningful~~

Total selling, general and administrative (SG&A) expense ~~increased 15.1~~decreased 3.8 percent in the ~~third~~second quarter of ~~2019~~2020 versus the prior year driven primarily by the following factors:

●

Lower workforce rebalancing charges (7 points);

●

The effects of currency (1 point); and

●

Lower acquisition-related charges associated with the Red Hat transaction (1 point); partially offset by

●

Higher amortization of acquired intangible assets associated with the Red Hat transaction (3 points); and

8471

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Management Discussion – (continued)

●

Higher spending (8(2 points) driven by Red Hat expense in the current year with no spending ~~(10 points); and~~

●

~~Higher acquisition-related charges and amortization of acquired intangible assets associated with~~in the ~~Red Hat transaction (8 points); partially offset by~~

●

~~The effects of currency (2~~prior year (10 points).

Operating (non-GAAP) expense ~~increased 7.6~~decreased 6.5 percent year to year primarily driven by the same factors excluding the acquisition-related charges and amortization of acquired intangible assets associated with the Red Hat transaction.

SG&A expense increased ~~3.5~~10.4 percent in the first ~~nine~~six months of ~~2019~~2020 versus the prior year driven primarily by ~~the~~ the following factors:

●

Higher spending (4 points) driven by Red Hat spending (3(11 points); and

●

Higher ~~acquisition-related charges and~~ amortization of acquired intangible assets associated with the Red Hat transaction (2(4 points); and

●

Higher workforce rebalancing charges (3 points); partially offset by

●

The effects of currency ~~(2 points)~~(1 point); and

●

Lower acquisition-related charges associated with the Red Hat transaction (1 point).

Operating (non-GAAP) expense increased ~~0.8~~7.7 percent year to year, primarily driven by the same factors excluding the acquisition-related charges and amortization of acquired intangible assets associated with the Red Hat transaction.

~~Bad debt~~Expected credit loss expense ~~decreased $6~~increased $90 million year to year in the first ~~nine~~six months of ~~2019.~~2020 due to increases in specific and unallocated reserves. The receivables provision coverage was ~~1.9~~2.4 percent at ~~September~~June 30, ~~2019,~~2020, an increase of 3070 basis points from both December 31, ~~2018~~2019 and ~~unchanged from September~~June 30, ~~2018.~~2019. The higher coverage rate at June 30, 2020 also reflects the adoption of the new guidance for credit losses.

Research, Development and Engineering

Yr. to Yr.

(Dollars in millions)

Percent

For the three months ended September 30:

2019

2018

Change

Research, development and engineering expense

$
1,553

$
1,252

24.1
%
Non-operating adjustment:







Acquisition-related charges

$
(53)

$
—

nm

Operating (non-GAAP) research, development and engineering expense

$
1,500

$
1,252

19.8
%


					Yr. to Yr.
(Dollars in millions)					Percent
For the three months ended June 30:	2020		2019		Change
Research, development and engineering expense	$	1,582	$	1,407	12.5	%
Non-operating adjustment:
Acquisition-related charges	$	—	$	—	—
Operating (non-GAAP) research, development and engineering expense	$	1,582	$	1,407	12.5	%

~~nm — not meaningful~~

Yr. to Yr.

(Dollars in millions)

Percent

For the nine months ended September 30:

2019

2018

Change

Research, development and engineering expense

$
4,393

$
4,021

9.3
%
Non-operating adjustment:







Acquisition-related charges

$
(53)

$
—

nm

Operating (non-GAAP) research, development and engineering expense

$
4,340

$
4,021

7.9
%


					Yr. to Yr.
(Dollars in millions)					Percent
For the six months ended June 30:	2020		2019		Change
Research, development and engineering expense	$	3,207	$	2,840	12.9	%
Non-operating adjustment:
Acquisition-related charges	$	—	$	—	—
Operating (non-GAAP) research, development and engineering expense	$	3,207	$	2,840	12.9	%

~~nm — not meaningful~~

Research, development and engineering (RD&E) expense was 8.7 percent and 9.0 percent of revenue in the second quarter and first six months of 2020, respectively, compared to 7.3 percent and 7.6 percent in the prior-year periods, respectively.

RD&E expense in the second quarter of 2020 increased 12.5 percent year to year primarily driven by:

●

Higher spending (13 points) including Red Hat spending (16 points); partially offset by

8572

Table of Contents

Management Discussion – (continued)

●

The effects of currency (1 point).

Research, development and engineering (RD&E) expense was 8.6 percent and 7.9 percent of revenue in the third quarter and first nine months of 2019, respectively, compared to 6.7 percent and 7.0 percent in the prior-year periods, respectively.

RD&E expense in the ~~third quarter~~first six months of ~~2019~~2020 increased ~~24.1~~12.9 percent year to year primarily driven by:

●

Higher spending ~~(21~~(13 points) including Red Hat spending (16 ~~points); and~~

●

~~Higher acquisition-related charges associated with the Red Hat transaction (4~~ points); partially offset by

●

The effects of currency (1 point).

~~Operating (non-GAAP) expense increased 19.8 percent year to year primarily driven by the same factors excluding~~ ~~acquisition-related charges associated with the Red Hat transaction.~~

~~RD&E expense in the first nine months of 2019 increased 9.3 percent year to year primarily driven by:~~

●

~~Higher spending (9 points) including investment in the z15 and Red Hat spending in the third quarter (5 points); and~~

●

~~Higher acquisition-related charges associated with the Red Hat transaction (1 point); partially offset by~~

●

~~The effects of currency (1 point).~~

~~Operating (non-GAAP) expense increased 7.9 percent year to year primarily driven by the same factors excluding acquisition-related charges associated with the Red Hat transaction.~~

Intellectual Property and Custom Development Income


					Yr. to Yr.						Yr. to Yr.
(Dollars in millions)					Percent						Percent
For the three months ended September 30:	2019		2018		Change
For the three months ended June 30:							2020		2019		Change
Intellectual Property and Custom Development Income:
Licensing of intellectual property including royalty-based fees	$	93	$	200	(53.6)	%	$	128	$	144	(11.1)	%
Custom development income		62		66	(7.4)			74		62	18.8
Sales/other transfers of intellectual property		11		8	32.7			1		16	(92.0)
Total	$	166	$	275	(39.8)	%	$	203	$	222	(8.7)	%


					Yr. to Yr.						Yr. to Yr.
(Dollars in millions)					Percent						Percent
For the nine months ended September 30:	2019		2018		Change
For the six months ended June 30:							2020		2019		Change
Intellectual Property and Custom Development Income:
Licensing of intellectual property including royalty-based fees	$	287	$	630	(54.5)	%	$	162	$	194	(16.6)	%
Custom development income		174		200	(12.9)			149		113	32.5
Sales/other transfers of intellectual property		28		12	121.6			8		17	(52.8)
Total	$	489	$	842	(42.0)	%	$	319	$	323	(1.3)	%

~~Licensing~~ Total intellectual property and custom development income decreased 8.7 percent and 1.3 percent year to year in the second quarter and first six months of 2020, respectively. This was primarily driven by a decrease in licensing of intellectual property including royalty-based fees, ~~decreased 53.6 percent and 54.5 percent~~partially offset by custom development income which grew year to year driven by new agreements in the ~~third quarter and first~~ ~~nine months of 2019, respectively. This was primarily due to a decline in new partnership agreements compared to the third quarter and first nine months of 2018.~~current-year periods. The timing and amount of licensing, sales or other transfers of IP may vary significantly from period to period depending upon the timing of licensing agreements, economic conditions, industry consolidation and the timing of new patents and know-how development.

8673

Table of Contents

Management Discussion – (continued)

Other (Income) and Expense


					Yr. to Yr.						Yr. to Yr.
(Dollars in millions)					Percent						Percent
For the three months ended September 30:	2019		2018		Change
For the three months ended June 30:							2020		2019		Change
Other (income) and expense:
Foreign currency transaction losses/(gains)	$	(597)	$	(76)	689.5	%	$	62	$	172	(63.8)	%
(Gains)/losses on derivative instruments		561		63	790.3			(92)		(271)	(66.2)
Interest income		(63)		(70)	(9.3)			(23)		(167)	(86.2)
Net (gains)/losses from securities and investment assets		(3)		(8)	(69.5)			0		(19)	nm
Retirement-related costs/(income)		145		389	(62.6)			273		136	100.6
Other		(74)		(23)	222.3			(43)		(597)	(92.9)
Total consolidated other (income) and expense	$	(31)	$	275	nm		$	179	$	(747)	nm
Non-operating adjustments:
Amortization of acquired intangible assets	$	(1)	$	(1)	(50.0)	%	$	(1)	$	(1)	—
Acquisition-related charges		10		—	nm			—		120	(100.0)	%
Non-operating retirement-related (costs)/income		(145)		(389)	(62.6)			(273)		(136)	100.6
Operating (non-GAAP) other (income) and expense	$	(166)	$	(115)	44.6	%	$	(95)	$	(764)	(87.5)	%

nm - not meaningful


					Yr. to Yr.						Yr. to Yr.
(Dollars in millions)					Percent						Percent
For the nine months ended September 30:	2019		2018		Change
For the six months ended June 30:							2020		2019		Change
Other (income) and expense:
Foreign currency transaction losses/(gains)	$	(598)	$	(349)	71.3	%	$	(64)	$	(1)	nm
(Gains)/losses on derivative instruments		358		449	(20.2)			9		(202)	nm
Interest income		(301)		(187)	61.0			(74)		(238)	(68.8)	%
Net (gains)/losses from securities and investment assets		(26)		(89)	(71.3)			(5)		(23)	(77.9)
Retirement-related costs/(income)		419		1,185	(64.6)			538		274	96.3
Other		(703)		(42)	nm			(42)		(630)	(93.3)
Total consolidated other (income) and expense	$	(850)	$	968	nm		$	361	$	(820)	nm
Non-operating adjustments:
Amortization of acquired intangible assets	$	(2)	$	(1)	50.0	%	$	(1)	$	(1)	—
Acquisition-related charges		154		—	nm			—		144	(100.0)	%
Non-operating retirement-related (costs)/income		(419)		(1,185)	(64.6)			(538)		(274)	96.3
Operating (non-GAAP) other (income) and expense	$	(1,118)	$	(219)	410.6	%	$	(178)	$	(951)	(81.3)	%

nm - not meaningful

Total consolidated other (income) and expense was ~~income~~expense of ~~$31~~$179 million in the ~~third~~second quarter of ~~2019~~2020 compared to income of $747 million in the prior-year period. The year-to-year change was primarily driven by:

●

Lower gains from divestitures reflected in other ($554 million);

●

Lower interest income ($144 million) due to lower average cash balances and interest rates in the current year; and

●

Higher non-operating retirement-related costs ($137 million). Refer to “Retirement-Related Plans” for additional information.

Table of Contents

Management Discussion – (continued)

Operating (non-GAAP) other (income) and expense was $95 million of income in the second quarter of 2020 and decreased $669 million compared to the prior-year period. The year-to-year change was driven primarily by the lower gains from divestitures described above and the effects of currency.

Total consolidated other (income) and expense was expense of ~~$275~~$361 million in the first six months of 2020 compared to income of $820 million in the prior year. The year-to-year change was primarily driven by:

●

Lower ~~non-operating retirement-related costs~~gains from divestitures reflected in other ($~~244~~514 million)~~. Refer to “Retirement-Related Plans” for additional information; and~~;

●

Higher ~~gains reflected in other from divestitures ($72 million).~~

Operating (non-GAAP) other (income) and expense was $166 million of income in the third quarter of 2019 and increased $51 million compared to the prior-year period. The year-to-year change was driven primarily by the higher gains from divestitures described above.

~~Table of Contents~~

~~Management Discussion – (continued)~~

Total consolidated other (income) and expense was income of $850 million in the first nine months of 2019 compared to expense of $968 million in the prior year. The year-to-year change was primarily driven by:

●

~~Lower~~ non-operating retirement-related costs ($~~766~~264 million). Refer to “Retirement-Related Plans” for additional information;

●

~~Higher gains reflected~~Lower interest income ($164 million) due to lower average cash balances and interest rates in ~~other from divestitures ($650 million);~~the current year; and

●

~~Net~~Lower net exchange gains (including derivative instruments) ~~in the current year versus net exchange losses (including derivative instruments) in the prior year ($340 million). The company’s~~of $148 million. Our hedging programs help mitigate currency impacts in the Consolidated ~~Statement of Earnings.~~Income Statement.

Operating (non-GAAP) other (income) and expense was ~~$1,118~~$178 million of income in the first ~~nine~~six months of ~~2019~~2020 and decreased $773 million compared ~~to income of $219 million in~~ the ~~prior year.~~prior-year period. The year-to-year change was driven primarily by the ~~dynamics~~lower gains from divestitures and lower net exchange gains described ~~above, excluding the lower non-operating retirement-related costs.~~above.

Interest Expense

Yr. to Yr.

(Dollars in millions)

Percent

For the three months ended September 30:

2019

2018

Change

Interest expense

$
432

$
191

125.7
%
Non-operating adjustment:







Acquisition-related charges

$
(24)

$
—

nm

Operating (non-GAAP) interest expense

$
408

$
191

113.2
%


					Yr. to Yr.
(Dollars in millions)					Percent
For the three months ended June 30:	2020		2019		Change
Interest expense	$	323	$	348	(7.1)	%
Non-operating adjustment:
Acquisition-related charges	$	—	$	(168)	(100.0)
Operating (non-GAAP) interest expense	$	323	$	180	79.9	%

~~nm - not meaningful~~

Yr. to Yr.

(Dollars in millions)

Percent

For the nine months ended September 30:

2019

2018

Change

Interest expense

$
990

$
530

86.9
%
Non-operating adjustment:







Acquisition-related charges

$
(228)

$
—

nm

Operating (non-GAAP) interest expense

$
762

$
530

43.9
%


					Yr. to Yr.
(Dollars in millions)					Percent
For the six months ended June 30:	2020		2019		Change
Interest expense	$	649	$	558	16.3	%
Non-operating adjustment:
Acquisition-related charges	$	—	$	(204)	(100.0)
Operating (non-GAAP) interest expense	$	649	$	354	83.3	%

~~nm - not meaningful~~

Interest expense decreased $25 million in the second quarter and increased ~~$241 million and $460~~$91 million year to year infor the ~~third quarter and~~ first ~~nine~~six months of ~~2019, respectively.~~2020. Interest expense is presented in cost of financing in the Consolidated Income Statement ~~of Earnings~~ if the related external borrowings are to support the Global Financing external business. Overall interest expense (excluding capitalized interest) for the ~~third~~second quarter and first ~~nine~~six months of ~~2019~~2020 was ~~$572~~$441 million and ~~$1,473~~$885 million, respectively, ~~an increase~~a decrease of ~~$188~~$71 million and ~~$376~~$16 million versus the comparable prior-year ~~periods,~~periods. The decreases were primarily driven by lower average interest rates, partially offset by a higher average debt balance ~~and higher average interest rates~~ in the current ~~year as the company issued debt to finance the Red Hat acquisition.~~year.

Operating (non-GAAP) interest expense increased ~~$217~~$144 million and ~~$232~~$295 million year to year in the ~~third~~second quarter and first ~~nine~~six months of ~~2019, respectively, and excludes the~~2020, respectively. The prior-year periods excluded Red Hat pre-closing debt financing costs. ~~Interest expense, post-Red Hat closing is included in operating (non-GAAP) interest expense.~~

8875

Table of Contents

Management Discussion – (continued)

Retirement-Related Plans

The following table provides the total pre-tax cost for all retirement-related plans. The operating cost amounts are included in the Consolidated Income Statement ~~of Earnings~~ within the caption (e.g., Cost, SG&A, RD&E) relating to the job function of the plan participants. The non-operating cost amounts are included in other (income) and expense.


					Yr. to Yr.						Yr. to Yr.
(Dollars in millions)					Percent						Percent
For the three months ended September 30:	2019		2018		Change
For the three months ended June 30:							2020		2019		Change
Retirement-related plans — cost:
Service cost	$	97	$	109	(11.0)	%	$	98	$	96	1.7	%
Multi-employer plans		10		9	12.4			7		8	(14.8)
Cost of defined contribution plans		260		247	5.1			267		253	5.3
Total operating costs/(income)	$	367	$	365	0.5	%	$	372	$	358	3.9	%
Interest cost	$	721	$	677	6.5	%	$	546	$	723	(24.5)	%
Expected return on plan assets		(1,042)		(1,007)	3.5			(854)		(1,047)	(18.4)
Recognized actuarial losses		455		731	(37.7)			559		454	23.2
Amortization of prior service costs/(credits)		(3)		(18)	(82.7)			0		(3)	nm
Curtailments/settlements		3		2	101.5			13		3	336.9
Other costs		11		5	130.4			9		6	57.2
Total non-operating costs/(income)	$	145	$	389	(62.6)	%	$	273	$	136	100.6	%
Total retirement-related plans — cost	$	512	$	754	(32.1)	%	$	645	$	494	30.6	%

nm - not meaningful


					Yr. to Yr.						Yr. to Yr.
(Dollars in millions)					Percent						Percent
For the nine months ended September 30:	2019		2018		Change
For the six months ended June 30:							2020		2019		Change
Retirement-related plans — cost:
Service cost	$	290	$	323	(10.2)	%	$	197	$	193	1.8	%
Multi-employer plans		26		29	(8.4)			14		17	(14.0)
Cost of defined contribution plans		761		763	(0.3)			532		501	6.2
Total operating costs/(income)	$	1,078	$	1,115	(3.4)	%	$	743	$	711	4.5	%
Interest cost	$	2,172	$	2,053	5.8	%	$	1,086	$	1,451	(25.2)	%
Expected return on plan assets		(3,139)		(3,047)	3.0			(1,706)		(2,097)	(18.6)
Recognized actuarial losses		1,366		2,212	(38.2)			1,122		911	23.1
Amortization of prior service costs/(credits)		(9)		(55)	(83.8)			1		(6)	nm
Curtailments/settlements		7		7	(0.2)			21		4	444.1
Other costs		22		16	38.2			14		11	36.1
Total non-operating costs/(income)	$	419	$	1,185	(64.6)	%	$	538	$	274	96.3	%
Total retirement-related plans — cost	$	1,497	$	2,300	(34.9)	%	$	1,281	$	985	30.0	%

nm - not meaningful

Total pre-tax retirement-related plan cost ~~decreased~~increased by ~~$242~~$151 million compared to the ~~third~~second quarter of ~~2018,~~2019 primarily driven by ~~a decrease in recognized actuarial losses ($276 million), primarily due to the change in the amortization period in the U.S. Qualified Personal Pension Plan and higher~~lower expected return on plan assets ($35193 million) and an increase in recognized actuarial losses ($105 million), partially offset by ~~higher~~lower interest costs ($44177 million). Total cost for the first ~~nine~~six months of ~~2019 decreased $803~~2020 increased $296 million versus the first ~~nine~~six months of ~~2018,~~2019, primarily driven by ~~a decrease in recognized actuarial losses ($846 million) primarily due to the amortization period change and higher~~lower expected return on plan assets ($92391 million); and an increase in recognized actuarial losses ($210 million), partially offset by ~~higher~~lower interest costs ($~~120~~365 million).

Table of Contents

Management Discussion – (continued)

As described in the “Operating (non-GAAP) Earnings” section, ~~the company~~management characterizes certain retirement-related costs as operating and others as non-operating. Utilizing this characterization, operating retirement-related costs in the

~~Table of Contents~~

~~Management Discussion – (continued)~~

~~third~~second quarter of ~~2019~~2020 were ~~$367~~$372 million, an increase of $2$14 million compared to the ~~third~~second quarter of ~~2018.~~2019. For the first six months of 2020, operating retirement-related costs were $743 million, an increase of $32 million compared to the prior-year period. Non-operating costs of ~~$145~~$273 million in the ~~third~~second quarter of ~~2019 decreased $244~~2020 increased $137 million year to year ~~driven primarily by lower recognized actuarial losses ($276 million)~~ and ~~a higher expected return on plan assets ($35 million), partially offset by higher interest costs ($44 million). For~~for the first ~~nine~~six months of ~~2019, operating retirement-related costs~~2020 were ~~$1,078~~$538 million, ~~a decrease~~an increase of ~~$38 million and non-operating costs were $419 million, a decrease of $766~~$264 million compared to the ~~prior year,~~prior-year period. These non-operating cost increases were driven primarily by the same factors as described above.

Taxes

The continuing operations ~~effective tax rate~~provision for income taxes for the ~~third~~second quarter of ~~2019~~2020 was ~~(9.9) percent, a decrease of 20.1 points~~$209 million, compared to $269 million in the ~~third~~second quarter of ~~2018.~~ 2019. The operating (non-GAAP) provision for income taxes for the second quarter of 2020 was $369 million, compared to $349 million in the second quarter of 2019.

The continuing operations ~~effective tax rate~~benefit from income taxes for the first ~~nine~~six months of ~~2019~~2020 was ~~6.6 percent, an increase of 4.6 points~~$1,017 million, compared to a tax provision of $558 million for the first ~~nine~~six months of ~~2018.~~2019. The operating (non-GAAP) ~~tax rate for the third quarter of 2019 was 0.1 percent, a decrease of 12.7 points compared to the third quarter of 2018. The operating (non-GAAP) tax rate~~benefit from income taxes for the first ~~nine~~six months of ~~2019~~2020 was ~~7.4 percent, an increase of 2.0 points~~$592 million, compared to a tax provision of $574 million for the first ~~nine~~six months of ~~2018.~~

2019. The ~~decrease in~~benefit from income taxes for the ~~continuing operations effective tax rate in the third quarter~~first six months of ~~2019~~2020 was primarily driven by a net tax benefit in the first quarter related to an intra-entity sale of certain of the company’s intellectual property and the related impacts of $939 million and an adjustment to the U.S. tax reform charge due to a foreign tax law change. The operating (non-GAAP) benefit from ~~the realization of a tax only capital loss in a subsidiary (10.7 points), an increase in tax benefits attributable to audit activity (4.3 points), as well as a benefit due to the mix of geographic~~ income year to year (5.0 points), primarily driven by Red Hat. The change in the continuing operations tax rate for the first nine months of 2019 compared to 2018 was primarily driven by reduced benefit related to audit activity (4.6 points). The change in the operating (non-GAAP) tax ratetaxes was primarily driven by the same ~~factors.~~factors, except for the adjustment to the U.S. tax reform charge.

IBM’s full-year tax provision and effective tax rate are impacted by recurring factors including the geographic mix of income before taxes, state and local taxes, the effects of various global income tax strategies and any discrete tax events, such as the settlement of income tax audits and changes in or new interpretations of tax laws. The GAAP tax provision and effective tax rate could also be affected by adjustments to the previously recorded charges for U.S. tax reform attributable to any changes in law, new regulations and guidance, audit adjustments, among others.

The company is no longer subject to income tax examination of its U.S. federal tax returns for years prior to 2013. The company’s U.S. income tax returns for 2013 and 2014 continue to be examined by the IRS with specific focus on certain cross-border transactions in 2013. With respect to major U.S. state and foreign taxing jurisdictions, the company is generally no longer subject to tax examinations for years prior to 2014. The company's U.S. income tax returns for 2013 and 2014 continue to be examined by the IRS with specific focus on certain cross-border transactions in 2013. The company is no longer subject to income tax examination of its U.S. federal tax return for years prior to 2013. The company is involved in a number of income tax-related matters in India challenging tax assessments issued by the India Tax Authorities. ~~The open~~As of June 30, 2020, the company has recorded $709 million as prepaid income taxes representing cash tax deposits paid over time to protect the company’s right to appeal various income tax assessments made by the India Tax Authorities. Tax years still subject to examination contain matters that could be subject to differing interpretations of applicable tax laws and regulations as it relates to the amount and/or timing of income, deductions and tax credits. Although the outcome of tax audits is always uncertain, the company believes that adequate amounts of tax, interest and penalties have been provided for any adjustments that are expected to result for these years.

The amount of unrecognized tax benefits at ~~September~~June 30, ~~2019~~2020 is ~~$6,899~~$8,445 million which can be reduced by ~~$600~~$594 million ~~of offsetting tax benefits~~ associated with timing adjustments, U.S. tax credits, potential transfer pricing adjustments, and state income taxes. The net amount of ~~$6,299~~$7,851 million, if recognized, would favorably affect the company’s effective tax rate.

Earnings Per Share

Basic earnings per share is computed on the basis of the weighted-average number of shares of common stock outstanding during the period. Diluted earnings per share is computed on the basis of the weighted-average number of shares of common stock outstanding plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options and stock awards.

9077

Table of Contents

Management Discussion – (continued)


					Yr. to Yr.						Yr. to Yr.
					Percent						Percent
For the three months ended September 30:	2019		2018		Change
For the three months ended June 30:							2020		2019		Change
Earnings per share of common stock from continuing operations:
Assuming dilution	$	1.87	$	2.94	(36.4)	%	$	1.52	$	2.81	(45.9)	%
Basic	$	1.89	$	2.95	(35.9)	%	$	1.53	$	2.82	(45.7)	%
Diluted operating (non-GAAP)	$	2.68	$	3.42	(21.6)	%	$	2.18	$	3.17	(31.2)	%
Weighted-average shares outstanding: (in millions)
Assuming dilution		892.8		915.2	(2.4)	%		894.9		890.8	0.5	%
Basic		886.0		911.2	(2.8)	%		889.4		886.3	0.4	%


					Yr. to Yr.						Yr. to Yr.
					Percent						Percent
For the nine months ended September 30:	2019		2018		Change
For the six months ended June 30:							2020		2019		Change
Earnings per share of common stock from continuing operations:
Assuming dilution	$	6.46	$	7.36	(12.2)	%	$	2.83	$	4.58	(38.2)	%
Basic	$	6.50	$	7.39	(12.0)	%	$	2.85	$	4.61	(38.2)	%
Diluted operating (non-GAAP)	$	8.10	$	8.96	(9.6)	%	$	4.02	$	5.42	(25.8)	%
Weighted-average shares outstanding: (in millions)
Assuming dilution		892.5		920.0	(3.0)	%		895.0		892.4	0.3	%
Basic		887.3		915.6	(3.1)	%		888.7		887.9	0.1	%

Actual shares outstanding at ~~September~~June 30, ~~2019~~2020 were ~~885.6~~ 890.6 million. The weighted-average number of common shares outstanding assuming dilution during the ~~third~~second quarter and first ~~nine~~six months of ~~2019~~2020 were ~~22.4~~4.1 million ~~(2.4~~(0.5 percent) and ~~27.5~~2.6 million ~~(3.0~~(0.3 percent) shares ~~lower~~higher than the same periods of ~~2018. The decreases were primarily the result of the common stock repurchase program.~~2019.

Financial Position

Dynamics

At ~~September~~June 30, ~~2019,~~2020, the balance sheet remained strong with flexibility to support the business. We continue to manage the investment portfolio to meet our capital preservation and liquidity objectives. In this unprecedented environment as a result of the COVID-19 pandemic, while we are supporting our clients and improving the flexibility and competitive position of our operations, we are also continuing to take actions to enhance our balance sheet strength and liquidity position. Cash, restricted cash and marketable securities at quarter end were ~~$10,957 million. The company continues to manage~~$14,250 million, an increase of $5,241 million since December 31, 2019. We accessed the ~~investment portfolio to meet its capital preservation~~debt markets in first-half 2020 with $8,586 million of issuances, while reducing $6,428 million of current and ~~liquidity objectives.~~2021 refinancing needs. Total debt of ~~$66,327~~$64,738 million at ~~September~~June 30, ~~2019~~2020 increased ~~$20,515~~$1,838 million from December 31, ~~2018, driven by new debt issuances~~2019. Commercial paper was a net decrease of ~~$26,263~~$189 million ~~to primarily fund~~in the ~~Red Hat acquisition; partially offset by debt maturities~~first half of ~~$5,376 million.~~2020, and a net decrease of $2,404 million in the second quarter of 2020. Within total debt, ~~$23,078~~$21,908 million is Global Financing debt, which is in support of IBM products and services and has a stable credit portfolio.

Our pension plans were well funded at the ~~Global Financing business.~~ end of 2019, with worldwide qualified plans funded at 102 percent. Overall pension funded status as of the end of June 2020 was fairly consistent with year-end 2019, and we currently have no change to expected plan contributions in 2020.

In the first ~~nine~~six months of ~~2019, the company~~2020, we generated ~~$11,319~~$8,052 million in net cash from operations, compared to ~~$11,128~~$7,700 million in the first ~~nine~~six months of ~~2018. The company has~~2019. This included a number of strategic actions taken to preserve cash and maintain a strong balance sheet and ample liquidity position. We have consistently generated strong cash flows from operations and ~~continues~~continue to have access to additional sources of liquidity through the capital markets and ~~its~~our $15,250 million of unused credit facilities. ~~The strong free cash flow generated by~~We do not currently have plans to draw on these facilities, however they are available as back-up liquidity. We have been opportunistic in the ~~company, portfolio actions taken~~capital markets and ~~the suspension of share repurchases position IBM~~remain fully committed to ~~return to its~~a target leverage ~~ratios within~~profile consistent with a mid to high single A credit rating. Refer to “Liquidity and Capital Resources” for additional

~~couple~~Table of ~~years. Through disciplined financial management, the company reduced debt by $6,712 million since June 30, 2019.~~Contents

Management Discussion – (continued)

information. In summary, we have a strong cash position and ample credit available during these uncertain times to support and invest in our business.

The assets and debt associated with the Global Financing business are a significant part of ~~the company’s~~our financial position. ~~At September 30, 2019 those balances reflect the wind down of its OEM IT commercial financing operations.~~ The financial position amounts appearing on pages 5 and 6 are the consolidated amounts including Global Financing.

~~Table of Contents~~

~~Management Discussion – (continued)~~

Global Financing Financial Position Key Metrics:


	At September 30,		At December 31,		At June 30,		At December 31,
(Dollars in millions)	2019		2018		2020		2019
Cash and cash equivalents	$	2,086	$	1,833	$	1,785	$	1,697
Net investment in sales-type and direct financing leases (1)		5,906		6,924		5,093		6,224
Equipment under operating leases — external clients (2)		276		444		170		238
Client loans		11,250		12,802		11,869		12,884
Total client financing assets		17,431		20,170		17,132		19,346
Commercial financing receivables		2,937		11,838		2,379		3,820
Intercompany financing receivables (3) (4)		3,756		4,873		3,735		3,870
Total assets	$	27,445	$	41,320	$	26,523	$	29,568
Debt	$	23,078	$	31,227	$	21,908	$	24,727
Total equity	$	2,564	$	3,470	$	2,433	$	2,749

(1)	Includes deferred initial direct costs which are eliminated in IBM’s consolidated results.

(2)	Includes intercompany mark-up, priced on an arm’s-length basis, on products purchased from the company’s product divisions which is eliminated in IBM’s consolidated results.

(3)	Entire amount eliminated for purposes of IBM’s consolidated results and therefore does not appear on ~~pages 5 and 6.~~page 5.

(4)	These assets, along with all other financing assets in this table, are leveraged at the value in the table using Global Financing debt.

At ~~September~~June 30, ~~2019,~~2020, substantially all client and commercial financing assets were IT related assets, and approximately 6058 percent of the total external portfolio was with investment grade clients with no direct exposure to consumers, ~~an increase~~a decrease of 62 points year to year. This investment grade percentage is based on the credit ratings of the companies in the ~~portfolio.~~portfolio and reflect mitigating credit enhancement actions taken by the customer to reduce the risk to IBM.

The company has a long-standing practice of taking ~~mitigating~~mitigation actions, in certain circumstances, to transfer credit risk to third ~~parties, including~~parties. These actions may include credit insurance, financial guarantees, ~~non-recourse~~nonrecourse borrowings, transfers of receivables recorded as true sales in accordance with accounting guidance or sales of equipment under operating lease. ~~Adjusting~~

In the second quarter of 2020, the company sold $711 million of financing receivables, consisting of lease and loan receivables of $417 million and $294 million, respectively, approximately half of which were scheduled to be due within the next 12 months. The transfer of these receivables qualified as true sales and therefore reduced Global Financing receivables and resulted in a benefit to cash flows from operating activities for the ~~mitigation actions,~~three and six months ended June 30, 2020 (with no impact to free cash flow). The impact to the ~~investment grade content would increase to 67 percent, a decrease~~Consolidated Income Statement, including fees and the net gain associated with the transfer of ~~3 points year to year.~~these receivables was not material.

IBM Working Capital


	At September 30,		At December 31,		At June 30,		At December 31,
(Dollars in millions)	2019		2018		2020		2019
Current assets	$	38,121	$	49,146	$	39,953	$	38,420
Current liabilities		35,066		38,227		38,442		37,701
Working capital	$	3,055	$	10,918	$	1,511	$	718
Current ratio		1.09:1		1.29:1		1.04:1		1.02:1

~~Working capital decreased $7,864 million from the year-end 2018 position. The key changes are described below:~~

~~Current assets decreased $11,025 million ($10,188 million adjusted for currency) due to:~~

●

A decline in receivables of $9,604 million ($9,213 million adjusted for currency) driven by a decline in financing receivables of $10,058 million primarily due to the wind down of OEM IT commercial financing; partially offset by an increase in other receivables of $1,133 million primarily related to divestitures; and

●

~~A decrease of $1,265 million ($917 million adjusted for currency) in cash, restricted cash, and marketable securities.~~

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Management Discussion – (continued)

Working capital increased $793 million from the year-end 2019 position. The key changes are described below:

Current assets increased $1,534 million ($2,479 million adjusted for currency) due to:

●

An increase of $5,241 million ($5,548 million adjusted for currency) in cash, restricted cash and marketable securities; and

●

An increase of $640 million ($847 million adjusted for currency) in total inventory, deferred costs and prepaid expenses and other current assets; partially offset by

●

A decline in receivables of $4,348 million ($3,916 million adjusted for currency) primarily as a result of collections of higher year-end balances and divestiture-related receivables, as well as sales of receivables.

Current liabilities ~~decreased $3,161~~increased $741 million ($~~2,524~~1,353 million adjusted for currency) as a result of:

●

~~A decrease~~An increase in ~~accounts payable~~short-term debt of ~~$2,515~~$492 million ($~~2,464~~564 million adjusted for currency) ~~reflecting declines~~due to reclassifications of $5,100 million from ~~seasonally higher year-end balances~~long-term debt to reflect upcoming maturities; partially offset by maturities of $4,387 million; and ~~the wind down~~

●

An increase in deferred income of ~~OEM IT commercial financing; and~~$443 million ($689 million adjusted for currency); partially offset by

●

A decrease in ~~short-term debt~~taxes of ~~$1,677~~$212 million ($~~1,655~~112 million adjusted for currency) ~~due to maturities of $5,368 million; partially offset by reclassifications of $3,319 million from long-term debt to reflect upcoming maturities and debt issuances of $331 million; partially offset by~~

●

~~An increase in operating lease liabilities of $1,377 million ($1,399 million adjusted for currency) as a result of the adoption of the new leasing standard on January 1, 2019.~~.

Receivables and Allowances

Roll Forward of Total IBM Receivables Allowance for Credit Losses (included in Total IBM)


(Dollars in millions)	(Dollars in millions)									(Dollars in millions)
January 1, 2019		Additions / (Releases) *		Write-offs **		Other ***		September 30, 2019
January 1, 2020 *										January 1, 2020 *	Additions / (Releases) **		Write-offs ***		Other +		June 30, 2020
$	639	$	51	$	(104)	$	(8)	$	578	612	$	123	$	(48)	$	(21)	$	665

* Opening balance does not equal the allowance at December 31, 2019 due to the adoption of the guidance on current expected credit losses.

Refer to note 2, “Accounting Changes,” for additional information.

** Additions for Allowance for Credit Losses are charged to expense.

*** Refer to note A, “Significant Accounting Policies,” in the company’s ~~2018~~2019 Annual Report for additional information regarding ~~Allowance~~allowance for ~~Credit Loss~~credit loss write-offs.

~~***~~+ Primarily represents translation adjustments.

The total IBM receivables provision coverage was ~~1.9~~2.4 percent at ~~September~~June 30, ~~2019,~~2020, an increase of 3060 basis points compared to ~~December 31, 2018.~~January 1, 2020. The increase was primarily driven by the overall decline in gross financing ~~receivables.~~receivables and trade receivables from collections from higher year-end volumes as well as sales of receivables and an increase in customer specific provisions. The global pandemic has resulted in some deterioration in customer credit quality and/or bankruptcies which have had impacts to provisions in the first-half 2020. The majority of the write-offs during the ~~nine~~six months ended ~~September~~June 30, ~~2019~~2020 related to receivables which had been previously reserved.

Table of Contents

Management Discussion – (continued)

Global Financing Receivables and Allowances

The following table presents external Global Financing receivables excluding ~~residual values, the allowance for credit losses and~~ immaterial miscellaneous receivables.


	At September 30,			At December 31,			At June 30,			At December 31,
(Dollars in millions)	2019			2018			2020			2019
Recorded investment (1)	$	19,723		$	31,182
Amortized cost/Recorded investment (1)(2)							$	19,604		$	22,446
Specific allowance for credit losses		207			220			180			177
Unallocated allowance for credit losses		50			72			84			45
Total allowance for credit losses		257			292			264			221
Net financing receivables	$	19,466		$	30,890		$	19,340		$	22,224
Allowance for credit losses coverage		1.3	%		0.9	%		1.3	%		1.0	%

(1)

~~Includes~~Prior to the January 1, 2020 adoption of the guidance on current expected credit losses, the presentation was recorded investment, subsequent to adoption the presentation is amortized cost. Both presentations include deferred initial direct costs which are eliminated in IBM’s consolidated results.

(2)

The amortized cost basis of a financial asset represents the original amount of the financing receivable (including residual value) adjusted for unearned income, deferred initial direct costs, cash collected, write-offs and any foreign exchange adjustments. Recorded investment excluded residual value.

~~The~~Upon the adoption of the guidance on current expected credit losses, the percentage of ~~Global Financing~~financing receivables reserved increased from ~~0.9~~1.0 percent at December 31, ~~2018,~~2019, to 1.1 percent January 1, 2020, primarily driven by a 74.2 percent increase in unallocated reserves. The percentage of financing receivables reserved increased from 1.1 percent at January 1, 2020, to 1.3 percent at ~~September~~June 30, ~~2019. The~~2020, which included an increase ~~was primarily driven by the overall decline~~ in ~~gross receivables. Unallocated~~unallocated reserves ~~decreased 30~~of 7.7 percent. Specific reserves increased 1.7 percent from ~~$72~~$177 million at December 31, ~~2018,~~2019, to ~~$50~~$180 million at ~~September~~June 30, ~~2019. Specific reserves decreased 6 percent from $220 million at December 31, 2018, to $207 million at September 30, 2019.~~2020.

~~Table of Contents~~

~~Management Discussion – (continued)~~

Roll Forward of Global Financing Receivables Allowance for Credit Losses


(Dollars in millions)	(Dollars in millions)									(Dollars in millions)
January 1, 2019		Additions / (Releases)*		Write-offs **		Other ***		September 30, 2019
January 1, 2020*										January 1, 2020*	Additions / (Releases)**		Write-offs ***		Other +		June 30, 2020
$	292	$	(6)	$	(23)	$	(6)	$	257	262	$	35	$	(21)	$	(12)	$	264

* Opening balance does not equal the allowance at December 31, 2019 due to the adoption of the guidance on current expected credit losses.

Refer to note 2, “Accounting Changes,” for additional information.

** Additions for Allowance for Credit Losses are charged to expense.

*** Refer to note A, “Significant Accounting Policies,” in the company’s ~~2018~~2019 Annual Report for additional information regarding allowance for credit loss write-offs.

~~***~~+ Primarily represents translation adjustments.

Global Financing’s ~~bad debt~~expected credit loss expense (including impacts from off-balance sheet commitments which are recorded in other liabilities) was ~~a release~~an addition of $1$28 million for the three months ended ~~September~~June 30, ~~2019,~~2020, compared to a release of $6$9 million for the same period in ~~2018.~~2019. The increase was primarily driven by higher specific and unallocated reserves in Americas in the second quarter.

Global Financing’s ~~bad debt~~expected credit loss expense (including impacts from off-balance sheet commitments which are recorded in other liabilities) was an addition of $39 million for the six months ended June 30, 2020, compared to a release of ~~$6 million for the nine months ended September 30, 2019, compared to an addition of $18~~$5 million for the same period in ~~2018, due to lower~~2019. The increase was primarily driven by higher unallocated and specific reserves in Americas and a higher unallocated ~~reserve release~~reserves in ~~2019.~~EMEA in the current year.

~~Noncurrent Assets and Liabilities~~

At September 30,

At December 31,
(Dollars in millions)

2019

2018
Noncurrent assets

$
111,499

$
74,236
Long-term debt

$
57,797

$
35,605
Noncurrent liabilities (excluding debt)

$
38,661

$
32,621

~~Noncurrent assets increased $37,263 million ($38,244 million adjusted for currency) due to:~~

●

~~A net increase in goodwill and net intangible assets of $34,211 million ($34,634 million adjusted for currency) due to the acquisition of Red Hat; and~~

●

~~An increase in operating right-of-use assets of $4,901 million ($4,991 million adjusted for currency) as a result of the adoption of the new leasing standard on January 1, 2019; partially offset by~~

●

~~A decrease in long-term financing receivables of $1,408 million ($1,337 million adjusted for currency) as a result of reductions from seasonally higher year-end balances.~~

~~Long-term debt increased $22,192 million ($22,412 million adjusted for currency) due to:~~

●

~~Issuances of $25,932 million primarily to finance the Red Hat acquisition; partially offset by~~

●

~~Reclassifications to short-term debt of $3,319 million to reflect upcoming maturities.~~

~~Noncurrent liabilities (excluding debt) increased $6,041 million ($6,650 million adjusted for currency) due to:~~

●

~~An increase in long-term operating lease liabilities of $3,790 million ($3,861 million adjusted for currency) as a result of the adoption of the new leasing standard on January 1, 2019; and~~

●

An increase in other liabilities of $3,390 million ($3,459 million adjusted for currency) primarily driven by an increase in deferred tax liabilities due to the acquisition of Red Hat; partially offset by

●

~~A decrease in retirement and postretirement plans of $1,076 million ($667 million adjusted for currency).~~

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Management Discussion – (continued)

Noncurrent Assets and Liabilities


	At June 30,		At December 31,
(Dollars in millions)	2020		2019
Noncurrent assets	$	114,247	$	113,767
Long-term debt	$	55,449	$	54,102
Noncurrent liabilities (excluding debt)	$	39,621	$	39,398

Noncurrent assets increased $480 million ($1,583 million adjusted for currency) due to:

●

An increase in deferred taxes of $3,507 million ($3,684 adjusted for currency) primarily due to an intra-entity sale of IP in the first quarter; partially offset by

●

A decrease in long-term financing receivables of $1,361 million ($1,250 million adjusted for currency) as a result of reductions from seasonally higher year-end balances as well as sales of receivables; and

●

A decrease in net intangible assets and goodwill of $1,353 million ($1,087 million adjusted for currency) primarily resulting from intangibles amortization and currency impacts.

Long-term debt increased $1,347 million ($1,230 million adjusted for currency) due to:

●

Issuances of $8,356 million; partially offset by

●

Reclassifications to short-term debt of $5,100 million to reflect upcoming maturities; and

●

Maturities and redemption of $2,041 million of certain outstanding bonds.

Noncurrent liabilities (excluding debt) increased $222 million ($794 million adjusted for currency) due to:

●

An increase in other liabilities of $1,140 million ($1,442 million adjusted for currency) primarily driven by an increase in deferred tax liabilities related to the first-quarter intra-equity IP sale; partially offset by

●

A decrease in retirement and postretirement benefit obligations of $659 million ($536 million adjusted for currency).

Debt

~~The company’s~~We continually monitor our funding requirements ~~are continually monitored~~ and execute our strategies ~~are executed~~ to manage the overall asset and liability profile. Additionally, the company maintains sufficient flexibility to access global funding sources as needed.


	At September 30,		At December 31,		At June 30,		At December 31,
(Dollars in millions)	2019		2018		2020		2019
Total company debt	$	66,327	$	45,812	$	64,738	$	62,899
Total Global Financing segment debt	$	23,078	$	31,227	$	21,908	$	24,727
Debt to support external clients		19,915		27,536		18,820		21,487
Debt to support internal clients		3,164		3,690		3,089		3,239
Non-Global Financing debt	$	43,249	$	14,585	$	42,829	$	38,173

Total debt of ~~$66,327~~$64,738 million increased ~~$20,515~~$1,838 million from December 31, ~~2018,~~2019, driven by new debt issuances of ~~$26,263~~$8,586 million; partially offset by debt maturities and early retirements of ~~$5,376~~$6,428 million. Commercial paper was a net decrease of $189 million in the first-half 2020, and a net decrease of $2,404 million in the second quarter of 2020.

Table of Contents

Management Discussion – (continued)

Non-Global Financing debt of ~~$43,249~~$42,829 million increased ~~$28,664~~$4,657 million from December 31, ~~2018 primarily driven by issuances to fund the Red Hat acquisition.~~2019 and decreased $5,227 million since June 30, 2019.

Global Financing debt of ~~$23,078~~$21,908 million decreased ~~$8,148~~$2,818 million from December 31, ~~2018,~~2019, primarily due to ~~the wind down of OEM IT commercial financing operations.~~lower funding requirements.

Global Financing provides financing predominantly for the company’s external client assets, as well as for assets under contract by other IBM units. These assets, primarily for Global Technology Services, generate long-term, stable revenue streams similar to the Global Financing asset portfolio. Based on their attributes, these Global Technology Services assets are leveraged with the balance of the Global Financing asset base.

The debt used to fund Global Financing assets is composed of intercompany loans and external debt. Total debt changes generally correspond with the level of client and commercial financing receivables, the level of cash and cash equivalents, the change in intercompany and external payables and the change in intercompany investment from IBM. The terms of the intercompany loans are set by the company to substantially match the term, currency and interest rate variability underlying the financing receivable and are based on arm’s-length pricing. The Global Financing debt-to-equity ratio remained at 9.0 to 1 at ~~September~~June 30, ~~2019.~~2020.

~~As previously stated, the company measures~~We measure Global Financing as a stand-alone entity, and accordingly, interest expense relating to debt supporting Global Financing’s external client and internal business is included in the “Global Financing Results of Operations” and in note 8,4, “Segments.” In the ~~company’s~~ Consolidated Income Statement, ~~of Earnings,~~ the external debt-related interest expense supporting Global Financing’s internal financing to the company is reclassified from cost of financing to interest expense.

Equity

Total equity ~~increased $1,166~~decreased $297 million from December 31, ~~2018,~~2019, primarily due to decreases from dividends paid ($2,890 million), partially offset by increases from net income ($~~5,761~~2,536 million) ~~and retirement-related plans ($1,095 million); partially offset by decreases from dividends paid ($4,269 million) and an increase in treasury stock ($1,404 million) primarily due to share repurchases.~~.

~~Table of Contents~~

~~Management Discussion – (continued)~~

Cash Flow

~~The company’s~~Our cash flows from operating, investing and financing activities, as reflected in the Consolidated Statement of Cash Flows on page 7, are summarized in the following table. These amounts include the cash flows associated with the Global Financing business.


(Dollars in millions)
For the nine months ended September 30:	2019		2018
For the six months ended June 30:					2020		2019
Net cash provided by/(used in) continuing operations:
Operating activities	$	11,319	$	11,128	$	8,052	$	7,700
Investing activities		(27,064)		(5,368)		(2,138)		3,309
Financing activities		14,717		(5,864)		(1,739)		22,894
Effect of exchange rate changes on cash, cash equivalents and restricted cash		(352)		(399)		(301)		27
Net change in cash, cash equivalents and restricted cash	$	(1,379)	$	(503)	$	3,874	$	33,930

Net cash provided by operating activities increased ~~$191~~$352 million as compared to the first ~~nine~~six months of ~~2018~~2019 driven primarily by:

●

An increase of ~~$838 million in~~ cash provided by receivables of $1,550 million primarily driven by business volumes, our continued focus on collections as well as sales of receivables, including financing ~~receivables; partially offset by~~receivables of $711 million; and

Table of Contents

Management Discussion – (continued)

●

~~Performance-related declines within net income~~Payroll tax and ~~Red Hat acquisition-related impacts.~~

~~Net cash used in investing activities increased $21,696 million driven by:~~

●

~~An increase in net cash used for acquisitions~~value-added tax payment deferrals and exemptions of ~~$32,507 million;~~approximately $550 million due to tax relief provided under the U.S. CARES Act and other non-U.S. government assistance programs related to COVID-19; partially offset by

●

An increase in interest payments on debt of ~~$5,719~~approximately $400 million;

●

An increase in workforce rebalancing payments of $283 million;

●

A net increase in cash payments for income taxes of $254 million primarily driven by withholding tax on intercompany dividends in the second quarter; and

●

Performance-related declines within net income.

Investing activities were a net use of cash of $2,138 million in the first six months of 2020 compared to a net source of cash of $3,309 million in 2019. The year-to-year change of $5,447 million was driven by:

●

A decrease of $3,733 million in cash provided by net non-operating finance receivables primarily driven by the wind down of the OEM IT commercial financing operations; ~~and~~partially offset by

●

~~A decrease~~An increase in cash used for net purchases of marketable securities and other investments of ~~$3,051 million; and~~

●

~~A decrease in cash used for net capital expenditures of $1,114~~$1,217 million; and

●

An increase in cash ~~provided by divestitures~~used for net capital expenditures of ~~$927~~$389 million.

Financing activities were a net use of cash of $1,739 million in the first six months of 2020 compared to a net source of cash of ~~$14,717~~$22,894 million in the first ~~nine~~six months of ~~2019 compared to a net use of cash of $5,864 million in the first nine months of 2018.~~2019. The year-to-year ~~increase in cash flow~~change of ~~$20,581~~$24,633 million was driven by:

●

~~An increase~~A decrease in net cash ~~sourced from~~provided by debt transactions of ~~$19,620~~$25,754 million driven primarily ~~driven~~ by a higher level of net ~~issuances used~~additions in the prior year to fund the Red Hat acquisition; ~~and~~partially offset by

●

A decrease in cash used for gross common share repurchases of ~~$1,032~~$1,236 million.

Looking Forward

~~The company~~IBM is focused on ~~chapter 2 of~~helping our clients in the two major transformational journeys they are on: hybrid cloud ~~which will shift mission-critical work to the cloud~~as well as data and ~~optimize everything from supply chains to core banking systems.~~ AI.To address ~~this~~the cloud opportunity, enterprises need to be able to move and manage data, services and workflows across multiple clouds and on-premises. Clients want to infuse AI into their workflows, automate their IT infrastructure to reduce cost and increase resiliency and secure their IT infrastructure to fend off growing cybersecurity threats. They ~~also~~ need to be able to address security concerns, data protection and protocols, availability and cloud management. This ~~requires~~is best addressed with a hybrid ~~multi-cloud,~~cloud, open approach. On July 9, 2019, ~~IBM~~we closed the acquisition of Red Hat, which ~~will~~ significantly ~~change~~changed the cloud landscape and will accelerate our high-value business model.

Hybrid cloud is the dominant force driving change in our industry but it is far from universal adoption. There remains a significant opportunity for IBM to capture clients’ mission-critical workloads that have not yet moved to the cloud. Hybrid cloud is an interoperable IT environment across on-premise, private and publicly-operated cloud environments, in most cases from multiple vendors. Together, IBM and Red Hat offer the leading hybrid platform built on open source technologies. It starts with Linux, which is the de facto operating system standard and we have a tremendous advantage with RHEL which is the market share leader. Linux, along with containers and Kubernetes, provides the architectural foundation of our hybrid platform and OpenShift is our core product. We have a vast software and middleware portfolio which has been containerized and runs on OpenShift and RHEL. The Cloud Paks we introduced in the second half of 2019 allow our middleware to run in a cloud-native environment and bridge our clients from the past to the future. Our

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Management Discussion – (continued)

~~landscape~~hybrid cloud platform also includes a set of advanced technologies that enterprises need such as Watson, analytics, encryption and IoT. Our clients can deploy our software anywhere OpenShift runs, as it is infrastructure agnostic, operates across public and private clouds, as well as on our mainframes and power systems platforms. The large ecosystem of partners and global coalition of best of breed independent software vendors we have brought together should accelerate adoption of the ~~company’s high~~platform. Nearly 50 percent of the hybrid cloud opportunity lies in services. An important part of our hybrid cloud platform’s value ~~business model. Together, IBM and Red Hat will drive innovation and shift clients’ mission-critical workloads~~is in the expertise we provide to help clients on their journey to the cloud, through modernization of applications, building cloud-native apps, migrating to the cloud, or managing these applications and public and private cloud infrastructures.

On April 20, 2020, we withdrew our full-year 2020 expectations. At this time, we are not providing full-year 2020 expectations given the continued level of uncertainty around the duration of the COVID-19 health crisis and the potential rate and pace of economic recovery. We maintain confidence in our strategy and our portfolio and while the current environment presents some near-term challenges for our clients, it also provides longer-term opportunities for us as our clients accelerate their transitions to digital environments. We have both a business profile and business model that provide some stability in the current environment and we have recently taken a number of actions that strengthen our operating model currently and for the future.

Looking forward to the second half of 2020, we have a compelling set of offerings and a strong pipeline across software, services and systems. The yield of that pipeline into revenue will be driven by ~~offering~~the rate and pace of global economic recovery, which will vary based on industry and markets around the world and influence client spending confidence. Our business has a ~~next-generation hybrid, multi-cloud platform built~~number of dynamics in the second half. Systems performance is typically reflective of our product cycles, which will have an impact in the second half as the z15 was introduced in the third quarter of 2019. From a software perspective, transaction versus annuity mix varies by quarter and historically we have a lower mix of software transactions in the third quarter and our largest transaction base in the fourth quarter. Depending on ~~open source technologies. The acquisition~~recovery of ~~Red Hat positions IBM~~client buying patterns, transactional content could continue to be impacted. With the ~~leading hybrid cloud provider.~~

~~Consistent with the acquisition~~one-year anniversary of ~~a highly profitable software business, non-cash purchase accounting adjustments will result in~~ the Red Hat acquisition being dilutive to full-year 2019 earnings per share expectations. In an acquisition, U.S. GAAP requires the company to record all assets acquired and liabilities assumed at the acquisition date fair value. This includes the acquired deferred revenue balance. This resulted in July, a ~~non-cash adjustment~~significant portion of $2.2 billion to the acquired deferred revenue balance and will result in a reduction to reported revenue post-closing. The level of adjustment reflects the high margin profile of Red Hat’s business, and deferred revenue is expected to be replenished over the subsequent two to three years, given Red Hat’s high renewal rates and a stable and growing client base.

Red Hat is expected to be free cash flow accretive to IBM in the first twelve months, with nominal dilution in second-half 2019. The company also remains on track to achieve free cash flow of approximately $12 billion in 2019. Combined with the additional software and services profits, and net of incremental interest to finance the transaction and other acquisition-related charges, Red Hat is expected to add $0.5 billion and $1 billion to IBM’s free cash flow in 2020 and 2021, respectively.

The combination of IBM and Red Hat is off to a strong start. In the third quarter, cloud revenue growth accelerated and within the segments, there was good growth in Cloud & Cognitive Software and GBS. In Systems there was a solid start to z15, which began shipping in the last week of the quarter and high-end storage was announced. GTS had strong cloud results, but overall performance was weaker than expectations. In the short term, the company is going to manage this business for margin and cash. Looking forward to the fourth quarter, it is the company’s seasonally largest transaction quarter. The company expects total revenue to increase between $3.5 billion and $3.7 billion from third quarter to fourth quarter of 2019. This is higher than the sequential improvement for the same periods in 2018, due primarily to the introduction of the IBM z15 mainframe late in September of 2019. For the fourth quarter, assuming a steady economic environment, the company is expecting a normal IBM Z cycle, solid software transactional execution while facing a strengthening U.S. dollar.

~~At the company’s~~ ~~August 2, 2019 investor briefing, IBM updated its full year operating (non-GAAP) earnings per share expectation, which was impacted by temporary non-cash items, including:~~ the deferred revenue ~~adjustment recorded in~~ purchase accounting equity and retention and share repurchase suspension. Through the third quarter, the company expects to achieve GAAP earnings per share from continuing operations for 2019 of at least $10.58. The company continues to expect operating (non-GAAP) earnings per share of at least $12.80, which excludes acquisition-related charges of $1.52 per share, non-operating retirement-related items of $0.51 per share and tax reform enactment impacts of $0.19 per share. In 2020, IBM expects to return to a sustainable revenue growth trajectory.

For full-year 2019, the company expects the GAAP effective tax rate to be approximately 8 to 9 percent, including an estimate for potential discrete tax events (discretes). The company updated its operating (non-GAAP) tax rate expectations at the August 2nd investor briefing. The company expects its operating (non-GAAP) tax rate for 2019 to be approximately 9 to 10 percent, including an estimate of potential discretes. Discretes by their nature are difficult to estimateadjustment and the ~~actual impacts~~impact from acquisition transaction charges will ~~be recorded as~~lessen in the ~~discrete events occur. The rates~~second half. From a total revenue perspective, it will change year to year based on discrete tax events, such as the settlement of income tax audits and changes in tax laws, as well as recurring factors including the geographic mix of income before taxes, state and local taxes and the effects of various global income tax strategies. The GAAP effective tax rate could also be ~~affected by adjustments~~one year since the close of the second quarter 2019 divestitures which had been a headwind to ~~the previously recorded charges for U.S. tax reform attributable to any changes in law, new regulations and guidance, audit adjustments, among others.~~

~~The Red Hat acquisition was funded through a combination of cash and debt, with the incremental debt issued~~revenue growth in the first half of ~~2019. The company~~2020. Within services, the savings from the structural actions that we took across our business will start to yield in the second half of 2020, providing better cost competitiveness and margin performance, especially in GTS. We could continue to be impacted by the reduction in client’s discretionary projects, in particular in GBS. In this unprecedented environment, we continue to take prudent actions to improve our operating model and accelerate our strategic priorities to emerge from this economic environment stronger and with a disciplined financial policy and is committed to maintaining strong investment grade credit ratings. The company is targeting a leverage profile consistent with a mid to high single A credit rating within a couple years, while maintaining its solid and growing dividend. IBM suspended its share repurchase

~~Table of Contents~~business positioned for growth.

~~Management Discussion – (continued)~~

~~program at the close of the acquisition to direct its~~We remain confident that we have ample free cash flow ~~towards reducing debt levels.~~and liquidity to support our business and return value to shareholders through dividends.

For the period ended June 30, 2020, we assessed certain accounting-related matters that generally require consideration of current information reasonably available to us and utilized forecasted financial data to help assess future impacts to IBM as a result of the COVID-19 pandemic. The ~~combination~~accounting matters considered for assessment included but were not limited to, the allowances for credit losses, the carrying values of ~~these actions provides~~goodwill and intangible assets and other long-lived assets, our net investments in sales-type or direct financing leases, any significant lease modifications, valuation allowances for tax assets and revenue recognition. Our assessments did not result in any material impacts to our consolidated financial results as of and for the ~~company with the flexibility to invest in the business going forward.~~

~~Beginning in the second~~ quarter of 2019 and continuing throughout the year, IBM’s Global Financing business is winding down the portion of its commercial financing operations, which provides short-term working capital solutions for OEM information technology suppliers, distributors and resellers. This is consistent with IBM’s capital allocation strategy and high-value focus. IBM Global Financingended June 30, 2020. We will continue to ~~provide differentiated end-to-end financing solutions, including commercial financing~~assess these matters in ~~support~~future periods. However, given the inherent uncertainty of ~~IBM partner relationships. The wind down~~the magnitude of future impacts from and/or the duration of the pandemic, there can be no assurance that impacts will not be material to our consolidated financial results in future periods.

Our pension plans are well funded coming into this ~~activity is expected to reduce IBM’s revenue, with a nominal impact to profit, however it does not change the company’s earnings per share~~environment and ~~free cash flow~~our expectations for ~~2019.~~

~~Beginning in 2019, within the IBM U.S. Qualified Personal Pension Plan, substantially all the~~our retirement-related plan participants are now considered inactive, which, as required by U.S. GAAP, resulted in a change in the amortization period of unrecognized actuarial losses, from the average remaining service period of active plan participants to the average remaining life expectancy of inactive plan participants. These periods are approximately 6 years and 18 years, respectively. As a result of this change, there will be a reduction to 2019 amortization expense of approximately $900 million. Actuarial loss amortization is reported within non-operating pension costs. There will be no impact to 2019 operating (non-GAAP) retirement-related costs, funded status, retiree benefit payments or funding requirements of the U.S. Qualified Personal Pension Plan. However, there will be an impact to free cash flow realization.

~~The company expects 2019~~contributions remain consistent with year-end 2019. We expect 2020 pre-tax retirement-related plan cost to be approximately ~~$2.0~~$2.7 billion, ~~a decrease~~an increase of approximately ~~$1 billion~~$600 million compared to ~~2018.~~2019. This estimate reflects current pension plan assumptions at December 31, ~~2018.~~2019. Within total retirement-related plan cost, operating retirement-related plan cost is expected to be approximately $1.5 billion, approximately flat versus ~~2018.~~2019. Non-operating retirement-related plan cost is expected to be approximately ~~$0.6~~$1.2 billion, ~~a decrease~~an increase of approximately ~~$1 billion~~$600 million compared to ~~2018,~~ 2019,

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Management Discussion – (continued)

primarily driven by lower ~~actuarial loss amortization resulting~~income from ~~the change in amortization period for the U.S. plan.~~expected return on assets. Contributions for all retirement-related plans are expected to be approximately ~~$2.2~~$2.3 billion in ~~2019, a decrease~~2020, an increase of approximately $100 million compared to ~~2018.~~2019.

Currency Rate Fluctuations

Changes in the relative values of non-U.S. currencies to the U.S. dollar (USD) affect ~~the company’s~~our financial results and financial position. At ~~September~~June 30, ~~2019,~~2020, currency changes resulted in assets and liabilities denominated in local currencies being translated into fewer dollars than at year-end ~~2018. The company uses~~2019. We use financial hedging instruments to limit specific currency risks related to financing transactions and other foreign currency-based transactions.

During periods of sustained movements in currency, the marketplace and competition adjust to the changing rates. For example, when pricing offerings in the marketplace, ~~the company~~we may use some of the advantage from a weakening U.S. dollar to improve ~~its~~our position competitively, and price more aggressively to win the business, essentially passing on a portion of the currency advantage to ~~its~~our customers. Competition will frequently take the same action. Consequently, ~~the company believes~~we believe that some of the currency-based changes in cost impact the prices charged to clients. ~~The company~~We also ~~maintains~~maintain currency hedging programs for cash management purposes which temporarily mitigate, but do not eliminate, the volatility of currency impacts on ~~the company’s~~our financial results.

~~The company translates~~We translate revenue, cost and expense in ~~its~~our non-U.S. operations at current exchange rates in the reported period. References to “adjusted for currency” or “constant currency” reflect adjustments based upon a simple mathematical formula. However, this constant currency methodology that ~~the company utilizes~~we utilize to disclose this information does not incorporate any operational actions that management could take to mitigate fluctuating currency rates. Currency movements impacted ~~the company’s~~our year-to-year revenue and earnings per share growth in the first ~~nine~~six months of ~~2019.~~2020. Based on the currency rate movements in the first ~~nine~~six months of ~~2019,~~2020, total revenue decreased ~~4.3~~4.4 percent as reported and ~~1.7~~2.9 percent at constant currency versus the first ~~nine~~six months of ~~2018.~~2019. On an income from continuing operations before income tax basis, these translation impacts mitigated by the net impact of hedging activities

~~Table of Contents~~

~~Management Discussion – (continued)~~

resulted in a theoretical maximum (assuming no pricing or sourcing actions) increase of approximately ~~$240~~$160 million in the first ~~nine~~six months of ~~2019~~2020 on an as-reported basis and an increase of approximately ~~$210~~$150 million on an operating (non-GAAP) basis. The same mathematical exercise resulted in an increase of approximately ~~$200~~$160 million in the first ~~nine~~six months of ~~2018~~2019 on an as-reported basis and an increase of approximately ~~$225~~$140 million on an operating (non-GAAP) basis. ~~The company views~~We view these amounts as a theoretical maximum impact to ~~its~~our as-reported financial results. Considering the operational responses mentioned above, movements of exchange rates, and the nature and timing of hedging instruments, it is difficult to predict future currency impacts on any particular period, but ~~the company believes~~we believe it could be substantially less than the theoretical maximum given the competitive pressure in the marketplace.

For non-U.S. subsidiaries and branches that operate in U.S. dollars or whose economic environment is highly inflationary, translation adjustments are reflected in results of operations. Generally, ~~the company manages~~we manage currency risk in these entities by linking prices and contracts to U.S. dollars.

Liquidity and Capital Resources

In ~~the company’s 2018~~our 2019 Annual Report, on pages 6057 to ~~62,~~59, there is a discussion of ~~the company’s~~our liquidity including two tables that present three years of data. The table presented on page 6058 includes net cash from operating activities, cash and cash equivalents, restricted cash and short-term marketable securities, and the size of ~~the company’s~~our global credit facilities for each of the past three years. For the ~~nine~~six months ended, or ~~as of,~~at, as applicable, ~~September~~June 30, ~~2019,~~2020, those amounts are ~~$11.3~~$8.1 billion of net cash from operating activities, ~~$11.0~~$14.3 billion of cash and cash equivalents, restricted cash and short-term marketable securities and $15.3 billion in global credit facilities, respectively. While we have no current plans to draw on these credit facilities, they are available as back-up liquidity.

On July 9, 2019, we closed the acquisition of Red Hat for cash consideration of $34.8 billion. The transaction was funded through a combination of cash on hand and proceeds from debt issuances. In order to reduce this debt and return

Table of Contents

Management Discussion – (continued)

to target leverage ratios within a couple of years, the company suspended its share repurchase program at the time of the Red Hat acquisition closing. Refer to note 11, “Borrowings,” for additional details of financing this transaction.

The major rating agencies’ ratings on ~~the company’s~~our debt securities at ~~September~~June 30, ~~2019~~2020 appear in the following ~~table:~~table and remain unchanged.

~~Can~~
	STANDARD	MOODY’S
	AND	INVESTORS
IBM and IBM Credit LLC ratings:	POOR’S	SERVICE
Senior long-term debt	A	A2
Commercial paper	A-1	Prime-1

~~On July 9, 2019, the company closed the acquisition of Red Hat for cash consideration of $34.8 billion. The transaction was funded through~~We remain committed to a ~~combination of cash on hand and proceeds from debt issuances. In order to reduce this debt and return to~~ target leverage ~~ratios~~profile consistent with a mid to high single A credit rating within a couple of years, the company suspended its share repurchase program at the time of the Red Hat acquisition closing. Refer to note 13, “Borrowings,” for additional details of financing this transaction. In the third-quarter 2019, the company reduced debt by $6.7 billion.

After closing the transaction, Moody’s, as expected, downgraded IBM and IBM Credit LLC’s long-term debt rating from A1 to A2 and improved its outlook to stable. The commercial paper rating from Moody’s remains unchanged. Standard and Poor’s ratings remain unchanged. Additionally, Fitch affirmed its rating before withdrawing coverage on IBM for commercial reasons.years.

~~IBM will continue with a disciplined financial policy and is committed to maintaining strong investment grade credit ratings. The company does~~We do not have “ratings trigger” provisions in ~~its~~our debt covenants or documentation, which would allow the holders to declare an event of default and seek to accelerate payments thereunder in the event of a change in credit rating. ~~The company’s~~Our debt covenants are well within the required levels. Our contractual agreements governing derivative instruments contain standard market clauses which can trigger the termination of the agreement if ~~the company’s~~our credit rating were to fall below investment grade. At ~~September~~June 30, ~~2019,~~2020, the fair value of those instruments that were in a liability position was ~~$1,074~~$491 million, before any applicable netting, and this position is subject to fluctuations in fair value period to period based on the level of ~~the company’s~~our outstanding instruments and market conditions. ~~The company has~~We have no other contractual arrangements

~~Table of Contents~~

~~Management Discussion – (continued)~~

that, in the event of a change in credit rating, would result in a material adverse effect on ~~its~~our financial position or liquidity.

In July 2017, the UK's Financial Conduct Authority, which regulates the London Interbank Offered Rate (LIBOR), announced that it intends to phase out LIBOR by the end of 2021. Various central bank committees and working groups continue to discuss replacement of benchmark rates, the process for amending existing LIBOR-based contracts, and the potential economic impacts of different alternatives. The Alternative Reference Rates Committee has identified the Secured Overnight Financing Rate (SOFR) as its preferred alternative rate for USD LIBOR. SOFR is a measure of the cost of borrowing cash overnight, collateralized by U.S. Treasury securities, and is based on directly observable U.S. Treasury-backed repurchase transactions. ~~The company is evaluating~~We are continuing to evaluate the potential impact of the replacement of the LIBOR benchmark interest rate, including risk management, internal operational readiness and monitoring the FASB standard-setting process for additional updates to address financial reporting issues that might arise in connection with transition from LIBOR to a new benchmark rate.

~~The company prepares its~~We prepare our Consolidated Statement of Cash Flows in accordance with applicable accounting standards for cash flow presentation on page 7 of this Form 10-Q and ~~highlights~~highlight causes and events underlying sources and uses of cash in that format on ~~page 96.~~pages 83 and 84. For the purpose of running its business, ~~the company~~IBM manages, monitors and analyzes cash flows in a different manner.

Management uses free cash flow as a measure to evaluate its operating results, plan share repurchase levels, strategic investments and assess its ability and need to incur and service debt. The entire free cash flow amount is not necessarily available for discretionary expenditures. ~~The company defines~~We define free cash flow as net cash from operating activities less the change in Global Financing receivables and net capital expenditures, including the investment in software. A key objective of the Global Financing business is to generate strong returns on equity, and increasing receivables is the basis for growth. Accordingly, management considers Global Financing receivables as a profit-generating investment, not as working capital that should be minimized for efficiency. Therefore, management includes presentations of both free cash flow and net cash from operating activities that exclude the effect of Global Financing receivables. Free cash flow guidance is derived using an estimate of profit, working capital and operational cash ~~outflows.~~flows. As previously noted, ~~the company views~~we view Global Financing receivables as a profit-generating investment which ~~it seeks~~we seek to maximize and therefore it is not considered when formulating guidance for free cash flow. As a result, ~~the company does~~we do not estimate a GAAP Net Cash from Operations expectation metric.

~~The following is management’s view of cash flows for the first nine months of 2019 and 2018 prepared in a manner consistent with the description above.~~

(Dollars in millions)

For the nine months ended September 30:

2019

2018
Net cash from operating activities per GAAP

$
11,319

$
11,128
Less: change in Global Financing receivables

3,712

2,874
Net cash from operating activities, excluding Global Financing receivables

$
7,607

$
8,254
Capital expenditures, net

(1,725)

(2,839)
Free cash flow

$
5,882

$
5,415
Acquisitions

(32,630)

(123)
Divestitures

927

—
Share repurchase

(1,361)

(2,393)
Common stock repurchases for tax withholdings

(186)

(148)
Dividends

(4,269)

(4,250)
Non-Global Financing debt

28,432

1,607
Other (includes Global Financing net receivables and Global Financing debt)

1,941

1,712
Change in cash, cash equivalents, restricted cash and short-term marketable securities

$
(1,265)

$
1,820

~~100~~87

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Management Discussion – (continued)

The following is management’s view of cash flows for the first six months of 2020 and 2019 prepared in a manner consistent with the description above.


(Dollars in millions)
For the six months ended June 30:	2020		2019
Net cash from operating activities per GAAP	$	8,052	$	7,700
Less: change in Global Financing receivables		2,971		2,577
Net cash from operating activities, excluding Global Financing receivables	$	5,081	$	5,123
Capital expenditures, net		(1,434)		(1,045)
Free cash flow	$	3,647	$	4,078
Acquisitions		(19)		(43)
Divestitures		757		888
Share repurchase		—		(1,236)
Common stock repurchases for tax withholdings		(211)		(152)
Dividends		(2,890)		(2,833)
Non-Global Financing debt		3,958		33,399
Other (includes Global Financing net receivables and Global Financing debt)		(1)		84
Change in cash, cash equivalents, restricted cash and short-term marketable securities	$	5,241	$	34,186

In the first ~~nine~~six months of ~~2019, the company~~2020, we generated free cash flow of ~~$5.9~~$3.6 billion, ~~an increase~~a decrease of ~~$0.5~~$0.4 billion versus the prior year. ~~The company made cash payments net~~In the first six months of ~~cash received of $32.6 billion to acquire Red Hat while~~2020, we also ~~continuing~~continued to return value to shareholders ~~including $4.3~~with $2.9 billion in ~~dividends and $1.4 billion in gross common stock repurchases.~~dividends.

Events that could temporarily change the historical cash flow dynamics discussed previously and in ~~the company’s 2018~~our 2019 Annual Report include significant changes in operating results, material changes in geographic sources of cash, unexpected adverse impacts from litigation, future pension funding requirements, periods of severe downturn in the capital markets or the timing of tax payments. Whether any litigation has such an adverse impact will depend on a number of variables, which are more completely described in note ~~14,~~13, “Contingencies,” in this Form 10-Q. With respect to pension funding, ~~the company expects~~we expect to make legally mandated pension plan contributions to certain non-U.S. defined benefit plans of approximately $300 million in ~~2019.~~2020. Contributions related to all retirement-related plans are expected to be approximately ~~$2.2~~$2.3 billion in ~~2019.~~2020. Financial market performance could increase the legally mandated minimum contributions in certain non-U.S. countries that require more frequent remeasurement of the funded status. ~~The company is~~We are not quantifying any further impact from pension funding because it is not possible to predict future movements in the capital markets or pension plan funding regulations.

In ~~2019, the company is~~2020, we are not legally required to make any contributions to the U.S. defined benefit pension plans.

~~The company’s~~Our cash flows are sufficient to fund ~~its~~our current operations and obligations, including investing and financing activities such as dividends and debt service. When additional requirements arise, ~~the company has~~we have several liquidity options available. These options may include the ability to borrow additional funds at reasonable interest rates and utilizing ~~its~~our committed global credit facilities. With our share repurchase program suspended since the close of the Red Hat acquisition, our overall shareholder payout remains at a comfortable level and we remain fully committed to our dividend.

Table of Contents

Management Discussion – (continued)

Global Financing Return on Equity Calculation



	For Three Months Ended						For Nine Months Ended						For Three Months Ended						For Six Months Ended
	September 30,						September 30,						June 30,						June 30,
(Dollars in millions)	2019			2018			2019			2018			2020			2019			2020			2019
Numerator
Global Financing after-tax income*	$	217		$	235		$	521		$	791		$	147		$	188		$	339		$	304
Annualized after-tax income (1)	$	867		$	940		$	694		$	1,055		$	588		$	754		$	677		$	608
Denominator
Average Global Financing equity (2)**	$	2,672		$	3,414		$	3,022		$	3,457		$	2,453		$	3,028		$	2,551		$	3,175
Global Financing return on equity (1)/(2)		32.4	%		27.5	%		23.0	%		30.5	%		24.0	%		24.9	%		26.5	%		19.2	%

* Calculated based upon an estimated tax rate principally based on Global Financing’s geographic mix of earnings as IBM’s provision for income taxes is determined on a consolidated basis.

** Average of the ending equity for Global Financing for the last two quarters and ~~four~~three quarters, for the three months ended ~~September~~June 30, and for the ~~nine~~six months ended ~~September~~June 30, respectively.

~~101~~89

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Management Discussion – (continued)

GAAP Reconciliation

The tables below provide a reconciliation of the company’s income statement results as reported under GAAP to its operating earnings presentation which is a non-GAAP measure. The company’s calculation of operating (non-GAAP) earnings, as presented, may differ from similarly titled measures reported by other companies. Refer to the “Operating (non-GAAP) Earnings” section for the company’s rationale for presenting operating earnings information.


				Acquisition-			Retirement-			U.S.									Acquisition-			Retirement-			U.S.
(Dollars in millions except per share amounts)				Related			Related			Tax Reform			Operating						Related			Related			Tax Reform			Operating
For the three months ended September 30, 2019:	GAAP			Adjustments			Adjustments			Charges**			(non-GAAP)
For the three months ended June 30, 2020:																GAAP			Adjustments			Adjustments			Impacts			(non-GAAP)
Gross profit	$	8,336		$	209		$	—		$	—		$	8,545		$	8,700		$	187		$	—		$	—		$	8,887
Gross profit margin		46.2	%		1.2	pts.		—	pts.		—	pts.		47.4	%		48.0	%		1.0	pts.		—	pts.		—	pts.		49.0	%
S,G&A	$	5,024		$	(451)		$	—		$	—		$	4,573		$	5,248		$	(285)		$	—		$	—		$	4,962
R,D&E		1,553			(53)			—			—			1,500			1,582			—			—			—			1,582
Other (income) and expense		(31)			10			(145)			—			(166)			179			(1)			(273)			—			(95)
Interest expense		432			(24)			—			—			408			323			—			—			—			323
Total expense and other (income)		6,813			(518)			(145)			—			6,150			7,129			(286)			(273)			—			6,570
Pre-tax income from continuing operations		1,522			727			145			—			2,395			1,571			473			273			—			2,318
Pre-tax margin from continuing operations		8.4	%		4.0	pts.		0.8	pts.		—	pts.		13.3	%		8.7	%		2.6	pts.		1.5	pts.		—	pts.		12.8	%
Provision for (benefit from) income taxes*	$	(151)		$	142		$	16		$	(5)		$	1
Provision for income taxes*																$	209		$	108		$	52		$	—		$	369
Effective tax rate		(9.9)	%		8.9	pts.		1.3	pts.		(0.2)	pts.		0.1	%		13.3	%		1.9	pts.		0.7	pts.		—	pts.		15.9	%
Income from continuing operations	$	1,673		$	586		$	130		$	5		$	2,394		$	1,362		$	365		$	222		$	—		$	1,949
Income margin from continuing operations		9.3	%		3.3	pts.		0.7	pts.		0.0	pts.		13.3	%		7.5	%		2.0	pts.		1.2	pts.		—	pts.		10.8	%
Diluted earnings per share from continuing operations	$	1.87		$	0.66		$	0.14		$	0.01		$	2.68		$	1.52		$	0.41		$	0.25		$	—		$	2.18

* The tax impact on operating (non-GAAP) pre-tax income from continuing operations is calculated under the same accounting principles applied to the GAAP pre-tax income which employs an annual effective tax rate method to the results.

** Operating (non-GAAP) earnings exclude charges associated with the enactment of U.S. tax reform due to their unique non-recurring nature.


				Acquisition-			Retirement-			U.S.									Acquisition-			Retirement-			U.S.
(Dollars in millions except per share amounts)				Related			Related			Tax Reform			Operating						Related			Related			Tax Reform			Operating
For the three months ended September 30, 2018:	GAAP			Adjustments			Adjustments			Charges**			(non-GAAP)
For the three months ended June 30, 2019:																GAAP			Adjustments			Adjustments			Impacts			(non-GAAP)
Gross profit	$	8,803		$	96		$	—		$	—		$	8,899		$	9,010		$	73		$	—		$	—		$	9,083
Gross profit margin		46.9	%		0.5	pts.		—	pts.		—	pts.		47.4	%		47.0	%		0.4	pts.		—	pts.		—	pts.		47.4	%
S,G&A	$	4,363		$	(112)		$	—		$	—		$	4,251		$	5,456		$	(149)		$	—		$	—		$	5,307
R,D&E		1,252			—			—			—			1,252			1,407			—			—			—			1,407
Other (income) and expense		275			(1)			(389)			—			(115)			(747)			119			(136)			—			(764)
Interest expense		191			—			—			—			191			348			(168)			—			—			180
Total expense and other (income)		5,807			(113)			(389)			—			5,304			6,242			(198)			(136)			—			5,907
Pre-tax income from continuing operations		2,996			209			389			—			3,594			2,768			272			136			—			3,176
Pre-tax margin from continuing operations		16.0	%		1.1	pts.		2.1	pts.		—	pts.		19.2	%		14.4	%		1.4	pts.		0.7	pts.		—	pts.		16.6	%
Provision for income taxes*	$	304		$	56		$	100		$	—		$	460		$	269		$	55		$	40		$	(14)		$	349
Effective tax rate		10.2	%		1.0	pts.		1.7	pts.		—	pts.		12.8	%		9.7	%		0.9	pts.		0.8	pts.		(0.4)	pts.		11.0	%
Income from continuing operations	$	2,692		$	153		$	289		$	—		$	3,134		$	2,499		$	217		$	97		$	14		$	2,827
Income margin from continuing operations		14.4	%		0.8	pts.		1.5	pts.		—	pts.		16.7	%		13.0	%		1.1	pts.		0.5	pts.		0.1	pts.		14.8	%
Diluted earnings per share from continuing operations	$	2.94		$	0.17		$	0.31		$	—		$	3.42		$	2.81		$	0.24		$	0.11		$	0.01		$	3.17

** Operating (non-GAAP) earnings exclude charges associated with the enactment of U.S. tax reform due to their unique non-recurring nature.

~~102~~90

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Management Discussion – (continued)


				Acquisition-			Retirement-			U.S.									Acquisition-			Retirement-			U.S.
(Dollars in millions except per share amounts)				Related			Related			Tax Reform			Operating						Related			Related			Tax Reform			Operating
For the nine months ended September 30, 2019:	GAAP			Adjustments			Adjustments			Charges**			(non-GAAP)
For the six months ended June 30, 2020:																GAAP			Adjustments			Adjustments			Impacts			(non-GAAP)
Gross profit	$	25,388		$	359		$	—		$	—		$	25,747		$	16,622		$	375		$	—		$	—		$	16,998
Gross profit margin		45.9	%		0.6	pts.		—	pts.		—	pts.		46.5	%		46.6	%		1.1	pts.		—	pts.		—	pts.		47.6	%
S,G&A	$	15,171		$	(724)		$	—		$	—		$	14,447		$	11,203		$	(570)		$	—		$	—		$	10,633
R,D&E		4,393			(53)			—			—			4,340			3,207			—			—			—			3,207
Other (income) and expense		(850)			152			(419)			—			(1,118)			361			(1)			(538)			—			(178)
Interest expense		990			(228)			—			—			762			649			—			—			—			649
Total expense and other (income)		19,215			(853)			(419)			—			17,942			15,101			(571)			(538)			—			13,992
Pre-tax income from continuing operations		6,173			1,212			419			—			7,805			1,522			946			538			—			3,006
Pre-tax margin from continuing operations		11.1	%		2.2	pts.		0.8	pts.		—	pts.		14.1	%		4.3	%		2.7	pts.		1.5	pts.		—	pts.		8.4	%
Provision for income taxes*	$	407		$	245		$	82		$	(160)		$	575
Provision for (benefit from) income taxes*																$	(1,017)		$	210		$	65		$	149		$	(592)
Effective tax rate		6.6	%		2.1	pts.		0.7	pts.		(2.0)	pts.		7.4	%		(66.8)	%		28.0	pts.		14.1	pts.		5.0	pts.		(19.7)	%
Income from continuing operations	$	5,766		$	967		$	338		$	160		$	7,230		$	2,538		$	736		$	472		$	(149)		$	3,598
Income margin from continuing operations		10.4	%		1.7	pts.		0.6	pts.		0.3	pts.		13.1	%		7.1	%		2.1	pts.		1.3	pts.		(0.4)	pts.		10.1	%
Diluted earnings per share from continuing operations	$	6.46		$	1.08		$	0.38		$	0.18		$	8.10		$	2.83		$	0.83		$	0.53		$	(0.17)		$	4.02

** Operating (non-GAAP) earnings exclude charges associated with the enactment of U.S. tax reform due to their unique non-recurring nature.


				Acquisition-			Retirement-			U.S.									Acquisition-			Retirement-			U.S.
(Dollars in millions except per share amounts)				Related			Related			Tax Reform			Operating						Related			Related			Tax Reform			Operating
For the nine months ended September 30, 2018:	GAAP			Adjustments			Adjustments			Charges**			(non-GAAP)
For the six months ended June 30, 2019:																GAAP			Adjustments			Adjustments			Impacts			(non-GAAP)
Gross profit	$	26,249		$	283		$	—		$	—		$	26,531		$	17,053		$	149		$	—		$	—		$	17,202
Gross profit margin		45.4	%		0.5	pts.		—	pts.		—	pts.		45.9	%		45.7	%		0.4	pts.		—	pts.		—	pts.		46.1	%
S,G&A	$	14,665		$	(332)		$	—		$	—		$	14,333		$	10,147		$	(273)		$	—		$	—		$	9,873
R,D&E		4,021			—			—			—			4,021			2,840			—			—			—			2,840
Other (income) and expense		968			(1)			(1,185)			—			(219)			(820)			142			(274)			—			(951)
Interest expense		530			—			—			—			530			558			(204)			—			—			354
Total expense and other (income)		19,341			(333)			(1,185)			—			17,822			12,402			(335)			(274)			—			11,793
Pre-tax income from continuing operations		6,908			616			1,185			—			8,709			4,651			484			274			—			5,409
Pre-tax margin from continuing operations		11.9	%		1.1	pts.		2.0	pts.		—	pts.		15.1	%		12.5	%		1.3	pts.		0.7	pts.		—	pts.		14.5	%
Provision for income taxes*	$	138		$	138		$	285		$	(93)		$	468		$	558		$	104		$	66		$	(155)		$	574
Effective tax rate		2.0	%		1.4	pts.		3.0	pts.		(1.1)	pts.		5.4	%		12.0	%		0.8	pts.		0.6	pts.		(2.9)	pts.		10.6	%
Income from continuing operations	$	6,770		$	478		$	900		$	93		$	8,241		$	4,093		$	381		$	208		$	155		$	4,836
Income margin from continuing operations		11.7	%		0.8	pts.		1.6	pts.		0.2	pts.		14.2	%		11.0	%		1.0	pts.		0.6	pts.		0.4	pts.		13.0	%
Diluted earnings per share from continuing operations	$	7.36		$	0.52		$	0.98		$	0.10		$	8.96		$	4.58		$	0.44		$	0.23		$	0.17		$	5.42

** Operating (non-GAAP) earnings exclude charges associated with the enactment of U.S. tax reform due to their unique non-recurring nature.

~~103~~91

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Management Discussion – (continued)

Forward-Looking and Cautionary Statements

Except for the historical information and discussions contained herein, statements contained in this Form 10-Q may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are based on the company’s current assumptions regarding future business and financial performance. These statements involve a number of risks, uncertainties and other factors that could cause actual results to differ materially, including, but not limited to, the following: a downturn in economic environment and client spending budgets; the company’s failure to meet growth and productivity objectives; a failure of the company’s innovation initiatives; damage to the company’s reputation; risks from investing in growth opportunities; failure of the company’s intellectual property portfolio to prevent competitive offerings and the failure of the company to obtain necessary licenses; cybersecurity and data privacy considerations; fluctuations in financial results; impact of local legal, economic, political, health and ~~health~~other conditions; adverse effects from environmental matters, tax matters and the company’s pension plans; ineffective internal controls; the company’s use of accounting estimates; impairment of the company’s goodwill or amortizable intangible assets; the company’s ability to attract and retain key employees and its reliance on critical skills; impacts of relationships with critical suppliers; product quality issues; impacts of business with government clients; currency fluctuations and customer financing risks; impact of changes in market liquidity conditions and customer credit risk on receivables; reliance on third party distribution channels and ecosystems; the company’s ability to successfully manage acquisitions, alliances and dispositions, including integration challenges, failure to achieve objectives, the assumption of liabilities, and higher debt levels; legal proceedings and investigatory risks; risk factors related to IBM securities; and other risks, uncertainties and factors discussed in the company’s Form 10-Qs, Form 10-K and in the company’s other filings with the U.S. Securities and Exchange Commission or in materials incorporated therein by reference. Any forward-looking statement in this Form 10-Q speaks only as of the date on which it is made. Except as required by law, the company assumes no obligation to update or revise any forward-looking statements.

Item 4. Controls and Procedures

The company’s management evaluated, with the participation of the Chief Executive Officer and Chief Financial Officer, the effectiveness of the company’s disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that the company’s disclosure controls and procedures were effective as of the end of the period covered by this report. There has been no change in the company’s internal control over financial reporting that occurred during the quarter covered by this report that has materially affected, or is reasonably likely to materially affect, the company’s internal control over financial reporting.

~~104~~92

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Part II — Other Information

Item 1. Legal Proceedings

Refer to note ~~14,~~13, “Contingencies,” in this Form 10-Q.

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

The following table provides information relating to the company’s repurchase of common stock for the ~~third~~second quarter of ~~2019.~~2020.


				Total Number	Approximate					Total Number	Approximate
				of Shares	Dollar Value					of Shares	Dollar Value
				Purchased as	of Shares that					Purchased as	of Shares that
	Total Number	Average		Part of Publicly	May Yet Be		Total Number	Average		Part of Publicly	May Yet Be
	of Shares	Price Paid		Announced	Purchased Under		of Shares	Price Paid		Announced	Purchased Under
Period	Purchased	per Share		Program	The Program*		Purchased	per Share		Program	The Program*
July 1, 2019 - July 31, 2019	822,159	$	140.42	822,159	$	2,007,611,768
April 1, 2020 - April 30, 2020							—	$	—	—	$	2,007,611,768

August 1, 2019 - August 31, 2019	—	$	—	—	$	2,007,611,768
May 1, 2020 - May 31, 2020							—	$	—	—	$	2,007,611,768

September 1, 2019 - September 30, 2019	—	$	—	—	$	2,007,611,768
June 1, 2020 - June 30, 2020							—	$	—	—	$	2,007,611,768

Total	822,159	$	140.42	822,159			—	$	—	—

* On October 30, 2018, the Board of Directors authorized $4.0 billion in funds for use in the company’s common stock repurchase program. The company stated that it would repurchase shares on the open market or in private transactions depending on market conditions. The common stock repurchase program does not have an expiration date. This table does not include shares tendered to satisfy the exercise price in connection with cashless exercises of employee stock options or shares tendered to satisfy tax withholding obligations in connection with employee equity awards.

The ~~company’s acquisition of Red Hat on July 9, 2019 was funded through a combination of debt and cash, with incremental debt issued earlier this year. The~~ company suspended its share repurchase program at the time of the Red Hat closing. At ~~September~~June 30, ~~2019~~2020 there was approximately $2.0 billion in authorized funds remaining for purchases under this program.

~~Item 5. Other Information~~

On September 24, 2019, the company announced that F. William McNabb III had been elected to the IBM Board of Directors, effective October 29, 2019. As a result, Article III, Section 2 of the company’s By-Laws was amended to increase the number of directors to thirteen, effective October 29, 2019. The full text of IBM’s By-Laws, as amended effective October 29, 2019, is included as Exhibit 3.2 to this report.

~~105~~93

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Item 6. Exhibits


Exhibit Number

~~3.2~~10.1		~~The By-Laws~~Terms and Conditions of IBM ~~as amended through October 29, 2019.~~LTPP Equity Awards, effective June 1, 2020.

~~10.1~~10.2		~~Forms~~Amendment No. 10 to the IBM Excess 401(k) Plus Plan, a compensatory plan, dated as of LTPP equity award agreements for (i) stock options, restricted stock, restricted stock units, cash-settled restricted stock units, SARS and (ii) performance share units as well as the Terms and Conditions of LTPP Equity Awards, effective October 1, 2019, in connection with the foregoing award agreements.April 13, 2020.

31.1		Certification by principal executive officer pursuant to Rule 13A-14(a) or 15D-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification by principal financial officer pursuant to Rule 13A-14(a) or 15D-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification by principal executive officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification by principal financial officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

101.INS		XBRL Instance Document – the instance document does not appear on the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document

101.SCH		XBRL Taxonomy Extension Schema Document

101.CAL		XBRL Taxonomy Extension Calculation Linkbase Document

101.DEF		XBRL Taxonomy Extension Definition Linkbase Document

101.LAB		XBRL Taxonomy Extension Label Linkbase Document

101.PRE		XBRL Taxonomy Extension Presentation Linkbase Document

104		Cover Page Interactive Data File – the cover page interactive data file does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document

~~106~~94

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SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


		International Business Machines Corporation
		(Registrant)

Date:	~~October 29, 2019~~July 28, 2020
		By:	/s/ Robert F. Del Bene
			Robert F. Del Bene
			Vice President and Controller

~~107~~95


	Three Months Ended September 30,					Nine Months Ended September 30,
(Dollars in millions except per share amounts)	2019		2018			2019			2018
Revenue:
Services	$	11,703	$	12,043	*	$	35,454	*	$	36,848	*
Sales		5,981		6,324	*		18,817	*		19,787	*
Financing		343		389			1,099			1,195
Total revenue		18,028		18,756			55,370			57,830
Cost:
Services		7,840		7,951	*		24,293	*		25,238	*
Sales		1,635		1,714	*		4,979	*		5,498	*
Financing		217		287			710			846
Total cost		9,692		9,953			29,982			31,582
Gross profit		8,336		8,803			25,388			26,249
Expense and other (income):
Selling, general and administrative		5,024		4,363			15,171			14,665
Research, development and engineering		1,553		1,252			4,393			4,021
Intellectual property and custom development income		(166)		(275)			(489)			(842)
Other (income) and expense		(31)		275			(850)			968
Interest expense		432		191			990			530
Total expense and other (income)		6,813		5,807			19,215			19,341
Income from continuing operations before income taxes		1,522		2,996			6,173			6,908
Provision for/(benefit from) income taxes		(151)		304			407			138
Income from continuing operations	$	1,673	$	2,692		$	5,766		$	6,770
Income/(loss) from discontinued operations, net of tax		(1)		2			(5)			7
Net income	$	1,672	$	2,694		$	5,761		$	6,777

Earnings/(loss) per share of common stock:
Assuming dilution:
Continuing operations	$	1.87	$	2.94		$	6.46		$	7.36
Discontinued operations		0.00		0.00			(0.01)			0.01
Total	$	1.87	$	2.94		$	6.45		$	7.37
Basic:
Continuing operations	$	1.89	$	2.95		$	6.50		$	7.39
Discontinued operations		0.00		0.00			(0.01)			0.01
Total	$	1.89	$	2.95		$	6.49		$	7.40

Weighted-average number of common shares outstanding: (millions)
Assuming dilution		892.8		915.2			892.5			920.0
Basic		886.0		911.2			887.3			915.6


(Dollars in millions)
At September 30, 2019	Level 1		Level 2		Level 3		Total
Assets:
Cash equivalents (1)
Time deposits and certificates of deposit	$	—	$	6,251	$	—	$	6,251	(6)
Money market funds		597		—		—		597
Total	$	597	$	6,251	$	—	$	6,848
Equity investments (2)		0		—		—		0
Debt securities – current (3)		—		733		—		733	(6)
Debt securities – noncurrent (2)		—		111		—		111	(6)
Derivative assets (4)		4		533		—		536
Total assets	$	601	$	7,628	$	—	$	8,229
Liabilities:
Derivative liabilities (5)	$	—	$	1,074	$	—	$	1,074


(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
Total assets	$	26	$	9,028	$	—	$	9,053
Liabilities:
Derivative liabilities (5)	$	40	$	343	$	—	$	383


	Fair Value of Derivative Assets					Fair Value of Derivative Liabilities
	Balance Sheet					Balance Sheet
(Dollars in millions)	Classification	9/30/2019		12/31/2018		Classification	9/30/2019		12/31/2018
Designated as hedging instruments:
Interest rate contracts	Prepaid expenses and other current assets	$	9	$	9	Other accrued expenses and liabilities	$	—	$	4
	Investments and sundry assets		106		212	Other liabilities		2		76
Foreign exchange contracts	Prepaid expenses and other current assets		368		348	Other accrued expenses and liabilities		165		110
	Investments and sundry assets		35		135	Other liabilities		869		129
	Fair value of derivative assets	$	518	$	704	Fair value of derivative liabilities	$	1,035	$	320
Not designated as hedging instruments:
Foreign exchange contracts	Prepaid expenses and other current assets	$	12	$	26	Other accrued expenses and liabilities	$	36	$	13
Equity contracts	Prepaid expenses and other current assets		6		2	Other accrued expenses and liabilities		2		51
	Fair value of derivative assets	$	18	$	28	Fair value of derivative liabilities	$	38	$	63
Total derivatives		$	536	$	731		$	1,074	$	383
Total debt designated as hedging instruments (1):
Short-term debt			N/A		N/A		$	—	$	—
Long-term debt			N/A		N/A			6,061		6,261
			N/A		N/A		$	6,061	$	6,261
Total		$	536	$	731		$	7,134	$	6,644


	September 30,			December 31,
(Dollars in millions)	2019			2018
Short-term debt:
Carrying amount of the hedged item	$	(326)		$	(1,878)
Cumulative hedging adjustments included in the carrying amount - assets/(liabilities)		(1)	(1)		(4)	(1)
Long-term debt:
Carrying amount of the hedged item	$	(4,834)		$	(6,004)
Cumulative hedging adjustments included in the carrying amount - assets/(liabilities)		(469)	(2)		(333)	(2)


						Gains/(Losses) of
(Dollars in millions)	Total					Total Hedge Activity
For the three months ended September 30:	2019		2018			2019		2018
Cost of services	$	7,840	$	7,951	*	$	22	$	1
Cost of sales		1,635		1,714	*		10		8
Cost of financing		217		287			(11)		(3)	*
SG&A expense		5,024		4,363			20		47
Other (income) and expense		(31)		275			(561)		(63)
Interest expense		432		191			(35)		(3)	*


(Dollars in millions)
At June 30, 2020:	Americas		EMEA		Asia Pacific		Total
Amortized cost	$	9,060	$	4,932	$	3,201	$	17,192

Allowance for credit losses
Beginning balance at December 31, 2019	$	120	$	54	$	36	$	210
Adjustment for adoption of new standard		21		15		5		41
Beginning balance at January 1, 2020	$	142	$	69	$	41	$	252
Write-offs	$	(17)	$	(1)	$	(2)	$	(21)
Recoveries		0		0		2		2
Additions/(releases)		28		9		(2)		34
Other*		(13)		0		(1)		(14)
Ending balance at June 30, 2020	$	140	$	76	$	37	$	253


	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	2019		2018		2019		2018
Derivative instruments in fair value hedges (1):
Interest rate contracts	Cost of financing	$	3	$	(27)	$	0	$	33
	Interest expense		9		(26)		0		33
Derivative instruments not designated as hedging instruments:
Foreign exchange contracts	Other (income) and expense		(114)		(55)		N/A		N/A
Equity contracts	SG&A expense		9		40		N/A		N/A
Total		$	(94)	$	(69)	$	0	$	66


	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 September 30:	2019		2018		Earnings Line Item	2019		2018			2019		2018
Derivative instruments in cash flow hedges:
Interest rate contracts	$	—	$	—	Cost of financing	$	(1)	$	—		$	—	$	—
					Interest expense		(3)		—			—		—
Foreign exchange contracts		(439)		(46)	Cost of services		22		1			—		—
					Cost of sales		10		8			—		—
					Cost of financing		(20)		(18)	*		—		—
					SG&A expense		11		7			—		—
					Other (income) and expense		(447)		(8)			—		—
					Interest expense		(61)		(18)	*		—		—
Instruments in net investment hedges (4):
Foreign exchange contracts		435		86	Cost of financing		—		—			7		9	*
					Interest expense		—		—			20		9	*
Total	$	(4)	$	40		$	(488)	$	(28)		$	27	$	18


~~At September 30:~~	~~2019~~
~~Weighted-average remaining lease term — finance leases~~		~~5.9~~	~~yrs.~~
~~Weighted-average remaining lease term — operating leases~~		~~5.3~~	~~yrs.~~
~~Weighted-average discount rate — finance leases~~		~~1.73~~	%
~~Weighted-average discount rate — operating leases~~		~~3.10~~	%


	Remainder of										Beyond		Imputed
(Dollars in millions)	2019		2020		2021		2022		2023		2023		Interest*		Total
Finance leases	$	10	$	42	$	43	$	36	$	24	$	53	$	(54)	$	155
Operating leases	$	402	$	1,419	$	1,123	$	847	$	604	$	1,160	$	(388)	$	5,167


(Dollars in millions)	Total
Remainder of 2019	$	847
2020		2,344
2021		1,571
2022		759
2023		216
Thereafter		43
Total undiscounted cash flows	$	5,781
Present value of lease payments (recognized as financing receivables)		5,337	*
Difference between undiscounted cash flows and discounted cash flows	$	444


(Dollars in millions)
At September 30, 2019:	Americas		EMEA		Asia Pacific		Total
At December 31, 2019:									Americas		EMEA		Asia Pacific		Total
Recorded investment
Lease receivables	$	3,279	$	1,096	$	961	$	5,337	$	3,419	$	1,186	$	963	$	5,567
Loan receivables		5,899		3,161		2,356		11,415		6,726		3,901		2,395		13,022
Ending balance	$	9,178	$	4,257	$	3,317	$	16,752	$	10,144	$	5,087	$	3,359	$	18,590
Recorded investment collectively evaluated for impairment	$	9,039	$	4,209	$	3,275	$	16,523	$	10,032	$	5,040	$	3,326	$	18,399
Recorded investment individually evaluated for impairment	$	139	$	48	$	43	$	229	$	112	$	47	$	32	$	191

Allowance for credit losses
Beginning balance at January 1, 2019
Lease receivables	$	53	$	22	$	24	$	99	$	53	$	22	$	24	$	99
Loan receivables		105		43		32		179		105		43		32		179
Total	$	158	$	65	$	56	$	279	$	158	$	65	$	56	$	279
Write-offs	$	(14)	$	(3)	$	(6)	$	(23)	$	(42)	$	(3)	$	(18)	$	(63)
Recoveries		0		0		0		1		1		0		1		2
Provision / (benefit)		4		(6)		(1)		(4)
Additions/(releases)										5		(7)		(3)		(5)
Other*		(3)		(2)		(1)		(6)		(1)		0		(1)		(2)
Ending balance at September 30, 2019	$	144	$	54	$	48	$	246
Ending balance at December 31, 2019									$	120	$	54	$	36	$	210
Lease receivables	$	35	$	23	$	22	$	81	$	33	$	23	$	16	$	72
Loan receivables	$	109	$	31	$	26	$	165	$	88	$	31	$	20	$	138

Related allowance, collectively evaluated for impairment	$	29	$	11	$	4	$	44	$	25	$	11	$	4	$	39
Related allowance, individually evaluated for impairment	$	115	$	43	$	43	$	202	$	96	$	43	$	32	$	171


(Dollars in millions)
At December 31, 2018:	Americas		EMEA		Asia Pacific		Total
Recorded investment
Lease receivables	$	3,827	$	1,341	$	1,152	$	6,320
Loan receivables		6,817		3,675		2,489		12,981
Ending balance	$	10,644	$	5,016	$	3,641	$	19,301
Recorded investment collectively evaluated for impairment	$	10,498	$	4,964	$	3,590	$	19,052
Recorded investment individually evaluated for impairment	$	146	$	52	$	51	$	249

Allowance for credit losses
Beginning balance at January 1, 2018
Lease receivables	$	63	$	9	$	31	$	103
Loan receivables		108		52		51		211
Total	$	172	$	61	$	82	$	314
Write-offs	$	(10)	$	(2)	$	(23)	$	(35)
Recoveries		0		0		2		2
Provision		7		9		0		16
Other*		(11)		(3)		(4)		(19)
Ending balance at December 31, 2018	$	158	$	65	$	56	$	279
Lease receivables	$	53	$	22	$	24	$	99
Loan receivables	$	105	$	43	$	32	$	179

Related allowance, collectively evaluated for impairment	$	39	$	16	$	5	$	59
Related allowance, individually evaluated for impairment	$	119	$	49	$	51	$	219


					Amortized		Billed
	Total		Amortized		Cost		Invoices		Amortized
(Dollars in millions)	Amortized		Cost		> 90 Days and		> 90 Days and		Cost Not
At June 30, 2020:	Cost		> 90 Days (1)		Accruing (1)		Accruing		Accruing (2)
Americas	$	9,060	$	323	$	231	$	30	$	111
EMEA		4,932		115		31		5		89
Asia Pacific		3,201		48		20		4		29
Total client financing receivables	$	17,192	$	486	$	283	$	38	$	229


					Recorded		Billed		Recorded
	Total		Recorded		Investment		Invoices		Investment
(Dollars in millions)	Recorded		Investment		> 90 Days and		> 90 Days and		Not
At December 31, 2019:	Investment		> 90 Days (1)		Accruing (1)		Accruing		Accruing (2)
Americas	$	3,419	$	187	$	147	$	11	$	41
EMEA		1,186		28		13		2		17
Asia Pacific		963		19		7		1		11
Total lease receivables	$	5,567	$	234	$	168	$	14	$	69

Americas	$	6,726	$	127	$	71	$	11	$	72
EMEA		3,901		77		8		3		72
Asia Pacific		2,395		26		6		2		21
Total loan receivables	$	13,022	$	231	$	85	$	15	$	166

Total	$	18,590	$	465	$	253	$	29	$	235


(Dollars in millions)	Lease Receivables						Loan Receivables
At December 31, 2019:	Americas		EMEA		Asia Pacific		Americas		EMEA		Asia Pacific
Credit rating:
Aaa – Aa3	$	465	$	54	$	43	$	1,028	$	193	$	189
A1 – A3		750		181		454		1,186		395		892
Baa1 – Baa3		955		409		147		1,882		1,527		619
Ba1 – Ba2		746		326		154		1,513		921		388
Ba3 – B1		215		140		101		471		564		205
B2 – B3		242		50		47		522		253		72
Caa – D		13		2		2		36		18		10
Total	$	3,385	$	1,162	$	947	$	6,638	$	3,871	$	2,376


	At June 30, 2020
	Gross Carrying		Accumulated		Net Carrying
(Dollars in millions)	Amount		Amortization		Amount*
Intangible asset class
Capitalized software	$	1,759	$	(776)	$	983
Client relationships		8,665		(1,665)		7,000
Completed technology		5,964		(1,466)		4,498
Patents/trademarks		2,213		(445)		1,768
Other**		56		(35)		20
Total	$	18,656	$	(4,387)	$	14,270


	Capitalized		Acquired
(Dollars in millions)	Software		Intangibles		Total
Remainder of 2020	$	288	$	905	$	1,193
2021		445		1,748		2,193
2022		215		1,686		1,901
2023		35		1,373		1,407
2024		0		1,323		1,323
Thereafter		—		6,251		6,251


									Foreign
									Currency
					Purchase				Translation
(Dollars in millions)	Balance		Goodwill		Price				And Other		Balance
Segment	1/1/2020		Additions		Adjustments		Divestitures		Adjustments**		6/30/2020
Cloud & Cognitive Software	$	43,037	$	11	$	(139)	$	—	$	(147)	$	42,762
Global Business Services		5,775		—		—		—		(45)		5,730
Global Technology Services		7,141		—		—		—		(61)		7,080
Systems		2,270		—		—		—		(8)		2,261
Other—divested businesses		—		—		—		—		—		—
Total	$	58,222	$	11	$	(139)	$	—	$	(260)	$	57,833

Pre-Swap Borrowing
		Balance		Balance
(Dollars in millions)	Maturities	6/30/2020		12/31/2019
U.S. dollar debt (weighted-average interest rate at June 30, 2020):*
2.2%	2020	$	1,513	$	4,326
1.6%	2021		5,536		8,498
2.6%	2022		6,246		6,289
3.3%	2023		2,403		2,388
3.3%	2024		5,041		5,045
6.6%	2025		654		636
3.3%	2026		4,350		4,350
3.0%	2027		2,219		969
6.5%	2028		313		313
3.5%	2029		3,250		3,250
2.0%	2030		1,350		—
5.9%	2032		600		600
8.0%	2038		83		83
4.5%	2039		2,745		2,745
2.9%	2040		650		—
4.0%	2042		1,107		1,107
7.0%	2045		27		27
4.7%	2046		650		650
4.3%	2049		3,000		3,000
3.0%	2050		750		—
7.1%	2096		316		316
		$	42,804	$	44,594
Other currencies (weighted-average interest rate at June 30, 2020, in parentheses):*
Euro (1.1%)	2020–2040	$	18,545	$	14,306
Pound sterling (2.7%)	2020–2022		1,301		1,390
Japanese yen (0.3%)	2022–2026		1,349		1,339
Other (3.1%)	2020–2022		203		375
		$	64,203	$	62,003
Finance lease obligations (1.8%)	2021–2030		268		204
		$	64,470	$	62,207
Less: net unamortized discount			892		881
Less: net unamortized debt issuance costs			165		142
Add: fair value adjustment**			480		440
		$	63,893	$	61,624
Less: current maturities			8,444		7,522
Total		$	55,449	$	54,102


(Dollars in millions)	Before Tax		Tax (Expense)/		Net of Tax
For the three months ended June 30, 2020:	Amount		Benefit		Amount
Other comprehensive income/(loss):
Foreign currency translation adjustments	$	4	$	135	$	139
Net changes related to available-for-sale securities:
Unrealized gains/(losses) arising during the period	$	1	$	0	$	1
Reclassification of (gains)/losses to other (income) and expense		—		—		—
Total net changes related to available-for-sale securities	$	1	$	0	$	1
Unrealized gains/(losses) on cash flow hedges:
Unrealized gains/(losses) arising during the period	$	(36)	$	9	$	(26)
Reclassification of (gains)/losses to:
Cost of services		1		0		1
Cost of sales		(9)		3		(7)
Cost of financing		7		(2)		5
SG&A expense		(7)		2		(5)
Other (income) and expense		(70)		18		(52)
Interest expense		19		(5)		15
Total unrealized gains/(losses) on cash flow hedges	$	(94)	$	25	$	(70)
Retirement-related benefit plans (1):
Prior service costs/(credits)	$	—	$	0	$	0
Net (losses)/gains arising during the period		57		(22)		35
Curtailments and settlements		13		(4)		9
Amortization of prior service (credits)/costs		0		1		1
Amortization of net (gains)/losses		566		(155)		411
Total retirement-related benefit plans	$	637	$	(180)	$	457
Other comprehensive income/(loss)	$	548	$	(21)	$	527


					Net Change		Net Unrealized
	Net Unrealized		Foreign		Retirement-		Gains/(Losses)		Accumulated
	Gains/(Losses)		Currency		Related		on Available-		Other
	on Cash Flow		Translation		Benefit		For-Sale		Comprehensive
(Dollars in millions)	Hedges		Adjustments*		Plans		Securities		Income/(Loss)
January 1, 2020	$	(179)	$	(3,700)	$	(24,718)	$	0	$	(28,597)
Other comprehensive income before reclassifications		(162)		(902)		38		1		(1,025)
Amount reclassified from accumulated other comprehensive income		25		—		841		—		866
Total change for the period	$	(137)	$	(902)	$	879	$	1	$	(160)
June 30, 2020	$	(316)	$	(4,602)	$	(23,839)	$	1	$	(28,757)


	Total
(Dollars in millions)	Consideration
Cash paid for outstanding Red Hat common stock	$	33,769
Cash paid for Red Hat equity awards		24
Cash paid to settle warrants		1,008
Cash consideration	$	34,801
Fair value of stock-based compensation awards attributable to pre-combination services		174
Stock issued to holders of vested performance share units		45
Settlement of pre-existing relationships		60
Total consideration	$	35,079


(Dollars in millions)	Total
2019 (for Q4)	$	1,949
2020		7,352
2021		9,741
2022		7,121
2023		5,278
2024 and beyond		32,071
Total	$	63,512


	For the Three Months Ended
	September 30, 2019		September 30, 2018
Number of shares on which basic earnings per share is calculated:
Weighted-average shares outstanding during period		886,018,372		911,152,848
Add — Incremental shares under stock-based compensation plans		5,368,268		2,566,139
Add — Incremental shares associated with contingently issuable shares		1,453,105		1,493,644
Number of shares on which diluted earnings per share is calculated		892,839,745		915,212,631

Income from continuing operations (millions)	$	1,673	$	2,692
Income/(loss) from discontinued operations, net of tax (millions)		(1)		2
Net income on which basic earnings per share is calculated (millions)	$	1,672	$	2,694

Income from continuing operations (millions)	$	1,673	$	2,692
Net income applicable to contingently issuable shares (millions)		—		—
Income from continuing operations on which diluted earnings per share is calculated (millions)	$	1,673	$	2,692
Income/(loss) from discontinued operations, net of tax, on which basic and diluted earnings per share is calculated (millions)		(1)		2
Net income on which diluted earnings per share is calculated (millions)	$	1,672	$	2,694

Earnings/(loss) per share of common stock:
Assuming dilution
Continuing operations	$	1.87	$	2.94
Discontinued operations		0.00		0.00
Total	$	1.87	$	2.94
Basic
Continuing operations	$	1.89	$	2.95
Discontinued operations		0.00		0.00
Total	$	1.89	$	2.95


	For the Nine Months Ended
	September 30, 2019		September 30, 2018
Number of shares on which basic earnings per share is calculated:
Weighted-average shares outstanding during period		887,291,199		915,632,501
Add — Incremental shares under stock-based compensation plans		4,007,433		3,000,429
Add — Incremental shares associated with contingently issuable shares		1,228,726		1,373,960
Number of shares on which diluted earnings per share is calculated		892,527,357		920,006,890

Income from continuing operations (millions)	$	5,766	$	6,770
Income/(loss) from discontinued operations, net of tax (millions)		(5)		7
Net income on which basic earnings per share is calculated (millions)	$	5,761	$	6,777

Income from continuing operations (millions)	$	5,766	$	6,770
Net income applicable to contingently issuable shares (millions)		0		(1)
Income from continuing operations on which diluted earnings per share is calculated (millions)	$	5,766	$	6,769
Income/(loss) from discontinued operations, net of tax, on which basic and diluted earnings per share is calculated (millions)		(5)		7
Net income on which diluted earnings per share is calculated (millions)	$	5,762	$	6,776

Earnings/(loss) per share of common stock:
Assuming dilution
Continuing operations	$	6.46	$	7.36
Discontinued operations		(0.01)		0.01
Total	$	6.45	$	7.37
Basic
Continuing operations	$	6.50	$	7.39
Discontinued operations		(0.01)		0.01
Total	$	6.49	$	7.40