IBM accounting gimmicks
In the last years, IBM has been making accounting choices that might be considered too aggressive, to the point of misleading stakeholders about the health of the company. In this post I will describe two gimmicks IBM has been using in the last years: The lack of deterioration of the goodwill and the pension plan contributions in the form of Treasuries.
IBM is a company with a long story. Founded in 1911, it has been operating for more than a hundred years. Among his most famous inventions are the Hard disk drive or the Fortran programming language. However, its income has been in a steady decline since 2011. The emergence of the cloud appears to be the main driver of this slump, as it has deteriorated IBM’s mainframe business.
IBM has tried to reverse this situation by acquiring numerous companies. The most prominent one has been Red Hat in 2018. IBM paid around 34B $ for Red Hat, one of the biggest acquisitions in the history of tech. And, despite that, IBM revenues kept going down. These circumstances are the perfect breeding ground for accounting gimmicks. In the following lines I will present two accounting gimmicks IBM has been using to misrepresent its financial statements: the inexistent deterioration of the goodwill and pension plan contributions in treasuries instead of cash to inflate Cash Flow from Operations.
Goodwill
The first thing that stands out when looking at the balance sheet is the massive size of the Goodwill. 59,6 Billions in 2020, 38,2% of total assets. This Goodwill is the result of years of acquisitions, likely at expensive prices. Most of the research regarding Mergers and Acquisitions seem to indicate that the success rate of acquisitions is around 50%.
Now, taking this into account, the absolute lack of impairment of the goodwill is striking. Has the goodwill of IBM shown the financial results that would justify the absence of impairment? Judging from the decline in income and profits I wouldn’t say so. The most obvious reason is that they don’t want to translate the costs of the acquisitions to the income statement, as it will worsen the already bad financial outlook of IBM. The second reason (also quite obvious, as you are just a subtraction away from the ugly truth) is that its equity would be negative were they to impair a substantial part of the goodwill. In 2020, a 34,8% impairment of the goodwill would have resulted in negative equity.
Another point that probably explains the lack of impairment is the existence of significant covenants governing IBM’s debt. One ratio that would be especially affected is the interest coverage ratio, which has already been declining in the last years. According to the annual statements, this ratio determines the access of IBM to credit facilities:
“The credit facilities also include a covenant on our 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.”
These credit facilities might be specially relevant to IBM if we take into account that the working capital in the last year has been negative.
Pension Plan Contributions
The second gimmick relates to its contributions to pension plans. In 2015, IBM started to make contributions to the pension plans it is responsible for in the form of US Treasuries. According to the notes to the financial statements, this transaction is considered a non-cash transaction. The respective notes don’t indicate the reason behind this type of contribution. But if we look at its evolution we can see a worrisome upward tendency which, absent any other explanations, seems to suggest that IBM is trying to hide something:
But how does this affect the Cash Flow? Contributions to pension plans are recorded as cash outflows in the operating section. However, contributions in US Treasuries don’t have the consideration of a cash transaction so the contribution is not recorded as a cash outflow. What it is indeed recorded is the purchase of those Treasuries, but not as an outflow from the operating section but from the investing section. In this way, IBM shifts operation cash outflows to the investing section.
Conclusion
To sum up, IBM seems to have been making some dubious accounting choices to try to disguise its financial position. In addition, the recent announcement of its intentions to spin-off the Managed Infrastructure Services business into a new company called Kyndryl seems to me like another sign of problems inside the company. I wonder how much of IBM’s debt will Kyndryl assume and what IBM’s creditors have to say about that.
