3 On 20 January 2012, International Business Machines Corp. (IBM) released its financial results for the fourth quarter of 2011. For the quarter, IBM reported a profit of $5.49 billion, or $4.62 a share, up from $5.26 billion, or $4.18 a share, a year earlier. Revenue increased 1.6% to $29.5 billion. Analysts recently projected earnings of $4.61 a share on revenue of $29 billion. For its three main business segments, service revenue rose 3% to $15.4 billion, software sales increased 9% to $7.6 billion, while hardware sales dropped 8% to $5.8 billion. As disclosed in its annual report, IBM recognizes revenue from service contracts in the period the services are provided using either a straight-line basis or the percentage-of completion method. For hardware sales, revenue is recognized when risk of loss has transferred to the client. For software sales, the company uses a combined approach depending on whether the software is sold with perpetual license or term license. The company reported new service contract signings of $20.4 billion, above the $12.3 billion posted for the third quarter and the consensus estimate of $20.38 billion. Meanwhile, its services backlog rose to $141 billion from $137 billion in the third quarter. Services backlog at the end of a quarter measures the current value of work under contract expected to be recognized as revenue in future quarters. IBM shares climbed 4.4% to $187.79 in response to the earnings announcement. On the same day the broad market barely moved, with S&P 500 index unchanged. According to Yahoo! Finance, IBM has a beta of 0.6. 3 Over the past 20 years, IBM's share price has consistently reacted strongly to its reported earnings, with estimated earnings response coefficients (ERC) equal to 5. The company has also reported highly persistent earnings. Required Assume semi-strong market efficiency in your answers: 1) Explain why IBM's share price reacted positively to its fourth quarter results. (10 Marks) 2) Suggest two explanations for IBM's high ERC. (10 Marks) 3) Assuming IBM plans to change its revenue recognition method for service contracts. Instead of using its current straight-line or percentage of completion approach, the company will recognize the full amount of the expected cash receipt brought by the contract (present value) as revenue during the year of contract inception. Correspondingly it will also charge all future costs expected to incur to service the contract (present value) as expense during the same year. a. Discuss if this new accounting method is consistent with the measurement approach. (10 Marks) b. Discuss how the change in revenue recognition would affect the company's ERC and persistence of reported earnings. (10 Marks)