Notes to the Consolidated Financial Statements

(Unaudited)

 

The accompanying unaudited financial statements of The McGraw-Hill Companies, Inc. (together with its consolidated subsidiaries, "McGraw-Hill," the “Company,” “we,” “us” or “our”) have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. Therefore, the financial statements included herein should be read in conjunction with the financial statements and notes included in our Annual Report on Form 10-K for the year ended December 31, 2011 (our “Annual Report”).

In the opinion of management all normal recurring adjustments considered necessary for a fair statement of the results of the interim periods have been included. The operating results for the three and six months ended June 30, 2012 are not necessarily indicative of the results that may be expected for the full year, partially due to the seasonal nature of some of our businesses. As a result, we have included the consolidated balance sheet as of June 30, 2011 for comparative purposes. Certain prior-year amounts have been reclassified to conform to the current presentation.

We have reported our Broadcasting Group, previously included in our Commodities & Commercial (“C&C”) segment, as a discontinued operation. We completed the sale on December 30, 2011 and, accordingly, the results of operations of the Broadcasting Group for all prior periods presented have been reclassified to reflect the business as a discontinued operation and the assets and liabilities of the business have been removed from the consolidated balance sheet as of December 31, 2011 and reclassified as held for sale as of June 30, 2011 . See Note 3 for further discussion.

Our critical accounting estimates are disclosed in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations , in our Annual Report. On an ongoing basis, we evaluate our estimates and assumptions, including those related to revenue recognition, allowance for doubtful accounts and sales returns, inventories, prepublication costs, accounting for the impairment of long-lived assets (including other intangible assets), goodwill and indefinite-lived intangible assets, retirement plans and post-retirement healthcare and other benefits, stock-based compensation, income taxes and contingencies. Since the date of our Annual Report, there have been no material changes to our critical accounting policies and estimates.

 

On September 12, 2011, we announced that our Board of Directors have unanimously approved a comprehensive Growth and Value Plan that includes separation into two public companies: McGraw-Hill Financial, focused on content and analytics for the financial markets, and McGraw-Hill Education, Inc. focused on education services and digital learning. The separation will be accomplished through a series of transactions in which the assets, liabilities and operations of the current McGraw-Hill Education segment ("MHE") of McGraw-Hill on a global basis will be transferred to McGraw-Hill Education, Inc. or entities that are, or will become prior to the separation, subsidiaries of McGraw-Hill Education, Inc. Each shareholder of McGraw-Hill will receive one share of McGraw-Hill Education, Inc. common stock for every three shares of McGraw-Hill common stock held on the record date for the share distribution. Current holders of McGraw-Hill stock will also retain their shares of McGraw-Hill.

We received a favorable tax ruling from the Internal Revenue Service on April 23, 2012, which provides that the separation of McGraw-Hill Education, Inc. will be tax free to the Company and its shareholders. In addition, we filed the initial McGraw-Hill Education, Inc. Form 10 registration statement with the U.S. Securities and Exchange Commission on July 11, 2012. We expect to complete the separation by the end of 2012 through a spin-off of the education business to the Company’s shareholders, subject to various conditions and regulatory approvals, including final Board approval. While we are pursuing a separation as described above we are also actively evaluating other options to deliver shareholder value, including a potential sale of MHE.

For the three and six months ended June 30, 2012 , we recorded $42 million and $75 million , respectively, of Growth and Value Plan related costs. These are costs necessary to enable separation, reduce our cost structure, accelerate growth and increase shareholder value. Specifically, these costs relate to professional fees, transaction costs for our S&P/Dow Jones Indices, LLC joint venture, severance charges, and for the six months, a charge related to a reduction in our lease commitments, and are included in selling and general expenses in the consolidated statements of income. Total costs incurred to date related to the Growth and Value Plan are $85 million .

Acquisitions

Acquisition of Coalition Development Ltd.

On July 4, 2012, CRISIL, our majority owned Indian credit rating agency, completed the acquisition of Coalition Development Ltd. (“Coalition”), a privately-held U.K. analytics company, and its subsidiaries. Coalition provides high-end analytics to leading global investment banks and other financial services firms. Coalition will be integrated into CRISIL's Global Research & Analytics business within our Standard & Poor's Ratings segment. Including the pro forma impact on earnings, the acquisition of Coalition was not material to our consolidated financial statements.

Acquisition of Dow Jones Index Business

On June 29, 2012 (the "Acquisition Date"), we closed our transaction with CME Group, Inc. (“CME Group”) and CME Group Index Services LLC (“CGIS”), a joint venture between CME Group and Dow Jones & Company, Inc., to form a new company, S&P/Dow Jones Indices, LLC (“S&P/DJ Indices”). We own 73% and CME Group and CGIS collectively own 27% of S&P/DJ Indices. In exchange for their 27% minority interest, CME Group and CGIS contributed their Dow Jones Index (“DJI”) business; in exchange for our 73% and controlling interest, we contributed our Standard & Poor's Index (“S&P Index”) business. The DJI business focuses on the development of financial benchmarks used by licensees to create exchange-traded funds, option contracts and futures contracts traded on exchanges as well as used as a metric to evaluate economic performance. The combination of these businesses creates the world's largest provider of financial market indices; we expect to increase revenue through international and asset-class expansion, new product development, enhanced market data offerings and increased cross-selling opportunities. The proforma impact on revenue and earnings from our joint venture with the DJI business was not material to our consolidated results for the three and six months ended June 30, 2012.

The terms of the operating agreement of S&P/DJ Indices contain redemption features whereby interests held by minority partners are redeemable. See Note 10 for further discussion.

Acquisition-Related Expenses

During the three and six months ended June 30, 2012 , the Company incurred $15 million of acquisition-related costs related to the formation of S&P/DJ Indices. These expenses are included in selling and general expenses in our unaudited consolidated statements of income.

Preliminary Allocation of Purchase Price

Because we consolidate S&P/DJ Indices, we have applied acquisition accounting to the S&P/DJ Indices contributed businesses and their results of operations will be included in our consolidated results of operations subsequent to the Acquisition Date.

The fair value of the DJI business acquired of $792 million was estimated by applying a market approach and an income approach. This fair value measurement is based on significant inputs not observable in the market and thus represents a Level 3 measurement. The fair value estimates of the proportionate shares of the contributed businesses are based on, but not limited to, future expected cash flows, appropriate discount rates ranging from 10% to 11% , long term growth rates of 2.5 to 3.5% , assumed financial multiples of companies deemed to be similar to the DJI, and market rate assumptions for contractual obligations. S&P Index continues to be recorded at its historical or carry-over basis.

At the Acquisition Date, our non-controlling interest has been recorded at the fair value of DJI we acquired plus the proportionate interest of the S&P Index business at our carry-over basis. As of June 30, 2012 , we recorded a redeemable noncontrolling interest in our consolidated financial statements (see Note 10 for further discussion) at the preliminary fair value of 27% of S&P/DJ Indices or $792 million due to the redemption provisions described above, representing CME Group's and CGIS' interest in S&P/DJ Indices.

The estimated values are not yet final and are subject to change, and the changes could be significant. We will finalize the amounts recognized as soon as possible as we obtain the information necessary to complete our analysis.

The tables below present the consideration transferred and the preliminary allocation of purchase price to the assets and liabilities

of the DJI business acquired as a result of the transaction.

The intangible assets, excluding goodwill, will be amortized over their anticipated useful lives, which will be determined when we finalize our purchase price allocation.

Income Taxes

We are responsible for the tax matters for S&P/DJ Indices, including the filing of returns and the administration of any proceedings with taxing authorities. For U.S. federal income tax purposes, S&P/DJ Indices is treated as a partnership. The income of S&P/DJ Indices will flow through and be subject to tax at the partners' level. However S&P/DJ Indices is expected to incur current and deferred income taxes in a limited number of states and localities and its foreign subsidiaries are expected to incur immaterial current and deferred foreign income taxes.

We recognized $216 million of non-current deferred tax liabilities in connection with CME Group and CGIS acquiring an indirect noncontrolling interest in the S&P Index business in exchange for our acquisition of a portion of our interest in the DJI business. Because we maintained control of the S&P Index business, the excess of fair value received over historical carrying value and the related tax impact were recorded in additional paid-in capital.

Goodwill and Identifiable Intangibles

Goodwill consists primarily of intangible assets that do not qualify for separate recognition, including assembled workforce, noncontractual relationships and agreements. Because our allocation of purchase price and estimated values of identifiable assets and liabilities are not yet final, the amount of total goodwill and identifiable intangibles are not yet final and subject to change. The goodwill is not expected to be deductible for tax purposes.

Acquisition of Credit Market Analysis Limited

On June 29, 2012 we acquired Credit Market Analysis Limited (“CMA”) from the CME Group. CMA provides independent data in the over-the-counter markets. CMA's data and technology will enhance our capability to provide clear, reliable pricing and related over-the-counter information. CMA will be integrated into our S&P Capital IQ / S&P Indices segment. Including the pro forma impact on earnings, the acquisition of CMA was not material to our consolidated financial statements.

Acquisition of QuantHouse

On April 3, 2012 we completed the acquisition of QuantHouse, an independent global provider of end-to-end systematic low-latency market data solutions. QuantHouse will be integrated into our S&P Capital IQ / S&P Indices segment. The acquisition allows us to offer unique real-time monitors, derived data sets and analytics as well as the ability to package and resell this data as part of a core solution. Including the pro forma impact on earnings, the acquisition of QuantHouse was not material to our

consolidated financial statements.

Acquisition of R² Technologies

On February 8, 2012, we completed the acquisition of R² Technologies (“R²”). R² provides advanced risk and scenario-based analytics to traders, portfolio and risk managers for pricing, hedging and capital management across asset classes. R² will be integrated into our S&P Capital IQ / S&P Indices segment. Including the pro forma impact on earnings, the acquisition of R² was not material to our consolidated financial statements.

Divestitures

We did not complete any dispositions during the six months ended June 30, 2012 .

During the three months and six months ended June 30, 2011 , we recorded a pretax gain of $13 million within other income in the consolidated statements of income, which related to the sale of our interest in LinkedIn Corporation in their initial public offering. This investment was held at our C&C segment.

On December 30, 2011, we completed the sale of the Broadcasting Group with The E.W. Scripps Company. This sale followed our previously announced plan to pursue the divestiture of our Broadcasting Group, which was part of our C&C segment. As a result, the results of operations of the Broadcasting Group for all prior periods presented have been reclassified to reflect the business as a discontinued operation, and the assets and liabilities of the business have been removed from the consolidated balance sheet as of December 31, 2011 and reclassified as held for sale as of June 30, 2011 .

The key components of loss from discontinued operations consist of the following for the three and six months ended June 30, 2011 :

 

The components of assets and liabilities classified as discontinued operations and included in prepaid and other current assets and other current liabilities in the consolidated balance sheet consist of the following as of:

 

 

In accordance with authoritative guidance for fair value measurements, certain assets and liabilities are required to be recorded at fair value and classified within a fair value hierarchy based on inputs used when measuring fair value. We have investments in equity securities classified as available-for-sale and an immaterial amount of forward exchange contracts that are adjusted to fair value on a recurring basis. The fair values of our investments in available-for-sale securities were determined using quoted market prices from daily exchange traded markets and are classified within Level 1 of the valuation hierarchy. The fair values of our available-for-sale securities are $11 million , $14 million and $12 million as of June 30, 2012 ,  December 31, 2011 and June 30, 2011 , respectively, and are included in other non-current assets in the consolidated balance sheets.

Other financial instruments, including cash and equivalents and short-term investments, are recorded at cost, which approximates fair value because of the short-term maturity and highly liquid nature of these instruments. The fair value of our total borrowings for each period presented is $1.3 billion and was estimated based on quoted market prices.

 

For the three and six months ended June 30, 2012 and 2011 , the effective tax rate for continuing operations was 36.3% . Including discontinued operations, the effective tax rate was 36.4% for the three and six months ended June 30, 2011 .

At the end of each interim period, we estimate the annual effective tax rate and apply that rate to our ordinary quarterly earnings. The tax expense or benefit related to significant, unusual or extraordinary items that will be separately reported or reported net of their related tax effect, and are individually computed, are recognized in the interim period in which those items occur. In addition, the effect of changes in enacted tax laws or rates or tax status is recognized in the interim period in which the change occurs.

As of June 30, 2012 ,  December 31, 2011 and June 30, 2011 , the total amount of federal, state and local, and foreign unrecognized tax benefits was $66 million , $57 million and $62 million , respectively, exclusive of interest and penalties. We recognize accrued interest and penalties related to unrecognized tax benefits in interest expense and operating expense, respectively. In addition to the unrecognized tax benefits, as of June 30, 2012 ,  December 31, 2011 and June 30, 2011 , we had $15 million , $13 million and $15 million , respectively, of accrued interest and penalties associated with uncertain tax positions.

Currently, we have the ability to borrow $1.2 billion in additional funds through our commercial paper program, which is supported by our $1.2 billion three-year credit agreement (our “credit facility”) that will terminate on July 30, 2013. We pay a commitment fee of 15 to 35 basis points for our credit facility, depending on our credit rating, whether or not amounts have been borrowed and currently pay a commitment fee of 20 basis points. The interest rate on borrowings under our credit facility is, at our option, calculated using rates that are primarily based on either the prevailing London Inter-Bank Offer Rate, the prime rate determined by the administrative agent or the Federal funds rate. For certain borrowings under this credit facility there is also a spread based on our credit rating added to the applicable rate. As of June 30, 2012 , we have not utilized our credit facility for additional funds.

Our credit facility contains certain covenants. The only financial covenant requires that our indebtedness to cash flow ratio, as defined in our credit facility, is not greater than 4 to 1 , and this covenant has never been exceeded.

 

We have a number of defined benefit pension plans and defined contribution plans covering substantially all employees. Our primary pension plan is a noncontributory plan under which benefits are based on employee career employment compensation. In December 2011, our Board of Directors approved a plan amendment that froze our U.S. Employee Retirement Plan (“U.S. ERP”) effective on April 1, 2012. Our U.S. ERP is a defined benefit plan. Under the amendment, no new employees will be permitted to enter the U.S. ERP and no additional benefits for current participants for future services will be accrued. This amendment decreased our pension benefit liabilities by $129 million as of December 31, 2011 , and resulted in an after-tax decrease in accumulated other comprehensive loss of $82 million . We also recorded an immaterial amount of pension plan curtailment expense in 2011 as a result of the plan amendment.

We also have unfunded non-U.S. benefit plans and supplemental benefit plans. The supplemental benefit plans provide senior management with supplemental retirement, disability and death benefits. Certain supplemental retirement benefits are based on final monthly earnings. In addition, we sponsor voluntary 401(k) plans under which we may match employee contributions up to certain levels of compensation as well as profit-sharing plans under which we contribute a percentage of eligible employees’ compensation to the employees’ accounts.

We also provide certain medical, dental and life insurance benefits for retired employees and eligible dependents. The medical and dental plans are contributory, while the life insurance plan is noncontributory. We currently do not prefund any of these plans.

The components of net periodic benefit cost for our retirement plans and post-retirement plans for the periods ended June 30 are as follows:

 

For the three and six months ended June 30, 2012 , our United Kingdom retirement plan accounted for $1 million and $2 million , respectively, of the net periodic benefit cost attributable to the funded plans. For the six months ended June 30, 2011 , our United Kingdom retirement plan accounted for $2 million of the net periodic benefit cost attributable to the funded plans.

As discussed in our Annual Report, we changed certain discount rate assumptions on our retirement and post-retirement plans and our expected return on assets assumption for our retirement plans, which became effective on January 1, 2012. The effect of the

assumption changes on retirement and post-retirement expense for the three and six months ended June 30, 2012 did not have a material impact to our financial position, results of operations or cash flows.

In the first six months of 2012 , we contributed $29 million to our retirement plans and expect to make additional required contributions of approximately $15 million to our retirement plans during the remainder of the year. We may elect to make additional non-required contributions depending on investment performance and the pension plan status in the second half of 2012.

 

We issue stock-based incentive awards to our eligible employees and Directors under two employee stock ownership plans (the 1993 and 2002 Employee Stock Incentive Plans) and a Director Deferred Stock Ownership Plan. No further awards may be granted under the 1993 Employees Stock Incentive Plan, although awards granted under this plan remain outstanding in accordance with their terms. The remaining outstanding options under the 1993 Employees Stock Incentive Plan will have fully met their maximum term in the first quarter of 2013. The 2002 Employee Stock Incentive Plan permits the granting of nonqualified stock options, stock appreciation rights, performance stock, restricted stock and other stock-based awards.

Stock-based compensation for the periods ended June 30 is as follows:

As of June 30, 2012 ,  December 31, 2011 and June 30, 2011 , we issued 0.7 million , 4.4 million and 2.6 million common shares, respectively, upon exercise of certain stock options outstanding.

Historically, we have granted equity awards to our employees at the beginning of the second quarter, however, given the timing of our Growth and Value Plan initiatives we have decided to defer granting these awards until the third quarter of 2012. The vesting period of these awards will be reduced to have a similar vesting date as if the awards were granted at the beginning of the second quarter.

 

Our purchased shares may be used for general corporate purposes, including the issuance of shares for stock compensation plans and to offset the dilutive effect of the exercise of employee stock options. As of June 30, 2012 , 22.7 million shares remained available under the 2011 Repurchase Program. The 2011 Repurchase Program has no expiration date and purchases under this

program may be made from time to time on the open market and in private transactions, depending on market conditions. As of December 31, 2011 , there were no remaining shares available under the 2007 stock repurchase program.

Accelerated Share Repurchase Program

On December 7, 2011 we entered into two separate Accelerated Share Repurchase Agreements (“ASR Agreements”) with a financial institution to initiate share repurchases, aggregating $500 million .

Uncollared ASR Agreement

We paid $250 million on December 12, 2011 and received an initial delivery of approximately 5 million shares from the financial institution subject to a 20% , or $50 million , holdback. At the conclusion of the uncollared ASR Agreement, which occurred on February 22, 2012, we received 0.8 million additional shares bringing the total shares repurchased under the uncollared ASR Agreement to approximately 6 million shares.

Capped ASR Agreement

We paid $250 million and received approximately 5 million shares representing the minimum number of common shares to be repurchased based on a calculation using a specific capped price per share. At the conclusion of the capped ASR Agreement, which occurred on April 23, 2012, we received 0.1 million additional shares bringing the total shares repurchased under the capped ASR Agreement to approximately 5 million shares.

The ASR Agreements were accounted for as two transactions; a stock purchase transaction and a forward stock purchase contract. The initial delivery of shares resulted in an immediate reduction of our outstanding shares used to determine our weighted average common shares outstanding for purposes of calculating basic and diluted net earnings per share. The forward stock purchase contract is classified as an equity instrument. As of June 30, 2012 and December 31, 2011 , the excess amount paid on a per share basis for the minimum shares purchased under the capped ASR Agreement was recorded as a reduction to additional paid-in capital in our consolidated balance sheets. We have evaluated the Capped ASR Agreement for its potential dilution and as a result, these additional shares were not included in our weighted average diluted earnings per share calculation because their effect would be antidilutive.

Redeemable Noncontrolling Interests

The agreement with the minority partners of our S&P/DJ Indices partnership discussed in Note 3 contains redemption features whereby interests held by minority partners are redeemable either (i) at the option of the holder or (ii) upon the occurrence of an event that is not solely within our control. Specifically, under the terms of the operating agreement of S&P/DJ Indices, after December 31, 2017, CME Group and CGIS will have the right at any time to sell, and we are obligated to buy, at least 20% of their share in S&P/DJ Indices. In addition, in the event there is a change of control of the Company, for the 15 days following a change in control, CME Group and CGIS will have the right to put their interest to us at the then fair value of CME Group's and CGIS' minority interest.

If interests were to be redeemed under this agreement, we would generally be required to purchase the interest at fair value on the date of redemption. This interest is presented on the unaudited consolidated balance sheet outside of equity under the caption “Redeemable noncontrolling interest” with an initial value based on fair value for the portion attributable to the net assets we acquired, and based on our historical cost for the portion attributable to our S&P Index business. Redeemable noncontrolling interest will be adjusted each reporting period at its estimated redemption value, but not less than its initial fair value. Any adjustments to the redemption value will impact retained income.

Noncontrolling interests that do not contain such redemption features are presented in equity.

Basic earnings per common share (“EPS”) is computed by dividing net income attributable to the common shareholders of the Company by the weighted-average number of common shares outstanding. Diluted EPS is computed in the same manner as basic EPS, except the number of shares is increased to include additional common shares that would have been outstanding if potential common shares with a dilutive effect had been issued. Potential common shares consist primarily of stock options, restricted stock and restricted stock units calculated using the treasury stock method. The calculation for basic and diluted EPS for the periods ended June 30 is as follows: