Bank of America | Annual Report (2003) | Complex Accounting Estimates and Principles

Complex Accounting Estimates and Principles

Our significant accounting principles are described in Note 1 of the consolidated financial statements and are essential in understanding Management's Discussion and Analysis of Results of Operations and Financial Condition. Some of our accounting principles require significant judgment to estimate values of either assets or liabilities. In addition, certain accounting principles require significant judgment in applying the complex accounting principles to complicated transactions to determine the most appropriate treatment. We have established procedures and processes to facilitate making the judgments necessary to estimate the values of our assets and liabilities and to analyze complex transactions to prepare financial statements.

The following is a summary of the more judgmental estimates and complex accounting principles. In each area, we have identified and described the development of the variables most important in the estimation process that, with the exception of accrued taxes, involves mathematical models used to derive the estimates. In many cases, there are numerous alternative judgments that could be used in the process of determining the inputs to the model. Where alternatives exist, we have used the factors that we believe represent the most reasonable value in developing the inputs. Actual performance that differs from our estimates of the key variables could impact net income. Separate from the possible future impact to net income from input and model variables, the value of our lending portfolio and market sensitive assets and liabilities may change subsequent to the balance sheet measurement, often significantly, due to the nature and magnitude of future credit and market conditions. Such credit and market conditions may change quickly and in unforeseen ways and the resulting volatility could have a significant, negative effect on future operating results and such fluctuations would not be indicative of deficiencies in our models or inputs.

Allowance for Credit Losses

The allowance for credit losses is our estimate of the probable losses in the loans and leases portfolio and within our unfunded lending commitments.

Changes to the allowance for credit losses are reported in the Consolidated Statement of Income in the provision for credit losses. Our process for determining the allowance for credit losses is discussed in detail in the Credit Risk Management section and Note 1 of the consolidated financial statements. Due to the variability in the drivers of the assumptions made in this process, estimates of the portfolio's inherent risks and overall collectibility will change as warranted by changes in the economy, individual industries and individual borrowers. The degree to which any particular assumption would affect the allowance for credit losses would depend on the severity of the change, and changes made, if necessary, to the other assumptions made in this process.

Key judgments used in determining the allowance for credit losses include: (i) risk ratings for pools of commercial loans, (ii) market and collateral values and discount rates for individually evaluated loans, (iii) product type classifications for both commercial and consumer loans, (iv) loss rates used for both commercial and consumer loans and (v) adjustments made to assess current events and conditions. Additionally, considerations regarding domestic and global economic uncertainty and overall credit conditions are used in calculating the allowance for credit losses.

The process of determining the level of the allowance for credit losses requires a high degree of judgment. It is possible that others, given the same information, may at any point in time reach different reasonable conclusions. For management analysis purposes, we do not develop alternative judgments regarding the allowance for credit losses because we do not believe such alternative judgments would provide useful information for determining the recorded allowance. While we do not develop alternative judgments, alternative judgments could result in different estimates of the required allowance for credit losses given a particular set of circumstances and such differences could be material.

Fair Value of Financial Instruments

Trading account assets and liabilities are recorded at fair value, which is primarily based on actively traded markets where prices can be obtained from either direct market quotes or observed transactions. A significant factor affecting the fair value of trading account assets or liabilities is the liquidity of a specific position within the market. Market price quotes may not be readily available for some specific positions, or positions within a market sector where trading activity has slowed significantly or ceased. Situations of illiquidity generally are triggered by the market's perception of credit regarding a single company or a specific market sector. In these instances, fair valuations are derived from the limited market information available and other factors, principally from reviewing the issuer's financial statements and changes in credit ratings made by one or more of the rating agencies. At December 31, 2003, $1.8 billion of trading account assets were fair valued using these alternative approaches, representing three percent of total trading account assets at December 31, 2003. An immaterial amount of trading account liabilities were fair valued using these alternative approaches at December 31, 2003.

Fair values of derivative assets and liabilities traded in the over-the-counter market are determined using quantitative models that require the use of multiple market inputs including rates, prices and indices to generate continuous yield or pricing curves and volatility factors, which are used to value the position. The predominance of market inputs utilized are actively quoted and can be validated through external sources, including brokers, market transactions and third party pricing services. Estimation risk is greater for derivative asset and liability positions that are either option-based or have longer maturity dates where observable market inputs are less readily available or are altogether unobservable, in which case quantitative-based extrapolations of rate, price or index scenarios are used in determining fair values.

The fair values of derivative assets and liabilities include adjustments for market liquidity, counterparty credit quality, future servicing costs and other deal specific factors, where appropriate. To ensure the prudent application of estimates and management judgment in determining the fair value of derivative assets and liabilities, various processes and controls have been adopted, which include: a Model Validation Policy that requires a review and approval of quantitative models used for deal pricing, financial statement fair value determination and risk quantification; a Trading Product Valuation Policy that requires verification of all traded product valuations; and a periodic review and substantiation of daily profit and loss reporting for all traded products. These processes and controls are performed independent of the business segment. At December 31, 2003, the fair values of derivative assets and liabilities determined by these quantitative models were $10.7 billion and $7.9 billion, respectively. These amounts reflect the full fair value of the derivatives and do not isolate the discrete value associated with the subjective valuation variable. Further, they represent five percent and four percent of derivative assets and liabilities, respectively, before the impact of legally enforceable master netting agreements. For the period ended December 31, 2003, there were no changes to the quantitative models, or uses of such models, that resulted in a material adjustment to the income statement.

Excess Spread Certificates (the Certificates), a mortgage banking asset, are carried at estimated fair value. The Certificates do not have readily observable prices; therefore, we value them using an option-adjusted spread model that requires several key components including the option-adjusted spread levels, portfolio characteristics, proprietary prepayment models, and delinquency rates. We compare our fair value estimates and assumptions to observable market data, where available, to recent market activity, portfolio experience and values necessary to meet reasonable return objectives. At December 31, 2003 and 2002, $2.3 billion and $1.6 billion of the Certificates were valued using this model. For more information on mortgage banking assets, see Note 1 and Note 8 of the consolidated financial statements.

Available-for-sale securities are recorded at fair value, which is based on direct market quotes from actively traded markets. None of the available-for-sale securities were valued using mathematical models.

Principal Investing

Principal Investing within the Equity Investments segment, discussed in more detail in "Equity Investments," is comprised of a diversified portfolio of investments in privately-held and publicly-traded companies at all stages, from start-up to buyout. These investments are made either directly in a company or held through a fund. Some of these companies may need access to additional cash to support their long-term business models. Market conditions as well as company performance may impact whether such funding is sourced from private investors or via capital markets.

Investments for which there are active market quotes are carried at estimated fair value. The majority of our investments do not have publicly available price quotations. At December 31, 2003, we had nonpublic investments of $5.0 billion or approximately 94 percent of the total portfolio. Valuation of these investments requires significant management judgment. Management determines values of the underlying investments based on varying methodologies including periodic reviews of the investee's financial statements and financial condition, discounted cash flows, the prospects of the investee's industry and current overall market conditions for similar investments. Periodically, when events occur or information comes to the attention of management regarding one or more investments that indicate a change in value of that investment is warranted, investments are adjusted from their original invested amount to estimated market values at the balance sheet date with changes being recorded in equity investment gains(losses) in the Consolidated Statement of Income. Investments are not adjusted above the original amount invested unless there is clear evidence of a market value in excess of the original invested amount. This evidence is typically in the form of a recent transaction in that particular investment. As part of the valuation process, senior management reviews the portfolio and determines when an impairment needs to be recorded. The Principal Investing portfolio is not material to our Consolidated Balance Sheet, but the impact of the valuation adjustments may be material to our operating results for any particular quarter.

Accrued Taxes

We estimate tax expense based on the amount we expect to owe various tax jurisdictions. We currently file income tax returns in approximately 85 jurisdictions. Our estimate of tax expense is reported in the Consolidated Statement of Income. Accrued taxes represent the net estimated amount due or to be received from taxing jurisdictions either currently or in the future and are reported as a component of accrued expenses and other liabilities on the Consolidated Balance Sheet. In estimating accrued taxes, we assess the relative merits and risks of the appropriate tax treatment of transactions taking into account statutory, judicial and regulatory guidance in the context of our tax position.

Changes to our estimate of accrued taxes occur periodically due to changes in the tax rates, implementation of new tax planning strategies, resolution with taxing authorities of issues with previously taken tax positions and newly enacted statutory, judicial and regulatory guidance. These changes, when they occur, affect accrued taxes and can be material to our operating results for any particular quarter. Taxes are discussed in more detail in Note 1 and Note 18 of the consolidated financial statements.

Goodwill

The nature and accounting for goodwill is discussed in detail in Note 1 and Note 10 of the consolidated financial statements. Assigned goodwill is subject to a market value recoverability test that records a loss if the implied fair value of goodwill is less than the amount recorded in the financial statements for any individual reporting unit. The first part of this test is a comparison, at the reporting unit level, of the fair value of each reporting unit to its carrying amount, including goodwill. The reporting units utilized for this test were those that are one level below the core business segments identified in Business Segment Operations.

The fair values of the reporting units are determined using a discounted cash flow model. The discounted cash flows were calculated by taking the net present value of estimated cash flows using a combination of historical results, estimated future cash flows and an appropriate price to earnings multiple. We use our internal forecasts to estimate future cash flows and actual results typically differ from forecasted results. However, these differences have not been material and we believe that this methodology provides a reasonable means to determine fair values. Cash flows are discounted using a discount rate based on a weighted average cost of capital resulting in a range of 8.7 percent to 11 percent. Weighted average cost of capital is determined using the 10-year U.S. Treasury rate adjusted for estimated required market returns and risk/return rates for similar industries of the reporting unit.

Our evaluations for the year ended December 31, 2003 indicated that none of our goodwill was impaired.

Accounting Standards

Our accounting for hedging activities, securitizations and off-balance sheet entities requires significant judgment in interpreting and applying the accounting principles related to these matters. Judgments include, but are not limited to: the determination of whether a financial instrument or other contract meets the definition of a derivative in accordance with SFAS 133 and the applicable hedge criteria including whether the derivative used in our hedging transactions is expected to be or has been highly effective as a hedge; the accounting for the transfer of financial assets and extinguishments of liabilities in accordance with SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities - a replacement of FASB Statement No. 125" (SFAS 140) and the applicable determination as to whether assets transferred meet the specific criteria for sale accounting; and the determination of when certain special purpose entities should be consolidated on our balance sheet and statement of income in accordance with Financial Accounting Standards Board (FASB) Interpretation No. 46 "Consolidation of Variable Interest Entities, an interpretation of ARB No. 51" (FIN 46) and the applicable determination of expected losses and returns as defined in FIN 46. For a more complete discussion of these principles, see Note 1, Note 6 and Note 9 of the consolidated financial statements.

The remainder of Management's Discussion and Analysis of Results of Operations and Financial Condition should be read in conjunction with the consolidated financial statements, beginning with the Consolidated Statement of Income, and related notes. See Note 1 for Recently Issued Accounting Pronouncements.

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2003 Annual Report: Financial Review: Management's Discussion and Analysis: Complex Accounting Estimates and Principles