Complex Accounting Estimates
Our
significant accounting principles as described in Note 1 of the Consolidated
Financial Statements are essential in understanding Management’s Discussion and
Analysis of Results of Operations and Financial Condition. Many of our
significant accounting principles require complex judgments to estimate values
of assets and liabilities. We have
procedures and processes to facilitate making these judgments.
The more judgmental estimates are summarized below.
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 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. These 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 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 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 change
with changes in the economy, individual industries, countries and individual
borrowers’ or counterparties’ ability and willingness to repay their
obligations. The degree to which any particular assumption affects the
allowance for credit losses depends on the severity of the change and its
relationship to the other assumptions.
Key judgments used in determining the allowance for
credit losses include: (i) risk ratings for pools of commercial loans and
leases, (ii) market and collateral values and discount rates for individually
evaluated loans, (iii) product type classifications for both consumer and
commercial loans and leases, (iv) loss rates used for both consumer and
commercial loans and leases, (v) adjustments made to assess current events and
conditions, (vi) considerations regarding domestic and global economic
uncertainty, and (vii) overall credit conditions.
Our
Allowance for Loan and Lease Losses is sensitive to the risk rating assigned to
commercial loans and leases and to the loss rates used for both the consumer
and commercial portfolios. Assuming a
downgrade of one level in the internal risk rating for commercial loans and leases,
except loans already risk rated Doubtful as defined by regulatory authorities, the
Allowance for Loan and Lease Losses for the commercial portfolio would increase
by approximately $1.6 billion at December 31, 2004. The Allowance for Loan and Lease Losses as a
percentage of loan and lease outstandings at December 31, 2004 was 1.65 percent
and this hypothetical increase in the allowance would raise the ratio to
approximately 2.0 percent. A 10 percent increase in the loss rates used on both
the consumer and commercial loan and lease portfolios would increase the
Allowance for Loan and Lease Losses at December 31, 2004 by approximately $370
million, of which $250 million would relate to consumer and $120 million to
commercial.
These
sensitivity analyses do not represent management’s expectations of the
deterioration in risk ratings or the increases in loss rates but are provided
as hypothetical scenarios to assess the sensitivity of the Allowance for Loan
and Lease Losses to changes in key inputs.
We believe the risk ratings and loss severities currently in use are
appropriate and that the probability of a downgrade of one level of the
internal credit ratings for commercial loans and leases within a short period of time is
remote.
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.
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 are based on either direct market
quotes or observed transactions. Liquidity is a significant factor in the
determination of the fair value of Trading Account Assets or Liabilities.
Market price quotes may not be readily available for some 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 uncertainty regarding a single company or a
specific market sector. In these instances, fair value is determined based on
limited available market information and other factors, principally from
reviewing the issuer’s financial statements and changes in credit ratings made
by one or more rating agencies. At December 31, 2004, $4.4 billion of Trading
Account Assets were fair valued using these alternative approaches, representing
five percent of total Trading Account Assets at December 31, 2004. An
immaterial amount of Trading Account Liabilities were fair valued using these
alternative approaches at December 31, 2004.
Trading Account Profits, which represent the
net amount earned from our trading positions, can be volatile and are largely
driven by general market conditions and customer demand. Trading Account
Profits are dependent on the volume and type of transactions, the level of risk
assumed, and the volatility of price and rate movements at any given time. To
evaluate risk in our trading activities, we focus on the actual and potential
volatility of individual positions as well as portfolios. At a portfolio and
corporate level, we use trading limits, stress testing and tools such as
VAR modeling, which estimates a range within which the next
day's profit or loss is expected, to measure and manage market risk. At
December 31, 2004, the amount of our VAR was $47 million based on a
99 percent confidence interval. For more information on VAR, see the discussion under Trading Risk Management.
The 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 interest 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 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 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 independently
within the business segment. At December 31, 2004, the fair values of
Derivative Assets and Liabilities determined by these quantitative models were
$10.3 billion and $7.3 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, 2004, there were no changes to the quantitative models, or uses of
such models, that resulted in a material adjustment to the Consolidated Statement of Income.
AFS Securities are recorded at fair value, which is
generally based on direct market quotes from actively traded markets.
Principal Investing
Principal
Investing is included within Equity Investments and is discussed in more
detail in Business Segment Operations. Principal Investing
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 and company performance may impact
whether funding is available from private investors or the capital markets.
Investments with active market quotes are carried at
estimated fair value; however, the majority of our investments do not have
publicly available price quotations. At December 31, 2004, we had nonpublic
investments of $7.0 billion, or approximately 96 percent of the total portfolio.
Valuation of these investments requires significant management judgment.
Management determines values of the underlying investments based on multiple
methodologies including in-depth semi-annual 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. In addition, on a quarterly basis as events occur or information comes to the
attention of management that indicates a change in the value of an investment
is warranted, investments are adjusted from their original invested amount to
estimated fair 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 fair value in excess of the original invested amount. This
evidence is often in the form of a recent transaction in the 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 Income Taxes
As more fully described in Note 1 and Note 17
of the Consolidated Financial Statements, we account for income taxes in accordance with SFAS No. 109,
“Accounting for Income Taxes” (SFAS 109). Accrued income taxes, reported as a
component of Accrued Expenses and Other Liabilities on our Consolidated Balance
Sheet, represents the net amount of current income taxes we expect to pay to or
receive from various taxing jurisdictions attributable to our operations to
date. We currently file income tax
returns in more than 100 jurisdictions and consider many factors — including
statutory, judicial and regulatory guidance — in estimating the appropriate
accrued income taxes for each jurisdiction.
In applying the principles of SFAS 109, we monitor
the state of relevant tax authorities and change our estimate of accrued income
taxes due to changes in income tax laws and their interpretation by the courts
and regulatory authorities. These
revisions of our estimate of accrued income taxes, which also may result from
our own income tax planning and from the resolution of income tax
controversies, can materially affect our operating results for any given
quarter.
Goodwill
The
nature of and accounting for Goodwill is discussed in detail in Note 1
and Note 9
of the Consolidated Financial Statements. Goodwill is reviewed for potential
impairment at the reporting unit level on an annual basis, or in interim
periods if events or circumstances indicate a potential impairment.
The reporting units utilized for this test were those that are one level below the
business segments identified at the beginning of Business Segment Operations. The
impairment test is performed in two phases. The first step of the Goodwill
impairment test compares the fair value of the reporting unit with its carrying
amount, including Goodwill. If the fair value of the reporting unit exceeds its
carrying amount, Goodwill of the reporting unit is considered not impaired;
however, if the carrying amount of the reporting unit exceeds its fair value,
an additional procedure must be performed. That additional procedure compares
the implied fair value of the reporting unit’s Goodwill (as defined in SFAS
142) with the carrying amount of that Goodwill. An impairment loss is recorded
to the extent that the carrying amount of Goodwill exceeds its implied fair
value.
The fair values of the reporting units were
determined using a combination of valuation techniques consistent with the
income approach and the market approach. For purposes of the income approach,
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 may 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 were discounted using a discount rate based on expected
equity return rates, which was 11 percent for 2004. Expected rates of equity
returns were estimated based on historical market returns and risk/return rates
for similar industries of the reporting unit. For purposes of the market
approach, valuations of reporting units were based on actual comparable market
transactions and market earnings multiples for similar industries of the
reporting unit.
Our evaluations for the year ended December 31, 2004
indicated there was no impairment of our Goodwill.
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