Discover 2009 Annual Report Download - page 73

Critical Accounting Estimates
In preparing our consolidated financial statements in conformity with GAAP, management must make judgments and
use estimates and assumptions about the effects of matters that are uncertain. For estimates that involve a high degree of
judgment and subjectivity, it is possible that different estimates could reasonably be derived for the same period. For
estimates that are particularly sensitive to changes in economic or market conditions, significant changes to the estimated
amount from period to period are also possible. Management believes the current assumptions and other considerations
used to estimate amounts reflected in our consolidated financial statements are appropriate. However, if actual
experience differs from the assumptions and other considerations used in estimating amounts in our consolidated
financial statements, the resulting changes could have a material adverse effect on our consolidated results of operations
and, in certain cases, could have a material adverse effect on our consolidated financial condition. Management has
identified the estimates related to our allowance for loan losses, our interest-only strip receivable, the valuation of certain
certificated retained interests in Discover Card Execution Note Trust (“DCENT”), the accrual of credit card customer
rewards cost, the evaluation of goodwill and other nonamortizable intangible assets for potential impairment and the
accrual of income taxes as critical accounting estimates.
Allowance for Loan Losses
The allowance for loan losses represents management’s estimate of probable net loan losses inherent in the loan
portfolio. Management evaluates the allowance monthly for adequacy. The allowance is maintained through an
adjustment to the provision for loan losses. In estimating losses inherent in the credit card loan portfolio, we use an
approach that utilizes a migration analysis of delinquent and current credit card receivables. A migration analysis is a
technique used to estimate the likelihood that a loan receivable will progress through the various stages of delinquency
and to charge-off. The migration analysis considers uncollectible principal, interest and fees reflected in loan receivables.
In determining the proper level of the allowance for loan losses, management also considers factors that may impact loan
loss experience, including current economic conditions, recent trends in delinquencies and bankruptcy filings, account
collection management, policy changes, account seasoning, loan volume and amounts, payment rates and forecasting
uncertainties.
If management used different assumptions in estimating probable losses, the impact to the allowance for loan losses
could have a material effect on our consolidated financial condition and results of operations. For example, a 10%
change in management’s estimate of probable net loan losses could have resulted in a change of approximately $176
million in the allowance for loan losses at November 30, 2009, with a corresponding change in the provision for loan
losses. See Note 5: Loan Receivables to our consolidated financial statements for further details about the allowance for
loan losses.
Accounting for Asset Securitization Transactions
We account for our securitization transactions in accordance with FASB Accounting Standards Codification (“ASC”)
Topic 860, Transfers of Financial Assets. The gain on a securitization transaction depends in part on the previous
carrying amount of the assets involved in the transfer, allocated between the assets transferred and the retained interests
based upon their respective fair values at the date of the transfer. The interest-only strip receivable represents the
contractual right to receive interest and certain loan fee revenues less certain costs, including loan losses on securitized
loans and the contractual rate of interest paid to third-party investors in the securitization as well as a servicing fee from
the trust over the life of the asset sold. In the absence of observable market prices, the fair value of the interest-only strip
receivable is estimated based on the present value of expected future cash flows using management’s best estimate of the
key assumptions, including forecasted interest yield, loan losses and payment rates, the interest paid to investors and a
discount rate commensurate with the risks involved. Changes in the estimated fair value of the interest-only strip
receivable, as well as certain other retained interests, are recorded in securitization income.
If management used different assumptions in estimating the value of the interest-only strip receivable, the impact could
have a material effect on our consolidated financial condition and results of operations. For example, a 10% change in the
excess spread assumption for all securitized loans could have resulted in a change of approximately $8 million in the value
of the interest-only strip receivable as of November 30, 2009. However, as described in “Accounting Treatment for
Off-Balance Sheet Securitizations,” pursuant to new FASB guidance related to transfers of financial assets and consolidation,
the securitized loans will be consolidated in the Company’s financial statements effective December 1, 2009, at which time
the entire value of the interest-only strip receivable will be derecognized. See Note 6: Credit Card Securitization Activities to
our consolidated financial statements for further information about the accounting for securitizations.
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