JP Morgan Chase 2006 Annual Report Download - page 87

JPMorgan Chase & Co. / 2006 Annual Report 85
For a discussion of the accounting for Private equity investments, see Note 4
on pages 98–99 of this Annual Report.
MSRs and certain other retained interests in securitizations
MSRs and certain other retained interests from securitization activities do not
trade in an active, open market with readily observable prices. For example,
sales of MSRs do occur, but the precise terms and conditions typically are not
readily available. Accordingly, the Firm estimates the fair value of MSRs and
certain other retained interests in securitizations using discounted future cash
flow (DCF) models.
For MSRs, the Firm uses an option adjusted spread (“OAS”) valuation model
in conjunction with the Firm’s proprietary prepayment model to project MSR
cash flows over multiple interest rate scenarios, which are then discounted at
risk-adjusted rates to estimate an expected fair value of the MSRs. The OAS
model considers portfolio characteristics, contractually specified servicing fees,
prepayment assumptions, delinquency rates, late charges, other ancillary rev-
enues, costs to service and other economic factors.
For certain other retained interests in securitizations (such as interest-only
strips), a single interest rate path DCF model is used and generally includes
assumptions based upon projected finance charges related to the securitized
assets, estimated net credit losses, prepayment assumptions, and contractual
interest paid to third-party investors. Changes in the assumptions used may
have a significant impact on the Firm’s valuation of retained interests.
For both MSRs and certain other retained interests in securitizations, the Firm
compares its fair value estimates and assumptions to observable market data
where available and to recent market activity and actual portfolio experience.
For further discussion of the most significant assumptions used to value
retained interests in securitizations and MSRs, as well as the applicable stress
tests for those assumptions, see Notes 14 and 16 on pages 114–118 and
121–122, respectively, of this Annual Report.
Goodwill impairment
Under SFAS 142, goodwill must be allocated to reporting units and tested for
impairment. The Firm tests goodwill for impairment at least annually, and more
frequently if events or circumstances, such as adverse changes in the business
climate, indicate that there may be justification for conducting an interim test.
Impairment testing is performed at the reporting-unit level (which is generally
one level below the six major business segments identified in Note 33 on
pages 139–141 of this Annual Report, plus Private Equity which is included in
Corporate). The first part of the test is a comparison, at the reporting unit level,
of the fair value of each reporting unit to its carrying amount, including good-
will. If the fair value is less than the carrying value, then the second part of the
test is needed to measure the amount of potential goodwill impairment. The
implied fair value of the reporting unit goodwill is calculated and compared
with the carrying amount of goodwill recorded in the Firm’s financial records.
If the carrying value of reporting unit goodwill exceeds the implied fair value of
that goodwill, then the Firm would recognize an impairment loss in the amount
of the difference, which would be recorded as a charge against Net income.
The fair values of the reporting units are determined using discounted cash
flow models based upon each reporting unit’s internal forecasts. In addition,
analysis using market-based trading and transaction multiples, where available,
are used to assess the reasonableness of the valuations derived from the
discounted cash flow models.
Accounting for share-based payments
Effective January 1, 2006, the Firm adopted SFAS 123R and all related inter-
pretations using the modified prospective transition method. SFAS 123R
requires all share-based payments to employees, including employee stock
options and stock-settled stock appreciation right (“SARs”), to be measured
at their grant date fair values. For additional information related to SFAS
123R, see Note 8 on pages 105–107 of this Annual Report.
Accounting for certain hybrid financial instruments – an amend-
ment of FASB Statements No. 133 and 140
In February 2006, the FASB issued SFAS 155, which applies to certain
“hybrid financial instruments” which are defined as financial instruments
that contain embedded derivatives. The new standard establishes a require-
ment to evaluate beneficial interests in securitized financial assets to deter-
mine if the interests represent freestanding derivatives or are hybrid finan-
cial instruments containing embedded derivatives requiring bifurcation. It
also permits an irrevocable election for fair value remeasurement of any
hybrid financial instrument containing an embedded derivative that other-
wise would require bifurcation under SFAS 133. The Firm adopted this stan-
dard effective January 1, 2006. For additional information related to SFAS
155, see Note 1 on page 95 of this Annual Report.
Accounting for servicing of financial assets
In March 2006, the FASB issued SFAS 156, which is effective as of the begin-
ning of the first fiscal year beginning after September 15, 2006, with early
adoption permitted. JPMorgan Chase elected to adopt the standard effective
January 1, 2006. The standard permits an entity a one-time irrevocable elec-
tion to adopt fair value accounting for a class of servicing assets. The Firm
has defined MSRs as one class of servicing assets for this election. For addi-
tional information related to the Firm’s adoption of SFAS 156 with respect to
MSRs, see Note 16 on pages 121–122 of this Annual Report.
ACCOUNTING AND REPORTING DEVELOPMENTS