JP Morgan Chase 2008 Annual Report Download - page 136

Notes to consolidated financial statements
134 JPMorgan Chase & Co./ 2008 Annual Report
Note 1 – Basis of presentation
JPMorgan Chase & Co. (“JPMorgan Chase” or the “Firm”), a financial
holding company incorporated under Delaware law in 1968, is a lead-
ing global financial services firm and one of the largest banking insti-
tutions in the United States of America (“U.S.”), with operations world-
wide. The Firm is a leader in investment banking, financial services for
consumers and businesses, financial transaction processing and asset
management. For a discussion of the Firm’s business segment informa-
tion, see Note 37 on pages 226–227 of this Annual Report.
The accounting and financial reporting policies of JPMorgan Chase
and its subsidiaries conform to accounting principles generally accept-
ed in the United States of America (“U.S. GAAP”). Additionally, where
applicable, the policies conform to the accounting and reporting
guidelines prescribed by bank regulatory authorities.
Certain amounts in prior periods have been reclassified to conform
to the current presentation.
Consolidation
The Consolidated Financial Statements include the accounts of
JPMorgan Chase and other entities in which the Firm has a control-
ling financial interest. All material intercompany balances and trans-
actions have been eliminated.
The usual condition for a controlling financial interest is the owner-
ship of a majority of the voting interests of the entity. However, a
controlling financial interest also may be deemed to exist with
respect to entities, such as special purpose entities (“SPEs”), through
arrangements that do not involve controlling voting interests.
SPEs are an important part of the financial markets, providing market
liquidity by facilitating investors’ access to specific portfolios of
assets and risks. For example, they are critical to the functioning of
the mortgage- and asset-backed securities and commercial paper
markets. SPEs may be organized as trusts, partnerships or corpora-
tions and are typically established for a single, discrete purpose. SPEs
are not typically operating entities and usually have a limited life and
no employees. The basic SPE structure involves a company selling
assets to the SPE. The SPE funds the purchase of those assets by
issuing securities to investors. The legal documents that govern the
transaction specify how the cash earned on the assets must be allo-
cated to the SPE’s investors and other parties that have rights to
those cash flows. SPEs are generally structured to insulate investors
from claims on the SPE’s assets by creditors of other entities, includ-
ing the creditors of the seller of the assets.
There are two different accounting frameworks applicable to SPEs:
The qualifying SPE (“QSPE”) framework under SFAS 140 and the
variable interest entity (“VIE”) framework under FIN 46R. The appli-
cable framework depends on the nature of the entity and the Firm’s
relation to that entity. The QSPE framework is applicable when an
entity transfers (sells) financial assets to an SPE meeting certain crite-
ria defined in SFAS 140. These criteria are designed to ensure that
the activities of the entity are essentially predetermined at the incep-
tion of the vehicle and that the transferor of the financial assets can-
not exercise control over the entity and the assets therein. Entities
meeting these criteria are not consolidated by the transferor or other
counterparties as long as they do not have the unilateral ability to
liquidate or to cause the entity to no longer meet the QSPE criteria.
The Firm primarily follows the QSPE model for securitizations of its
residential and commercial mortgages, and credit card, automobile
and student loans. For further details, see Note 16 on pages
180–188 of this Annual Report.
When an SPE does not meet the QSPE criteria, consolidation is
assessed pursuant to FIN 46R. Under FIN 46R, a VIE is defined as an
entity that: (1) lacks enough equity investment at risk to permit the
entity to finance its activities without additional subordinated finan-
cial support from other parties; (2) has equity owners that lack the
right to make significant decisions affecting the entity’s operations;
and/or (3) has equity owners that do not have an obligation to
absorb the entity’s losses or the right to receive the entity’s returns.
FIN 46R requires a variable interest holder (i.e., a counterparty to a
VIE) to consolidate the VIE if that party will absorb a majority of the
expected losses of the VIE, receive the majority of the expected resid-
ual returns of the VIE, or both. This party is considered the primary
beneficiary. In making this determination, the Firm thoroughly evalu-
ates the VIE’s design, capital structure and relationships among the
variable interest holders. When the primary beneficiary cannot be
identified through a qualitative analysis, the Firm performs a quanti-
tative analysis, which computes and allocates expected losses or
residual returns to variable interest holders. The allocation of expect-
ed cash flows in this analysis is based upon the relative rights and
preferences of each variable interest holder in the VIE’s capital struc-
ture. The Firm reconsiders whether it is the primary beneficiary of a
VIE when certain events occur as required by FIN 46R. For further
details, see Note 17 on pages 189–198 of this Annual Report.
All retained interests and significant transactions between the Firm,
QSPEs and nonconsolidated VIEs are reflected on JPMorgan Chase’s
Consolidated Balance Sheets and in the Notes to consolidated finan-
cial statements.
Investments in companies that are considered to be voting-interest
entities under FIN 46R in which the Firm has significant influence
over operating and financing decisions are either accounted for in
accordance with the equity method of accounting or at fair value if
elected under SFAS 159 (“Fair Value Option”). These investments are
generally included in other assets, with income or loss included in
other income.
For a discussion of the accounting for private equity investments, see
Note 6 on pages 159–160 of this Annual Report.
Assets held for clients in an agency or fiduciary capacity by the Firm
are not assets of JPMorgan Chase and are not included in the
Consolidated Balance Sheets.
Use of estimates in the preparation of consolidated finan-
cial statements
The preparation of Consolidated Financial Statements requires man-
agement to make estimates and assumptions that affect the reported
amounts of assets and liabilities, revenue and expense, and disclosures