KeyBank 2006 Annual Report Download - page 22

22
MANAGEMENT’S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION & RESULTS OF OPERATIONS KEYCORP AND SUBSIDIARIES
Derivatives and related hedging activities. Key uses derivatives known
as interest rate swaps and caps to hedge interest rate risk for asset and
liability management purposes. These instruments modify the repricing
characteristics of specified on-balance sheet assets and liabilities. Key’s
accounting policies related to derivatives reflect the accounting guidance
in SFAS No. 133, “Accounting for Derivative Instruments and Hedging
Activities,” as revised and further interpreted by SFAS No. 149,
“Amendment of Statement 133 on Derivative Instruments and Hedging
Activities,” and other related accounting guidance. In accordance with
this accounting guidance, all derivatives are recognized as either assets
or liabilities on the balance sheet at fair value. Accounting for changes
in the fair value (i.e., gains or losses) of derivatives differs depending on
whether the derivatives have been designated and qualify as part of a
hedging relationship, and further, on the type of hedging relationship.
The application of hedge accounting requires significant judgment in
the interpretation of the relevant accounting guidance as well as the
assessment of hedge effectiveness, the identification of similar hedged
item groupings, and the measurement of changes in the fair value of the
hedged items. Management believes that Key’s methods of addressing
these judgmental areas and applying the accounting guidance are in
accordance with GAAP and consistent with industry practices. However,
interpretations of SFAS No. 133 and related guidance continue to
change and evolve. In the future, these evolving interpretations could
result in material changes to Key’s accounting for derivative financial
instruments and related hedging activities. Although such changes may
not have a material effect on Key’s financial condition, they could have
amaterial adverse effect on Key’s results of operations in the period they
occur. Additional information relating to Key’s use of derivatives is
included in Note 1 under the heading “Derivatives Used for Asset and
Liability Management Purposes” on page 70 and Note 19, “Derivatives
and Hedging Activities,” which begins on page 100.
Valuation methodologies. Valuation methodologies often involve a
significant degree of judgment, particularly when thereareno observable
liquid markets for the items being valued. The outcomes of valuations
performed by management have a direct bearing on the carrying amounts
of assets and liabilities, including principal investments, goodwill, and
pension and other postretirement benefit obligations. To determine the
values of these assets and liabilities, as well as the extent to which
related assets may be impaired, management makes assumptions and
estimates related to discount rates, asset returns, prepayment rates and
other factors. The use of different discount rates or other valuation
assumptions could produce significantly different results, which could
affect Key’s results of operations.
Key’s principal investments include direct and indirect investments,
predominantly in privately-held companies. The fair values of these
investments are estimated by considering a number of factors, including
the investee’s financial condition and results of operations, values of public
companies in comparable businesses, market liquidity, and the nature
and duration of resale restrictions. Due to the subjective nature of the
valuation process, it is possible the actual fair values of these investments
differ from the estimated values, thereby affecting Key’s financial
condition and results of operations. The fair value of principal investments
was $830 million at December 31, 2006; a 10% positive or negative
variance in that fair value would have increased or decreased Key’s
2006 earnings by $83 million ($52 million after tax), or $.13 per share.
The valuation and testing methodologies used in Key’s analysis of
goodwill impairment are summarized in Note 1 under the heading
“Goodwill and Other Intangible Assets” on page 70. The first step in
testing for impairment is to determine the fair value of each reporting
unit. Key’s reporting units for purposes of this testing are its major
business groups: Community Banking and National Banking. Two
primary assumptions are used in determining these fair values: Key’s
revenue growth rate and the future weighted-average cost of capital
(“WACC”). Key’s goodwill impairment testing for 2006 assumed a
revenue growth rate of 6.00% and a WACC of 11.50%. The second step
of impairment testing is necessary only if the carrying amount of either
reporting unit exceeds its fair value, suggesting goodwill impairment.
Assuming that only one of the primary assumptions (revenue growth rate
or WACC) changes at a time, the carrying amount of Key’s reporting
units would exceed fair value in the following circumstances:
Community Banking — negative 11.81% rate of revenue growth or
28.34% WACC
National Banking — negative 9.42% rate of revenue growth or 22.11%
WACC
These sensitivities are not completely realistic since a change in one of
these assumptions is evaluated without changing the other. In reality, a
change in one assumption could affect the other.
The primaryassumptions used in determining Key’s pension and other
postretirement benefitobligations and related expenses, including
sensitivity analyses of these assumptions, arepresented in Note 16
(“Employee Benefits”), which begins on page 92.
When a potential asset impairment is identified through testing,
observable changes in liquid markets or other means, management
also must exercise judgment in determining the natureof the potential
impairment (i.e., whether the impairment is temporary or other-than-
temporary) in order to apply the appropriate accounting treatment.
For example, unrealized losses on securities available for sale that are
deemed temporary are recorded in shareholders’ equity; those deemed
“other-than-temporary” are recorded in earnings. Additional information
regarding temporary and other-than-temporary impairment on securities
available for sale at December 31, 2006, is provided in Note 6
(“Securities”), which begins on page 80.
Revenue recognition
Improprieties committed by various publicly-traded companies related
to revenue recognition have received a great deal of attention. Although
all companies face the risk of intentional or unintentional misstatements,
Key’s management believes that such misstatements are less likely in the
financial services industry because most of the revenue (i.e., interest
accruals) is driven by nondiscretionary formulas based on written
contracts, such as loan agreements.
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