KeyBank 2007 Annual Report Download - page 71

69
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS KEYCORP AND SUBSIDIARIES
Accounting for changes in fair value (i.e., gains or losses) of derivatives
differs depending on whether the derivative has been designated and
qualifies as part of a hedging relationship, and further, on the type of
hedging relationship. For derivatives that are not designated as hedging
instruments, the gain or loss is recognized immediately in earnings. A
derivative that is designated and qualifies as a hedging instrument must
be designated a fair value hedge, a cash flow hedge or a hedge of a net
investment in a foreign operation. Key does not have any derivatives that
hedge net investments in foreign operations.
“Effectiveness” measures the extent to which changes in the fair value
of a derivative instrument offset changes in the fair value of the hedged
item. If the relationship between the change in the fair value of the
derivative instrument and the fair value of the hedged item falls within
a range considered to be the industry norm, the hedge is considered
“highly effective” and qualifies for hedge accounting. A hedge is
“ineffective” if the offsetting difference between the fair values falls
outside the acceptable range.
A fair value hedge is used to limit exposure to changes in the fair value
of existing assets, liabilities and firm commitments caused by changes in
interest rates or other economic factors. Key recognizes the gain or loss
on these derivatives, as well as the related gain or loss on the underlying
hedged item, in earnings during the period in which the fair value
changes. If a hedge is perfectly effective, the change in the fair value of
the hedged item will be offset, resulting in no net effect on earnings.
A cash flow hedge is used to minimize the variability of future cash flows
that is caused by changes in interest rates or other economic factors. The
effective portion of a gain or loss on any cash flow hedge is reported as
a component of “accumulated other comprehensive income (loss)” and
reclassified into earnings in the same period or periods that the hedged
transaction affects earnings. Any ineffective portion of the derivative gain
or loss is recognized in earnings during the current period.
DERIVATIVES USED FOR CREDIT RISK
MANAGEMENT PURPOSES
Key uses credit derivatives — primarily credit default swaps — to
mitigate credit risk by transferring a portion of the risk associated
with the underlying extension of credit to a third party. These instruments
also are used to manage portfolio concentration and correlation risks.
Key also provides credit protection to other lenders through the sale of
credit default swaps.
These derivatives are recorded on the balance sheet at fair value, which
is based on the creditworthiness of the borrowers. Related gains or losses,
as well as the premium paid or received for credit protection, are
included in “investment banking and capital markets income” on the
income statement.
DERIVATIVES USED FOR TRADING PURPOSES
Key enters into derivative contracts to make a market for clients and for
proprietary trading purposes. Derivatives used for trading purposes
typically include financial futures, credit and energy derivatives, foreign
exchange forward and spot contracts, written and purchased options
(including currency options), and interest rate swaps, caps and floors.
All derivatives used for trading purposes are recorded at fair value. Fair
value is calculated using applicable market variables such as interest rate
volatility and other relevant market inputs. Changes in fair value
(including payments and receipts) are recorded in “investment banking
and capital markets income” on the income statement.
GUARANTEES
Key’s accounting policies related to certain guarantees reflect the
guidance in FASB Interpretation No. 45, “Guarantor’s Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees
of Indebtedness of Others.” Based on this guidance, Key has recognized
a liability, which is included in “accrued expense and other liabilities”
on the balance sheet, for the fair value of its obligation under certain
guarantees issued or modified on or after January 1, 2003.
If Key receives a fee for a guarantee requiring liability recognition, the
amount of the fee represents the initial fair value of the “stand ready”
obligation. If there is no fee, the fair value of the “stand ready”
obligation is determined using expected present value measurement
techniques, unless observable transactions for comparable guarantees are
available. The subsequent accounting for these “stand ready” obligations
depends on the nature of the underlying guarantees. Key accounts for its
release from risk under a particular guarantee when the guarantee
expires or is settled, or by a systematic and rational amortization
method, depending on the risk profile of the guarantee.
Additional information regarding guarantees is included in Note 18
(“Commitments, Contingent Liabilities and Guarantees”) under the
heading “Guarantees” on page 98.
REVENUE RECOGNITION
Key recognizes revenues as they are earned based on contractual terms,
as transactions occur, or as services are provided and collectibility is
reasonably assured. Key’s principal source of revenue is interest income.
This revenue is recognized on an accrual basis primarily according to
nondiscretionary formulas in written contracts such as loan agreements
or securities contracts.
STOCK-BASED COMPENSATION
From January 1, 2003, until January 1, 2006, Key used the fair value
method of accounting as outlined in SFAS No. 123, “Accounting for
Stock-Based Compensation.” Key opted to apply the new rules of SFAS
No. 123 prospectively to all awards as permitted under SFAS No. 148,
“Accounting for Stock-Based Compensation Transition and Disclosure.”
Effective January 1, 2006, Key adopted SFAS No. 123R, “Share-Based
Payment,” which replaced SFAS No. 123. SFAS 123R requires stock-based
compensation to be measured using the fair value method of accounting,
with the measured cost to be recognized over the period during which the
recipient is required to provide service in exchange for the award. SFAS
No. 123R also changes the manner of accounting for forfeited stock-based
awards. As of the effective date, Key did not have any nonvested awards
outstanding that had not previously been accounted for using the fair value
method. Consequently, the adoption of SFAS No. 123R did not have a