eTrade 2001 Annual Report Download - page 54

Our investments include direct and indirect investments in privately-held companies. We have made significant investments in venture
capital funds, which invest in privately-held companies. In addition to the potential for financial returns, our venture activities increase
our knowledge of emerging markets and technologies. Certain officers of our company manage two of the venture funds. Generally
accepted accounting principles require venture capital funds to adjust their investments in publicly-traded and privately-held
companies to current market value each period. Because we account for our investment in these funds on the equity method, our
earnings are impacted each period by our allocated portion of these market value changes. The determination of market value for
privately-held companies requires significant judgment on the part of the fund managers. The general practice in the venture capital
industry, which is followed by the funds managed by our officers, is to only record an increase in fair value when it is demonstrated
through a third-party transaction, such as sales of stock to an unrelated investor. Decreases in fair value are generally recognized upon
a similar event, or sooner if general market conditions or company-specific events indicate there has been a decline in value. During
fiscal 2001, we recorded losses of $34.7 million on our venture fund investments.
Accounting for financial derivatives
The Bank uses various financial derivatives in managing the risks inherent in its business. One of the most significant risks arises
because the principal investments of the Bank are residential mortgages and other mortgage-backed securities, which often pay a fixed
interest rate over a long time horizon, whereas the principal source of funds to make these investments are customer deposits and
short-term borrowings whose interest rates are fixed for a much shorter period of time, if at all. In order to manage this differential, the
Bank has purchased interest rate derivatives, including interest rate swaps, caps, and floors.
Under generally accepted accounting principles, all derivatives must be reflected in the balance sheet at their fair market value each
period; this fair market value reflects the gain or loss implicit in the derivative. The income statement accounting for derivatives differs
significantly depending on whether or not a derivative is designated as a “hedge.” In order to qualify as a hedge, management must
designate a derivative as a hedge of a specific balance sheet item or future expected cash flow at the time it is purchased, as well as
continue to demonstrate that the instrument functions as an effective hedge of that item. Management has designated substantially all
of the derivatives it held as of December 31, 2001 as hedges. By doing so, the balance sheet items that are hedged are adjusted to
market as well as the derivative itself, resulting in a net offset to the extent that the hedge is effective, gains and losses on cash flow
hedges are recognized only as a component of other comprehensive income, and excluded from earning. More information concerning
our derivatives is contained in Item 7A, “Quantitative and Qualitative Disclosures about Market Risk” and in the Notes to
Consolidated Financial Statements in this Annual Report on Form 10-K. At December 31, 2001, as a result of interest rate changes our
balance sheet hedges were in an aggregate loss position of $253.3 million, and our cash flow hedges had an aggregate gain of $119.6
million.
Recognition of deferred tax assets
We have recognized for financial statement purposes the tax benefits connected with losses related to our domestic operations. This
recognition assumes that we will be able to generate sufficient future taxable income
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so that the carryforwards of these losses will be realized. The factors that we consider in assessing the likelihood of realization include
our forecast of future taxable income and available tax planning strategies that could be implemented to realize the deferred tax asset.
At December 31, 2001, we had recorded net deferred tax assets of $165.5 million. Should we determine that we will not be able to
realize all or part of this deferred tax asset in the future, a valuation reserve against the asset would be charged to income tax expense
in that period.
We have also incurred losses in certain foreign countries and from certain capital transactions. We have not recorded the potential tax
benefit of these losses, because we believe it is less certain that we will be able to generate income in these countries, or future
2002. EDGAR Online, Inc.