Bank of Montreal 2007 Annual Report Download - page 66

Management’s Discussion and Analysis
62 BMO Financial Group 190th Annual Report 2007
MD&A
recognized in income would also be different. The interest rate used
to discount expected future cash flows is the estimate that most affects
the gain on securitization. A 10% decrease in interest rates would have
resulted in a decrease of less than $32 million in the amount of the
deferred purchase price recorded in available-for-sale securities in our
Consolidated Balance Sheet.
Additional information concerning accounting for securitizations,
including sensitivity analysis for key assumptions, is included in Note 7
on page 104 of the financial statements.
Accounting for Variable Interest Entities
In the normal course of business, BMO enters into arrangements
with variable interest entities (VIEs). VIEs include entities with equity
that is considered insufficient to finance the entity’s activities or in
which the equity holders do not have a controlling financial interest.
We are required to consolidate VIEs if the investments we hold in
these entities and/or the relationships we have with them result
in us being exposed to the majority of their expected losses, being
able to benefit from a majority of their expected residual returns,
or both, based on a calculation determined by standard setters.
We use a qualitative estimation process to determine whether
an entity is a VIE and whether BMO holds a variable interest in that VIE.
We also use a variety of complex estimation processes involving quali-
tative and quantitative factors to calculate and analyze a VIE’s expected
losses and its expected residual returns. These processes involve esti-
mating the future cash flows and performance of the VIE, analyzing
the variability of those cash flows and allocating the losses and returns
among the identified parties holding variable interests. These processes
enable us to identify the party that is exposed to the majority of the
VIE’s expected losses, expected residual returns, or both, and thus which
party should consolidate the entity.
Additional information concerning BMO’s involvement with
variable interest entities is included in Note 8 on page 106 of the
financial statements.
Pensions and Other Employee Future Benefits
BMO’s pensions and other employee future benefits expense is calcul-
ated by our actuaries using assumptions determined by management.
If actual experience differs from the assumptions used, pension and
other employee future benefits expense could increase or decrease in
future years. The expected rate of return on plan assets is the man-
agement estimate that most affects the calculation of pension expense.
Our expected rate of return on plan assets is determined using the
plan’s target asset allocation and estimated rates of return for each
asset class. Estimated rates of return are based on expected returns
from fixed income securities, which take into consideration bond yields.
An equity risk premium is then applied to estimate expected equity
returns. Expected returns from other asset classes are established to
reflect the risks of these asset classes relative to fixed income and
equity assets. With all other assumptions held constant, a 1 percentage
point decline in the expected rate of return on plan assets would result
in an increase in pension expense for 2007 of approximately $41 mil-
lion. The impact of changes in expected rates of return on plan assets
is not significant for our other employee future benefits expense since
only small amounts of assets are held in these plans.
Pension and other employee future benefits expense and obli-
gations are also sensitive to changes in discount rates. For our Canadian
plans, which currently represent 86% of BMO’s pension obligations,
we determine a discount rate at each year-end using market rates
applicable to high-quality debt instruments with cash flows that match
the timing and amount of expected benefit payments.
Additional information regarding our accounting for pensions
and other employee future benefits, including sensitivity analysis
for key assumptions, is included in Note 23 on page 125 of the
financial statements.
Other Than Temporary Impairment
We review available-for-sale and other securities at each quarter-end
reporting period to identify and evaluate investments that show indica-
tions of possible impairment. An investment is considered impaired if its
unrealized losses represent impairment that is considered to be other
than temporary. In making this assessment, we consider such factors as
the type of investment, the length of time and extent to which the fair
value has been below the cost, the financial condition and near-term
prospects of the issuer, and our intent and ability to hold the investment
long enough to allow for any anticipated recovery. The decision to record
a write-down, its amount and the period in which it is recorded could
change if management’s assessment of those factors were different. We
do not record impairment write-downs on debt securities when impair-
ment is due to changes in market interest rates, since we expect to
realize the full value of these investments by holding them to maturity.
We also have investments in securities issued or guaranteed
by Canadian or U.S. governments, corporate debt and equity securities,
mortgage-backed securities and collateralized mortgage obligations.
Quoted market value is considered to be fair value for actively traded
securities. At the end of 2007, there were total unrealized losses
of $48 million on securities on which the cost exceeded fair value and
an impairment write-down had not been recorded. Of this amount,
$14 million related to securities on which the cost had exceeded fair
value for 12 months or more. In most cases, these unrealized losses
resulted from increases in market interest rates and not from deteriora-
tion in the creditworthiness of the issuer.
Additional information regarding our accounting for available-for-
sale securities and other securities is included in Note 3 on page 97 of
the financial statements. Additional information concerning our method
of determining fair value is included in Note 3 on page 98, Note 9 on
page 110 and Note 29 on page 133 of the financial statements.
Customer Loyalty Program
We record the liability related to our credit card customer loyalty
program when our customers become entitled to redeem the rewards.
We pay the loyalty program administrator when air miles are redeemed.
In determining the liability, we estimate the expected future redemp-
tion rate and apply the cost of expected redemptions. Our estimate
of the expected future redemption rate is based on a statistical analysis
of past customer behaviour. Changes in actual redemption rates may
cause future assessments of the liability to be different from the current
assessment, resulting in an increase or decrease in the liability. Changes
in redemption rates can result from factors such as shifts in customer
behaviour, types of rewards offered and general economic conditions.
If our estimate of the redemption rate increased by 1 percentage
point, our annual card fee revenue would decrease by approximately
$12 million. During fiscal 2007, we increased the liability related to
future customer redemptions by $185 million ($120 million after-tax).
Additional information regarding our accounting for our
customer loyalty program is included in Note 16 on page 117 of
the financial statements.
Income Taxes
The provision for income taxes is calculated based on the expected tax
treatment of transactions recorded in our Consolidated Statements of
Income or Changes in Shareholders’ Equity. In determining the provision
for income taxes, we interpret tax legislation in a variety of jurisdictions
and make assumptions about the expected timing of the reversal of
future tax assets and liabilities. If our interpretations differ from those
of tax authorities or if the timing of reversals is not as anticipated,
our provision for income taxes could increase or decrease in future
periods. The amount of any such increase or decrease cannot be
reasonably estimated.
Additional information regarding our accounting for income taxes
is included in Note 24 on page 128 of the financial statements.