JP Morgan Chase 2003 Annual Report Download - page 88

Notes to consolidated financial statements
J.P. M organ Chase & Co.
Basis of Presentation
J.P. M organ Chase & Co. (“ JPM organ Chase” or the “ Firm” ) is
a financial holding company for a group of subsidiaries that
provide a w ide range of services to a global client base that
includes corporations, governments, institutions and individuals.
For a discussion of the Firm’s business segment information, see
Note 34 on pages 126–127 of this Annual Report.
The accounting and financial reporting policies of JPM organ
Chase and its subsidiaries conform to accounting principles
generally accepted in the United States of America (“ GAAP” )
and prevailing industry practices. Additionally, where applicable,
the policies conform to the accounting and reporting guidelines
prescribed by bank regulatory authorities.
Consolidation
The consolidated financial statements include accounts of
JPM organ Chase and other entities in w hich the Firm has a
controlling financial interest. All material intercompany balances
and transactions have been eliminated.
The usual condition for a controlling financial interest is ow ner-
ship of a majority of the voting interests of an entity. How ever,
a controlling financial interest may also exist in entities, such as
special purpose entities (“ SPEs” ), through arrangements that do
not involve voting interests.
SPEs are an important part of the financial markets, providing
market liquidity by facilitating investors’ access to specific port-
folios of assets and risks. They are, for example, critical to the
functioning of the mortgage- and asset-backed securities and
commercial paper markets. SPEs may be organized as trusts,
partnerships or corporations and are typically set up for a single,
discrete purpose. SPEs are not operating entities and usually
have no employees and a limited life. 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 describe how
the cash earned on the assets must be allocated to the SPE’s
investors and other parties that have rights to those cash flow s.
SPEs can be structured to be bankruptcy-remote, thereby insu-
lating investors from the impact of the creditors of other
entities, including the seller of the assets.
There are tw o different accounting framew orks applicable to
SPEs, depending on the nature of the entity and the Firm’s rela-
tion to that entity; the qualifying SPE (“ QSPE” ) framework
under SFAS 140 and the variable interest entity (“ VIE” )
framew ork under FIN 46. The QSPE framework is applicable
w hen an entity transfers (sells) financial assets to an SPE meet-
ing certain criteria. These criteria are designed to ensure that the
Note 1 activities of the SPE are essentially predetermined in their
entirety at the inception of the vehicle and that the transferor
cannot exercise control over the entity. Entities meeting these
criteria are not consolidated by the transferors. The Firm prima-
rily follow s the QSPE model for the securitizations of its
residential and commercial mortgages, credit card loans and
automobile loans. For further details, see Note 13 on pages
100–103 of this Annual Report.
When the SPE does not meet the QSPE criteria, consolidation is
assessed pursuant to FIN 46. A VIE is defined as an entity that:
lacks enough equity investment at risk to permit the entity to
finance its activities w ithout additional subordinated financial sup-
port from other parties; has equity ow ners w ho are unable to
make decisions, and/or; has equity ow ners that do not absorb or
receive the entity’s losses and returns. VIEs encompass vehicles tra-
ditionally view ed as SPEs and may also include other entities or
legal structures, such as certain limited-purpose subsidiaries, trusts
or investment funds. Entities excluded from the scope of FIN 46
include all QSPEs, regardless of w hether the Firm w as the trans-
feror, as long as the Firm does not have the unilateral ability to
liquidate the vehicle or cause it to no longer meet the QSPE crite-
ria, and other entities that meet certain criteria specified in FIN 46.
FIN 46 requires a variable interest holder (counterparty to a VIE)
to consolidate the VIE if that party w ill absorb a majority of the
expected losses of the VIE, receive a majority of the residual
returns of the VIE, or both. This party is considered the primary
beneficiary of the entity. The determination of w hether the Firm
meets the criteria to be considered the primary beneficiary of a
VIE requires an evaluation of all transactions (such as investments,
liquidity commitments, derivatives and fee arrangements) w ith
the entity. The foundation for this evaluation is an expected-loss
calculation prescribed by FIN 46. For further details, see Note 14
on pages 103-106 of this Annual Report.
Prior to the Firm’s adoption of FIN 46, the decision of w hether or
not to consolidate depended on the applicable accounting princi-
ples for non-QSPEs, including a determination regarding the
nature and amount of investment made by third parties in the
SPE. Consideration w as given to, among other factors, w hether a
third party had made a substantive equity investment in the SPE;
w hich party had voting rights, if any; w ho made decisions about
the assets in the SPE; and who was at risk of loss. The SPE w as
consolidated if JPM organ Chase retained or acquired control over
the risks and rew ards of the assets in the SPE.
Financial assets sold to an SPE or a VIE are derecognized when:
(1) the assets are legally isolated from the Firm’s creditors, (2)
the accounting criteria for a sale are met and (3) the SPE is a
QSPE under SFAS 140, or the SPE can pledge or exchange the
financial assets. All significant transactions and retained interests
86 J.P. Morgan Chase & Co. / 2003 Annual Report