JP Morgan Chase 2005 Annual Report Download - page 85

JPMorgan Chase & Co. /2005 Annual Report 83
see the Private equity risk management discussion on page 80 and Note 9
on pages 103–105 of this Annual Report.
MSRs and certain other retained interests in securitizations
MSRs and certain other retained interests from securitization activities do not
trade in an active, open market with readily observable prices. For example,
sales of MSRs do occur, but the precise terms and conditions are typically not
readily available. Accordingly, the Firm estimates the fair value of MSRs and
certain other retained interests in securitizations using discounted future cash
flow (DCF) models.
For MSRs, the model considers portfolio characteristics, contractually specified
servicing fees and prepayment assumptions, delinquency rates, late charges,
other ancillary revenues, costs to service and other economic factors. During
the fourth quarter of 2005, the Company began utilizing an option adjusted
spread (“OAS”) valuation approach when determining the fair value of MSRs.
This approach, when used in conjunction with the Firm’s proprietary prepayment
model, projects MSR cash flows over multiple interest rate scenarios, which
are then discounted at risk-adjusted rates, to estimate an expected fair value
of the MSRs. The OAS valuation approach is expected to provide improved
estimates of fair value. The initial valuation of MSRs under OAS did not have
a material impact to the Firm’s financial statements.
For certain other retained interests in securitizations (such as interest only
strips), a single interest rate path DCF model is used and generally includes
assumptions based upon projected finance charges related to the securitized
assets, estimated net credit losses, prepayment assumptions, and contractual
interest paid to the third-party investors. Changes in the assumptions used
may have a significant impact on the Firm’s valuation of retained interests.
For both MSRs and certain other retained interests in securitizations, the Firm
compares its fair value estimates and assumptions to observable market data
where available and to recent market activity and actual portfolio experience.
Management believes that the assumptions used to estimate fair values are
supportable and reasonable.
For a further discussion of the most significant assumptions used to value
retained interests in securitizations and MSRs, as well as the applicable stress
tests for those assumptions, see Notes 13 and 15 on pages 108–111 and
114–116, respectively, of this Annual Report.
Goodwill impairment
Under SFAS 142, goodwill must be allocated to reporting units and tested for
impairment. The Firm tests goodwill for impairment at least annually or more
frequently if events or circumstances, such as adverse changes in the business
climate, indicate that there may be justification for conducting an interim test.
Impairment testing is performed at the reporting-unit level (which is generally
one level below the six major business segments identified in Note 31 on
pages 130–131 of this Annual Report, plus Private Equity which is included
in Corporate). The first part of the test is a comparison, at the reporting unit
level, of the fair value of each reporting unit to its carrying amount, including
goodwill. If the fair value is less than the carrying value, then the second part
of the test is needed to measure the amount of potential goodwill impairment.
The implied fair value of the reporting unit goodwill is calculated and compared
to the carrying amount of goodwill recorded in the Firm’s financial records.
If the carrying value of reporting unit goodwill exceeds the implied fair value
of that goodwill, then the Firm would recognize an impairment loss in the
amount of the difference, which would be recorded as a charge against
Net income.
The fair values of the reporting units are determined using discounted cash
flow models based upon each reporting unit’s internal forecasts. In addition,
analysis using market-based trading and transaction multiples, where available,
are used to assess the reasonableness of the valuations derived from the
discounted cash flow models.
Goodwill was not impaired as of December 31, 2005 or 2004, nor was any
goodwill written off due to impairment during the years ended December 31,
2005, 2004 and 2003. See Note 15 on page 114 of this Annual Report for
additional information related to the nature and accounting for goodwill and
the carrying values of goodwill by major business segment.
Accounting for income taxes – repatriation of foreign earnings
under the American Jobs Creation Act of 2004
On October 22, 2004, the American Jobs Creation Act of 2004 (the “Act”) was
signed into law. The Act creates a temporary incentive for U.S. companies to
repatriate accumulated foreign earnings at a substantially reduced U.S. effective
tax rate by providing a dividends received deduction on the repatriation of
certain foreign earnings to the U.S. taxpayer (the “repatriation provision”).
The new deduction is subject to a number of limitations and requirements.
In the fourth quarter of 2005, the Firm applied the repatriation provision to
$1.9 billion of cash from foreign earnings, resulting in a net tax benefit of
$55 million. The $1.9 billion of cash will be used in accordance with the Firm’s
domestic reinvestment plan pursuant to the guidelines set forth in the Act.
Accounting for share-based payments
In December 2004, the FASB issued SFAS 123R, which revises SFAS 123 and
supersedes APB 25. In March 2005, the Securities and Exchange Commission
(“SEC”) issued SAB 107 which provides interpretive guidance on SFAS 123R.
Accounting and reporting under SFAS 123R is generally similar to the SFAS
123 approach. However, SFAS 123R requires all share-based payments to
employees, including grants of employee stock options, to be recognized in
the income statement based upon their fair values. Pro forma disclosure is no
longer an alternative. SFAS 123R permits adoption using one of two methods
– modified prospective or modified retrospective. In April 2005, the SEC
approved a new rule that, for public companies, delays the effective date of
SFAS 123R to no later than January 1, 2006. The Firm adopted SFAS 123R
on January 1, 2006, under the modified prospective method.
The Firm continued to account for certain stock options that were outstanding
as of December 31, 2002, under APB 25 using the intrinsic value method.
Therefore, compensation expense for some previously granted awards that
was not recognized under SFAS 123 will be recognized commencing January 1,
2006, under SFAS 123R. Had the Firm adopted SFAS 123R in prior periods,
the impact would have approximated that shown in the SFAS 123 pro forma
disclosures in Note 7 on pages 100–102 of this Annual Report, which presents
net income and earnings per share as if all outstanding awards were
accounted for at fair value.
Prior to adopting SFAS 123R, the Firm’s accounting policy for share-based
payment awards granted to retirement-eligible employees was to recognize
Accounting and reporting developments