KeyBank 2008 Annual Report Download - page 24

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MANAGEMENT’S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION & RESULTS OF OPERATIONS KEYCORP AND SUBSIDIARIES
The application of hedge accounting requires significant judgment to
interpret the relevant accounting guidance, as well as to assess hedge
effectiveness, identify similar hedged item groupings, and measure
changes in the fair value of the hedged items. Management believes
that Key’s methods of addressing these judgmental areas and applying the
accounting guidance are in accordance with GAAP and consistent with
industry practices. However, interpretations of SFAS No. 133 and related
guidance continue to change and evolve. In the future, these evolving
interpretations could result in material changes to Key’s accounting
for derivative financial instruments and related hedging activities.
Although such changes may not have a material effect on Key’s financial
condition, they could have a material adverse effect on Key’s results of
operations in the period they occur. Additional information relating to
Key’s use of derivatives is included in Note 1 under the heading
“Derivatives Used for Asset and Liability Management Purposes” on page
81, and Note 19 (“Derivatives and Hedging Activities”), which begins
on page 115.
Valuation methodologies. Valuation methodologies often involve a
significant degree of judgment, particularly when there are no observable
active markets for the items being valued. Todetermine the values of
assets and liabilities, as well as the extent to which related assets may be
impaired, management makes assumptions and estimates related to
discount rates, asset returns, prepayment rates and other factors. The use
of different discount rates or other valuation assumptions could produce
significantly different results. The outcomes of valuations performed by
management have a direct bearing on the carrying amounts of assets and
liabilities, including loans held for sale, principal investments, goodwill,
and pension and other postretirement benefit obligations.
Adiscussion of the valuation methodology applied to Key’sloans held
for sale is included in Note 1 under the heading “Loans held for sale”
on page 78.
Key’sprincipal investments include direct and indirect investments,
predominantly in privately held companies. The fair values of these
investments aredetermined by considering a number of factors, including
the target company’sfinancial condition and results of operations,
values of public companies in comparable businesses, market liquidity,
and the nature and duration of resale restrictions. The fair value of
principal investments was $990 million at December 31, 2008; a 10%
positive or negative variance in that fair value would have increased or
decreased Key’s 2008 earnings by $99 million ($62 million after tax, or
$.14 per share).
The valuation and testing methodologies used in Key’s analysis of
goodwill impairment are summarized in Note 1 under the heading
“Goodwill and Other Intangible Assets” on page 80. The first step in
testing for impairment is to determine the fair value of each reporting
unit. Key’s reporting units for purposes of this testing are its major
business segments, Community Banking and National Banking.
Fair values of reporting units are estimated using discounted cash
flow models derived from internal earnings forecasts. The primary
assumptions management uses include earnings forecasts for five years,
terminal values based on future growth rates, and discount rates that
reflect the range of Key’s market capitalization and a control premium.
Management believes that the estimates and assumptions used in the
goodwill impairment analysis for its reporting units are reasonable;
however, if actual results and market conditions differ from the
assumptions or estimates used, the fair value of each reporting unit could
change in the future.
The second step of impairment testing is necessary only if the carrying
amount of either reporting unit exceeds its fair value, suggesting
goodwill impairment. In such a case, Key would estimate a hypothetical
purchase price for the reporting unit (representing the unit’s fair value)
and then compare that hypothetical purchase price with the fair value
of the unit’s net assets (excluding goodwill). Any excess of the estimated
purchase price over the fair value of the reporting unit’s net assets
represents the implied fair value of goodwill. An impairment loss would
be recognized as a charge to earnings if the carrying amount of the
reporting unit’s goodwill exceeds the implied fair value of goodwill.
During the fourth quarter, Key’s annual testing for goodwill impairment
indicated that the estimated fair value of the National Banking unit was
less than its carrying amount, reflecting unprecedented weakness in the
financial markets. As a result, Key recorded an after-tax noncash
accounting charge of $420 million, or $.85 per share. Key’s regulatory
and tangible capital ratios werenot affected by this adjustment, nor
would they be affected by any further goodwill impairment that may
occur in the future.
Due to the ongoing uncertainty regarding market conditions, which
may continue to negatively impact the performance of Key’s reporting
units, management will continue to monitor the goodwill impairment
indicators and evaluate the carrying amount of Key’s goodwill, if
necessary.Events and circumstances that could trigger the need for
interim impairment testing include:
•a significant change in legal factors or in the business climate;
•an adverse action or assessment by a regulator;
• unanticipated competition;
•a loss of key personnel;
•amore-likely-than-not expectation that a reporting unit or a significant
portion of a reporting unit will be sold or otherwise disposed of;
• the testing for recoverability under SFAS No. 144, “Accounting for
the Impairment or Disposal of Long-Lived Assets,” of a significant
asset group within a reporting unit; and
• recognition of a goodwill impairment loss in the financial statements
of a subsidiary that is a component of a reporting unit.
The primary assumptions used in determining Key’s pension and other
postretirement benefit obligations and related expenses, including
sensitivity analysis of these assumptions, are presented in Note 16
(“Employee Benefits”), which begins on page 106.
When potential asset impairment is identified through testing,
observable changes in active markets or other means, management
must exercise judgment to determine the nature of the potential
impairment (i.e., temporary or other-than-temporary) in order to
apply the appropriate accounting treatment. For example, unrealized