Merrill Lynch

Delivering Shareholder Value
Selected Financial Data
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Management's Discussion and Analysis Introduction
Business Environment
Consolidated Results of Operations
Business Segments
Global Operations
Non-Interest Expenses
Income Taxes
Balance Sheet
Capital Adequacy and Liquidity
Capital Projects and Expenditures
Risk Management
Non-Investment Grade Holdings and Highly Leveraged Transactions
Litigation and Recent Developments
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Management's Discussion of Financial Responsibility
Independent Auditors' Report
Consolidated Statements of Earnings
Consolidated Balance Sheets
Changes in Stockholders' Equity
Comprehensive Income
Cash Flows
Note 1 - Summary of Significant Accounting Policies
Note 2 - Other Significant Events
Note 3 - Trading and Related Activities
Note 4 - Investments
Note 5 - Borrowings
Note 6 - Fair Value Information and Non-Trading Derivatives
Note 7 - Preferred Securities Issued by Subsidiaries
Note 8 - Stockholders’ Equity and Earnings Per Share
Note 9 - Commitments and Contingencies
Note 10 - Employee Benefit Plans
Note 11 - Employee Incentive Plans
Note 12 - Income Taxes
Note 13 - Regulatory Requirements and Dividend Restrictions
Note 14 - Segment and Geographic Information
Supplemental Financial Information (unaudited)


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Note 1. Summary of Significant Accounting Policies
Description of Business
Merrill Lynch & Co., Inc. ("ML & Co.") provides investment, financing, insurance, and related services to individuals and institutions on a global basis through its broker, dealer, banking, insurance, and other financial services subsidiaries. Its principal subsidiaries include:

  • Merrill Lynch, Pierce, Fenner & Smith Incorporated ("MLPF&S"), a U.S.-based broker-dealer in securities;
  • Merrill Lynch International ("MLI"), a U.K.-based broker-dealer in securities and dealer in equity derivatives;
  • Merrill Lynch Government Securities Inc. ("MLGSI"), a dealer in U.S. Government securities;
  • Merrill Lynch Capital Services, Inc., a dealer in interest rate, currency, and credit derivatives;
  • Merrill Lynch Investment Managers, LP, a U.S.-based asset management company;
  • Merrill Lynch Investment Managers Limited, a U.K.-based asset management company;
  • Merrill Lynch Bank USA ("MLBUSA"), a U.S.-based FDIC insured bank;
  • Merrill Lynch Bank & Trust Co. ("MLB&T"), a U.S.-based FDIC insured bank;
  • Merrill Lynch International Bank Limited, a U.K.-based bank; and
  • Merrill Lynch Capital Markets Bank Limited, an Ireland-based bank.

    Services provided to clients by ML & Co. and subsidiaries (collectively, "Merrill Lynch") include:
  • securities brokerage, trading, and underwriting;
  • investment banking, strategic services, including mergers and acquisitions, and other corporate finance advisory activities;
  • asset management;
  • origination, brokerage and related activities in swaps, options, forwards, exchange-traded futures, other derivatives and foreign exchange traded products;
  • securities clearance and settlement services;
  • equity, debt, foreign exchange, commodities and economic research;
  • banking, trust, and lending services, including mortgage lending and related services;
  • insurance sales and underwriting services; and
  • investment advisory and related recordkeeping services.

Basis of Presentation
The Consolidated Financial Statements include the accounts of Merrill Lynch and are presented in accordance with accounting principles generally accepted in the United States of America and prevailing industry practices. All material intercompany transactions and balances have been eliminated.

Certain reclassifications and format changes have been made to prior year amounts to conform to the current year presentation. Prior year amounts have been restated to reflect the 2000 merger of Herzog, Heine, Geduld, Inc. ("Herzog") with Merrill Lynch, which has been accounted for as a pooling-of-interests (see Note 2 for further information). In addition, the Consolidated Balance Sheets reflect the adoption of Statement of Financial Accounting Standards ("SFAS") No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities." SFAS No. 140 eliminates the requirement to report collateral received from certain repurchase agreement and securities lending transactions. SFAS No. 140 also requires the reclassification of certain pledged assets and disclosures regarding collateral for the December 29, 2000 Consolidated Balance Sheet, but does not require comparative information for periods prior to December 29, 2000.

The Consolidated Financial Statements are presented in U.S. dollars. Many non-U.S. subsidiaries have a functional currency (i.e., the currency in which activities are primarily conducted) that is other than the U.S. dollar, often the currency of the country in which a subsidiary is domiciled. Subsidiaries' assets and liabilities are translated to U.S. dollars at year-end exchange rates, while revenues and expenses are translated at average exchange rates during the year. Adjustments that result from translating amounts in a subsidiary's functional currency, net of hedging gains or losses and related tax effects, are reported in stockholders' equity as a component of Accumulated other comprehensive loss. All other translation adjustments are included in earnings.

In presenting the Consolidated Financial Statements, management makes estimates regarding certain trading inventory valuations, the outcome of litigation, the carrying amount of goodwill, the realization of deferred tax assets and recovery of insurance deferred acquisition costs, and other matters that affect the reported amounts and disclosure of contingencies in the financial statements. Estimates, by their nature, are based on judgment and available information. Therefore, actual results could differ materially from those estimates.

Merrill Lynch defines cash equivalents as short-term, highly liquid securities and interest-earning deposits with original maturities of 90 days or less, other than those used for trading purposes. For purposes of the Consolidated Statements of Cash Flows, cash flows from trading derivatives are classified in operating activities.

At December 29, 2000 and December 31, 1999, substantially all financial instrument assets and the majority of financial instrument liabilities are carried at fair value or amounts that approximate fair value. Fair values of financial instruments are disclosed in Note 6.

Trading Activities
Merrill Lynch's trading activities consist primarily of securities brokerage, trading, and underwriting; derivatives dealing and brokerage; and securities financing transactions. Trading assets and trading liabilities consist of cash instruments (such as securities) and derivative instruments used for trading purposes or for hedging other trading inventory.

SECURITIES
Trading securities and other cash instruments (e.g., loans held for trading purposes) are recorded on a trade date basis at fair value. Included in trading liabilities are securities that Merrill Lynch has sold but did not own and will therefore be obligated to purchase at a future date ("short sales"). Changes in fair value (i.e., unrealized gains and losses) are recognized as principal transactions revenues in the current period. Realized gains and losses and any related interest amounts are included in principal transactions revenues and interest revenues and expenses, depending on the nature of the instrument.

Fair values of trading securities are based on quoted market prices, pricing models (utilizing indicators of general market conditions or other economic measurements), or management's estimates of amounts to be realized on settlement, assuming current market conditions and an orderly disposition over a reasonable period of time.

DERIVATIVES
A derivative is typically defined as an instrument whose value is "derived" from an underlying instrument or index such as a future, forward, swap, or option contract, or other financial instrument with similar characteristics. Derivative contracts often involve future commitments to exchange interest payment streams or currencies based on a notional or contractual amount (e.g., interest rate swaps or currency forwards) or to purchase or sell other financial instruments at specified terms on a specified date (e.g., options to buy or sell securities or currencies).

Derivatives are often referred to as off-balance-sheet instruments since neither their notional amounts nor the under-lying instruments are reflected on the balance sheet; however, the fair values of trading derivatives are recorded in trading assets and liabilities. Derivatives are reported separately as assets and liabilities unless a legal right of setoff exists under a master netting agreement enforceable at law. Balances related to swap and forward transactions and foreign currency options are included in Contractual agreements on the Consolidated Balance Sheets. All other derivative balances are recorded in the related trading asset or liability caption. The fair value of equity options purchased, for example, is recorded in the Equities and convertible debentures trading asset caption.

Changes in fair values of derivatives are recorded as principal transactions revenues in the current period. Fair values for certain exchange-traded derivatives, principally futures and certain options, are based on quoted market prices. Fair values for over-the-counter ("OTC") derivative financial instruments, principally forwards, options, and swaps, represent amounts that would be received from or paid to a third party in settlement of these instruments. These amounts are determined using pricing models based on the present value of estimated future cash flows employing mid-market valuations with appropriate adjustments. These adjustments are integral components of the mark-to-market process and relate to credit quality and concentration, market liquidity, and exposure close-out costs associated with unmatched positions. Adjustments are also made for administrative costs incurred to service periodic cash flows and to maintain hedges over the life of the contract. A portion of income related to long-term contracts is recognized as the related administrative costs are incurred.

New, complex instruments may have immature or limited markets. The precision of the pricing model for a complex product, which involves multiple variables and assumptions, will evolve over time. As the markets for these products develop, Merrill Lynch continually refines its pricing models based on experience to correlate more closely to the market risk of these instruments.

SECURITIES FINANCING TRANSACTIONS
Merrill Lynch enters into repurchase and resale agreements and securities borrowed and loaned transactions to accommodate customers (i.e., matched-book), finance firm inventory positions, and obtain securities for settlement. Merrill Lynch also engages in securities financing for customers through margin lending (see Customer Transactions).

Resale and repurchase agreements are accounted for as collateralized financing transactions and are recorded at their contractual amounts plus accrued interest. Merrill Lynch's policy is to obtain possession of collateral with a market value equal to or in excess of the principal amount loaned under resale agreements. To ensure that the market value of the underlying collateral remains sufficient, collateral is valued daily, and Merrill Lynch may require counterparties to deposit additional collateral or return collateral pledged, when appropriate. Substantially all repurchase and resale activities are transacted under master netting agreements that give Merrill Lynch the right, in the event of default, to liquidate collateral held and to offset receivables and payables with the same counterparty. Merrill Lynch offsets certain repurchase and resale agreement balances with the same counterparty on the Consolidated Balance Sheets.

Securities borrowed and loaned transactions are recorded at the amount of cash collateral advanced or received. Securities borrowed transactions require Merrill Lynch to provide the counterparty with collateral in the form of cash, letters of credit, or other securities. Merrill Lynch receives collateral in the form of cash or other securities for securities loaned transactions. For these transactions, the fees received or paid by Merrill Lynch are recorded as interest revenue or expense. On a daily basis, Merrill Lynch monitors the market value of securities borrowed or loaned against the collateral value. Although substantially all securities borrowing and lending activities are transacted under master netting agreements, such receivables and payables with the same counterparty are not set off on the Consolidated Balance Sheets.

On the Consolidated Balance Sheet as of December 29, 2000, all firm-owned securities pledged to counterparties where the counterparty has the right, by contract or custom, to sell or repledge the securities are classified as securities pledged as collateral as required by SFAS No. 140, which does not require the restatement of prior years presented for comparison. As of December 31, 1999 such balances are included as trading assets.

Interest rate swaps may be used to modify the interest rate characteristics of long-term resale and repurchase agreements. These swaps are accounted for on an accrual basis, with amounts to be paid or received recognized as adjustments to interest expense or revenue. (See the Non-trading Derivatives section for additional information on accounting policy for non-trading derivatives).

Investment Banking and Advisory Services
Underwriting revenues and fees for merger and acquisition advisory services are accrued when services for the transactions are substantially completed. Transaction-related expenses are deferred to match revenue recognition.

Customer Transactions
Customer securities and commodities transactions are recorded on a settlement date basis. Receivables from and payables to customers include amounts due on cash and margin transactions. Securities owned by customers, including those that collateralize margin or other similar transactions, are not reflected on the Consolidated Balance Sheets.

Commissions charged for executing customer transactions are accrued on a trade date basis and are included in current period earnings. Financial consultant compensation and benefits expense is accrued in the same period as revenue is recognized.

Mutual fund distribution fee revenues are accrued as earned, and redemption fee revenues are recognized upon receipt. Certain compensation costs related to sales of rear-load open-end mutual funds are deferred to match revenue recognition.

Investing Activities
Merrill Lynch's non-broker-dealer subsidiaries hold debt and equity investments, which are primarily classified as available-for-sale.

Debt and marketable equity securities classified as available-for-sale are reported at fair value. Unrealized gains or losses on these securities are reported in stockholders' equity as a component of Accumulated other comprehensive loss, net of applicable income taxes and other related items.

Debt securities that Merrill Lynch has the positive intent and ability to hold to maturity are classified as held-to-maturity. These investments are recorded at amortized cost unless a decline in value is deemed other than temporary, in which case the carrying value is reduced. The amortization of premiums or accretion of discounts and any unrealized losses deemed other than temporary are included in current period earnings.

Debt and marketable equity securities purchased principally for the purpose of resale in the near-term are classified as trading investments and are reported at fair value. Unrealized gains or losses on these investments are included in current period earnings.

Restricted equity investment securities or equity investment securities without available market quotations held by non-broker-dealer subsidiaries are reported at the lower of cost or estimated net realizable value. Restricted equity investment securities held by broker-dealer subsidiaries are recorded at management's best estimate of fair value. Adjustments in carrying values are included in current period earnings.

Realized gains and losses on investments are included in current period earnings. The cost basis of each investment sold is specifically identified for purposes of computing realized gains and losses.

Derivative contracts may be used to modify interest rate characteristics of available-for-sale securities. Merrill Lynch also uses derivatives to manage the currency exposure arising from investments in non-U.S. subsidiaries (see Basis of Presentation for accounting policy for these investments). Unrealized gains and losses on these derivatives are reported net of tax in stockholders' equity as a component of Accumulated other comprehensive loss, along with unrealized gains and losses from the hedged items (see Non-trading Derivatives section for additional information on accounting policy for non-trading derivatives).

Lending and Related Activities
Merrill Lynch's lending and related activities include loan originations, syndications, securitizations, and servicing. Merrill Lynch also engages in secondary market loan trading and margin lending (see Trading Activities and Customer Transactions, respectively).

Loans held for investment purposes, including consumer and small business loans, are carried at their principal amount outstanding. The allowance for loan losses is established through provisions that are based on management's assessment of the collectibility of the loan portfolio. Loans are charged off against the allowance for loan losses when management determines that collection of principal is unlikely.

Loans held for sale, which include certain residential mortgage and home equity loans, are reported at the lower of cost (less allowance for loan losses) or estimated fair value determined on a portfolio basis. Mortgage servicing assets and residual interests in mortgage loans underlying Real Estate Mortgage Investment Conduits and revolving trusts are (1) recognized upon sales of loans when servicing is retained, and (2) amortized into income in proportion to, and over the estimated life of, net servicing income. Mortgage servicing assets are initially recognized based upon an allocation of the loan's original cost, in proportion to the resulting asset's fair value, subsequently measured using the present value of future cash flows, periodically evaluated for impairment, and included in Other assets on the Consolidated Balance Sheets. Residual interests are categorized as available-for-sale and reported in Other investments on the Consolidated Balance Sheets (see Investing Activities).

Merrill Lynch securitizes commercial and residential mortgage and home equity loans, government and corporate bonds, and lease and trade receivables. Merrill Lynch may retain an interest in the securitized assets in the form of residual interests, one or more subordinated tranches, and/or servicing rights. The gain or loss on sale of the receivables is determined with reference to the previous carrying amount of the financial assets transferred, which is allocated between the assets sold and the retained interests, if any, based on their relative fair value at the date of transfer. To obtain fair values, quoted market prices are used if available. Where quotes are unavailable for retained interests, Merrill Lynch generally estimates fair value based on the present value of expected future cash flows using management's best estimates of the key assumptions, including credit losses, prepayment rates, forward yield curves, and discount rates, commensurate with the risks involved. Retained interests in securitized receivables were not material at December 29, 2000. In 2000, cash proceeds from securitizations totaled $26.3 billion.

Borrowing Activities
Merrill Lynch's unsecured general-purpose funding is principally obtained from commercial paper and long-term borrowings. Commercial paper, when issued at a discount, is recorded at the proceeds received and accreted to its par value. Long-term borrowings are carried at the principal amount borrowed, net of unamortized discounts or premiums.

Merrill Lynch uses derivatives to manage the interest rate, currency, equity, and other risk exposures of its borrowings. Derivatives that hedge the interest rate risk on borrowings are generally accounted for on an accrual basis, with amounts to be paid or received recognized as adjustments to the related interest expense. Unrealized gains and losses on other derivatives hedging borrowings are recognized currently (see Non-trading Derivatives section for additional information).

Non-Trading Derivatives
As part of its overall risk management strategy, Merrill Lynch uses derivatives to manage its market risk exposures arising from non-trading assets and liabilities. These exposures include interest rate, currency, equity and other risks. Derivatives used for hedging borrowings and other non-trading assets and liabilities must be effective at reducing the risk being managed and be designated as a hedge at inception.

Realized gains and losses on early terminations of derivatives are deferred over the remaining lives of the hedged assets or liabilities. At December 29, 2000 and December 31, 1999, there were $6 million and $27 million, respectively, in deferred gains relating to terminated derivative contracts.

Insurance Activities
Insurance liabilities are future benefits payable under annuity and interest-sensitive life insurance contracts and include deposits received plus interest credited during the contract accumulation period, the present value of future payments for contracts which have annuitized, and a mortality provision for certain products. Certain policyholder liabilities are also adjusted for those investments classified as available-for-sale. Liabilities for unpaid claims consist of the mortality benefit for reported claims and an estimate of unreported claims based upon prior experience.

Substantially all security investments of insurance subsidiaries are classified as available-for-sale and recorded at fair value. These investments support Merrill Lynch's in-force, universal life-type contracts. Merrill Lynch records adjustments to deferred acquisition costs and policyholder account balances which, when combined, are equal to the adjustment that would have been recorded if those available-for-sale investments had been sold at their estimated fair values and the proceeds reinvested at current yields. The corresponding credits or charges for these adjustments are recorded in stockholders' equity as a component of Accumulated other comprehensive loss, net of applicable income taxes.

Certain variable costs related to the sale or acquisition of new and renewal insurance contracts have been deferred, to the extent deemed recoverable, and amortized over the estimated lives of the contracts in proportion to the estimated gross profit for each group of contracts.

Merrill Lynch maintains separate accounts representing segregated funds held for purposes of funding variable life and annuity contracts. Separate account assets are accounted for as customer assets since the contract holders bear the risk of ownership, consistent with Merrill Lynch's other investment products. Accordingly, separate account assets and the related liabilities are not consolidated with the assets and liabilities of Merrill Lynch.

Stock-Based Compensation
Merrill Lynch accounts for stock-based compensation in accordance with the intrinsic value-based method in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," rather than the fair value-based method in SFAS No. 123, "Accounting for Stock-Based Compensation." Compensation expense for stock options is not recognized since Merrill Lynch grants stock options without any intrinsic value. Compensation expense related to other stock-based compensation plans is recognized over the vesting period. For certain stock-based compensation grants, the unamortized portion of the grant value is reflected as a reduction of stockholders' equity in Employee stock transactions on the Consolidated Balance Sheets.

Goodwill
Goodwill, which represents the cost of acquired businesses in excess of fair value of the related net assets at acquisition, is amortized on a straight-line basis. Goodwill associated with the purchase of the Mercury Asset Management Group is amortized over 30 years. Goodwill related to other acquisitions is amortized over periods generally not exceeding 15 years.

Merrill Lynch periodically assesses the recoverability of goodwill by comparing expected undiscounted future cash flows from the underlying business operation with recorded goodwill balances. If such assessments indicate that the undiscounted future cash flows are not sufficient to recover the related carrying value, the assets are adjusted to fair values.

Equipment and Facilities
Equipment and facilities primarily consist of technology hardware and software, leasehold improvements, and owned facilities. Equipment and facilities are reported at historical cost, net of accumulated depreciation and amortization, except for land, which is reported at historical cost.

Depreciation and amortization are computed using the straight-line method. Equipment is depreciated over its estimated useful life, while leasehold improvements are amortized over the lesser of the improvement's estimated economic useful life or the term of the lease. Maintenance and repair costs are expensed as incurred.

Included in the Occupancy and related depreciation expense category was depreciation and amortization of $235 million, $207 million, and $193 million in 2000, 1999, and 1998, respectively. Depreciation and amortization recognized in the Communications and technology expense category was $611 million, $516 million, and $396 million for 2000, 1999, and 1998, respectively.

Costs incurred in the development of internal-use software are amortized over the useful life of the developed software, generally not exceeding three years.

Income Taxes
ML & Co. and certain of its wholly-owned subsidiaries file a consolidated U.S. federal income tax return.

Merrill Lynch uses the asset and liability method in providing income taxes on all transactions that have been recognized in the Consolidated Financial Statements. The asset and liability method requires that deferred taxes be adjusted to reflect the tax rates at which future taxable amounts will likely be settled or realized. The effects of tax rate changes on future deferred tax liabilities and deferred tax assets, as well as other changes in income tax laws, are recognized in net earnings in the period such changes are enacted. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.