Morgan Stanley

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Item 8. Financial Statements and Supplementary Data.

INDEPENDENT AUDITORS’ REPORT

To the Board of Directors and Shareholders of

Morgan Stanley:

We have audited the accompanying consolidated statements of financial condition of Morgan Stanley and subsidiaries (the “Company”) as of fiscal years ended November 30, 2002 and 2001, and the related consolidated statements of income, comprehensive income, cash flows and changes in shareholders’ equity for each of the three fiscal years in the period ended November 30, 2002. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the accompanying consolidated financial statements present fairly, in all material respects, the consolidated financial position of Morgan Stanley and subsidiaries at fiscal years ended November 30, 2002 and 2001, and the consolidated results of their operations and their cash flows for each of the three fiscal years in the period ended November 30, 2002, in conformity with accounting principles generally accepted in the United States of America.

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New York, New York

January 10, 2003

MORGAN STANLEY

Consolidated Statements of Financial Condition

(dollars in millions, except share data)

	November 30, 2002		November 30, 2001
Assets
Cash and cash equivalents	$	29,212	$	26,596
Cash and securities deposited with clearing organizations or segregated under federal and other regulations (including securities at fair value of $27,721 at November 30, 2002 and $36,146 at November 30, 2001)		38,411		46,326
Financial instruments owned (approximately $71 billion and $74 billion were pledged to various parties at November 30, 2002 and November 30, 2001, respectively):
U.S. government and agency securities		32,474		25,696
Other sovereign government obligations		27,694		22,039
Corporate and other debt		55,254		47,607
Corporate equities		21,996		23,143
Derivative contracts		35,615		32,078
Physical commodities		355		285
Securities purchased under agreements to resell		76,910		54,618
Securities received as collateral		12,200		13,163
Securities borrowed		130,404		120,758

Receivables:
Consumer loans (net of allowances of $928 at November 30, 2002 and $847 at November 30, 2001)		23,404		20,108
Customers, net		22,262		22,188
Brokers, dealers and clearing organizations		2,250		6,462
Fees, interest and other		4,892		5,283
Office facilities, at cost (less accumulated depreciation of $2,206 at November 30, 2002 and $2,124 at November 30, 2001)		2,270		2,579
Aircraft under operating leases (less accumulated depreciation of $769 at November 30, 2002 and $479 at November 30, 2001)		4,849		4,753
Goodwill		1,449		1,438
Other assets		7,598		7,508

Total assets	$	529,499	$	482,628

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MORGAN STANLEY

Consolidated Statements of Financial Condition—(Continued)

(dollars in millions, except share data)

	November 30, 2002			November 30, 2001
Liabilities and Shareholders’ Equity
Commercial paper and other short-term borrowings	$	50,789		$	32,842
Deposits		13,757			12,276
Financial instruments sold, not yet purchased:
U.S. government and agency securities		13,235			17,203
Other sovereign government obligations		11,679			10,906
Corporate and other debt		12,240			9,125
Corporate equities		18,320			13,046
Derivative contracts		28,985			27,286
Physical commodities		1,833			2,044
Securities sold under agreements to repurchase		136,463			122,695
Obligation to return securities received as collateral		12,200			13,163
Securities loaned		43,229			36,776

Payables:
Customers		88,229			93,719
Brokers, dealers and clearing organizations		4,610			4,331
Interest and dividends		3,363			2,761
Other liabilities and accrued expenses		12,245			12,795
Long-term borrowings		55,161			49,668

		506,338			460,636

Capital Units		66			66

Preferred securities subject to mandatory redemption		1,210			1,210


Commitments and contingencies

Shareholders’ equity:
Preferred stock		—			345
Common stock ($0.01 par value, 3,500,000,000 shares authorized, 1,211,685,904 and 1,211,685,904 shares issued, 1,081,417,377 and 1,093,006,744 shares outstanding at November 30, 2002 and November 30, 2001, respectively)		12			12
Paid-in capital		3,678			3,745
Retained earnings		25,250			23,270
Employee stock trust		3,003			3,086
Accumulated other comprehensive income (loss)		(251	)		(262	)

Subtotal		31,692			30,196
Note receivable related to ESOP		(13	)		(31	)
Common stock held in treasury, at cost ($0.01 par value, 130,268,527 and 118,679,160 shares at November 30, 2002 and November 30, 2001, respectively)		(7,176	)		(6,935	)
Common stock issued to employee trust		(2,618	)		(2,514	)

Total shareholders’ equity		21,885			20,716

Total liabilities and shareholders’ equity	$	529,499		$	482,628

See Notes to Consolidated Financial Statements.

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MORGAN STANLEY

Consolidated Statements of Income

(dollars in millions, except share and per share data)

	Fiscal Year
	2002			2001			2000
Revenues:
Investment banking	$	2,527		$	3,425		$	5,008
Principal transactions:
Trading		2,685			5,491			7,361
Investments		(35	)		(316	)		193
Commissions		3,280			3,162			3,647
Fees:
Asset management, distribution and administration		3,945			4,216			4,405
Merchant and cardmember		1,420			1,349			1,256
Servicing		2,091			1,904			1,489
Interest and dividends		15,866			24,127			21,234
Other		636			516			513

Total revenues		32,415			43,874			45,106
Interest expense		11,970			20,729			18,148
Provision for consumer loan losses		1,336			1,052			810

Net revenues		19,109			22,093			26,148


Non-interest expenses:
Compensation and benefits		7,933			9,372			10,896
Occupancy and equipment		825			881			755
Brokerage, clearing and exchange fees		775			700			600
Information processing and communications		1,379			1,460			1,317
Marketing and business development		1,133			1,277			1,582
Professional services		1,094			1,299			1,278
Other		1,015			1,370			1,201
Restructuring and other charges		235			—			—

Total non-interest expenses		14,389			16,359			17,629

Gain on sale of business		—			—			35

Income before income taxes, dividends on preferred securities subject to mandatory redemption, extraordinary item and cumulative effect of accounting change		4,720			5,734			8,554
Provision for income taxes		1,645			2,074			3,070
Dividends on preferred securities subject to mandatory redemption		87			50			28

Income before extraordinary item and cumulative effect of accounting change		2,988			3,610			5,456
Extraordinary item		—			(30	)		—
Cumulative effect of accounting change		—			(59	)		—

Net income	$	2,988		$	3,521		$	5,456

Preferred stock dividend requirements	$	—		$	32		$	36

Earnings applicable to common shares	$	2,988		$	3,489		$	5,420


Earnings per common share:
Basic before extraordinary item and cumulative effect of accounting change	$	2.76		$	3.29		$	4.95
Extraordinary item		—			(0.03	)		—
Cumulative effect of accounting change		—			(0.05	)		—

Basic	$	2.76		$	3.21		$	4.95

Diluted before extraordinary item and cumulative effect of accounting change	$	2.69		$	3.19		$	4.73
Extraordinary item		—			(0.03	)		—
Cumulative effect of accounting change		—			(0.05	)		—

Diluted	$	2.69		$	3.11		$	4.73


Average common shares outstanding:
Basic		1,083,270,783			1,086,121,508			1,095,858,438

Diluted		1,109,637,953			1,121,764,086			1,145,011,515

See Notes to Consolidated Financial Statements.

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MORGAN STANLEY

Consolidated Statements of Comprehensive Income

(dollars in millions)

	Fiscal Year
	2002			2001			2000
Net income	$	2,988		$	3,521		$	5,456
Other comprehensive income (loss), net of tax:
Foreign currency translation adjustment		30			(59	)		(64	)
Cumulative effect of accounting change		—			(13	)		—
Net change in cash flow hedges		—			(99	)		—
Minimum pension liability adjustment		(19	)		—			—

Comprehensive income	$	2,999		$	3,350		$	5,392

See Notes to Consolidated Financial Statements.

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MORGAN STANLEY

Consolidated Statements of Cash Flows

(dollars in millions)

	Fiscal Year
	2002			2001			2000
CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	2,988		$	3,521		$	5,456
Adjustments to reconcile net income to net cash used for operating activities:
Non-cash charges (credits) included in net income:
Cumulative effect of accounting change		—			59			—
Asset impairment charge		74			87			—
Gain on sale of business		—			—			(35	)
Gain on sale of building		(73	)		—			—
Gain on sale of self-directed online brokerage accounts		(52	)		—			—
Deferred income taxes		55			(427	)		(219	)
Compensation payable in common or preferred stock		388			653			908
Depreciation and amortization		787			729			727
Provision for consumer loan losses		1,336			1,052			810
Restructuring and other charges		235			—			—
Changes in assets and liabilities:
Cash and securities deposited with clearing organizations or segregated under federal and other regulations		7,915			2,311			(38,924	)
Financial instruments owned, net of financial instruments sold, not yet purchased		(15,380	)		(16,288	)		(10,524	)
Securities borrowed, net of securities loaned		(3,193	)		(13,962	)		(15,036	)
Receivables and other assets		5,280			(2,519	)		2,078
Payables and other liabilities		(5,414	)		693			52,376

Net cash used for operating activities		(5,054	)		(24,091	)		(2,383	)

CASH FLOWS FROM INVESTING ACTIVITIES
Net (payments for) proceeds from:
Office facilities and aircraft under operating leases		(1,124	)		(1,998	)		(896	)
Purchase of Quilter Holdings Limited, net of cash acquired		—			(183	)		—
Purchase of Ansett Worldwide Aviation Services, net of cash acquired		—			—			(199	)
Net principal disbursed on consumer loans		(8,677	)		(7,053	)		(11,885	)
Sale of self-directed online brokerage accounts		98			—			—
Sales of consumer loans		4,048			7,638			10,294
Sale of office building		—			709			—

Net cash used for investing activities		(5,655	)		(887	)		(2,686	)

CASH FLOWS FROM FINANCING ACTIVITIES
Net proceeds from (payments for) short-term borrowings		17,947			5,088			(10,563	)
Securities sold under agreements to repurchase, net of securities purchased under agreements to resell		(8,524	)		21,839			12,154
Net proceeds from:
Deposits		1,481			346			1,533
Issuance of common stock		179			197			338
Issuance of put options		6			5			42
Issuance of long-term borrowings		11,043			18,498			22,475
Issuance of preferred securities subject to mandatory redemption		—			810			—
Payments for:
Repayments of long-term borrowings		(6,472	)		(11,201	)		(9,351	)
Redemption of cumulative preferred stock		(345	)		(200	)		—
Redemption of Capital Units		—			(4	)		(513	)
Repurchases of common stock		(990	)		(1,583	)		(3,628	)
Cash dividends		(1,000	)		(1,040	)		(924	)

Net cash provided by financing activities		13,325			32,755			11,563

Net increase in cash and cash equivalents		2,616			7,777			6,494
Cash and cash equivalents, at beginning of period		26,596			18,819			12,325

Cash and cash equivalents, at end of period	$	29,212		$	26,596		$	18,819

See Notes to Consolidated Financial Statements.

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MORGAN STANLEY

Consolidated Statements of Changes in Shareholders’ Equity

(dollars in millions)

	Preferred Stock			Common Stock		Paid-in Capital			Retained Earnings			Employee Stock Trust			Accumulated Other Comprehensive Income (Loss)			Note Receivable Related to ESOP			Common Stock Held in Treasury at Cost			Common Stock Issued to Employee Trust			Total
BALANCE AT NOVEMBER 30, 1999	$	670		$	12	$	3,836		$	16,285		$	2,426		$	(27	)	$	(55	)	$	(4,355	)	$	(1,778	)	$	17,014
Net income		—			—		—			5,456			—			—			—			—			—			5,456
Dividends		—			—		—			(939	)		—			—			—			—			—			(939	)
Conversion of ESOP Preferred Stock		(125	)		—		(817	)		—			—			—			—			942			—			—
Issuance of common stock		—			—		(446	)		—			—			—			—			784			—			338
Issuance of put options		—			—		42			—			—			—			—			—			—			42
Exercise of put options		—			—		(4	)		—			—			—			—			4			—			—
Repurchases of common stock		—			—		—			—			—			—			—			(3,628	)		—			(3,628	)
Compensation payable in common stock		—			—		766			—			616			—			—			229			(570	)		1,041
ESOP shares allocated, at cost		—			—		—			—			—			—			11			—			—			11
Translation adjustments		—			—		—			—			—			(64	)		—			—			—			(64	)

BALANCE AT NOVEMBER 30, 2000		545			12		3,377			20,802			3,042			(91	)		(44	)		(6,024	)		(2,348	)		19,271
Net income		—			—		—			3,521			—			—			—			—			—			3,521
Dividends		—			—		—			(1,053	)		—			—			—			—			—			(1,053	)
Redemption of 7-³/4 % Cumulative Preferred Stock		(200	)		—		—			—			—			—			—			—			—			(200	)
ESOP shares allocated, at cost		—			—		—			—			—			—			13			—			—			13
Issuance of common stock		—			—		(364	)		—			—			—			—			561			—			197
Issuance of put options		—			—		5			—			—			—			—			—			—			5
Exercise of put options		—			—		(12	)		—			—			—			—			12			—			—
Repurchases of common stock		—			—		—			—			—			—			—			(1,583	)		—			(1,583	)
Compensation payable in common stock		—			—		739			—			44			—			—			99			(166	)		716
Cumulative effect of accounting change and net change in cash flow hedges		—			—		—			—			—			(112	)		—			—			—			(112	)
Translation adjustments		—			—		—			—			—			(59	)		—			—			—			(59	)

BALANCE AT NOVEMBER 30, 2001		345			12		3,745			23,270			3,086			(262	)		(31	)		(6,935	)		(2,514	)		20,716
Net income		—			—		—			2,988			—			—			—			—			—			2,988
Dividends		—			—		—			(1,008	)		—			—			—			—			—			(1,008	)
Redemption of Cumulative Preferred Stock		(345	)		—		—			—			—			—			—			—			—			(345	)
Issuance of common stock		—			—		(350	)		—			—			—			—			529			—			179
Issuance of put options		—			—		6			—			—			—			—			—			—			6
Exercise of put options		—			—		(5	)		—			—			—			—			5			—			—
Repurchases of common stock		—			—		—			—			—			—			—			(990	)		—			(990	)
Compensation payable in common stock		—			—		282			—			(83	)		—			—			215			(104	)		310
ESOP shares allocated, at cost		—			—		—			—			—			—			18			—			—			18
Minimum pension liability adjustment		—			—		—			—			—			(19	)		—			—			—			(19	)
Translation adjustments		—			—		—			—			—			30			—			—			—			30

BALANCE AT NOVEMBER 30, 2002	$	—		$	12	$	3,678		$	25,250		$	3,003		$	(251	)	$	(13	)	$	(7,176	)	$	(2,618	)	$	21,885

See Notes to Consolidated Financial Statements.

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MORGAN STANLEY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Introduction and Basis of Presentation.

The Company. Morgan Stanley (the “Company”) is a global financial services firm that maintains leading market positions in each of its business segments—Institutional Securities, Individual Investor Group, Investment Management and Credit Services. The Company’s Institutional Securities business includes securities underwriting and distribution; financial advisory services, including advice on mergers and acquisitions, restructurings, real estate and project finance; sales, trading, financing and market-making activities in equity securities and related products and fixed income securities and related products, including foreign exchange and commodities; principal investing and aircraft financing activities. The Company’s Individual Investor Group business provides comprehensive financial planning and investment advisory services designed to accommodate individual investment goals and risk profiles. The Company’s Investment Management business provides global asset management products and services for individual and institutional investors through three principal distribution channels: a proprietary channel consisting of the Company’s financial advisors and investment representatives; a non-proprietary channel consisting of third-party broker-dealers, banks, financial planners and other intermediaries; and the Company’s institutional channel. The Company’s private equity activities also are included within the Investment Management business segment. The Company’s Credit Services business offers Discover^®-branded cards and other consumer finance products and services and includes the operation of Discover Business Services, a network of merchant and cash access locations primarily in the U.S.

In fiscal 2002, the Company’s name changed from “Morgan Stanley Dean Witter & Co.” to “Morgan Stanley.”

Basis of Financial Information. The consolidated financial statements for the 12 months ended November 30, 2002 (“fiscal 2002”), November 30, 2001 (“fiscal 2001”) and November 30, 2000 (“fiscal 2000”) are prepared in accordance with accounting principles generally accepted in the U.S., which require the Company to make estimates and assumptions regarding the valuations of certain financial instruments, consumer loan loss levels, the potential outcome of litigation, and other matters that affect the consolidated financial statements and related disclosures. The Company believes that the estimates utilized in the preparation of the consolidated financial statements are prudent and reasonable. Actual results could differ materially from these estimates.

The consolidated financial statements include the accounts of the Company, its wholly-owned subsidiaries and other entities in which the Company has a controlling financial interest. The Company’s policy is to consolidate all subsidiaries in which it owns more than 50% of the outstanding voting stock unless it does not control the subsidiary. For investments in companies in which the Company has significant influence over operating and financial decisions (generally defined as owning a voting or economic interest of 20% to 50%), the Company applies the equity method of accounting. In those cases where the Company’s investment is less than 20% and significant influence does not exist, such investments are carried at cost.

The Company’s U.S. and international subsidiaries include Morgan Stanley & Co. Incorporated (“MS&Co.”), Morgan Stanley & Co. International Limited (“MSIL”), Morgan Stanley Japan Limited (“MSJL”), Morgan Stanley DW Inc. (“MSDWI”), Morgan Stanley Investment Advisors Inc. and NOVUS Credit Services Inc.

Certain reclassifications have been made to prior-year amounts to conform to the current presentation. All material intercompany balances and transactions have been eliminated.

2. Summary of Significant Accounting Policies.

Consolidated Statements of Cash Flows. For purposes of these statements, cash and cash equivalents consist of cash and highly liquid investments not held for resale with maturities, when purchased, of three months or less.

In connection with the fiscal 2001 purchase of Quilter Holdings Limited (“Quilter”), the Company issued approximately $37 million of notes payable, including approximately $13 million of notes that are convertible into common shares of the Company.

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MORGAN STANLEY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

In connection with the fiscal 2000 purchase of Ansett Worldwide Aviation Services (“Ansett Worldwide”), the Company assumed $1,380 million of long-term borrowings.

Consumer Loans. Consumer loans, which consist primarily of general purpose credit card, mortgage and consumer installment loans, are reported at their principal amounts outstanding less applicable allowances. Interest on consumer loans is credited to income as earned.

Interest is accrued on credit card loans until the date of charge-off, which generally occurs at the end of the month during which an account becomes 180 days past due, except in the case of bankruptcies and fraudulent transactions, which are charged off earlier. The interest portion of charged-off credit card loans is written off against interest revenue. Origination costs related to the issuance of credit cards are charged to earnings over periods not exceeding 12 months.

Allowance for Consumer Loan Losses. The allowance for consumer loan losses is a significant estimate that represents management’s estimate of probable losses inherent in the consumer loan portfolio. The allowance for consumer loan losses is an allowance applicable to the owned homogeneous consumer credit card loan portfolio that is evaluated quarterly for adequacy and is established through a charge to the provision for consumer loan losses.

In calculating the allowance for consumer loan losses, the Company uses a systematic and consistently applied approach. The amount of the allowance is established through a process that begins with estimates of the losses inherent in the consumer loan portfolio based on coverage of a rolling average of historical credit losses. In addition, the Company regularly performs a migration analysis (a technique used to estimate the likelihood that a consumer loan will progress through the various stages of delinquency and ultimately charge-off) of delinquent and current consumer credit card accounts in order to determine the appropriate level of the allowance for consumer loan losses. The migration analysis considers uncollectible principal, interest and fees reflected in consumer loans. In evaluating the adequacy of the allowance for consumer loan losses, management also considers factors that may impact future credit loss experience, including current economic conditions, recent trends in delinquencies and bankruptcy filings, account seasoning, loan volume and amounts, payment rates and forecasting uncertainties. A provision for consumer loan losses is charged against earnings to maintain the allowance for consumer loan losses at an appropriate level.

Financial Instruments Used for Trading and Investment. Financial instruments owned and financial instruments sold, not yet purchased, which include cash and derivative products, are recorded at fair value in the consolidated statements of financial condition, and gains and losses are reflected in principal trading revenues in the consolidated statements of income. Loans and lending commitments associated with the Company’s lending activities also are recorded at fair value. Fair value is the amount at which financial instruments could be exchanged in a current transaction between willing parties, other than in a forced or distressed sale.

The price transparency of the particular product will determine the degree of judgment involved in determining the fair value of the Company’s financial instruments. Price transparency is affected by a wide variety of factors, including, for example, the type of product, whether it is a new product and not yet established in the marketplace, and the characteristics particular to the transaction. Products for which actively quoted prices or pricing parameters are available or for which fair value is derived from actively quoted prices or pricing parameters will generally have a higher degree of price transparency. By contrast, products that are thinly or not quoted will generally have reduced to no price transparency.

A substantial percentage of the fair value of the Company’s financial instruments owned and financial instruments sold, not yet purchased, is based on observable market prices, observable market parameters, or is derived from such prices or parameters. The availability of observable market prices and pricing parameters can vary from product to product. Where available, observable market prices and pricing parameters in a product

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MORGAN STANLEY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(or a related product) may be used to derive a price without requiring significant judgment. In certain markets, observable market prices or market parameters are not available for all products, and fair value is determined using techniques appropriate for each particular product. These analyses may involve a degree of judgment.

The fair value of over-the-counter (“OTC”) derivative contracts is derived from pricing models, which may require multiple market input parameters. The Company relies on pricing models as a valuation methodology to determine fair value for OTC derivative products because market convention is to quote input parameters to models rather than prices, not because of a lack of an active trading market. The term “model” typically refers to a mathematical calculation methodology based on accepted financial theories. Depending on the product and the terms of the transaction, the fair value of OTC derivative products can be modeled using a series of techniques, including closed form analytic formulae, such as the Black-Scholes option pricing model, simulation models or a combination thereof, applied consistently. In the case of more established derivative products, the pricing models used by the Company are widely accepted by the financial services industry. Pricing models take into account the contract terms, including the maturity, as well as quoted market parameters such as interest rates, volatility and the creditworthiness of the counterparty.

Interest and dividend revenue and interest expense arising from financial instruments used in trading activities are reflected in the consolidated statements of income as interest and dividend revenue or interest expense. Purchases and sales of financial instruments as well as commission revenues and related expenses are recorded in the accounts on trade date. Unrealized gains and losses arising from the Company’s dealings in OTC financial instruments, including derivative contracts related to financial instruments and commodities, are presented in the accompanying consolidated statements of financial condition on a net-by-counterparty basis, when appropriate.

Equity securities purchased in connection with private equity and other principal investment activities initially are carried in the consolidated financial statements at their original costs, which approximate fair value. The carrying value of such equity securities is adjusted when changes in the underlying fair values are readily ascertainable, generally as evidenced by observable market prices or transactions that directly affect the value of such equity securities. Downward adjustments relating to such equity securities are made in the event that the Company determines that the eventual realizable value is less than the carrying value. The Company’s partnership interests, including general partnership and limited partnership interests in real estate funds, are included within Other assets in the Company’s consolidated statements of financial condition and are recorded at fair value based upon changes in the fair value of the underlying partnership’s net assets.

Financial Instruments Used for Asset and Liability Management. The Company enters into various derivative financial instruments for non-trading purposes. These instruments are included within Financial instruments owned—derivative contracts or Financial instruments sold, not yet purchased—derivative contracts within the consolidated statements of financial condition and include interest rate swaps, foreign currency swaps, equity swaps and foreign exchange forwards. The Company uses interest rate and currency swaps and equity derivatives to manage interest rate, currency and equity price risk arising from certain borrowings. The Company also utilizes interest rate swaps to match the repricing characteristics of consumer loans with those of the borrowings that fund these loans. Certain of these derivative financial instruments are designated and qualify as fair value hedges and cash flow hedges in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended.

The Company’s designated fair value hedges consist primarily of hedges of fixed rate borrowings, including fixed rate borrowings that fund consumer loans. The Company’s designated cash flow hedges consist primarily of hedges of floating rate borrowings in connection with its aircraft financing business. In general, interest rate exposure in this business arises to the extent that the interest obligations associated with debt used to finance the Company’s

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MORGAN STANLEY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

aircraft portfolio do not correlate with the aircraft rental payments received by the Company. The Company’s objective is to manage the exposure created by its floating interest rate obligations given that future lease rates on new leases may not be repriced at levels that fully reflect changes in market interest rates. The Company utilizes interest rate swaps to minimize the risk created by its longer-term floating rate interest obligations and measures that risk by reference to the duration of those obligations and the expected sensitivity of future lease rates to future market interest rates.

For qualifying fair value hedges, the changes in the fair value of the derivative and the gain or loss on the hedged asset or liability relating to the risk being hedged are recorded currently in earnings. These amounts are recorded in interest expense and provide offset of one another. For qualifying cash flow hedges, the changes in the fair value of the derivative are recorded in Accumulated other comprehensive income in shareholder’s equity, net of tax effects, and amounts in Accumulated other comprehensive income are reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. The Company estimates that approximately $56 million of the unrealized loss recognized in Accumulated other comprehensive income as of November 30, 2002 will be reclassified into earnings within the next 12 months. Ineffectiveness relating to fair value and cash flow hedges, if any, is recorded within interest expense. The impact of hedge ineffectiveness on the Company’s consolidated statements of income was not material for all periods presented.

The Company also utilizes foreign exchange forward contracts to manage the currency exposure relating to its net monetary investments in non-U.S. dollar functional currency operations. The gain or loss from revaluing these contracts is deferred and reported within Accumulated other comprehensive income in shareholders’ equity, net of tax effects, with the related unrealized amounts due from or to counterparties included in Receivables from or Payables to brokers, dealers and clearing organizations. The interest elements (forward points) on these foreign exchange forward contracts are recorded in earnings.

In fiscal 2001, the Company recorded an after-tax charge to net income from the cumulative effect of the adoption of SFAS No. 133, as amended, of $59 million and an after-tax decrease to Accumulated other comprehensive income of $13 million. The Company’s adoption of SFAS No. 133, as amended, affects the accounting for, among other things, the Company’s hedging strategies, including those associated with certain financing activities.

Office Facilities. Office facilities are stated at cost less accumulated depreciation and amortization. Depreciation and amortization of buildings, leasehold improvements, furniture, fixtures and equipment are provided principally by the straight-line method over the estimated useful life of the asset. Estimates of useful lives are as follows: buildings—39 years; furniture and fixtures—7 years; and computer and communications equipment—3 to 5 years. Leasehold improvements are amortized over the lesser of the estimated useful life of the asset or, where applicable, the remaining term of the lease, but generally not exceeding 15 years.

Aircraft under Operating Leases. Aircraft under operating leases are stated at cost less accumulated depreciation. Depreciation is calculated on a straight-line basis over the estimated useful life of the aircraft asset, which is generally 25 years from the date of manufacture. In accordance with SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of,” the Company’s aircraft are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the aircraft may not be recoverable. In the fourth quarter of fiscal 2001 and the third quarter of fiscal 2002, the Company recognized impairment charges pursuant to SFAS No. 121 (see Note 19).

Revenue from aircraft under operating leases is recognized on a straight-line basis over the lease term. Certain lease contracts may require the lessee to make separate payments for flight hours and passenger miles flown. In such instances, the Company recognizes these other revenues as they are earned in accordance with the terms of the applicable lease contract.

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MORGAN STANLEY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Investment Banking. Underwriting revenues and fees for mergers, acquisitions and advisory assignments are recorded when services for the transactions are determined to be completed, generally as set forth under the terms of the engagement. Transaction-related expenses, primarily consisting of legal, travel and other costs directly associated with the transaction, are deferred to match revenue recognition.

Income Taxes. Income tax expense is provided for using the asset and liability method, under which deferred tax assets and liabilities are determined based upon the temporary differences between the financial statement and income tax bases of assets and liabilities, using currently enacted tax rates.

Earnings per Share. The Company calculates earnings per share (“EPS”) in accordance with SFAS No. 128, “Earnings per Share.” The calculations of earnings per share are based on the weighted average number of common shares and share equivalents outstanding and give effect to preferred stock dividend requirements.

“Basic EPS” reflects no dilution from common stock equivalents, and “diluted EPS” reflects dilution from common stock equivalents and other dilutive securities based on the average price per share of the Company’s common stock during the period.

Cardmember Rewards. Cardmember rewards, primarily the Cashback Bonus^® award, pursuant to which the Company pays Discover Classic Card, Discover Platinum Card and Morgan Stanley Platinum Card cardmembers a percentage of their purchase amounts ranging up to 1% based upon a cardmember’s level and type of purchases. The liability for cardmember rewards, included in Other liabilities and accrued expenses, is accrued at the time that qualified cardmember transactions occur and is calculated on an individual cardmember basis. In accordance with Emerging Issues Task Force (“EITF”) Issue No. 00-22, “Accounting for ‘Points’ and Certain Other Time-Based or Volume-Based Sales Incentive Offers, and Offers for Free Products or Services to Be Delivered in the Future,” the Company records its Cashback Bonus award program as a reduction of Merchant and cardmember fees.

Stock-Based Compensation. SFAS No. 123, “Accounting for Stock-Based Compensation” encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans at fair value. The Company currently accounts for its stock-based compensation plans using the intrinsic value method prescribed by Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” Under the provisions of APB No. 25, compensation cost for stock options is measured as the excess, if any, of the quoted market price of the Company’s common stock at the date of grant over the amount an employee must pay to acquire the stock. In August 2002, the Company announced that beginning in fiscal 2003, it will expense employee stock options in accordance with SFAS No. 123 (see “New Accounting Pronouncements” herein).

Translation of Foreign Currencies. Assets and liabilities of operations having non-U.S. dollar functional currencies are translated at year-end rates of exchange, and income statement accounts are translated at weighted average rates of exchange for the year. In accordance with SFAS No. 52, “Foreign Currency Translation,” gains or losses resulting from translating foreign currency financial statements, net of hedge gains or losses and related tax effects, are reflected in Accumulated other comprehensive income (loss), a separate component of shareholders’ equity. Gains or losses resulting from foreign currency transactions are included in net income.

Goodwill. Prior to the Company’s adoption of SFAS No. 142, “Goodwill and Other Intangible Assets,” on December 1, 2001, goodwill was amortized on a straight-line basis over periods from five to 40 years but

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MORGAN STANLEY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

generally not exceeding 25 years. At November 30, 2002 and November 30, 2001, goodwill of approximately $1.4 billion was included in the Company’s consolidated statements of financial condition (see Note 3).

Deferred Compensation Arrangements. In accordance with EITF Issue No. 97-14, “Accounting for Deferred Compensation Arrangements Where Amounts Earned Are Held in a Rabbi Trust and Invested,” assets of rabbi trusts are to be consolidated with those of the employer, and the value of the employer’s stock held in rabbi trusts should be classified in shareholders’ equity and generally accounted for in a manner similar to treasury stock. The Company, therefore, has included its obligations under certain deferred compensation plans in Employee stock trust. Shares that the Company has issued to its rabbi trusts are recorded in Common stock issued to employee trust. Both Employee stock trust and Common stock issued to employee trust are components of shareholders’ equity. The Company recognizes the original amount of deferred compensation (fair value of the restricted stock unit award at the date of grant — see Note 14) as the basis for recognition in Employee stock trust and Common stock issued to employee trust. Consistent with EITF Issue No. 97-14, changes in the fair value of amounts owed to employees are not recognized as the Company’s deferred compensation plans do not permit diversification and must be settled by the delivery of a fixed number of shares of the Company’s common stock. The amount recorded in Employee stock trust is only higher than the amount in Common stock issued to employee trust at fiscal year-end because the transfer of the shares to the rabbi trusts occurs subsequent to fiscal year-end, whereas compensation expense relating to these shares is recorded at fiscal year-end.

Software Costs. In accordance with American Institute of Certified Public Accountants (“AICPA”) Statement of Position (“SOP”) 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use,” certain costs incurred in connection with internal-use software projects are capitalized and amortized over the expected useful life of the asset.

Securitization Activities. The Company engages in securitization activities related to commercial and residential mortgage loans, corporate bonds and loans, U.S. agency collateralized mortgage obligations, municipal bonds, credit card loans and other types of financial assets (see Notes 4 and 5). The Company may retain interests in the securitized financial assets as one or more tranches of the securitization, an undivided seller’s interest, accrued interest receivable subordinate to investors’ interests (see Note 5), cash collateral accounts, servicing rights, and rights to any excess cash flows remaining after payments to investors in the securitization trusts of their contractual rate of return and reimbursement of credit losses. The exposure to credit losses from securitized loans is limited to the Company’s retained contingent risk, which represents the Company’s retained interest in securitized loans, including any credit enhancement provided. The gain or loss on the sale of financial assets depends in part on the previous carrying amount of the assets involved in the transfer, and each subsequent transfer in revolving structures, allocated between the assets sold and the retained interests based upon their respective fair values at the date of sale. To obtain fair values, observable market prices are used if available. However, observable market prices are generally not available for retained interests, so the Company estimates fair value based on the present value of expected future cash flows using its best estimates of the key assumptions, including forecasted credit losses, payment rates, forward yield curves and discount rates commensurate with the risks involved. The present value of future net servicing revenues that the Company estimates it will receive over the term of the securitized loans is recognized in income as the loans are securitized. A corresponding asset also is recorded and then amortized as a charge to income over the term of the securitized loans, with actual net servicing revenues continuing to be recognized in income as they are earned.

New Accounting Pronouncements. In August 2002, the Company announced that beginning in fiscal 2003 it will expense employee stock options in accordance with SFAS No. 123. Under the fair value-based method of SFAS No. 123, compensation expense is recognized based on the fair value of stock options on the date of grant. In December 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure, an amendment of FASB Statement No. 123.”

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MORGAN STANLEY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value-based method of accounting for stock-based compensation. In addition, SFAS No. 148 requires, on an annual basis, disclosures about the method of accounting for stock-based compensation and tabular information about the effect of the method of accounting for stock-based compensation on net income and earnings per share, including pro forma amounts, in the “Summary of Significant Accounting Policies.” On a quarterly basis, SFAS No. 148 requires prominent disclosure in tabular form of the effect of the method of stock-based compensation on net income and earnings per share for all periods presented if awards of stock-based compensation were outstanding and accounted for under APB Opinion No. 25. Pursuant to its announcement to begin expensing stock options in fiscal 2003, the Company adopted SFAS No. 148 on December 1, 2002 and has elected the prospective method of transition to the fair value-based method of accounting for stock-based compensation. The Company is in the process of evaluating the impact of adopting the fair value-based method of accounting and the recognition provisions of the prospective method of transition for stock-based employee compensation plans.

In November 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 identifies characteristics of certain guarantee contracts and requires that a liability be recognized at fair value at the inception of such guarantees for the obligations undertaken by the guarantor. Additional disclosures also are prescribed for certain guarantee contracts. The initial recognition and initial measurement provisions of FIN 45 are effective for these guarantees issued or modified after December 31, 2002. The disclosure requirements of FIN 45 are effective for the Company for its quarter ending February 28, 2003. The Company currently is evaluating the impact of FIN 45 on its consolidated financial statements.

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities”. FIN 46 clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements”, to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties (“variable interest entities”). Variable interest entities (“VIEs”) are required to be consolidated by their primary beneficiaries if they do not effectively disperse risks among parties involved. The primary beneficiary of a VIE is the party that absorbs a majority of the entity’s expected losses, receives a majority of its expected residual returns, or both, as a result of holding variable interests. FIN 46 also requires new disclosures about VIEs.

On February 1, 2003, the Company adopted FIN 46 for VIEs created after January 31, 2003 and for VIEs in which the Company obtains an interest after January 31, 2003. The Company will adopt FIN 46 on September 1, 2003 for VIEs in which it holds a variable interest that it acquired before February 1, 2003. The Company is currently evaluating the impact of the provisions of FIN 46 on its consolidated financial statements. The Company is involved with various entities in the normal course of business that may be deemed to be VIEs and may hold interests therein, including interest-only strip investments and derivative instruments, that may be considered variable interests. Transactions associated with these entities include asset- and mortgage-backed securitizations and structured financings (including collateralized debt, bond or loan obligations and credit-linked notes). The Company principally engages in these transactions to facilitate client needs and as a means of selling financial assets. The Company currently consolidates entities in which it has a controlling financial interest in accordance with accounting principles generally accepted in the U.S. For those entities deemed to be qualifying special purpose entities (as defined in SFAS No. 140), which includes the credit card asset securitization master trust (see Note 5), the Company does not consolidate the entity.

The Company believes that it is reasonably possible that it will either disclose information in its Form 10-K for fiscal 2003 about certain VIEs created before February 1, 2003 for which it holds a significant variable interest or it will be the primary beneficiary of the entity and thus be required to consolidate the VIE on September 1, 2003.

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MORGAN STANLEY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

At November 30, 2002, in connection with its institutional securities business, the aggregate size of the entities for which the Company’s interest is either significant or for which the Company could be deemed to be the primary beneficiary of the entity was approximately $8.5 billion. The Company’s variable interests associated with these entities, primarily financial asset-backed securitization and collateralized debt and bond obligation entities, was approximately $120 million, which represents the Company’s maximum exposure to loss at November 30, 2002. In connection with its investment management business, where the Company is the asset manager for collateralized bond and loan obligation entities, the aggregate size of potential VIEs at November 30, 2002 was approximately $2.5 billion. The Company’s variable interests associated with its investment management activities was approximately $1 million, which represents the Company’s maximum exposure to loss at November 30, 2002.

The Company purchases and sells interests in entities that may be deemed to be VIEs in its market-making capacity in the ordinary course of its institutional securities business. As a result of these activities, it is reasonably possible that such entities may be consolidated and deconsolidated at various points in time. Therefore, the Company’s variable interests included above may not be held by the Company at its fiscal 2003 year-end.

3. Goodwill.

In June 2001, the FASB issued SFAS No. 142, which no longer permits the amortization of goodwill and indefinite-lived intangible assets. Instead, these assets must be reviewed annually (or more frequently under certain conditions) for impairment. Intangible assets that do not have indefinite lives will continue to be amortized over their useful lives and reviewed for impairment. The Company early adopted the provisions of SFAS No. 142 and therefore discontinued the amortization of goodwill effective December 1, 2001. During fiscal 2002, the Company completed the initial transitional goodwill impairment test, which did not indicate any goodwill impairment and therefore did not have an effect on the Company’s consolidated financial condition or results of operations.

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MORGAN STANLEY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The following table presents a reconciliation of reported net income and earnings per share to the amounts adjusted for the exclusion of goodwill amortization, net of the related income tax effect:

	Fiscal 2002		Fiscal 2001			Fiscal 2000
	(dollars in millions, except per share amounts)
Net income
Income before extraordinary item and cumulative effect of accounting change	$	2,988	$	3,610		$	5,456
Add: Goodwill amortization, net of tax		—		81			72

		2,988		3,691			5,528
Extraordinary item		—		(30	)		—
Cumulative effect of accounting change		—		(59	)		—

Adjusted	$	2,988	$	3,602		$	5,528

Basic earnings per common share

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