Barclays 2006 Annual Report Download - page 112

Barclays PLC
Annual Report 2006
108
The Group’s accounting policies are set out on pages 151 to 160.
Certain of these policies, as well as estimates made by management, are
considered to be important to an understanding of the Group’s financial
condition since they require management to make difficult, complex or
subjective judgements and estimates, some of which may relate to
matters that are inherently uncertain. The following accounting policies
include estimates which are particularly sensitive in terms of judgements
and the extent to which estimates are used. Other accounting policies
involve significant amounts of judgements and estimates, but the total
amounts involved are not significant to the financial statements.
Management has discussed the accounting policies and critical
accounting estimates with the Board Accounts Committee.
Fair value of financial instruments
Some of the Bank’s financial instruments are carried at fair value
through profit or loss, including derivatives held for trading or risk
management purposes. The fair value of a financial instrument is the
amount at which the instrument could be exchanged in a current
transaction between willing parties, other than in a forced or liquidation
sale. Financial instruments entered into as trading transactions,
together with any associated hedging, are measured at fair value and
the resultant profits and losses are included in net trading income, along
with interest and dividends arising from long and short positions and
funding costs relating to trading activities. Assets and liabilities resulting
from gains and losses on financial instruments held for trading are
reported gross in trading portfolio assets and liabilities or derivative
financial instruments, reduced by the effects of netting agreements
where there is an intention to settle net with counterparties.
Financial instruments are either priced with reference to a quoted
market price for that instrument or by using a valuation model. Where
the fair value is calculated using financial markets pricing models, the
methodology is to calculate the expected cash flows under the terms of
each specific contract and then discount these values back to a present
value. These models use as their basis independently sourced market
parameters including, for example, interest rate yield curves, equities
and commodities prices, option volatilities and currency rates. Most
market parameters are either directly observable or are implied from
instrument prices. However, profits or losses are recognised upon initial
recognition only when such profits can be measured solely by reference
to observable current market transactions or valuation techniques
based solely on observable market inputs.
The calculation of fair value for any financial instrument may also
require adjustment of the quoted price or model value to reflect the cost
of credit risk (where not embedded in underlying models or prices
used), or to reflect hedging costs not captured in pricing models (to the
extent they would be taken into account by a market participant in
determining a price). The process of calculating fair value on illiquid
instruments or from a valuation model may require estimation of certain
pricing parameters, assumptions or model characteristics. These
estimates are calibrated against industry standards, economic models
and observed transaction prices.
The effect of changing these assumptions for those financial
instruments for which the fair values were measured using valuation
techniques that are determined in full or in part on assumptions that are
not supported by observable market prices to a range of reasonably
possible alternative assumptions, would be to provide a range of £123m
(2005: £87m) lower to £139m (2005: £121m) higher than the fair
values recognised in the financial statements. The fair value of financial
instruments is provided in Note 58 to the accounts.
Allowances for loan impairment
Allowances for loan impairment represent management’s estimate
of the losses incurred in the loan portfolios as at the balance sheet
date. Changes to the allowances for loan impairment and changes
to the provisions for undrawn contractually committed facilities and
guarantees provided are reported in the consolidated income statement
as part of the impairment charge.
Within the retail and small businesses portfolios, which comprise large
numbers of small homogeneous assets with similar risk characteristics
where credit scoring techniques are generally used, statistical
techniques are used to calculate impairment allowances on a portfolio
basis, based on historical recovery rates and assumed emergence
periods. These statistical analyses use as primary inputs the extent to
which accounts in the portfolio are in arrears and historical information
on the eventual losses encountered from such delinquent portfolios.
There are many such models in use, each tailored to a product, line of
business or customer category. The models are updated from time to
time. However, experience suggests that the models are reliable and
stable, stemming from the very large numbers of accounts from which
the model building information is drawn. Judgement and knowledge is
needed in selecting the statistical methods to use when the models are
developed or revised. The impairment allowance reflected in the
financial statements for these portfolios is therefore considered to be
reasonable and supportable. The impairment charge reflected in the
income statement for these portfolios is £1,809m (2005: £1,254m) and
amounts to 87% (2005: 80%) of the total impairment charge in 2006.
For larger accounts, impairment allowances are calculated on an
individual basis and all relevant considerations that have a bearing on
the expected future cash flows are taken into account, for example, the
business prospects for the customer, the realisable value of collateral,
the Group’s position relative to other claimants, the reliability of
customer information and the likely cost and duration of the work-out
process. The level of the impairment allowance is the difference
between the value of the discounted expected future cash flows
(discounted at the loan’s original effective interest rate), and its carrying
amount. Subjective judgements are made in this process. Furthermore,
judgements change with time as new information becomes available or
as work-out strategies evolve, resulting in frequent revisions to the
impairment allowance as individual decisions are taken, case by case.
Changes in these estimates would result in a change in the allowances
and have a direct impact on the impairment charge. The impairment
charge reflected in the financial statements in relation to larger
accounts is £265m (2005: £320m) or 13% (2005: 20%) of the total
impairment charge in 2006. Further information on impairment
allowances is set out on pages 83 to 85.
Critical accounting estimates