TD Bank 2010 Annual Report Download - page 75

TD BANK GROUP ANNUAL REPORT 2010 MANAGEMENT’S DISCUSSION AND ANALYSIS 73
ACCOUNTING STANDARDS AND POLICIES
Critical Accounting Estimates
The Bank’s accounting policies are essential to understanding its results
of operations and financial condition. A summary of the Bank’s signifi-
cant accounting policies is presented in the Notes to the Consolidated
Financial Statements. Some of the Bank’s policies require subjective,
complex judgments and estimates as they relate to matters that are
inherently uncertain. Changes in these judgments or estimates could
have a significant impact on the Bank’s Consolidated Financial State-
ments. The Bank has established procedures to ensure that accounting
policies are applied consistently and that the processes for changing
methodologies are well controlled and occur in an appropriate and
systematic manner. In addition, the Bank’s critical accounting policies
are reviewed with the Audit Committee on a periodic basis. Critical
accounting policies that require management’s judgment and estimates
include accounting for loan losses, accounting for the fair value of
f inancial instruments, accounting for securitizations and variable interest
entities, the valuation of goodwill and other intangibles, accounting
for pensions and post-retirement benefits, accounting for income taxes,
and contingent liabilities.
LOAN LOSSES
Accounting for loan losses is an area of importance given the size of
the Bank’s loan portfolio. A loan is considered impaired when there is
objective evidence subsequent to the initial recognition of the loan
that there has been a deterioration of credit quality to the extent that
management no longer has reasonable assurance as to the timely
collection of the full amount of principal and interest. The Bank has
two types of allowances against loan losses – specific and general.
A specific allowance is recorded against loans that are classified as
impaired, which occurs when there is objective evidence of impairment
at the specific loan level. Judgment is required as to the timing of
designating a loan as impaired and the amount of the required specific
allowance. Management exercises judgment as to the amount that
will be recovered once the borrower defaults. Changes in the amount
management expects to recover can have a direct impact on the
provision for credit losses and may result in a change in the allowance.
Changes in the specific allowance, if any, would primarily impact the
Canadian Personal and Commercial Banking, the U.S. Personal and
Commercial Banking, and the Wholesale Banking segments.
The general allowance captures the credit losses in circumstances
where the loss event is considered to have occurred, but for which
there is not yet objective evidence of impairment at the specific loan
level. In establishing the general allowance, the Bank refers to internally
developed models that utilize parameters for probability of default
(PD), loss given default (LGD) and exposure at default (EAD). These
models calculate the probable range of general allowance levels.
Management’s judgment is used to determine the point within the
range that is the best estimate of losses, based on an assessment
of business and economic conditions, historical loss experience, loan
portfolio composition, and other relevant indicators that are not fully
incorporated into the model calculation. If the wholesale and commer-
cial parameters were independently increased or decreased by 10%,
then the model would indicate an increase or decrease to the mean
of the range in the amount or $25 million for PD, $25 million for LGD,
and $77 million for EAD, respectively. Changes in the general allow-
ance, if any, would primarily impact the Corporate and U.S. Personal
and Commercial Banking segments.
The “Managing Risk – Credit Risk” section of this MD&A provides
a more detailed discussion regarding credit risk. Also, see Note 3 to the
Bank’s Consolidated Financial Statements and the “Credit Portfolio
Quality” section of this MD&A for additional disclosures regarding the
Bank’s allowance for credit losses.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The fair value of financial instrument is based on quoted prices in
active markets, where available, adjusted for daily margin settlements,
where applicable. Where there is no active market for the instrument,
fair value may be based on other observable current market transactions
involving the same instrument, without modification or repackaging,
or is based on a valuation technique which maximizes the use of
observable market inputs. Observable market inputs include interest
rate yield curves, foreign exchange rates, and option volatilities.
Valuation techniques include comparisons with similar instruments
where market observable prices exist, discounted cash flow analysis,
option pricing models, and other valuation techniques commonly used
by market participants. For certain complex or illiquid financial instru-
ments,
fair values may be determined in whole or in part using valuation
techniques, such as internally developed valuation models, which may
incorporate non-observable market inputs.
Inputs estimated are subject to management’s judgment. For example,
certain credit products are valued using models with non-observable
inputs such as correlation and recovery rates. Uncertainty in estimating
the inputs can impact the amount of revenue or loss recorded for a
particular position. Management’s judgment is also used in recording
fair value adjustments to model valuations to account for measure-
ment uncertainty when valuing complex and less actively traded financial
instruments. Valuation adjustments are described further in Note 29
to the Consolidated Financial Statements.
The Bank has controls in place to ensure that the valuations derived
from the models and inputs are appropriate. These include independent
review and approval of valuation models and inputs, and independent
review of the valuations by qualified personnel. If the market for complex
financial instrument products develops, the pricing for these products
may become more transparent, resulting in refinement of valuation
models. For a discussion of market risk, refer to the “Managing Risk –
Market Risk” section of this MD&A. As described in Note 29 to the
Consolidated Financial Statements, for financial instruments whose fair
value is estimated using valuation techniques based on non-observable
market inputs that are significant to the overall valuation, the difference
between the best estimate of fair value at initial recognition represented
by the transaction price, and the fair value determined using the valua-
tion technique, is recognized in income as the non-observable inputs
become observable. Note 29 also summarizes the difference between
the transaction price and amount determined at inception using
valuation techniques with significant non-observable market inputs.
The process for obtaining multiple quotes of external market prices,
consistent application of models over a period of time, and the controls
and processes described above, support the reasonability of the valua-
tion models. The valuations are also validated by past experience and
through actual cash settlement under the contract terms.
Valuation of private equity investments requires management’s
judgment due to the absence of quoted market prices, inherent lack
of liquidity, and the longer-term nature of such investments. Private
equity investments are recorded at cost and are compared with fair
value on a periodic basis to evaluate whether an impairment in value
has occurred that is other than temporary in nature. Fair value is
determined using valuation techniques, including discounted cash
flows and a multiple of earnings before taxes, depreciation, and
amortization. Management applies judgment in the selection of the
valuation methodology and the various inputs to the calculation, which
may vary from one reporting period to another. These estimates are
monitored and reviewed on a regular basis by management for consis-
tency and reasonableness. Any imprecision in these estimates can
affect the resulting fair value. The inherent nature of private equity
investing is that management’s valuation will change over time as
the underlying investment matures and an exit strategy is developed
and realized. Estimates of fair value may also fluctuate due to develop-
ments in the business underlying the investment. Such fluctuations may
be significant depending on the nature of the factors going into the
valuation methodology and the extent of change in those factors.