Barclays 2005 Annual Report Download - page 107

Barclays PLC
Annual Report 2005 105
3.3
Financial review
Critical accounting estimates
Critical Accounting Estimates
The Group’s accounting policies are set out on pages 134 to 145.
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,
such as the determination of the cost of share-based payments also
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 qualifying
netting agreements 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 £87m lower to £121m higher than the fair
values recognised in the financial statements.
The fair value of financial instruments is provided in Note 57 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 and other credit risk provisions.
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. These models do not contain
judgemental inputs, but 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 £1,254m and amounts to 80% of the total impairment
charge in 2005.
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. However, the
impairment charge reflected in the financial statements in relation
to larger accounts is £320m or 20% of the total impairment charge
in 2005.
Further information on impairment allowances is set out on pages 64
and 65.
Goodwill
Management have to consider at least annually whether the current
carrying value of goodwill is impaired. The first step of the impairment
review process requires the identification of independent operating
units, by dividing the Group business into as many largely independent
income streams as is reasonably practicable. The goodwill is then
allocated to these independent operating units. The first element of this
allocation is based on the areas of the business expected to benefit
from the synergies derived from the acquisition. The second element