Barclays 2007 Annual Report Download - page 64

Financial review
Critical accounting estimates
62 Barclays PLC Annual Report 2007
The Group’s accounting policies are set out on pages 165 to 173.
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 Audit Committee.
Fair value of financial instruments
Some of the Group’s financial instruments are carried at fair value through
profit or loss such as those held for trading, designated by management
under the fair value option and non-cash flow hedging derivatives.
Other non-derivative financial assets may be designated as available
for sale. Available for sale financial investments are initially recognised at
fair value and are subsequently held at fair value. Gains and losses arising
from changes in fair value of such assets are included as a separate
component of equity. 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.
Valuation methodology
The method of determining the fair value of financial instruments can
be analysed into the following categories:
(a) Unadjusted quoted prices in active markets where the quoted price
is readily available and the price represents actual and regularly
occurring market transactions on an arm’s length basis.
(b) Valuation techniques using market observable inputs. Such techniques
may include:
– using recent arm’s length market transactions;
– reference to the current fair value of similar instruments;
– discounted cash flow analysis, pricing models or other techniques
commonly used by market participants.
(c) Valuation techniques used above, but which include significant inputs
that are not observable. On initial recognition of financial instruments
measured using such techniques the transaction price is deemed to
provide the best evidence of fair value for accounting purposes.
The valuation techniques in (b) and (c) use inputs such as interest rate
yield curves, equity prices, commodity and currency prices/yields,
volatilities of underlyings and correlations between inputs. The models used
in these valuation techniques are calibrated against industry standards,
economic models and to observed transaction prices where available.
The following tables set out the total financial instruments stated at fair
value as at 31st December 2007 and those fair values are calculated with
valuation techniques using unobservable inputs.
Unobservable
inputs Total
£m £m
Assets stated at fair value
Trading portfolio assets 4,457 193,691
Financial assets designated at fair value:
– held on own account 16,819 56,629
– held in respect of linked liabilities to customers
under investment contracts – 90,851
Derivative financial instruments 2,707 248,088
Available for sale financial investments 810 43,072
Total 24,793 632,331
Unobservable
inputs Total
£m £m
Liabilities stated at fair value
Trading portfolio liabilities 42 65,402
Financial liabilities designated at fair value 6,172 74,489
Liabilities to customers under investment contracts – 92,639
Derivative financial instruments 4,382 248,288
Total 10,596 480,818
Various factors influence the availability of observable inputs and these
may vary from product to product and change over time. Factors include
for example, the depth of activity in the relevant market, the type of
product, whether the product is new and not widely traded in the market
place, the maturity of market modelling and the nature of the transaction
(bespoke or generic).
To the extent that valuation is based on models or inputs that are not
observable in the market, the determination of fair value can be more
subjective, dependant on the significance of the unobservable input to
the overall valuation. Unobservable inputs are determined based on the
best information available, for example by reference to similar assets,
similar maturities, appropriate proxies, or other analytical techniques.
The effect of changing the 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 inputs to a range of reasonably possible alternative
assumptions, would be to provide a range of £1.2bn (2006: £0.1bn)
lower to £1.5bn (2006: £0.1bn) higher than the fair values recognised
in the financial statements.
The size of this range will vary over time in response to market volatility,
market uncertainty and changes to benchmark proxy relationships of
similar assets and liabilities. The calculation of this range is performed
on a consistent basis each period.
Further information on the fair value of financial instruments is provided
in Note 49 to the accounts.
The following summary sets out those instruments which use inputs
where it may be necessary to use valuation techniques as described above.
Corporate bonds
Corporate bonds are generally valued using observable quoted prices or
recently executed transactions. Where observable price quotations are
not available, the fair value is determined based on cash flow models
where significant inputs may include yield curves, bond or single name
credit default swap spreads.