HSBC 2007 Annual Report Download - page 136

HSBC HOLDINGS PLC
Report of the Directors: Financial Review (continued)
Critical accounting policies > Financial summary / Income statement
134
expected cash flows continued to exceed the
carrying amount including goodwill in the CGU, and
therefore no goodwill impairment has occurred.
However, in the event of further significant
deterioration in the economic and credit conditions
beyond the levels already reflected by management
in the cash flow forecasts for the CGU, a further
special review would be made, in addition to the
annual review of the carrying value, including
goodwill against the recoverable amount for the
CGU. If this review indicated that the deterioration
in current conditions and future outlook is
sufficiently severe, this could result in a material
adjustment to the carrying amount of goodwill.
Valuation of financial instruments
HSBC’s accounting policy for valuation of financial
instruments is described in Note 2d on the Financial
Statements.
The best evidence of fair value is a quoted price
in an actively traded market. If the market for a
financial instrument is not active, a valuation
technique is used. The majority of valuation
techniques employ only observable market data,
and so the reliability of the fair value measurement
is high. However, certain financial instruments are
valued on the basis of valuation techniques that
feature one or more significant market inputs that
are not observable. Valuation techniques that rely to
a greater extent on non-observable inputs require a
higher level of management judgement to calculate
a fair value than those based wholly on observable
inputs.
Valuation techniques used to calculate fair
values include comparisons with similar financial
instruments for which market observable prices
exist, discounted cash flow analysis, option pricing
models and other valuation techniques commonly
used by market participants. Valuation techniques
incorporate assumptions that other market
participants would use in their valuations, including
assumptions about interest rate yield curves,
exchange rates, volatilities, and prepayment and
default rates. When valuing instruments by reference
to comparable instruments, management takes into
account the maturity, structure and rating of the
instrument with which the position held is being
compared.
The main assumptions and estimates which
management considers when applying a model with
valuation techniques are:
• the likelihood and expected timing of future
cash flows on the instrument. These cash flows
are usually governed by the terms of the
instrument, although management judgement
may be required when the ability of the
counterparty to service the instrument in
accordance with the contractual terms is in
doubt. Future cash flows may be sensitive to
changes in market rates;
• selecting an appropriate discount rate for
the instrument. Management bases the
determination of this rate on its assessment of
what a market participant would regard as the
appropriate spread of the rate for the instrument
over the appropriate risk-free rate; and
• judgement to determine what model to use to
calculate fair value in areas where the choice of
valuation model is particularly subjective, for
example, when valuing complex derivative
products.
When applying a model with unobservable
inputs, estimates are made to reflect uncertainties in
fair values resulting from a lack of market data
inputs, for example, as a result of illiquidity in the
market. For these instruments, the fair value
measurement is less reliable. Inputs into valuations
based on non-observable data are inherently
uncertain because there are little or no current
market data available from which to determine the
level at which an arm’s length transaction would
occur under normal business conditions. However,
in most cases there are some market data available
on which to base a determination of fair value, for
example historical data, and the fair values of most
financial instruments will be based on some market
observable inputs even where the non-observable
inputs are significant.
Note 33 on the Financial Statements provides
an analysis of the basis for valuation of financial
instruments measured at fair value in the financial
statements. The value of financial assets and
liabilities that use a valuation technique are
US$625.5 billion and US$400.7 billion or 66 per
cent and 68 per cent of total assets and total
liabilities measured at fair value respectively. Note
33 on the Financial Statements presents a sensitivity
analysis of fair values for financial instruments with
significant unobservable inputs to reasonably
possible alternative assumptions. Given the
uncertainty and subjective nature of valuing financial
instruments at fair value, it is possible that the
outcomes within the next financial year could be
different from the assumptions used, and this would
result in a material adjustment to the carrying
amount of financial instruments measured at fair
value.