TD Bank 2006 Annual Report Download - page 71

TD BANK FINANCIAL GROUP ANNUAL REPORT 2006 Management’s Discussion and Analysis 67
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 significant accounting policies is presented in the Notes to
the Consolidated Financial Statements. Some of the Bank’s poli-
cies 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 Statements. The Bank has estab-
lished 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 financial instruments held in trading portfolios,
accounting for income taxes, the valuation of investment securi-
ties, accounting for securitizations and variable interest entities,
the valuation of goodwill and intangible assets, accounting for
pensions and post-retirement benefits, and contingent liabilities.
ACCOUNTING FOR LOAN LOSSES
Accounting for loan losses is an area of importance given the
size of the Bank’s loan portfolio. The Bank has two types of
allowances against loan losses – specific and general. Loan
impairment is recognized when the Bank determines, based on
its identification and evaluation of problem loans and accounts,
that the timely collection of all contractually due interest and
principal payments is no longer assured. Judgment is required as
to the timing of designating a loan as impaired and the amount
of the required specific allowance. Management’s judgment is
based on its assessment of probability of default, loss given
default and exposure at default. Changes in these estimates,
due to a number of circumstances, can have a direct impact on
the provision for loan losses and may result in a change in the
allowance. Changes in the allowance, if any, would primarily
impact the Canadian Personal and Commercial Banking, the U.S.
Personal and Commercial Banking and the Wholesale Banking
segments. Reviews by regulators in Canada and the U.S. bring a
measure of uniformity to specific allowances recorded by banks.
General allowance requires management’s judgment and the
provision depends upon an assessment of business and economic
conditions, historical and expected loss experience, loan portfolio
composition and other relevant indicators. In establishing the
appropriateness of general allowance, in addition to manage-
ment’s judgment, the Bank refers to an internally developed
model that utilizes parameters for probability of default, loss
given default and usage given default. If these parameters were
independently increased or decreased by 10%, then the model
would indicate an increase or decrease to the aggregate corpo-
rate and commercial allowance of $43 million for probability of
default, $43 million for loss given default and $16 million for
usage given default, respectively.
The Managing Risk section on pages 57 to 66 of this MD&A
provides a moredetailed discussion regarding credit risk. Also,
see Note 3 to the Bank’s Consolidated Financial Statements
for additional disclosures regarding the Bank’s allowance for
credit losses.
ACCOUNTING FOR THE FAIR VALUE OF FINANCIAL
INSTRUMENTS HELD IN TRADING PORTFOLIOS
The Bank’s trading securities, obligations related to securities
sold short and trading derivatives are carried at fair value in
the Consolidated Balance Sheet with the resulting realized and
unrealized gains or losses recognized immediately in other
income. See Notes 2, 17 and 19 to the Bank’s Consolidated
Financial Statements for more details.
The fair value of exchange-traded financial instruments is
based on quoted market prices, adjusted for daily margin settle-
ments, where applicable. Note 17 to the Bank’s Consolidated
Financial Statements provides disclosures of the estimated fair
value of all financial instruments at October 31, 2006.
The fair value for a substantial majority of financial instru-
ments held in trading portfolios is based on quoted market price
or valuation models that use independently observable market
parameters. Independently observable market parameters
include interest rate yield curves, foreign exchange rates and
option volatilities. The valuation models incorporate prevailing
market rates and prices on underlying instruments with similar
maturities and characteristics and take into account factors,
such as counterparty credit quality, liquidity and concentration.
Certain derivatives are valued using models with unobservable
market parameters, where the parameters estimated are subject
to management’s judgment. These derivatives are normally not
actively traded and are complex. For example, certain credit
products are valued using models with parameters, such as cor-
relation and recovery rates, that are unobservable. Uncertainty in
estimating the parameters can impact the amount of revenue or
loss recorded for a particular position. Where a market parame-
ter is not observable, the Bank defers all of the inception profit.
Management’s judgement is also used in recording fair value
adjustments to model valuations to account for measurement
uncertainty when valuing complex and less actively traded
derivatives.
The Bank has controls in place to ensure that the valuations
derived from the models are appropriate. These include indepen-
dent review and approval of valuation models and independent
review of the valuations by qualified personnel. As the market
for complex derivative products develops, the pricing for these
products becomes more transparent, resulting in refinement of
valuation models.
We believe that the estimates of fair value are reasonable,
given 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. The
valuations are also validated by past experience and through the
actual cash settlement of contracts. This policy primarily impacts
the Wholesale Banking. For a discussion of market risk, refer to
page 60 of this MD&A.
ACCOUNTING FOR INCOME TAXES
Accounting for current income taxes requires the Bank to
exercise judgement for issues relating to certain complex
transactions, known issues under discussion with tax authorities
and matters yet to be settled in court. As a result, the Bank
maintains a tax provision for contingencies and regularly assesses
the adequacy of this tax provision.
Futureincome taxes are recorded to account for the effects of
future taxes on transactions occurring in the current period. The
accounting for future income taxes impacts all of the Bank’s seg-
ments and requires judgement in the following key situations:
•Futuretax assets are assessed for recoverability. The Bank
records a valuation allowance when it believes, based on all
available evidence, that it is morelikely than not that all of
the futuretax assets recognized will not be realized prior to
their expiration. The amount of the future income tax asset