Accounting policies
Critical Accounting Judgements
The preparation of the financial statements necessarily requires the exercise of judgement both in the application of accounting policies which are set out on pages 160 to 167. These judgements are continually reviewed and evaluated based on historical experience and other factors. The principal critical accounting judgements made by the Group that have a material financial impact on the financial statements are as follows:
Designation of Financial Instruments
The Group has classified its financial instruments in accordance with IAS 39 ‘Financial Instruments: Recognition and Measurement’. In some instances the classification is prescribed whilst in others the Group is able to exercise judgement in determining the classification as follows:
- Non-derivative financial assets, other than those held for trading, where there is no active market and which have fixed or determinable payments are classified as ‘loans and receivables’;
- The Group’s ‘trading’ portfolio is classified as ‘held for trading’. The Group exercises judgement in determining which financial instruments form part of its trading book. This is determined at acquisition by the purpose for which the instrument is acquired and the business area that acquires it;
- Derivative instruments are automatically classified as ‘at fair value through the income statement’ unless they form part of a qualifying hedging relationship. The Group’s accounting policy for hedge accounting is described under the policy for derivatives;
- Instruments that are deemed by the Group on initial recognition to eliminate a measurement mismatch or where they contain an embedded derivative which is not separated from the host contract are designated on initial recognition as ‘at fair value through the income statement’. In addition portfolios of assets, liabilities or both that are managed and the performance evaluated on a fair value basis in accordance with a documented risk or investment management strategy are designated on initial recognition ‘at fair value through the income statement’.
- In addition the venture capital exemption is taken for investments where significant influence or joint control is present and the investing area operates as a venture capital business. These investments are designated ‘at fair value through the income statement’. This policy is applied consistently across the Group’s portfolios. Judgement is applied when determining whether or not a business area operates as a venture capital business. The judgement is based on consideration of whether, in particular, the primary business activity is investing for current income, capital appreciation or both; whether the investment activities are clearly and objectively distinct from any other activities of the Group; and whether the investee operates as a separate business autonomous from the Group;
- Assets in support of the general insurance and long term assurance businesses are designated by the Group, as ‘at fair value through the income statement’;
- Investment contracts within the long term assurance business are designated by the Group as ‘at fair value through the income statement’;
- The Group has chosen not to designate any financial assets as ‘held to maturity’;
- All other financial assets are automatically classified as ‘available for sale’; and
- All other financial liabilities are automatically classified as ‘at amortised cost’.
The accounting treatment of these financial instruments is set out in the relevant accounting policy.
Impairment of Available for Sale Investments
The Group has considered the fall in fair values of investments classified as available for sale to ascertain whether any impairment has occurred. Impairment is recognised when there is objective evidence that a specific financial asset is impaired. Evidence may include a debt issuer failing to make an interest or principal repayment or breaching a covenant within the security’s terms and conditions or a significant or prolonged decline in the fair value of an equity instrument below its cost. Except when a default event has occurred, the determination of whether or not objective evidence of impairment is present requires the exercise of critical accounting judgement by the Group.
Unarranged Overdraft Charges
The Group’s accounting policy in respect of regulatory provisions is given in the section on provisions. In the absence of a legal obligation, judgement is necessary in determining the existence of a constructive obligation. In respect of the claims made for refunds of unarranged overdraft charges, the judgement of the Group is that there is no constructive obligation pending the outcome of the legal case. The contingent liability in respect of ‘ex-gratia’ refunds of unarranged overdraft charges is explained in Note 41.
Syndications
As explained in the accounting policy on syndications, the Group has elected to treat loans and advances pending syndication as loans and receivables rather than account for them as trading assets. Accordingly these are initially recognised at the draw down date at the fair value as at the commitment date plus directly attributable incremental transaction costs.
Critical Accounting Estimates
The preparation of the financial statements requires the Group to make estimations where uncertainty exists. The principal critical accounting estimates made by the Group are considered below. Disclosures about estimates and the related assumptions are also included in the appropriate Note.
Fair Values
The designation of financial instruments for measurement purposes is set out under the critical accounting judgements above and the valuation methodologies for financial instruments are set out in the appropriate accounting policies.
Derivatives and other financial instruments designated as at fair value through the income statement or available for sale are recognised at fair value.
As explained in the accounting policy on investment securities, asset backed securities (‘ABS’) not traded in an active market are valued using valuation models that include non-market observable inputs. These models use observed issuance prices, benchmarking methodology and modelled market correlations. For each asset class within the ABS portfolio, the implied spread arrived at by using this methodology is applied to the securities within that asset class. Additional assessments are then made on possible deterioration in credit risk for each individual security.
At 31 December 2007, the value of ABS measured using models with non-market observable inputs comprised investment securities of £5,404m (2006 £nil) within financial assets held for trading and £12,386m (2006 £nil) within assets classified as available for sale.
During the year, a £78m pre-tax negative fair value adjustment was recognised in the income statement, within net trading income, on ABS that were valued using models with non-market observable inputs (2006 £nil). In addition to this a post-tax negative fair value adjustment of £158m (2006 £nil) on ABS classified as available for sale was recognised in equity reserves.
For ABS asset valuations using non-market observable inputs, the effect of a one basis point move in credit spreads would result in a pre-tax movement of £2m for ABS assets classified as held for trading and a post-tax movement of £4m, recognised in equity reserves, on assets classified as available for sale.
The use of non-market observable inputs in the valuation models will diminish as and when activity returns to these markets.