HSBC 2010 Annual Report Download - page 36

HSBC HOLDINGS PLC
Report of the Directors: Operating and Financial Review (continued)
Financial summary > Critical accounting policies
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financial year could differ from the assumptions built
into the models, resulting in a material adjustment to
the carrying amount of loans and advances.
Goodwill impairment
Our accounting policy for goodwill is described in
Note 2p on the Financial Statements. Note 24 on the
Financial Statements lists our cash generating units
(‘CGU’s) by geographical region and global
business. HSBC’s total goodwill amounted to
US$22bn at 31 December 2010 (2009: US$23bn).
The review of goodwill impairment reflects
management’s best estimate of the following factors:
• the future cash flows of the CGUs are sensitive
to the cash flows projected for the periods for
which detailed forecasts are available and to
assumptions regarding the long-term pattern
of sustainable cash flows thereafter. Forecasts
are compared with actual performance and
verifiable economic data, but they necessarily
and appropriately reflect management’s view
of future business prospects at the time of the
assessment; and
• the rates used to discount future expected cash
flows are based on the costs of capital assigned
to individual CGUs and can have a significant
effect on their valuation. The cost of capital
percentage is generally derived from a Capital
Asset Pricing Model, which incorporates inputs
reflecting a number of financial and economic
variables, including the risk-free interest rate in
the country concerned and a premium for the
inherent risk of the business being evaluated.
These variables are subject to fluctuations in
external market rates and economic conditions
beyond our control and therefore require the
exercise of significant judgement and are
consequently subject to uncertainty.
A decline in a CGU’s expected cash flows
and/or an increase in its cost of capital reduces the
CGU’s estimated recoverable amount. If this is
lower than the carrying value of the CGU, a charge
for impairment of goodwill is recognised in our
income statement for the year.
The accuracy of forecast cash flows is subject to
a high degree of uncertainty in volatile market
conditions. In such market conditions, management
retests goodwill for impairment more frequently than
annually to ensure that the assumptions on which the
cash flow forecasts are based continue to reflect
current market conditions and management’s best
estimate of future business prospects.
During 2010, no impairment of goodwill was
identified (2009: nil). In addition to the annual
impairment test which was performed as at 1 July
2010, management reviewed the current and expected
performance of the CGUs as at 31 December 2010
and determined that there was no indication of
potential impairment of the goodwill allocated to
them. However, in the event of a significant
deterioration in economic and credit conditions
compared with those reflected by management in
the cash flow forecasts for the CGUs, a material
adjustment to a CGU’s recoverable amount may
occur which may result in the recognition of an
impairment charge in the income statement.
Note 24 on the Financial Statements includes
details of the CGU’s with significant balances of
goodwill, states the key assumptions used to assess
the goodwill in each of those CGUs for impairment
and provides a discussion of the sensitivity of the
carrying value of goodwill to changes in key
assumptions.
Valuation of financial instruments
Our accounting policy for determining the fair value
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. In the event that 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 unobservable. Valuation
techniques that rely to a greater extent on
unobservable 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 are discussed in Note 16 on the Financial
Statements. The main assumptions and estimates
which management consider 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 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;