RBS 2008 Annual Report Download - page 187

Accounting policies continued
RBS Group Annual Report and Accounts 2008186
Collective component – this is made up of two elements: loan
impairment provisions for impaired loans that are below individual
assessment thresholds (collective impaired loan provisions) and for loan
losses that have been incurred but have not been separately identified
at the balance sheet date (latent loss provisions). These are established
on a portfolio basis using a present value methodology taking into
account the level of arrears, security, past loss experience, credit
scores and defaults based on portfolio trends. The most significant
factors in establishing these provisions are the expected loss rates and
the related average life. These portfolios include credit card receivables
and other personal advances including mortgages. The future credit
quality of these portfolios is subject to uncertainties that could cause
actual credit losses to differ materially from reported loan impairment
provisions. These uncertainties include the economic environment,
notably interest rates and their effect on customer spending, the
unemployment level, payment behaviour and bankruptcy trends.
Pensions
The Group operates a number of defined benefit pension schemes as
described in Note 4 on the accounts. The assets of the schemes are
measured at their fair value at the balance sheet date. Scheme liabilities
are measured using the projected unit method, which takes account of
projected earnings increases, using actuarial assumptions that give the
best estimate of the future cash flows that will arise under the scheme
liabilities. These cash flows are discounted at the interest rate
applicable to high-quality corporate bonds of the same currency and
term as the liabilities. Any recognisable surplus or deficit of scheme
assets over liabilities is recognised in the balance sheet as an asset
(surplus) or liability (deficit). In determining the value of scheme
liabilities, assumptions are made as to price inflation, dividend growth,
pension increases, earnings growth and employees. There is a range of
assumptions that could be adopted in valuing the schemes’ liabilities.
Different assumptions could significantly alter the amount of the surplus
or deficit recognised in the balance sheet and the pension cost charged
to the income statement. The assumptions adopted for the Group’s
pension schemes are set out in Note 4 on the accounts together with
the sensitivity of reported amounts to changes in those assumptions. A
pension asset of £36 million and a liability of £2,032 million were
recognised in the balance sheet at 31 December 2008 (2007 asset –
£575 million; liability – £460 million).
Fair value – financial instruments
Financial instruments classified as held-for-trading or designated as at
fair value through profit or loss and financial assets classified as
available-for-sale are recognised in the financial statements at fair value.
All derivatives are measured at fair value. Gains or losses arising from
changes in the fair value of financial instruments classified as held-for-
trading or designated as at fair value through profit or loss are included
in the income statement. Unrealised gains and losses on available-for-
sale financial assets are recognised directly in equity unless an
impairment loss is recognised.
Financial instruments measured at fair value include:
Loans and advances (held-for-trading and designated as at fair value
though profit or loss) – principally comprise reverse repurchase
agreements (reverse repos) and syndicated loans. In repurchase
agreements one party agrees to sell securities to another and
simultaneously agrees to repurchase the securities at a future date for a
specified price. The repurchase price is fixed at the outset, usually
being the original sale price plus an amount representing interest for the
period from the sale to the repurchase. Syndicated loans measured at
fair value are amounts retained, from syndications where the Group was
lead manager or underwriter, in excess of the Group’s intended long
term participation.
Debt securities (held-for-trading, designated as at fair value though
profit or loss and available-for-sale) – debt securities include those
issued by governments, municipal bodies, mortgage agencies and
financial institutions as well as corporate bonds, debentures and
residual interests in securitisations.
Equity securities (held-for-trading, designated as at fair value though
profit or loss and available-for-sale) – comprise equity shares of
companies or corporations both listed and unlisted.
Deposits by banks and customer accounts (held-for-trading and
designated as at fair value though profit or loss) – deposits measured
at fair value principally include repurchase agreements (repos)
discussed above and investment contracts issued by the Group’s life
assurance businesses.
Debt securities in issue (held-for-trading and designated as at fair
value though profit or loss) – measured at fair value and principally
comprise medium term notes.
Short positions (held-for-trading) – arise in dealing and market making
activities where debt securities and equity shares are sold which the
Group does not currently possess.
Derivatives – these include swaps, forwards, futures and options. They
may be traded on an organised exchange (exchange-traded) or over-
the-counter (OTC). Holders of exchange traded derivatives are generally
required to provide margin daily in the form of cash or other collateral.
Swaps include currency swaps, interest rate swaps, credit default
swaps, total return swaps and equity and equity index swaps. A swap is
an agreement to exchange cash flows in the future in accordance with a
pre-arranged formula. In currency swap transactions, interest payment
obligations are exchanged on assets and liabilities denominated in
different currencies; the exchange of principal may be notional or
actual. Interest rate swap contracts generally involve exchange of fixed
and floating interest payment obligations without the exchange of the
underlying principal amounts.
Forwards include forward foreign exchange contracts and forward rate
agreements. A forward contract is a contract to buy (or sell) a specified
amount of a physical or financial commodity, at an agreed price, on an
agreed future date. Forward foreign exchange contracts are contracts
for the delayed delivery of currency on a specified future date. Forward