HSBC 2007 Annual Report Download - page 134

HSBC HOLDINGS PLC
Report of the Directors: Financial Review (continued)
Critical accounting policies
132
Critical accounting policies
(Audited)
Introduction
The results of HSBC are sensitive to the accounting
policies, assumptions and estimates that underlie the
preparation of its consolidated financial statements.
The accounting policies used in the preparation of
the consolidated financial statements are described in
Note 2 on the Financial Statements.
When preparing the financial statements, it is
the directors’ responsibility under UK company law
to select suitable accounting policies and to make
judgements and estimates that are reasonable and
prudent.
The accounting policies that are deemed critical
to HSBC’s IFRSs results and financial position, in
terms of the materiality of the items to which the
policy is applied, and which involve a high degree of
judgement including the use of assumptions and
estimation, are discussed below.
Impairment of loans and advances
HSBC’s accounting policy for losses arising from
the impairment of customer loans and advances is
described in Note 2f on the Financial Statements.
Loan impairment allowances represent
management’s best estimate of losses incurred
in the loan portfolios at balance sheet date.
Management is required to exercise judgement
in making assumptions and estimations when
calculating loan impairment allowances on both
individually and collectively assessed loans and
advances. Of the Group’s total loans and advances
to customers before impairment allowances of
US$1,000.8 billion (2006: US$881.7 billion),
US$6.5 billion (2006: US$5.8 billion) or 1 per cent
(2006: 1 per cent) were individually assessed for
impairment, and US$994.3 billion (2006:
US$875.9 billion) or 99 per cent (2006: 99 per cent)
were collectively assessed for impairment.
The most significant judgemental area is the
calculation of collective impairment allowances.
HSBC’s most significant geographical area of
exposure to collectively assessed loans and
advances is North America, which comprised
US$301.4 billion (2006: US$284.8 billion) or 30 per
cent (2006: 33 per cent) of HSBC’s total collectively
assessed loans and advances. Collective impairment
allowances in North America were US$11.9 billion
(2006: US$7.1 billion), representing 72 per cent
(2006: 65 per cent) of the total collectively
assessed loan impairment allowance.
HSBC uses two alternative methods to calculate
collective impairment allowances on homogeneous
groups of loans that are not considered individually
significant:
• When appropriate empirical information is
available, HSBC utilises roll-rate methodology.
This methodology employs statistical analysis
of historical data and experience of delinquency
and default to estimate the likelihood that loans
will progress through the various stages of
delinquency and ultimately prove irrecoverable.
The estimated loss is the difference between the
present value of expected future cash flows,
discounted at the original effective interest rate
of the portfolio, and the carrying amount of the
portfolio.
• In other cases, when the portfolio size is small
or when information is insufficient or not
reliable enough to adopt a roll-rate
methodology, HSBC adopts a formulaic
approach which allocates progressively higher
percentage loss rates the longer a customer’s
loan is overdue. Loss rates are based on
historical experience.
Both methodologies are subject to estimation
uncertainty, in part because it is not practicable to
identify losses on an individual loan basis because
of the large number of individually insignificant
loans in the portfolio.
In addition, the use of statistically assessed
historical information is supplemented with
significant management judgement to assess whether
current economic and credit conditions are such that
the actual level of inherent losses is likely to be
greater or less than that suggested by historical
experience. In normal circumstances, historical
experience provides the most objective and relevant
information from which to assess inherent loss
within each portfolio. In certain circumstances,
historical loss experience provides less relevant
information about the inherent loss in a given
portfolio at the balance sheet date, for example,
where there have been changes in economic,
regulatory or behavioural conditions such that the
most recent trends in the portfolio risk factors are not
fully reflected in the statistical models. In these
circumstances, such risk factors are taken into
account when calculating the appropriate levels of
impairment allowances, by adjusting the impairment
allowances derived solely from historical loss
experience.
This key area of judgement is subject to
uncertainty and is highly sensitive to factors such as
loan portfolio growth, product mix, unemployment