HSBC 2012 Annual Report Download - page 58

HSBC HOLDINGS PLC
Report of the Directors: Operating and Financial Review (continued)
Financial summary > Critical accounting policies
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for this CGU and concluded that there was no
impairment.
Note 23 on the Financial Statements includes
details of the CGUs 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 for the instrument being
measured 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 include 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 15 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
estimated based on the terms of the instrument,
and 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;
• selecting an appropriate discount rate for
the instrument. The determination of this rate
is based on an assessment of what a market
participant would regard as the appropriate
spread of the rate for the instrument over the
appropriate risk-free rate; and
• judgement to determine what model to use to
calculate fair value in areas where the choice of
valuation model is particularly subjective, for
example, when valuing complex derivative
products.
When applying a model with unobservable
inputs, estimates are made to reflect uncertainties
in fair values resulting from a lack of market data
inputs, for example, as a result of illiquidity in
the market. For these instruments, the fair value
measurement is less reliable. Inputs into valuations
based on unobservable data are inherently uncertain
because there is little or no current market data
available from which to determine the level at
which an arm’s length transaction would occur under
normal business conditions. However, in most cases
there is some market data available on which to base
a determination of fair value, for example historical
data, and the fair values of most financial
instruments are based on some market observable
inputs even when unobservable inputs are
significant.
The fair values of financial assets and liabilities
of US$718bn (2011: US$665bn) and US$622bn
(2011: US$569bn), respectively, were determined
using valuation techniques which represented 60%
(2011: 61%) and 83% (2011: 82%), respectively, of
financial assets and liabilities measured at fair value.
The methodology for estimating credit
valuation adjustments (‘CVA’) and debit valuation
adjustments (‘DVA’) has been revised as at
31 December 2012 as a result of changing market
practices in response to regulatory and accounting
changes, as well as general market developments.
A key input into the calculation of CVA is the
probability of default (‘PD’). Prior to the revision
of the methodology, the PD was based on HSBC’s
internal credit rating for the counterparty. The
revised methodology maximises the use of PD based
on market-observable data, such as credit default
swap (‘CDS’) spreads. Where CDS spreads are not
available, PDs are estimated having regard to market
practice, considering relevant data including CDS
indices and historical rating transition matrices.
In addition, HSBC aligned its methodology for
determining DVA to be consistent with that applied
for CVA as at 31 December 2012. Historically,
HSBC considered that a zero spread was appropriate
in respect of own credit risk and consequently did
not adjust derivative liabilities for its own credit risk.
The types and amounts of adjustments made in
determining the fair value of financial instruments
measured at fair value using valuation techniques,
and a sensitivity analysis of fair values for financial
instruments with significant unobservable inputs to
reasonably possible alternative assumptions, are
described in Note 15 on the Financial Statements.
Given the uncertainty and subjective nature
of valuing financial instruments at fair value, it is