Notes to the Accounts
Accounting policies
Statement of Compliance
The financial statements of HBOS plc comprise the Consolidated Income Statement and the Consolidated and Company Balance Sheets, Cash Flow Statements and Statements of Recognised Income and Expense together with the related Notes to the Accounts. The 2006 financial statements set out on pages 124 to 191 have been prepared in accordance with International Financial Reporting Standards as adopted by the European Union (‘IFRS’). The standards adopted by the Group and Company are those endorsed by the European Union and effective at the date the financial statements are approved by the Board.
The financial statements also comply with the relevant provisions of Part VII of the Companies Act 1985, as amended by the Companies Act 1985 (International Accounting Standards and Other Accounting Amendments) Regulations 2004. Additionally the Group has applied Financial Reporting Standard 27 ‘Life Assurance’ issued by the UK Accounting Standards Board as appropriate.
Basis of Preparation
The financial statements have been prepared under the historical cost basis, except that the following assets and liabilities are stated at their fair values: derivatives, financial instruments held for trading, financial instruments designated at fair value through the income statement, financial instruments classified as available for sale and investment properties.
Critical Accounting Estimates and Judgements
The preparation of the financial statements necessarily requires the exercise of judgement both in the application of accounting policies which are set out below and in the selection of assumptions used in the calculation of estimates. These estimates and judgements are reviewed on an ongoing basis and are continually evaluated based on historical experience and other factors. However, actual results may differ from these estimates. The most significantly affected components of the financial statements and associated critical judgements are as follows:
Impairment Losses on Loans and Advances Impairment loss calculations involve the estimation of future cash flows of loans and advances based on observable data at the balance sheet date and historical loss experience for assets with similar credit risk characteristics. These calculations are undertaken on a portfolio basis other than in respect of significant balances, relating principally to larger corporate customers, which are assessed individually. In applying the portfolio basis the Group makes use of various statistical modelling techniques which are specific to different portfolio types. Significant judgement is applied in selecting and updating these models. In calculating individual impairment provisions the Group takes account of a number of relevant considerations including historical experience, future prospects of the customer, value of collateral held and reliability of information. Significant judgement is applied in estimating the impact of these considerations on
the expected future cash flows.
Effective Interest Rate In calculating the effective interest rate of financial instruments and in particular loans and advances the Group takes into account interest received or paid, fees and commissions paid or received, expected early redemptions and related penalties and premiums and discounts on acquisition or issue that are integral to the yield as well as incremental transaction costs. These calculations are undertaken on a portfolio basis other than in respect of significant balances, relating principally to larger corporate customers, which are assessed individually. In applying the portfolio basis the Group makes use of various statistical modelling techniques which are specific to different portfolios in estimating the expected cash flows from early redemptions and related fees to the extent that these are applicable. Significant judgement is applied in selecting and updating these models. In calculating the effective interest rates of individually significant balances the Group takes into account a number of relevant considerations to estimate the cash flows from early redemptions including previous experience of customer behaviour, credit scoring of the customer and anticipated future market conditions at the date of acquisition. Significant judgement is applied in estimating the impact of these considerations on the expected future cash flows.
Defined Benefit Schemes The estimation of the expected cash flows used in the calculation of the defined benefit schemes’ liabilities includes a number of assumptions around mortality, inflation rates applicable to defined benefits and the average expected service lives of the employees. The selection of these assumptions requires the application of significant judgement by the Group. Similarly, judgement is applied in selecting the discount rate used to calculate the defined benefit scheme liabilities based on the market yield at the balance sheet date of high quality bonds with a similar duration to that of the schemes’ liabilities. The sensitivity of the scheme liabilities to changes in the principal assumptions used are set out in Note 7 post retirement benefits.
Long Term Assurance Business The estimation of the Group’s insurance and investment contracts with discretionary participating features (‘DPF’) liabilities and related value of in-force (‘VIF’) assets relies on a number of assumptions in forecasting future experience. The selection of appropriate assumptions requires the application of material judgement and is made with reference to historic trends, taking into account the analysis of actual versus expected experience as well as industry data. The sensitivity of the Group’s results to changes in certain key variables on long term insurance contracts and investment contracts with DPF are disclosed in Note 24 value of in-force long term assurance business.
IFRS Not Yet Applied
The following standards and interpretations have been adopted by the European Union but are not effective for the year ended 31 December 2006 and have not been applied in preparing the financial statements:
IFRS 7 ‘Financial Instruments: Disclosure’ and the ‘Capital disclosure amendment’ to IAS 1 ‘Presentation of financial statements’ which are applicable for periods commencing on or after 1 January 2007. The application of these standards in 2006 would not have had any financial impact as they are only concerned with disclosure.
IFRIC 7 ‘Applying the Restatement Approach under IAS 29 Financial Reporting in Hyperinflationary Economies’ which is effective for periods commencing on or after 1 March 2006. The application of this interpretation in 2006 would not have affected the financial statements as the Group does not operate in hyperinflationary economies.
IFRIC 8 ‘Scope of IFRS 2 Share-based Payment’ which is effective for periods commencing on or after 1 May 2006. The application of this interpretation in 2006 would not have affected the financial statements as share-based payment transactions in the Group are made for the receipt of identifiable services.
IFRIC 9 ‘Reassessment of Embedded Derivatives’ which is effective for periods commencing on or after 1 June 2006. The application of this interpretation in 2006 would not have affected the financial statements because the Group’s approach to reassessing embedded derivatives already reflects the requirements of the interpretation.
The following standards and interpretations have not yet been adopted by the European Union, are not effective for the year ended 31 December 2006 and have not been applied in preparing the financial statements:
IFRS 8 ‘Operating Segments’ which is applicable for periods commencing on or after 1 January 2009. The application of this standard in 2006 would not have had any financial impact as it is only concerned with disclosure.
IFRIC 10 ‘Interim Financial Reporting and Impairment’ which is effective for periods commencing on or after 1 November 2006. The application of this interpretation in 2006 would not have affected the financial statements as no reversals to impairment losses within the scope of this interpretation have been made.
IFRIC 11 ‘Group and Treasury Share Transactions’ which is effective for periods commencing on or after 1 March 2007. The application of this interpretation in 2006 would not have affected the financial statements because the interpretation deals with accounting for share-based payments at subsidiary level.
IFRIC 12 ‘Service Concession Arrangements’ which is effective for periods commencing on or after 1 January 2008. The application of this interpretation in 2006 would not have affected the financial statements.
Basis of Consolidation
The consolidated financial statements include the results of the Company and its subsidiary undertakings, together with the Group’s interests in associated undertakings and jointly controlled entities.
Subsidiaries
The financial statements of subsidiaries and special purpose entities controlled by the Group are consolidated within the Group financial statements commencing on the date control is obtained until the date control ceases. Control is defined as being where the Group has power, directly or indirectly, to govern the financial and operating policies of such entities. In assessing control, potential voting rights that presently are exercisable or convertible are taken into account. The effects of intra-group transactions are eliminated on consolidation.
Associated Undertakings and Jointly Controlled Entities
Associated undertakings are entities over which the Group has significant influence, but not control over the financial and operating policies. Significant influence is the power to participate in the financial and operating policy decisions of the entity but is not control over those policies.
Jointly controlled entities are entities over which the Group has joint control under a contractual arrangement with other parties.
The attributable shares of results of associated undertakings and jointly controlled entities, generally based on audited accounts, are included in the consolidated financial statements using the equity method of accounting. The share of any losses is restricted to a level that reflects an obligation to fund such losses.
Designation of Financial Instruments
The Group has classified its financial instruments in accordance with IAS 39 ‘Financial Instruments: Recognition and Measurement’ as follows:
- Non-derivative financial assets 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’.
- Derivative instruments are automatically classified as ‘at fair value through the income statement’ unless they form part of an effective hedging relationship.
- Instruments that are deemed 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 ‘at fair value through the income statement’.
- Assets in support of the general insurance and long term assurance business are designated ‘at fair value through the income statement’.
- Investment contracts within the long term assurance business are designated 'at fair value through the income statement'.
- No financial assets are designated as 'held to maturity'.
- All other financial assets are classified as ‘available for sale’.
- All other financial liabilities are classified as ‘at amortised cost’.
The resulting treatment of these financial instruments is set out in the accounting policies below.
Derivatives
Derivatives are initially recognised at fair value on the date the contract is entered into. Where the fair value of a derivative is positive, it is carried as a derivative asset and where negative as a derivative liability. The gain or loss on remeasurement to fair value at the balance sheet date is taken to net trading income except for the interest accrual element relating to derivatives used for economic hedging purposes that do not qualify for hedge accounting treatment which is taken to net interest income, insurance and investment related derivatives which are taken to net investment income related to insurance and investment business or when cash flow hedge accounting is employed.
Hedge accounting allows one financial instrument, generally a derivative such as a swap, to be designated as a hedge of another financial instrument such as a loan or deposit or a portfolio of the same. At inception of the hedge relationship formal documentation must be drawn up specifying the hedging strategy, the component transactions and the methodology that will be used to measure effectiveness.
Monitoring of hedge effectiveness is undertaken on an ongoing basis. A hedge is regarded as effective if the change in fair value or cash flows of the hedge instrument and the hedged item are negatively correlated within a range of 80% to 125% either for the period since effectiveness was last tested or cumulatively since inception.
The Group uses three hedge accounting methods.
Firstly, fair value hedge accounting offsets the change in the fair value of the hedging instrument against the change in the fair value of the hedged item in respect of the risk being hedged. The hedged item is adjusted for the fair value of the risk being hedged irrespective of its financial instrument classification. These changes in fair value are recognised in the income statement through net trading income. Adjustments made to the carrying amount of the hedged item for fair value hedges will be amortised on an effective interest rate basis over the remaining expected life in line with the presentation of the underlying hedged item. If the hedge is highly effective the net impact on the income statement is minimised.
Secondly, cash flow hedge accounting matches the cash flows of hedged items against the corresponding cash flow of the hedging derivative. The effective part of any gain or loss on a hedging instrument is recognised directly in equity in the cash flow hedge reserve and the hedged item is accounted for in accordance with the policy for that financial instrument. Any ineffective portion of the hedging instrument’s fair value is recognised immediately in the income statement through net trading income. The amount deferred in reserves remains until the designated transaction occurs at which time it is released and accounted for in the income statement in line with the treatment of the hedged item. Additionally, in circumstances where the hedge relationship subsequently proves ineffective, is early settled or is terminated the associated gains and losses that were recognised directly in reserves are reclassified to the income statement through net trading income.
Thirdly, hedging of net investments in foreign operations is discussed within the foreign currencies accounting policy.
A derivative may be embedded in another financial instrument, known as the host contract. Where the economic characteristics and risks of an embedded derivative are not closely related to those of the host contract the embedded derivative is separated from the host and held on balance sheet at fair value except for those instruments that have been designated at fair value through the income statement where the derivative is not separated from the host instrument. Movements in fair value are posted to the income statement through net trading income, whilst the host contract is accounted for in accordance with the policy for that class of financial instrument.
Derivative fair values are determined using valuation techniques that are consistent with techniques commonly used by market participants to price these instruments. These techniques include discounted cash flow analysis and other pricing models. The fair values calculated from these models are regularly compared with prices obtained in actual market transactions to ensure reliability. In all material instances these techniques use only observable market data.
Loans and Advances
Loans and advances held for trading are carried at fair value. Gains, losses and related income are taken to net trading income as they arise.
Loans and advances classified or designated at fair value through the income statement are carried at fair value. Gains, losses and related income are taken to other operating income as they arise, except for those related to insurance and investment business which are taken to net investment income related to insurance and investment business.
All other loans and advances are classified as loans and receivables. They are initially recognised at fair value plus directly related transaction costs and are subsequently carried at amortised cost using the effective interest method less provision for impairment.
The Group assesses impairment individually for financial assets that are significant and individually or collectively for assets that are not significant.
Individual impairment is identified at a counterparty specific level following objective evidence that a financial asset is impaired. This may be after an interest or principal payment is missed or when a banking covenant is breached. The present value of estimated cash flows recoverable is determined after taking into account any security held. The amount of any impairment is calculated by comparing the present value of the cash flows discounted at the loan’s original effective interest rate with the carrying value. If impaired, the carrying value is adjusted and the difference charged to the income statement.
The written down value of the impaired loan is compounded back to the net realisable balance over time using the original effective interest rate. This is reported through interest receivable within the income statement and represents the unwinding of the discount.
A write-off is made when all or part of a claim is deemed uncollectable or forgiven. Write-offs are charged against previously established provisions for impairment or directly to the income statement.
In circumstances where an asset has been individually assessed for impairment and no objective evidence of impairment exists, then it will be subject to a collective assessment.
Collective impairment is identified for groups of assets that share similar risk characteristics. Collective impairment is assessed using a methodology based on existing risk conditions or events that have a strong correlation with a tendency to default.
Loans and advances to customers include advances that are subject to non-returnable finance arrangements following securitisation of portfolios of mortgages and other advances. The principal benefits of these advances were acquired by special purpose securitisation companies that fund their purchase primarily through the issue of floating rate notes. These floating rate notes are accounted for as debt securities in issue on the balance sheet.
The fair value of loans and advances to customers is estimated by discounting anticipated cash flows, including interest, at a current market rate of interest. The fair value of floating rate placements and overnight deposits is equal to carrying value. The fair value of fixed interest bearing deposits is based on cash flows discounted using current money market interest rates for debts with similar maturity and credit risk characteristics.
Finance Leases and Operating Leases
Assets leased to customers that transfer substantially all the risks and rewards incidental to ownership to the customer are classified as finance leases. Together with instalment credit agreements, they are recorded at an amount equal to the net investment in the lease, less any provisions for impairment, within loans and advances to customers.
The difference between the gross receivable and the present value of the receivable is recognised as unearned finance income. Lease income is recognised over the term of the lease using the net investment method, which reflects a constant periodic rate of return on the net investment.
All other assets leased to customers are classified as operating leases. These assets are separately disclosed in the balance sheet and are recorded at cost less aggregate depreciation, which is calculated on a straight-line basis. Operating lease rentals are recognised in operating income on a straight-line basis over the lease term. Operating lease assets are reviewed for impairment when there is an indication of impairment.
Investment Securities
Investment securities held for trading are classified as financial assets held for trading and are carried at fair value. Gains, losses and related income are taken to net trading income as they arise.
Investment securities designated at fair value through the income statement are carried at fair value. Gains, losses and related income are taken to other operating income as they arise, except for those related to insurance and investment business which are taken to net investment income related to insurance and investment business.
Debt securities other than those held for trading or designated at fair value and for which there is no active market are classified as loans and receivables. They are initially recognised at fair value plus directly related transaction costs and are subsequently carried on the balance sheet at amortised cost using the effective interest method less provision for impairment.
All other investment securities are classified as available for sale. They are initially recognised at fair value plus directly related transaction costs and are subsequently carried on the balance sheet at fair value. Unrealised gains or losses are recognised directly in equity in the available for sale reserve, except for impairment losses or foreign exchange gains or losses related to debt securities, which are recognised immediately in the income statement in impairment on investment securities or other operating income respectively. Income on debt securities is recognised on an effective interest rate basis and taken to interest receivable through the income statement. Income from equity shares is credited to other operating income, with income on listed equity shares being credited on the ex-dividend date and income on unlisted equity shares being credited on an equivalent basis. On sale or maturity, previously unrealised gains and losses are recognised in other operating income.
Impairment losses on available for sale equity instruments are not reversed through the income statement. Any increase in the fair value of an available for sale equity instrument after an impairment loss has been recognised is treated as a revaluation and recognised directly in equity. An impairment loss on an available for sale debt instrument is reversed through the income statement, if there is evidence that the increase in fair value is due to an event that occurred after the impairment loss was recognised.
The fair value of investment securities is based on market prices or broker/dealer valuations. Where this information is not available, the fair value is estimated using quoted market prices for securities with similar credit, maturity and yield characteristics or similar valuation models.
The Group uses settlement date accounting when recording the purchase and sale of investment securities, with the exception of those held for trading for which trade date accounting is used.
Repurchase Agreements
Debt securities sold subject to repurchase agreements are retained within the balance sheet where the Group retains substantially all of the risks and rewards of ownership. Funds received under these arrangements are included within deposits by banks or customer accounts. Conversely, debt securities acquired under commitments to resell are not recognised in the balance sheet as debt securities where substantially all the risks and rewards do not pass to the Group. In this case, the purchase price is included within loans and advances to banks or loans and advances to customers. The difference between sale and repurchase prices for such transactions is reflected in the income statement over the lives of the transactions, within interest payable or interest receivable as appropriate.
Goodwill
The excess of the cost of a business combination over the interest in the net fair value of the identifiable assets, liabilities and contingent liabilities at the date of acquisition, of subsidiary undertakings, associated undertakings (including jointly controlled entities) and other businesses, is capitalised as goodwill.
After initial recognition, goodwill is measured at cost less any accumulated impairment losses. Goodwill carried in the consolidated balance sheet is subject to a six monthly impairment review by comparing the value in use with the carrying value. When this indicates that the carrying value is not recoverable, it is irrevocably written down through the income statement by the amount of any impaired loss identified. IFRS 3, ‘Business Combinations’ has not been applied retrospectively to business combinations that occurred before 1 January 2004.
Software
Costs associated with the development of software for internal use, subject to de minimis limits, are capitalised if the software is technically feasible and the Group has both the intent and sufficient resources to complete the development. Costs are only capitalised if the asset can be reliably measured, will generate future economic benefits and there is an ability to use or sell the asset.
Only costs that are directly attributable to bringing the asset into working condition for its intended use are capitalised. These costs include all directly attributable costs necessary to create, produce and prepare the asset to be capable of operating in a manner intended by management. Other development expenditure is recognised in the income statement as an expense as incurred.
Capitalised development expenditure and purchased software is stated at cost less accumulated amortisation and impairment losses. Once the software is ready for use, the capitalised costs are amortised over their expected lives, generally four years. Capitalised software is assessed for impairment where there is an indication of impairment. Where impairment exists, the carrying amount of the asset is reduced to its recoverable amount and the impairment loss recognised in the income statement. The amortisation charge for the asset is then adjusted to reflect the asset’s revised carrying amount.
Subsequent expenditure is only capitalised when it increases the future economic benefits embodied in the specific asset to which it relates.
