NOTE 3. CRITICAL ACCOUNTING ESTIMATES AND JUDGEMENTS
The preparation of financial statements in conformity with IFRS requires the use of estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses as well as the disclosure of contingent assets and liabilities. Estimates and judgements are continually evaluated and are based on historical experience and other factors, including expectations of future events that are believed to be reasonable under the circumstances. As management judgement involves an estimate of the likelihood of future events, actual results could differ from those estimates, which could affect the future reported amounts of assets and liabilities.
Management believes that the underlying assumptions used are appropriate and that the Group's financial statements therefore present the financial position and results fairly. The areas involving a higher degree of judgement or complexity, or areas where assumptions and estimates are significant to the consolidated financial statements are described as follows:
3.1 Fair value of loans and receivables at acquisition
IAS 39 requires all financial assets, including loans and receivables, to be recognised initially at fair value and states that the best evidence of fair value is the transaction or acquisition price. NAMA believes that at the time of acquisition, there was no active market for the type of assets which it acquired, and is satisfied that the transaction price is an appropriate measure of fair value.
As described in accounting policy 2.6, loans acquired by NAMA are initially recognised at their acquisition price as adjusted for specified movements in the loan balance between the loan valuation date and acquisition date. The acquisition price for loans acquired by NAMA was determined using the LTEV methodology as set out in the Act and related regulations.
This methodology used a collateral based valuation model which involved projections of property related cash flows and assumptions about the realisation of the property collateral. The valuation basis for all property collateral is the value of the underlying property at 30 November 2009, but the Act allows for an uplift for the long-term economic value of the property collateral, to reflect the value that the asset could be reasonably expected to obtain in a stable financial system when the crisis conditions prevailing at the passing of the Act have eased. The key inputs to the model are the independent property valuation and assessment of cash flows, discounted to determine the asset's present value.
3.2 Impairment of loans and receivables and related derivatives acquired
The Group's policy is to review its portfolio of loans and receivables for impairment semi-annually. In determining whether an impairment loss should be recorded in the consolidated income statement at the reporting date, the Group makes judgements as to whether any observable data exists indicating evidence of impairment which would be likely to result in a measurable decrease in the timings and amounts of the estimated future cash flows. The Group's policy on impairment is set out in accounting policy 2.12.
Assets are either individually assessed or grouped together and collectively assessed for impairment. The individually assessed debtors representing loans and associated derivatives with a carrying value of €22.3 billion (2011: €23.5 billion), comprise the majority (84%) of loans and receivables managed by NAMA. The remaining loans, representing a carrying value of €4.1 billion (2011: €5.2 billion), and which relate to debtors principally managed by Participating Institutions have not been individually assessed and are grouped together as one portfolio for collective assessment.
The impairment assessment of individually assessed debtors is based on cash flow projections which were prepared by individual case managers and reviewed by management for each individually assessed debtor connection.
The cash flows reflect NAMA's best estimate of expected future cash flows for each individually assessed debtor and include the future estimated cash flows from the disposal of property collateral and other non-disposal income (such as rental income).
The projection of cash flows involves the exercise of considerable judgement and estimation by management (taking into account the actual underlying cash flows) involving assumptions in respect of local economic conditions, the trading performance of the debtor and the value of the underlying property collateral. As a result the actual cash flows, and their timing, may differ significantly from the projected cash flows prepared by management for the purposes of determining the amount of impairment provision for individually significant debtors.
The assumptions used for projecting both the amount and timing of future cash flows for individual debtors are reviewed regularly by management and cash flow projections are updated.
Following the completion of all individual debtor cash flows these are grouped together and the cash flows are subject to sensitivity analysis to assess the likely impact on the impairment provision of a change in the timing and amount of cash flows.
The 2012 impairment provision is determined after the following inputs are assessed:
- Estimated cash flows generated from underlying security as collateral to a loan.
- Expected disposal value of the underlying security.
- Expected timing of the realisation of cash flows including the timing of the expected future disposal of the security.
Following the completion of a detailed cash flow assessment of debtors with a combined value of €22.3 billion (2011: €23.5 billion), (includes €0.3m of associated borrower derivatives (2011: €0.3m)), the consolidated results of this cash flow assessment allow NAMA to apply certain sensitivities to its portfolio and assess the impact of these sensitivities on the impairment provision.
The table below sets out the impact on the 2012 impairment provision of a change in the amount of disposal cash flows over certain geographies and asset types.
| Ireland | UK (including Northern Ireland) | |
|---|---|---|
| €m | €m | |
| Land and development | 28 | 6 |
| Residential | 21 | 5 |
| Commercial | 22 | 14 |
| Retail | 21 | 11 |
| Hotel and leisure | 9 | 4 |
| Total | 101 | 40 |
Debtors that are not individually assessed are considered collectively for the purposes of performing an impairment assessment ('collective assessment'). This collective assessment is calculated by taking the impairment experience of the individually significant debtors. The average impairment rate, for the individually significant debtors, is applied to the collectively assessed loans.
The amount of any impairment provision recognised is estimated by management in the light of the level of impairment experienced in the individually assessed portion of the loan portfolio. In doing so, its key assumption is that the level of impairment in both parts of the portfolio will be similar. If the performance of the individually assessed assets differs from expectation or if the performance of the collectively assessed debtors differs significantly from the individually assessed debtors, this would have an impact on the level of the collective impairment provision.
An independent review is carried out by NAMA's internal auditors of the impairment process annually. The scope of this review includes assessing the impairment review process and the accuracy and completeness of inputs to the individual and collective assessments.
3.3 Income recognition on loans and receivables
The accounting policy for the recognition of interest income for loans and receivables is set out in accounting policy 2.9. The loan portfolio acquired by the Group was acquired at a significant discount to the Par value of the loans, reflecting loan losses already incurred on the loans pre acquisition by NAMA. The EIR of this portfolio is set as the discount rate that equates the present value of the cash flows assumed in the loan acquisition valuation model to the acquisition value. This rate is set at valuation date and becomes the original EIR of the loan.
Actual cash flows over the life of a debtor may differ positively or negatively from the expected cash flows assumed in the acquisition valuation model. The Group reviews expected cash flows at least annually as part of its impairment review (see note 3.2). Any changes to assumptions would have an impact on interest income on loans and receivables carried at amortised cost as disclosed in Note 5. Interest income will not be recognised on any impaired portion of an asset, thus reducing interest income where revised estimated cash flows are less than the original expected cash flows in the loan acquisition model.
3.4 Deferred tax
The accounting policy for deferred tax is set out in accounting policy 2.17. Deferred income tax assets are recognised in respect of tax losses carried forward only to the extent that realisation of the related tax benefit is probable. A net deferred tax asset of €337m is recognised in the financial statements at the year end, comprising a deferred income tax asset of €133m (2011: €236m) in respect of unutilised tax losses and deferred tax on derivatives of €204m (2011: €70m).
Deferred tax assets are recognised to the extent that management believe those assets will be realised in future periods. The realisation of deferred tax assets is dependent on the Group generating future taxable profits to offset deferred tax assets recognised. Having regard to the profit generated by the Group in 2011 and 2012, and the realisation in the current year of a significant portion of the deferred tax assets recognised in 2011, management believes that future taxable profits will be available to offset any deferred tax asset recognised and therefore consider it appropriate to continue to recognise deferred tax assets at the reporting date.