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 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 of financial assets is set out in accounting policy 2.12.
Loans and receivables 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 €19.6bn (includes €0.1bn of associated borrower derivatives (2012: €0.3bn)), (2012: €22.3bn), comprise the majority, 85%, (2012:84%) of loans and receivables managed by NAMA. The remaining loans, representing a carrying value of €3.6bn (2012: €4.1bn), 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 incremental impairment charge for 2013 is €914m (2012: €518m). This brings the total cumulative impairment provision to €4,125m (2012: €3,263m), representing a coverage of 17.5% (2012: 12.4%).
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 performance of the debtor and the value of the underlying property collateral. As a result the actual cash flows, and their timing, may differ from the projected cash flows prepared by management for the purposes of determining the amount of impairment provision for individually significant debtors. Cash flow projections are prepared based on the most recent agreed strategy for each debtor. Cash flow estimates may change if there is a change in a strategy for example from an asset disposal strategy to a loan sale strategy.
The net increase in the specific impairment provision of €552m reflects a very detailed review undertaken by NAMA at end-2013 in respect of its individually assessed debtors and with a particular focus on the disposal value of property collateral scheduled for disposal during the period from 2014 to 2016. The Board decided to perform a detailed three-year review at end-2013 compared to a two-year detailed review at end-2012. Based on this assessment, NAMA has adjusted the disposal value of property collateral to reflect market movements since the cash flows were originally prepared (as part of the debtor business plan process) and to reflect also NAMA's current expectations based on market conditions and other available evidence.
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 2013 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 €19.6bn (2012: €22.3bn) 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.
Individual cash flows are projected for each individual property (collateral) asset. These are then consolidated into a single cash flow for each debtor connection for the purposes of the impairment assessment exercise.
NAMA performs its sensitivity analysis at a property (collateral) asset level. In practice, this means the projected disposal value for each individual property asset by location is reduced by 1%. The debtor connection cash flows are then updated with the revised projected disposal values and a revised impairment provision is calculated for each debtor connection. The overall revised provision is then compared to the actual impairment provision to demonstrate the impact of a 1% reduction in projected disposal values.
The table below sets out the impact on the 2013 impairment provision of a change in the amount of cash flows over certain geographies and asset types.
Estimated increase in €m on the 2013 impairment charge of a 1% decrease in the amount of expected cash flows by asset type and location.
Ireland €m |
UK (including Northern Ireland) €m |
ROW €m |
Ireland €m |
UK (including Northern Ireland) €m |
|
|---|---|---|---|---|---|
| 2013 | 2013 | 2013 | 2012 | 2012 | |
| Land and development | 25 | 4 | 2 | 28 | 6 |
| Residential | 15 | 3 | 1 | 21 | 5 |
| Commercial | 18 | 4 | 2 | 22 | 14 |
| Retail | 21 | 8 | 1 | 21 | 11 |
| Hotel and leisure | 6 | 3 | 3 | 9 | 4 |
| Total | 85 | 22 | 9 | 101 | 40 |
Debtors that are not individually assessed are considered collectively for the purposes of performing an impairment assessment ('collective assessment'). The debtors which are collectively assessed represent principally the Participating Institutions managed debtors. For the purpose of the collective assessment, in 2013 NAMA has calculated an impairment loss rate using a sample of cash flows which were prepared in respect of the Participating Institutions managed debtors. This rate is then applied to the collectively assessed debt to determine the level of collective impairment provision required. This is a revised method to the collective assessment from previous periods and reflects more information being available in respect of expected cash flows for participating institutions managed debtors. The revised method has resulted in an increase in the collective impairment provisioning rate from 12.4% to 23.0% and a recommended total collective provision of €822m (2012: €512m).
The amount of any collective impairment provision recognised is estimated by management in the light of the level of impairment experienced in the sample selected. In doing so, its key assumption is that the performance characteristics of the Participating Institution managed portfolio is similar to that of the sample of debtors selected to estimate the collective impairment provision. If the performance of cash flows differs from expectation or if the performance of the remaining portfolio differs from the sample selected this would have an impact on the level of the collective impairment provision.
NAMA continues to enhance the impairment process for the purpose of calculating the collective impairment provision on the participating institution managed portfolio. At end 2013 NAMA requested the Participating Institutions to prepare cash flows using the "Sales Tracker" forecasting tool for all debtors managed by them. The primary objective of this exercise which is due to be completed by 30 June 2014 is to facilitate the collection of asset level data on the Participating Institution managed portfolio for strategic analysis and management of the portfolio. However the additional information gathered will be used by NAMA to enhance the calculation of the collective impairment provision at 30 June 2014 as part of its half-year impairment assessment. While the 2013 process for determining the collective provision has been enhanced, the further enhancement of this process and additional information which will be available to NAMA in 2014 in respect of its Participating Institution managed portfolio cash flows may result in increases or decreases to the amount 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.
On 7 February 2013, the Minister issued a series of directions to NAMA under the IBRC Act. Among the Directions issued to NAMA were;
This directs NAMA (or a NAMA SPV) to enter a Deed of Assignment and Transfer with the Central Bank to acquire;
a) A loan facility deed between IBRC and the Central Bank
b) A legal charge between IBRC and the Central Bank over the assets of IBRC.
c) The benefit of a guarantee given by the Minister in favour of the Central Bank.
This directs NAMA (or a NAMA SPV) to make a bid for the assets of IBRC at an independent valuation price established by the joint Special Liquidators.
In response to these Directions, NAMA established a new NAMA group entity, National Asset Resolution Limited (NARL), which was incorporated on 11 February 2013.
On 28 March 2013, NAMA and NARL entered into the Deed of Assignment and Transfer with the Central Bank. Consideration paid was €12.928bn in the form of €12.928bn of Government Guaranteed debt securities and cash of €343k. The debt securities were issued by NAML and transferred to NARL via a profit participating loan facility. The debt securities were used by NARL to acquire the facility deed from the Central Bank (secured by a floating charge over the assets of IBRC).
At the reporting date the balance outstanding on the loan facility deed was €11.7bn, following the repayment during the year of €1.4bn in principal and interest by the joint Special Liquidators. In accordance with IFRS, the loan facility deed is required to be assessed for impairment at 31 December 2013. The recoverability of the loan facility deed by NARL is dependent on repayment of the underlying loans and the realisation of the value of the underlying assets of the IBRC portfolio, over which NAMA has a floating charge. NARL is the senior creditor of IBRC (in liquidation), therefore funds received by the joint Special Liquidators are used to reduce the loan facility deed in the first instance. In April 2014, the joint Special Liquidators concluded the loan sales process and the majority of the IBRC loan portfolio has been sold to third parties. The Minister announced on 25 April 2014 that no IBRC loans will transfer to NAMA. It is expected that the joint Special Liquidators will remit sufficient cash to NAMA during 2014 to repay the loan facility deed in full and permit the full redemption of the NAMA senior bonds issued to the Central Bank at the time of the IBRC liquidation.
At the date of authorisation of the financial statements for issue, the balance on the NARL facility deed is €8.5bn. As sales complete, cash proceeds of sale will be remitted to NAMA by the joint Special Liquidators, which will then be used to repay outstanding senior debt securities in issue to the Central Bank.
3.2 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 original 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 3.1). 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.
3.3 Surplus income
The Group's policy is to review its portfolio of debtors for surplus income semi-annually. The Group recognises surplus income in two instances:
- Debtors who have made debt repayments in excess of their NAMA debt. These repayments resulted in the recognition of €306m in 2013 (2012: €108m).
- Debtors with positive net present values and who have passed stringent stressed conditions. The Group realised €225m (2012: €64m) from these debtors in 2013.
The net present value (NPV) for each individually assessed debtor involves the projection of their future cash flows (including the future estimated cash flows from the disposal of property collateral and other non-disposal income). The estimated discounted future cash flows are then compared to their carrying value in order to calculate the NPV surplus of each debtor.
In the case of debtors that result in a NPV positive value, stringent stressed conditions are then applied which may result in the recognition of surplus income for a very limited number of debtors with significant positive NPVs. These stressed conditions which include an assessment of the level of workout of the debtor and the application of a NPV sensitivity buffer are assessed semi-annually.
The projection of cash flows involves the exercise of judgement and estimation by management, as a result the actual cash flows, and their timing, may differ from the projected cash flows. Assumptions used for the cash flow projections are reviewed and updated regularly by management.
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 €202m (2012: €337m) is recognised in the financial statements at the year end, comprising a deferred income tax asset of €93m (2012: €133m) in respect of unutilised tax losses and deferred tax on derivatives of €110m (2012: €204m).
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 2012 and 2013, and the realisation in 2012 and 2013 of a significant portion of the deferred tax assets recognised in 2011, management believes that future taxable profits will be available to offset any remaining deferred tax asset recognised and therefore consider it appropriate to continue to recognise deferred tax assets at the reporting date.