Interim Report - 17 of 21

Footnotes to Financial Statements

1 Adjustment to bring changes between opening and closing balance sheet amounts to average rates. This is not done on a line-by-line basis, as details cannot be determined without unreasonable expense.

2 Share premium includes the deduction of US$1 million (30 June 2009: US$1 million; 31 December 2009: nil) in respect of issue costs incurred during the period.

3 Cumulative goodwill amounting to US$5,138 million has been charged against reserves in respect of acquisitions of subsidiaries prior to 1 January 1998, including US$3,469 million charged against the merger reserve arising on the acquisition of HSBC Bank plc. The balance of US$1,669 million was charged against retained earnings.

4 Retained earnings include 127,950,817 (US$1,578 million) of own shares held within HSBC's insurance business, retirement funds for the benefit of policyholders or beneficiaries within employee trusts for the settlement of shares expected to be delivered under employee share schemes or bonus plans, and the market-making activities in Global Markets (30 June 2009: 180,429,757 (US$2,429 million); 31 December 2009: 179,964,968 (US$2,572 million)).

5 Amounts transferred to the income statement in respect of cash flow hedges include US$129 million loss (30 June 2009: US$284 million loss; 31 December 2009: US$218 million loss) taken to 'Net interest income' and US$1,515 million loss (30 June 2009: US$572 million loss; 31 December 2009: US$266 million gain) taken to 'Net trading income'.

6 Statutory share premium relief under Section 131 of the Companies Act 1985 (the 'Act') was taken in respect of the acquisition of HSBC Bank plc in 1992, HSBC France in 2000 and HSBC Finance Corporation in 2003 and the shares issued were recorded at their nominal value only. In HSBC's consolidated financial statements the fair value differences of US$8,290 million in respect of HSBC France and US$12,768 million in respect of HSBC Finance Corporation were recognised in the merger reserve. The merger reserve created on the acquisition of HSBC Finance Corporation subsequently became attached to HSBC Overseas Holdings (UK) Limited ('HOHU'), following a number of intra-group reorganisations. At 30 June 2010, nil (30 June 2009: nil; 31 December 2009: US$5,945 million) was transferred from this reserve to retained earnings as a result of impairment in HSBC Holdings' investment in HOHU. During 2009, pursuant to Section 131 of the Companies Act 1985, statutory share premium relief was taken in respect of the rights issue and US$15,796 million was recognised in the merger reserve. The merger reserve includes the deduction of US$614 million in respect of costs relating to the rights issue, of which US$149 million was subsequently transferred to the income statement. Of this US$149 million, US$121 million was a loss arising from accounting for the agreement with the underwriters as a contingent forward contract. The merger reserve excludes the loss of US$344 million on a forward foreign exchange contract associated with hedging the proceeds of the rights issue.

7 During June 2010, HSBC Holdings issued US$3,800 million of Perpetual Subordinated Capital Securities, Series 2 ('capital securities'), on which there were US$82 million of issuance costs which are classified as equity under IFRSs. The capital securities are exchangeable at HSBC Holdings' option into non-cumulative US dollar preference shares on any coupon payment date. Interest on the capital securities is paid quarterly and may be deferred at the discretion of HSBC Holdings. The capital securities may only be redeemed at the option of HSBC Holdings.

(a) Compliance with International Financial Reporting Standards

The interim consolidated financial statements of HSBC have been prepared in accordance with the Disclosure Rules and Transparency Rules of the Financial Services Authority and IAS 34 'Interim Financial Reporting' ('IAS 34') as issued by the International Accounting Standards Board ('IASB') and as endorsed by the European Union ('EU').

The consolidated financial statements of HSBC at 31 December 2009 were prepared in accordance with International Financial Reporting Standards ('IFRSs') as issued by the IASB and as endorsed by the EU. EU‑endorsed IFRSs may differ from IFRSs as issued by the IASB if, at any point in time, new or amended IFRSs have not been endorsed by the EU. At 31 December 2009, there were no unendorsed standards effective for the year ended 31 December 2009 affecting the consolidated financial statements at that date, and there was no difference between IFRSs endorsed by the EU and IFRSs issued by the IASB in terms of their application to HSBC. Accordingly, HSBC's financial statements for the year ended 31 December 2009 were prepared in accordance with IFRSs as issued by the IASB.

At 30 June 2010, there were no unendorsed standards effective for the period ended 30 June 2010 affecting these interim consolidated financial statements, and there was no difference between IFRSs endorsed by the EU and IFRSs issued by the IASB in terms of their application to HSBC.

IFRSs comprise accounting standards issued by the IASB and its predecessor body as well as interpretations issued by the International Financial Reporting Interpretations Committee ('IFRIC') and its predecessor body.

During the period ended 30 June 2010, HSBC adopted the following significant changes to IFRSs:

·; On 1 January 2010, HSBC adopted the revised IFRS 3 'Business Combinations' ('IFRS 3') and the amendments to IAS 27 'Consolidated and Separate Financial Statements'. The main changes under the standards are that:

- acquisition-related costs are recognised as an expense in the income statement in the period in which they are incurred;

- all consideration transferred, including contingent consideration, is recognised and measured at fair value at the acquisition date;

- equity interests held prior to control being obtained are remeasured to fair value at the date of obtaining control, and any gain or loss is recognised in the income statement;

- changes in a parent's ownership interest in a subsidiary that do not result in a change of control are treated as transactions between equity holders and are reported in equity; and

- an option is available, on a transaction-by-transaction basis, to measure any non-controlling (previously referred to as minority) interests in the entity acquired either at fair value, or at the non-controlling interests' proportionate share of the net identifiable assets of the entity acquired.

In terms of their application to HSBC, the revised IFRS 3 and the amendments to IAS 27 apply prospectively to acquisitions made on or after 1 January 2010, and have no significant effect on these consolidated financial statements.

In addition to the above, during the period ended 30 June 2010, HSBC adopted a number of standards and interpretations and amendments thereto which had an insignificant effect on these consolidated financial statements.

(b) Presentation of information

HSBC's consolidated financial statements are presented in US dollars which is also HSBC Holdings' functional currency. HSBC Holdings' functional currency is the US dollar because the US dollar and currencies linked to it are the most significant currencies relevant to the underlying transactions, events and conditions of its subsidiaries, as well as representing a significant proportion of its funds generated from financing activities. HSBC uses the US dollar as its presentation currency in its consolidated financial statements because the US dollar and currencies linked to it form the major currency bloc in which HSBC transacts and funds its business.

(c) Comparative information

These interim consolidated financial statements include comparative information as required by IAS 34, the UK Disclosure Rules and Transparency Rules and the Hong Kong Listing Rules.

(d) Use of estimates and assumptions

The preparation of financial information requires the use of estimates and assumptions about future conditions. The use of available information and the application of judgement are inherent in the formation of estimates; actual results in the future may differ from those reported. Management believes that HSBC's critical accounting policies where judgement is necessarily applied are those which relate to impairment of loans and advances, goodwill impairment, the valuation of financial instruments, the impairment of available-for-sale financial assets and deferred tax assets. These critical accounting policies are described on pages 61 to 65 of the Annual Report and Accounts 2009.

(e) Consolidation

The interim consolidated financial statements of HSBC comprise the financial statements of HSBC Holdings and its subsidiaries. The method adopted by HSBC to consolidate its subsidiaries is described on page 367 of the Annual Report and Accounts 2009.

(f) Future accounting developments

At 30 June 2010, a number of standards and interpretations, and amendments thereto, had been issued by the IASB which are not yet effective for these consolidated financial statements. Except for those described on page 368 of the Annual Report and Accounts 2009, HSBC does not expect the adoption of any of these to have a significant effect on these consolidated financial statements.

(g) Changes in composition of the Group

There were no material changes in the composition of the Group.

The accounting policies adopted by HSBC for these interim consolidated financial statements are consistent with those described on pages 369 to 385 of the Annual Report and Accounts 2009, except as discussed in Note 1, 'Basis of preparation'. The methods of computation applied by HSBC for these interim consolidated financial statements are consistent with those applied for the Annual Report and Accounts 2009.

Dividends to shareholders of the parent company were as follows:

The Directors have declared a second interim dividend in respect of the financial year ending 31 December 2010 of US$0.08 per ordinary share, a distribution of approximately US$1,401 million. The second interim dividend will be payable on 6 October 2010. Further details are contained in item 6 of the Additional Information section on page 244. No liability is recorded in the financial statements in respect of the second interim dividend for 2010.

On 15 July 2010, HSBC paid a further coupon on the capital securities of US$0.508 per security, a distribution of US$45 million. No liability is recorded in the balance sheet at 30 June 2010 in respect of this coupon payment.

Basic earnings per ordinary share was calculated by dividing the profit attributable to ordinary shareholders of the parent company by the weighted average number of ordinary shares outstanding, excluding own shares held. Diluted earnings per ordinary share was calculated by dividing the basic earnings, which require no adjustment for the effects of dilutive potential ordinary shares, by the weighted average number of ordinary shares outstanding, excluding own shares held, plus the weighted average number of ordinary shares that would be issued on conversion of dilutive potential ordinary shares.

Profit attributable to ordinary shareholders of the parent company

Basic and diluted earnings per share

Included within 'Employee compensation and benefits' are components of net periodic benefit cost related to HSBC's defined benefit pension plans and other post-employment benefits, as follows:

HSBC revalues its defined benefit post-employment plans each year at 31 December, in consultation with the plans' local actuaries. The assumptions underlying the calculations are used to determine the expected income statement charge for the year going forward.

At 30 June each year, HSBC revalues all plan assets to current market prices. HSBC also reviews the assumptions used to calculate the defined benefit obligations (the liabilities of the plans) and updates the carrying amount of the obligations if there have been significant changes as a consequence of changes in assumptions.

In the first half of 2010, there was a decrease in the average yields of high quality (AA rated or equivalent) debt instruments in the UK, together with a decrease in inflation expectations. As a result, the defined benefit obligation for the HSBC Bank (UK) Pension Scheme increased by US$576 million in respect of actuarial losses mainly caused by the changes to discount and inflation rate assumptions. For other plans, the average discount rates used generally decreased after 31 December 2009, resulting in actuarial losses and an increase in the defined benefit obligations of US$479 million. All differences from changes in the assumptions used were recognised directly in other comprehensive income as actuarial gains or losses.

In November 2009, the Board of Directors of HSBC North America Holdings, Inc. ('HNAH') approved actions to cease all future benefit accruals for legacy participants under the final average pay formula components of the HSBC North America Pension Plan with effect from 1 January 2011. Affected employees were informed of this decision in February 2010. As a result of these changes, HNAH recorded a one-time curtailment gain of US$147 million.

The discount rates used to calculate HSBC's obligations under its defined benefit pension and post-employment healthcare plans were as follows:

Discount rates

The inflation rate used to calculate the HSBC Bank (UK) Pension Scheme obligation at 30 June 2010 was 3.5 per cent (30 June 2009: 3.6 per cent; 31 December 2009: 3.7 per cent). There were no material changes to other assumptions.

Actuarial gains and losses

1 Other movements include changes in the effect of the limit on plan surpluses.

Actuarial gains and losses comprise experience adjustments on plan assets and liabilities as well as adjustments arising from changes in actuarial assumptions. The experience gains and losses on plan assets arise as a result of the difference between the expected returns on the plan assets and the actual movement in the value of the plan assets during the period. The changes in actuarial assumptions arise as a result of changes in the plan assumptions, primarily discount rates and inflation rates, as previously described.

Total cumulative net actuarial losses, including the cumulative effect of the limit on plan surpluses recognised in equity at 30 June 2010, were US$4,742 million (30 June 2009: US$4,652 million cumulative losses; 31 December 2009: US$4,660 million cumulative losses). Of this the cumulative effect of the limit on plan surpluses was US$29 million (30 June 2009: US$9 million; 31 December 2009: US$47 million).

In February 2010, HSBC Bank plc agreed with the Trustee of the HSBC Bank (UK) Pension Scheme ('the Scheme') to reduce the deficit of the plan by meeting a schedule of future funding payments, as disclosed on page 390 of the Annual Report and Accounts 2009. On 17 June 2010, HSBC Bank plc agreed with the Trustee to accelerate the reduction of the deficit of the plan with a special contribution of £1,760 million (US$2,638 million) in 2010 followed by a revised payment schedule in the following years, as shown below:

1 The payment schedule was agreed with the Trustee in pounds sterling and the equivalent US dollar amounts are shown at the exchange rate effective as at 30 June 2010.

On the same day, HSBC Bank plc made the £1,760 million (US$2,638 million) contribution and the Scheme used the contribution to acquire debt securities with a fair value of £1,760 million (US$2,638 million) from HSBC in a transaction at an arm's length value determined by the Scheme's independent third-party advisors. The debt securities sold comprised supranational, agency and government-guaranteed securities, asset-backed securities, corporate subordinated debt and auction rate securities. The contribution together with an actuarial gain on plan assets of US$986 million helped achieve a reduction in the net liability of the scheme from US$3,822 million at 31 December 2009 to US$495 million at 30 June 2010.

As disclosed in 'Related party transactions' on page 470 in the Annual Report and Accounts 2009, HSBC Bank (UK) Pension Scheme entered into collateralised swap transactions with HSBC to manage the inflation and interest rate sensitivity of the Scheme's pension obligations. At 30 June 2010, the swaps had a positive fair value of US$1,891 million to the scheme (30 June 2009: US$609 million positive to the scheme; 31 December 2009: US$1,049 million positive to the scheme). All swaps were executed at prevailing market rates and within standard market bid-offer spreads.

The UK corporation tax rate applying to HSBC was 28 per cent (2009: 28 per cent). Overseas tax included Hong Kong profits tax of US$426 million (first half of 2009: US$416 million; second half of 2009: US$367 million). Subsidiaries in Hong Kong provided for Hong Kong profits tax at the rate of 16.5 per cent (2009: 16.5 per cent) on the profits for the period assessable in Hong Kong. Other overseas subsidiaries and overseas branches provided for taxation at the appropriate rates in the countries in which they operate. The following table reconciles the overall tax expense which would apply if all profits had been taxed at the UK corporation tax rate:

1 Interim period income tax expense is accrued using the estimated average annual effective income tax rates, which have been substantially enacted by 30 June 2010, and which will be applicable to expected total annual earnings.

2 In August 2009, the UK Government enacted legislation that gains or losses on transactions designated to hedge foreign exchange exposures connected to rights issues should be disregarded for tax purposes.

3 Low income housing tax credits arise in the US and are designed to encourage the provision of rental housing for low income households.

On 22 June 2010, the UK Government announced its intention to reduce the main rate of corporation tax from 28 per cent to 24 per cent. The fall will be phased in over a period of four years with a 1 per cent reduction in the main corporation tax rate for each year starting on 1 April 2011. The Finance (No. 2) Act 2010 enacted on 27 July 2010 included legislation on the initial phase to reduce the main rate of corporation tax from 28 per cent to 27 per cent from 1 April 2011. The tax rate change was not substantively enacted at 30 June 2010, therefore the change has not been reflected in the amounts recognised as at that date. However, it is not expected that the proposed rate changes will have a significant effect on the net UK deferred tax position recognised at 30 June 2010 of US$301 million.

For the period ended 30 June 2010, HSBC's share of associates' tax on profit was US$356 million (30 June 2009: US$203 million; 31 December 2009: US$287 million), which is included within share of profit in associates and joint ventures in the income statement.

Of the total net deferred tax assets of US$6.2 billion at 30 June 2010 (30 June 2009: US$7.9 billion; 31 December 2009: US$8.6 billion), US$3.5 billion (30 June 2009: US$4.9 billion; 31 December 2009: US$5.1 billion) arose in respect of HSBC's US operations where there has been a recent history of losses. Management's analysis of the recognition of these deferred tax assets significantly discounts the benefit which would arise from future expected profits from the US operations and relies to a greater extent on capital support to the US operations from HSBC, including tax planning strategies implemented in relation to such support. Further to the implementation of this strategy, an internal reorganisation on 31 January 2010 provided substantial support for the recoverability of the US deferred tax assets, and the associated taxable gain arising in the US operations reduced the deferred tax assets by US$1.6 billion. Management's updated analysis is consistent with the assumption that it is probable that there will be sufficient taxable income to support the resulting deferred tax assets that have been recognised in respect of the US operations as at 30 June 2010.

US legislation enacted on 6 November 2009 allowed for an extended carryback period for certain federal tax net operating losses. This had the effect of reducing the net deferred tax assets related to such losses by approximately US$1.6 billion at 31 December 2009, and the equivalent federal tax refund was received in early 2010.

Trading securities valued at fair value

1 Included within the above figures are debt securities issued by banks and other financial institutions of US$35,424 million (30 June 2009: US$41,590 million; 31 December 2009: US$41,466 million), of which US$8,399 million (30 June 2009: US$4,129 million; 31 December 2009: US$7,280 million) are guaranteed by various governments.

2 Includes securities that are supported by an explicit guarantee issued by the US Government.

3 Excludes asset-backed securities included under US Treasury and US Government agencies.

Trading securities listed on a recognised exchange and unlisted

1 Included within listed securities are US$3,384 million (30 June 2009: US$3,552 million; 31 December 2009: US$3,229 million) of investments listed in Hong Kong.

2 Unlisted treasury and other eligible bills primarily comprise treasury bills not listed on a recognised exchange but for which there is a liquid market.

Loans and advances to banks held for trading

Loans and advances to customers held for trading

Securities designated at fair value

1 Included within the above figures are debt securities issued by banks and other financial institutions of US$9,643 million (30 June 2009: US$13,391 million; 31 December 2009: US$13,745 million), of which US$46 million (30 June 2009: US$47 million; 31 December 2009: US$49 million) are guaranteed by various governments.

2 Includes securities that are supported by an explicit guarantee issued by the US Government.

3 Excludes asset-backed securities included under US Treasury and US Government agencies.

Securities listed on a recognised exchange and unlisted

1 Included within listed securities are US$544 million (30 June 2009: US$608 million; 31 December 2009: US$506 million) of investments listed in Hong Kong.

Fair values of derivatives by product contract type