Herbert M. Chain
Deputy Technical Director
Herbert Chain is a highly experienced author is a financial expert with 40 years of experience in business, accounting, and audit, having served as a Senior Audit Partner at Deloitte. He holds certifications from the National Association of Corporate Directors and the Private Directors Association, with knowledge of private company governance and effective risk management. He has extensive knowledge in the financial services sector, including asset management and insurance, and experience with SPACs.
Accounting in the US: Examining bank failures
March 23, 2023
Herbert Chain, the technical director at Kreston Global Audit Group and a director at CBIZ, talks about “hold-to-maturity” accounting in the US context following recent bank failures. With the collapse of Silicon Valley Bank and Signature Bank, much discussion has been on the accounting treatment of debt securities held until maturity. This article delves into the accounting principles from a US standpoint, examines the consequences of this approach, particularly for banks in a period of increasing interest rates, and explores the considerations for external auditors in assessing going concerned and auditing debt securities held until maturity. It also briefly touches on the failures of the two banks concerning the timing of the audit reports.
FASB’s accounting methods for debt securities
The US Financial Accounting Standards Board (FASB) has established accounting standards codification (ASC) sections related to “hold-to-maturity” (HTM) accounting for debt securities. These include ASC 320-10-25, which pertains to the recognition and measurement of debt and equity securities; ASC 320-10-35, which covers the subsequent size of debt securities; and ASC 320-10-65, which relates to the impairment of other debt securities. The FASB has three accounting methods for debt securities: HTM, available-for-sale (AFS), and trading.
The key differences between these methods are that HTM securities are held until maturity, AFS securities may be sold before maturity but are not part of regular trading activities, and trading securities are intended for short-term sale to profit from price fluctuations. In HTM accounting, securities are recorded at cost and recognised based on interest income, while changes in fair value are not reflected in the financial statements. In AFS accounting, securities are initially recorded at fair value, and changes in fair value are recognised in other comprehensive income. In trading accounting, securities are also initially recorded at fair value, and changes in fair value are identified in the income statement.
Asset-liability management and disclosing gains and losses
Banks heavily rely on managing asset-liability risks, mainly because they hold a considerable amount of debt securities and depend on short-term deposits to fund their day-to-day operations. To avoid facing liquidity risk, banks must ensure that their investments’ maturities align with their liabilities’ maturities. If banks mismanage these risks, they may have to liquidate their HTM securities to meet depositors’ demands, resulting in significant losses.
With the recent increase in interest rates, the market values of debt securities decreased accordingly, resulting in unrealised losses for HTM securities. These losses were not initially recorded in the bank’s equity or income but were disclosed in the notes to the financial statements according to GAAP. However, when the banks had to sell HTM debt securities to fund depositor withdrawals, the previously undisclosed losses were recognised in income. Therefore, it’s essential to note that a savvy financial statement user would have considered the disclosed unrealised gains and losses to assess the bank’s financial condition.
The two banks that failed shortly after receiving audit reports from a Big Four firm have sparked discussions on the role of external auditors in assessing a company’s ability to continue as a going concern.
The role of external auditors
Management must evaluate any conditions or events that raise doubts about the company’s ability to continue as a going concern. At the same time, external auditors must judge whether there are any such conditions or events that raise substantial doubts about the company’s ability to continue as a going concern for a reasonable period. The banks’ failure occurred after the financial statements, and related audit reports were issued, but it is unknown if there were any indications or conditions at the report issuance date that the external auditors needed to recognise. As for the audit of HTM securities, external auditors should ensure that a company’s accounting treatment of these securities aligns with accounting standards and that they are valued and disclosed appropriately.
Auditing HTM securities
To audit HTM securities, the external auditor should evaluate management’s ability and intent to hold the securities to maturity. Reviewing the company’s investment policy, liquidity position, cash flow projections, and external factors affecting its ability to control the stakes can achieve this. However, since it’s challenging to audit management’s intent, external auditors often include an item in the management representation letter related to their intent to hold the securities to maturity. The auditor can also examine the company’s history of holding HTM securities to maturity to evaluate management’s decision-making and internal controls. Apart from assessing management’s intent, the external auditor should also ensure that the securities are valued appropriately, which involves obtaining market data, reviewing the company’s valuation methods, and evaluating the amortisation of premiums or discounts. Finally, the auditor should consider any impairment losses recognised, or that should be recognised on HTM securities as well.
In auditing HTM securities, the external auditor should also review the company’s disclosures regarding investments and unrealised gains or losses, assess whether they comply with accounting standards, determine if any impairment should be recognised and recorded, and ensure that the financial statements provide sufficient information for users to understand the nature and extent of the investments and their impact on the financial statements.
The collapses of Silicon Valley Bank and Signature Bank had serious repercussions for the stability of the worldwide banking system, necessitating prompt action from banking regulators. The ensuing concerns were linked to how banks manage the balance between their assets and liabilities, the accounting methods applied to held-to-maturity debt securities, and, in the end, the part played by external auditors in such situations.
This article by Herbert Chain was featured in International Accounting Bulletin. If you want to talk to our US market experts get in touch here.