Kreston Global Audit Group technical director & CBIZ Marks Paneth director, Herbert Chain, discusses “hold-to-maturity” accounting from the US perspective in light of recent bank failures.
Much has been written recently since the demise of Silicon Valley Bank and Signature Bank on “hold-to-maturity” accounting for debt securities owned. This article will discuss the accounting from a U. S. perspective, address the implications of such accounting, especially for banks in a period of rising interest rates, and external auditor considerations of going concern and auditing old-to-maturity debt securities. It will also briefly discuss the failures of the two banks in light of the timing of the issued audit reports.
What is the relevant US GAAP?
Under accounting principles generally accepted in the United States of America (GAAP), the US Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) contains sections that relate to HTM accounting for debt security positions. These include:
· ASC 320-10-25: Recognition and Measurement—Debt and Equity Securities
· ASC 320-10-35: Subsequent Measurement—Debt Securities
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By GlobalData· ASC 320-10-65: Impairment—Other Debt Securities
What are the differences Between HTM, Available-for-Sale, and Trading Accounting?
The FASB has three accounting methods for accounting for debt securities: HTM, available-for-sale (AFS), and trading. The main differences between these methods are:
· HTM securities are debt securities that the company intends and has the ability to hold until maturity.
· AFS securities are debt securities that are not intended to be held until maturity and are not classified as trading securities.
· Trading securities are debt securities that are bought and held primarily for the purpose of selling them in the near term.
According to the Financial Accounting Standards Board (FASB) Codification, HTM securities are “securities that the entity has the positive intent and ability to hold to maturity.” (ASC 320-10-15-4). When a company uses HTM accounting, the securities are initially recorded at cost, and any premiums or discounts are amortized over the life of the security. The company recognizes interest income based on the effective interest rate of the security, and any impairment losses are recognized in the income statement. The fair value of the security is not considered in HTM accounting, and changes in the fair value are not reflected in the income statement or balance sheet, unless the security is deemed to be impaired.
The AFS method is used for debt securities that a company may sell before maturity but not as part of its regular trading activities. These securities are initially recorded at fair value, and any changes in the fair
value are recognized in other comprehensive income. The trading method is used for debt securities that a company intends to sell in the near term, with the intention of profiting from short-term price fluctuations. These securities are initially recorded at fair value, and changes in the fair value are recognized in the income statement.
How did risk management policies and governance and HTM accounting affect the banks?
As recently experienced, banks are particularly reliant on asset-liability risk management, as they hold a significant amount of debt securities and often rely on short-term deposits to fund their operations. Banks must ensure that the maturities of their investments are aligned with the maturities of their liabilities to manage liquidity risk. Mismanagement of these risks can lead to significant losses being recognized if HTM securities are required to be liquidated to meet depositor withdrawal demands or other liquidity issues. The problem was exacerbated by the increase in interest rates as central banking authorities reacted to fears of inflation.
As rates increased, the market values of the debt securities decreased accordingly. For the HTM securities, the unrealized losses were not recorded in equity or in income, but were, rather, reflected in the notes to the financial statements in accordance with GAAP. Thus, when the banks were required to sell the HTM debt securities to fund depositor withdrawals, the unrealized (and previously only disclosed) losses were recognized in income. (It should be noted that a sophisticated user of the financial statements should have considered the disclosed unrealized gains and losses in assessing the banks financial condition.)
Assets did not match liabilities … HTM securities had to be sold … losses were recognized … and the banks failed – What is the role of the external auditor?
Assessment of going concern: There has been much discussion as to why the failures of the two banks occurred just weeks after the issuance of the audit reports by the two banks’ external auditor (a Big 4 firm). The role of the external auditor thus needs to be considered.
In preparing financial statements, management is required to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the company’s ability to continue as a going concern for one year after the date that the financial statements are available to be issued. The external auditor in turn is required to conclude whether, in its judgment, there are conditions or events, considered in the aggregate, that raise substantial doubt about the company’s ability to continue as a going concern for a reasonable period of time.
The liquidity difficulties and subsequent failure of by these banks appear to have occurred after the financial statements and related audit reports were issued. Unless there were indications and conditions existing at the report issuance date that were not recognized by the external auditors (that as outsiders we do not know), it appears that that the audit reports were appropriate under the circumstances. (Of course, more information will no doubt come out during the course of the multiple investigations by regulators and civil lawsuits that will be commenced.)
Audit of HTM securities: An external audit of a company’s financial statements should include an audit of the company’s HTM securities to ensure that the accounting treatment is in compliance with accounting standards and that the securities are appropriately valued and disclosed.
From the external auditor’s perspective, the audit of HTM securities should include an assessment of management’s intent and ability to hold the securities to maturity. The external auditor should review the
company’s investment policy, evaluate the company’s liquidity position and cash flow projections, and consider any external factors that may impact the company’s ability to hold the securities to maturity.
Because it is difficult if not impossible to audit management’s intent to hold the debt securities to maturity, external auditors often add an item to the required management representation letter relating to management’s intent (and ability) to hold such securities to maturity. The external auditor can also look to the company’s history of holding HTM securities to maturity; if there is a history of selling such positions, it may reflect on management’s decision-making criteria and/or internal controls, its integrity, or, simply, changed circumstances. In any case, sales of HTM securities in the past may suggest that the external auditor look even more closely at management decisions made in connection with the financial statements being audited.
In addition to assessing management’s intent and ability to hold the securities to maturity (and thus the appropriateness of the classification), the external auditor should also perform procedures to ensure that the securities are appropriately valued. This may include obtaining market data to assess the fair value of the securities, reviewing the company’s valuation methods, and evaluating the reasonableness of the amortization of any premiums or discounts. The auditor should also consider the implications of any impairment losses recognized or that should be recognized on HTM securities.
In auditing HTM securities, the external auditor should also consider the company’s disclosures regarding its investments and any unrealized gains or losses. The auditor should assess whether the disclosures comply with accounting standards, whether an impairment should be recognized and recorded, and whether the financial statements provide sufficient information for users of the financial statements to understand the nature and extent of the company’s investments and their impact on the financial statements.
So… where are we?
The failures of Silicon Valley Bank and Signature Bank had significant implications for the stability of the global banking ecosystem, requiring immediate responses by banking regulators. The spillover questions that resulted from these events relate to risk management of the asset-liability mix for banks, the accounting treatment afforded to held-to-maturity debt securities owned, and ultimately, the role of the external auditor in these circumstances.
