Banks Face Tough Accounting Questions as Second Quarter Dawns
April 6, 2023
The collapse of three banks and the urgent rescue of another hangs over US lenders and their auditors as they close the books on a tumultuous first quarter.
Questions loom about unrealized losses on long-term assets, the risks of spiking interest rates, and having too many customers in one industry—problems that contributed to the collapse of Silicon Valley Bank and Signature Bank and a banker bailout of First Republic Bank. Silvergate Financial Corp., which catered largely to crypto companies, faced an exodus of depositors after the failure of crypto exchange FTX and voluntarily shuttered in March.
Expect banks—and their auditors—to try to get ahead of these questions by cramming new details into their upcoming first-quarter 10-Qs about what exactly the risks are and how they plan to deal with them.
“There’s a big effort afoot to try to assuage fears,” said Graham Dyer, partner at Grant Thornton LLP.
Banks are expected to err on the side of more, not fewer, details about risks related to interest rates as well as customer concentration and how much they can rely on steady core deposits. First-quarter reports typically come out around May, but financial statement preparers start working on them now.
“What I really want to know is, what caused the deposit withdrawal in the first place, and are banks managing that risk?” said Ariste Reno, managing director for the risk and compliance practice at Protiviti Inc. “As an accountant or audit firm or regulator I’d want to see that analysis.”
The details most likely will be disclosed in the section of the financial statement dedicated to management’s discussion and analysis, which isn’t audited but gets reviewed by auditors. Given all the volatility in the banking sector, there will be meaningful “tire kicking” from auditors this quarter, Grant Thornton’s Dyer said.
US accounting rulemakers more than a decade ago attempted to beef up the mandatory details banks have to include in their footnotes about their risks to liquidity and exposure to interest rate risk. A Financial Accounting Standards Board proposal, released in 2012, would have required banks to draw up a table presenting the effects on net income and shareholders’ equity of hypothetical, instantaneous shifts in interest rates. It also would have required narrative and numerical details about how banks managed changes during the reporting period.
Banks and trade groups panned the proposal, saying it called for forward-looking information that the lenders couldn’t reasonably provide. They also argued that the US Securities and Exchange Commission already requires significant risk disclosures for banks. FASB retreated from the plan.
The accounting standard-setters—and banks themselves—focused on transparency around credit quality instead of fluctuating interest rates. That was in part because rates were steadily low for years, said Stephen Masterson, managing partner and co-leader of risk advisory services at CFGI.
“They never thought interest rates would go up this fast or get this high again,” Masterson said. “A lot of people got caught flat-footed, including the regulatory agencies in monitoring.”
In addition to interest rate risk, auditors are expected to question banks about how they label the assets on their books. Under US accounting rules, banks categorize their assets as either “available for sale,” which means they could be bought or sold at any time, or “held to maturity,” which means they’re hanging onto them for the long term. The label determines how banks recognize and measure the assets. Changes in the value of available for sale assets must be measured at fair value, with ups and downs reported in equity. Long-term assets get measured at amortized cost, but banks disclose the fair value, including unrealized losses, in their footnotes.
“Every external auditor, every Big Four auditor is going to quadruple down on looking at unrealized losses sitting in the held-to-maturity portfolio and available for sale,” Masterson said.
Questions will include whether assets a bank labels held-to-maturity asset can truly be held onto long term. Auditors will ask if banks have liquidity pressures, whether they’ll have to sell them, he said.
“That’s really where they’re going to have to really bite down hard,” he said.