Some investor protection advocates expressed disappointment following the Financial Accounting Standards Board’s (FASB) decision last week not to add a standard-setting project to its technical agenda to consider eliminating held-to-maturity (HTM) classification for debt securities. This accounting approach was highlighted by high-profile bank failures earlier in the year, including Silicon Valley Bank (SVB) in March.
While respecting the board’s decision, Council of Institutional Investors (CII) General Counsel Jeffrey Mahoney said he is “disappointed that the board failed to have any public discussion about the recent empirical evidence by Professor Stephen G. Ryan supporting our proposal to consider eliminating the held-to maturity classification.”
The research showed that banks classify fixed-rate debt investment securities as HTM rather than available for sale (AFS) when HTM classification provides “preferred financial accounting and regulatory capital treatments, not because they have a distinct economically motivated intent and ability to hold the securities to maturity.”
The FASB’s December 20, 2023, decision comes as investor groups, such as the CII and the CFA Institute, urged the accounting board to require companies to account debt securities at fair value on the balance sheet because it provides more useful information to analysts than other accounting methods, including amortized accounting that accompanies HTM classification for debt securities.
They say that amortized cost measurement does not provide information about key risks such as liquidity, interest-rate sensitivity, and asset liability duration mismatches. Amortization might mask the real economics of the underlying financial instruments and the company as a whole.
Not the First Time
This is not a new debate.
In the aftermath of the global financial crisis over a decade ago, there was a debate about whether some financial instruments should be carried at amortized cost or at fair value—AFS.
The FASB had considered but ultimately dropped a 2010 proposal that would have required many financial instruments to be accounted for at fair value.
Investor groups support the fair value option because management intent about what to do with debt securities does not alter the value of a financial instrument, as is allowed under current standard. A mixed measurement model creates inconsistency, making it confusing and difficult to compare between companies. Moreover, the mixed model hides economic mismatches because assets are reported at fair value but liabilities at amortized cost.
Fair value, on the other hand, highlights those mismatches by reporting the changing value of assets and liabilities. The standard-setter retreated from the proposal under political pressure, the CFA Institute noted.
“What that means is that the financial statement carrying value of those financial instruments held -to-maturity is reflected at amortized cost, or what management paid for the asset sometime in the past plus amortization of the discount or premium from the face value. The fair value is only disclosed on the face of the financial statement and in the footnotes. Any unrealized loss is ‘hidden in plain sight,’” wrote CFA Institute’s Sandra Peters in a blog in March. “But management intent and business model do not change the value of financial instruments. The HTM classification only makes it harder for investors and depositors to see.”
In late April, CII had formally asked the FASB to consider eliminating HTM classification and to improve financial instrument disclosures about liquidity risk and interest rate risk, saying it generally supports the CFA Institute’s recommendation.
SVB had most of its assets invested in fixed income securities and chose to classify $91 billion of those assets as HTM and reported them at amortized cost on the balance sheet with a parenthetical disclosure that those assets had a fair value of $76 billion.
The assets classified as HTM had a $15 billion unrealized loss created largely because of the Federal Reserve’s seven interest rate increases last year, and the loss would have wiped out most of SVB’s total equity of $16 billion at 2022 year-end had it been recognized.
The Fed in February and March again raised interest rates. And SVB suffered a massive run on deposits, leaving the bank with insufficient cash reserves. SVB as a result said that it sold about $21 billion or most of all of its AFS securities at a realized loss of $1.8 billion and sought to raise over $2 billion through stock offerings.
The FASB staff had recommended that the board not start a project to eliminate the HTM classification because, among other issues, costs would outweigh benefits. And the information is already in the footnotes.
The board also stated that accounting standards were not the cause of the bank failures, which CII agrees. But the investor group said that the failure raised “legitimate questions” about classifying HTM under Topic 320, Investments–Debt Securities, and the lack of required footnote disclosures about the liquidity risk and interest rate risk of financial instruments under Topic 825, Financial Instruments.
“I am also disappointed the board failed to publicly discuss our proposal, derived from prior recommendations of [former FASB members] Thomas Linsmeier and Marc Siegel, to consider requiring improvements to the footnote disclosures about the liquidity and interest rate risk of financial instruments,” CII’s Mahoney said. “I, however, remain optimistic that a future board will address and resolve the long-standing deficiencies in the financial accounting and reporting of financial instruments.”
On December 20, FASB members said further research is needed for issues related to interest rate and liquidity risks.
Jack Ciesielski, president & portfolio manager of R.G. Associates, Inc. agreed that the FASB’s decision on HTM accounting is “very disappointing.”
“The board skips an opportunity to greatly simplify accounting standards and make financial statements more robust,” said Ciesielski, who also serves as a member of the FASB’s Emerging Issues Task Force and the PCAOB’s Investor Advisory Group.
“By hanging on to HTM accounting, they support a disclosure regime that makes auditors have to assess whether or not an issuer has the ability and wherewithal to actually hold securities to their ultimate maturity – something that some auditors either seem to have forgotten to do last year or made that assessment carelessly,” he said. “Yet in arguing against adding the project, one board member cited ‘higher costs and complexities for banks.’ That seems to be a misplaced priority – as well as doublespeak.”
Ciesielski’s views are backed by research he has conducted following bank failures, showing that HTM values for debt securities can be very different when compared to market realities.
He looked at what higher interest rates would have done to bank capital if loans and HTM securities were reported at fair value. For example, he looked at 349 banks’ reporting of second quarter of 2023.
The gross carrying value of the loans and HTM securities was $478.3 billion higher than what they would have gotten if they needed to be sold. “In other words, there is $478.3 billion of imaginary assets on the collective balance sheets,” he wrote in his research.
Not Everyone Thinks HTM Accounting is Bad
In the meantime, the FASB’s decision is likely to have support by some accounting experts who believe HTM should not be eliminated.
Denny Beresford, who served as chairman of the FASB from 1987 to 1997, said that the original accounting for marketable securities standard was issued in 1993 in SFAS 115, Accounting for Certain Investments in Debt and Equity Securities.
“I can certainly see excellent arguments both pro and con for the current accounting standards as well as the changes suggested by Peters,” Beresford said in the spring. “But I don’t think long-standing accounting should be changed as a result of one bank failure that could have easily been foreseen had investors, regulators and others read the financial statements with some reasonable care. As Peters’s post said, the matter was ‘hidden in plain sight.’”
This article originally appeared in the December 26, 2023, edition of Accounting & Compliance Alert, available on Checkpoint.
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