By now almost everyone knows that Silicon Valley Bank (SVB), which largely lent to tech companies, failed almost overnight on March 10, 2023, when everyone wanted to pull out their deposits. This was the largest bank failure since the 2008 financial crisis. Then on March 12, regulators had to shut down Signature Bank to prevent a crisis in the broader financial system.
What is less known and discussed is whether the financial statement disclosures required of these companies are adequate. For example, KPMG LLP, the independent auditor of both banks, gave a clean audit opinion about these banks’ financial condition only a few weeks ago in February.
“I suspect that may cause some people to question the value of an audit, but I believe the audit is incredibly valuable to investors” said Public Company Accounting Oversight Board’s (PCAOB) former chief auditor Marty Baumann, who is now an adjunct professor with The Washington Campus. He was previously chief financial officer of Freddie Mac and a partner and a global banking leader at PricewaterhouseCoopers LLP.
“But I do question whether accounting disclosures of asset and liability duration mismatch is adequate,” he added.
Going Concern Not Calibrated Correctly?
Baumann also raised questions about the standards related to going concern—or a company’s ability to stay afloat when obligations are due.
In the 2008 financial crisis, several large financial companies collapsed, two of the nation’s Big Three car makers had to be rescued by the federal government, and the pain was felt throughout the economy. The failures happened with little to no advance warning from the companies involved. Since then, regulators have sought to change the accounting and auditing standards and reporting rules to produce a better warning system.
Fifteen years ago, there was already an auditing standard in place but not an accounting standard.
During the savings and loan crisis in the 1980s, then-Congressman Ron Wyden—he is a senator now—said that accounting firms were not to blame, but they could have blown the whistle earlier.
“So, out of that came the going concern standard whereby auditors then had to evaluate as of the opinion date, was there substantial doubt about the ability of a company to continue as a going concern,” Baumann explained. “And that was supposed to say ‘step back, evaluate liquidity, evaluate the business model, evaluate all kinds of things. Is there a substantial doubt about their ability [to stay afloat.] When a company goes out of business 14 days after an opinion? Well, that’s going to call into question.”
Section 10A of the Securities Exchange Act of 1934 and PCAOB Auditing Standard 2415, Consideration of an Entity’s Ability to Continue as a Going Concern, require auditors to assess a public company’s prospects for staying in business. The evaluations are based on whether there is “substantial doubt” about a company’s ability to continue business operations. If there is, the auditor needs to report it in the auditor’s opinion that is part of a public company’s regulatory filing.
While the PCAOB has been debating how to change the going concern standards since the 2008 financial crisis, the Financial Accounting Standards Board (FASB) came up with its own going concern standard in 2014, which some say were inadequate. The U.S. GAAP requires management to alert investors if they have “substantial doubt” about the company’s survival. The FASB defines substantial doubt using a threshold of “probable” that a company will not be able to pay debts as they come due during the next 12 months.
The difference between the audit standard and the FASB’s guidance prompted the PCAOB to release Staff Audit Practice Alert No. 13, Matters Related to the Auditor’s Consideration of a Company’s Ability to Continue as a Going Concern, to emphasize that the current audit standard remains in effect.
The auditor’s evaluation continues to be qualitative and does not necessarily have to rise to the level of the “probable” threshold that the FASB set. The accounting standard-setter “liberalized” the threshold with that decision, Baumann said.
Because management and auditors have different going concern thresholds, the PCAOB staff has been examining financial statements filed with the SEC to look at both the management’s disclosures and the auditor’s going concern opinions. For 2016 financials, for example, the staff found that in 13 percent of cases, auditors reported substantial doubt while management did not make the disclosures.
“So, there’s still this incredible inconsistency. The auditing standard and the accounting standard are not at the same level,” Baumann said.
Inadequacy of Disclosures about Liquidity Risks
Another problem about the bank run has to do with inadequate disclosure requirements related to liquidity risks, Baumann explained.
Companies must disclose high level of credit risk if there could be a problem. But the disclosure requirement is not the same for risk disclosure for deposits. SVB had a concentration of deposit risk, deposits from many high-tech companies.
“So, if for some reason, these high-tech companies, venture capital companies were worried about their cash sitting in SVB, and they took the cash out, it’s one industry that would be taking it out quickly. I think there could be an accounting question here,” he said, “whether the SEC and FASB have adequately assessed the need to discuss liquidity risk in the financial statements that you can lose all your depositors at one time because they have similar characteristics.”
The Securities and Exchange Commission, as the capital markets regulator, oversees both the PCAOB and the FASB.
“While the SEC might say ‘well we have all kinds of risk disclosure requirements.’ But they are not in the financial statements,” Baumann said.
Some may argue that things happened so fast. But Baumann questioned that argument.
“Then I go back to: are there inadequate accounting disclosure requirements in the financial statements about the mismatch, the duration risks between assets and liabilities? So that when people read the financial statements, they will understand the risk of the duration spread on a bank’s financial condition – especially coupled with a high concentration of similar large depositors,” he explained.
Focus on Traditional Financials
In addition, Baumann had some criticisms that the SEC may be too focused on non-traditional disclosures, such as environmental, social and governance (ESG) matters.
“The SEC is very interested in new climate disclosures, but fundamental things like risks in the financial statements of a bank, and understanding those financial statements, maybe some of the fundamentals, and blocking and tackling, some of those things may have been ignored,” he said. “I’m not opposed to ESG; I’m just saying maybe there is excessive focus on climate related disclosures versus issues like bank liquidity and asset liability duration risk. ESG isn’t going to take down our country, but inadequate disclosure of banking liquidity risks may.”
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