In a recent Wall Street Journal article titled “Auditors Didn’t Flag Risks Building Up in Banks,” questions have arisen about whether KPMG failed in its duty by not highlighting the risk of held-to-maturity (HTM) bonds on Silicon Valley Bank’s balance sheet as a critical audit matter (CAM).
Let’s explore the concept of CAMs, the risks involved with HTM securities, and what the failure of auditors to issue CAMs for banks means for the accounting profession.
What Are Critical Audit Matters?
Auditors are expected to issue a critical audit matter (CAM) in their auditor’s report when they have identified a matter that is both material and involves an “especially challenging, subjective, or complex” judgment by the auditor.
Introduced in 2017 by the Public Company Accounting Oversight Board (PCAOB), the goal is to improve the transparency of the audit process and increase confidence in the reliability and usefulness of the audit report to investors.
The Hidden Risk in HTM Bonds
Held-to-Maturity (HTM) securities represent debt securities that a company plans to retain until their maturity date. These securities are reported at their original cost, not the current market value, which can hide potential losses if the market value falls below the original cost. This, combined with flighty deposits, could threaten a bank’s stability.
Why Silicon Valley Bank Failed
Bad Management
In SVB’s case, the bank had unwisely invested significant deposits in United States Treasury Bonds without hedging against the risk of rising interest rates.
When interest rates go up, bond prices go down.
So when the Federal Reserve raised rates rapidly over 2022, the value of SVBs bond portfolio plummeted by billions of dollars. In fact, the bank’s losses of $15 billion at the end of 2022 would have wiped out almost all of its $16 billion in equity — had the bank not classified the bonds as HTM.
Concentrated Risk
SVB also experienced a significant concentration of depositors within the technology sector. As the Federal Reserve increased interest rates, the tech industry faced a downturn, resulting in a concurrent decline in deposits.
In early 2023, when the bank had to sell a portion of its HTM bonds to cover withdrawals, it incurred a sudden and unexpected loss of $1.8 billion. This spooked investors and depositors, triggering a bank run and resulting in the bank’s swift collapse.
Should KPMG Have Flagged the HTM Bond Risk as a CAM?
According to WSJ, Martin Baumann, former PCAOB chief auditor, believes that KPMG should have flagged the HTM bond risk as a CAM, as SVB’s unrealized losses “meet every definition of a possible critical audit matter.”
However, defenders of the audit industry argue that auditors cannot anticipate “extremely remote” scenarios like the one that brought down SVB.
A Wider Problem in the Banking Industry
WSJ examined the audit opinions of nine other US banks exposed to bond losses. Their auditors also did not flag bond-related issues as CAMs, focusing instead on loan losses, which brought down banks in the 2008 crisis.
So Where Does That Leave Auditors?
The SVB collapse is causing many to question the effectiveness of the CAM concept and the role auditors play in identifying potential risks. Changes to the way banks are audited may be on the horizon. And KPMG might find itself in court if shareholders decide to include the firm in lawsuits.
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