 Hello everyone and welcome to this session in which I will discuss again Silicon Valley Bank, not from an accounting perspective, which I already did, it's going to be from an auditing perspective. This video is based on an article, a news article that was in the Wall Street Journal April 10, 2023. And it's titled auditors did not flag risks building up in banks bond losses such as those at Silicon Valley Bank could have been raised as critical audit matters. So now the main question is this, were the bank bond losses on Silicon Valley and other banks should be raised as critical audit matters. Now the first thing we need to know is what is critical audit matters, because if you don't know what that is, then we cannot answer these questions. Well, here's how regulators define it. They define it as matters, things that have significant impact on the financial statement and involve challenging, subjective or complex judgment by the auditor. Simply put, the auditor will have to decide whether a matter, an issue is critical audit matter. If it is a critical audit matter, if it is determined as a critical audit matter, then this critical audit matter should be in the audit report. In the audit report itself as part of the report and under a critical audit matter. Why? Because you want to highlight this issue. You want to bring attention to it. Now the question becomes, are we going to do so? In your opinion, what happened? Is it critical audit matter or not? Because we're going to see there are two sides of this story. So I'm going to show you both. But how we determine whether an issue is a critical audit matter? Well, this is, I do cover this on my channel. And basically, how do we know if we have a possible critical audit matter? The first question we have to ask ourselves is, was the matter communicated or required to be communicated to the audit committee? If the answer is no, then we don't have critical audit matter. So we have to determine now the factors that led to the Silicon Valley collapse. Was any of it, was it communicated to the audit committee or was required? Now there are certain things that are required, which is we don't cover here. This is not an audit lecture. But the point is, was it or was not required to be audited or should have been audited, communicated to the audit committee? If the answer is yes, we go to the next question. Is the matter related to account or disclosure that is material to the financial statement? So whatever we are discussing with the audit committee, if we happen to discuss with it, is this account material to the financial statement? I believe the account that led to the collapse of SVB is material. Matter of fact, any account that lead to the collapse of a company after the fact is material, of course. Then if the answer is yes, well if the answer is no, we have no can. If the answer is yes, matter involves specially challenging, subjective or complex audit judgment. Did the matter involve challenging, subjective or complex audit judgment? If the answer is yes, again, if we have yes for all those three questions, we have a critical audit matter. So there's no definition other than was the matter communicated to the audit committee or required to be communicated? Is the amount, the account and the disclosure material and does it involve challenging, subjective and complex judgment? Now in my opinion, again you can use your own judgment. I believe the account involved was material. Was it required to be communicated? I don't believe the issue was required. Again, we'll see what the issue is. Was the matter communicated? I'm not sure. Was the matter communicated anyhow? That we don't know unless we look at the work papers. And the third one, was the matter involving challenging, subjective or complex audit issue? I don't believe so. I don't believe this question is yes. Because the issue you're going to see, it has nothing to do with the complexity of the audit. But again, you can look at this the way you would like to look at it. I mean the way you understand the concept. Before we proceed any further, I have a public announcement about my company farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions as well as exercises. Go ahead. Start your free trial today. No obligation, no credit card required. So what led to the Silicon Valley collapse? Three factors. Liquidity crisis. They did not have enough money. Obviously this is how any company with collapse, especially banks, interest rate risks. What's interest rate risk? The interest rate went up. As a result, the bond holding at Silicon Valley Bank went down. The bond holdings went down. They have losses. What happened is no one reported those losses because those losses were on these bonds that were held to maturity. They were hidden under the category held to maturity, which we talked about in the prior session. We will discuss again. So nobody reported them or highlighted those losses. When those losses occur, we did not have to report them. But when we faced the liquidity crisis, we had to sell them and the losses were realized. And as a result, as they were realized, they let the collapse of Silicon Valley Bank simply put the losses were large enough not to be able to meet the liquidity crisis. In a nutshell, this is what happened at Silicon Valley Bank. You can view the prior recording basically, you know, Silicon Valley Bank collapsed from an accounting perspective to understand this little bit more from an accounting perspective. Now here are some factors. These are right from the article from the Wall Street Journal. The parent company had 91 billion and held to maturity bonds as of December 31st balance sheet here and which a footnote said it has a fair value of 76. So the first thing I can tell you is this. We reported the losses. The losses we did not report them on the financial statement, but they were reported in a sense they were not hitting the 15 billion of losses. They were clearly if you look at the financial statements you would see in the footnotes that our held to maturity bonds, this investment we paid for it, 91 billion, it's worth 76. So you can see that the losses are there. Now they were not booked. They were not accrued. They were not recorded. Why? Because they were held to maturity, held to maturity. Now we're going to talk a little bit more about held to maturity. So this 15 billion dollar of losses was big enough to wipe out the bank's total equity at that point, which happens to be 16 billion. Now accounting rules, this is from the article itself. Accounting rules says that we can classify bonds at held to maturity only if the company have both the intent and the ability to hold them. If you do so, then you can classify those investments as held to maturity. Now the intent is easy. Well, Silicon Valley Bank had them as held to maturity means they had the intent to hold them. Now the question is about their ability. Did they know they did not need them? Did they know whether they needed them or not? They're going to need them in the near future. That is the main question and we really cannot answer this question unless we know what happened between the auditor management and the audit committee. Was that issue raised? If that issue was raised, then yes indeed, the auditor did made a mistake not raising, not bringing this issue as critical audit matter. Rather than having to sell them to meet demand for withdrawals. So if the auditor knew or if the auditor guessed that yes, those they cannot hold them for held to maturity. Well, under what circumstances? KPMG would have to predict there will be a bank run. People would run and they want their money under those circumstances. Well, SVB cannot hold those bonds as held to maturity. But was this was that issue raised? That's the question. And I believe this is a question for the regulators, for the bank regulators, the top friend, Frank, not not the auditors, not KPMG. Also this article mentioned that the lender's total deposit had shrank from the previous year. What's more, its reported cash was only 8% of total deposit, heightening the risk. It would need to sell those long term asset if significant numbers of its depositors left. Now, the question is, how do we know whether significant numbers would leave or not? We don't know this, but guess what? In the annual report, I'm going to show you in a moment, the annual report clearly spelled out that risk. The annual report says if a significant number of depositors leave us, basically we're going to be in trouble. Now, matter of fact, no bank doesn't matter how small or big can survive a bank run. But the question is, should the auditor make those assumptions? If they make those assumptions, well, they have to question the company. If they question the company, if they communicated this matter with the audit committee, then it becomes a camp. But the assumption here is, do we have to do this assumption going forward? Basically, for any bank, should we assume if we have a bank run, can the bank survive? And if so, it becomes a critical audit matter. And what if, let's do what if, what if KPMG mentioned this issue as a camp and as a result, it triggered the bank run? Well, how about this? Would the investors now sue KPMG because KPMG triggered this bank run? So how do you approach this? Again, there's no easy answer, but we're going to see later what's going to happen. I'm pretty sure this issue is going to be discussed again and again to determine what's included in those camps. So notice here, this is page 32 under annual report, and they say we have experienced significant balance sheet growth, which is deposit in 2020 through the first half of 2022. And they explain why they get those deposits. They look from client across all segment, obtaining liquidity through liquidity events, IPOs, secondary offerings, SPACs, fundraising, venture capital investments, so on and so forth. So they were aware they had a lot of money that they needed to invest, and they did invest it in HTM. And this is what I explained in the accounting part of SVB. The bank collapsed because they did not have enough cash. They invested everything under health to maturity bonds. Notice, although clients have historically retained significant portion of their funds on their balance sheet, clients began to move more funds of the balance sheet in the second half of 2022. So the Wall Street Journal article is saying, well, if significant numbers of depositors left. Yes, the company told you if that happens, we could have a crisis. They told you this. And they also mentioned under liquidity. They're aware what a liquidity is. They told you as a user, the objective of liquidity management is to ensure that funds are available in a timely manner to meet our financial obligation, including the availability of funds for both anticipated and unanticipated funding uses as necessary, paying creditors, depositors, need accommodating loan demand growth, funding investment, so on and so forth. And here it says, we regularly assess the amount and likelihood of projected funding requirement through the range of business unusual and potential stress scenario based on review factors such as historical deposit volatility and funding pattern. Could have they predicted what happened? I'm not really sure. Again, this is all from the annual report. And I'm showing you the page. You can download their annual report again. The company should should hedge their interest rate risk. Indeed, they did hatch their interest rate risk, but they hatched their interest rates risk only for available for sale securities. Remember, we have available for sale securities and we have held to maturity securities. Well, they have a portfolio of bonds of available for sale. And indeed, they were hedging those securities for HTM. Do you really need to hedge them if you're not reporting them at fair value? There was no mention of held to maturity. They did not hedge them because they were not thinking they will need to sell them. So the point is, if the bank did not think about this, now, again, I'm not saying they did not think about it. I mean, again, management, they were mismanaging the bank. They did not really, they did not properly invest their money. Why would they put everything in HTM? Were they trying to hide their losses? You know, many of their executive sell their stocks beforehand. But the question is, was that issue raised between the auditor and management? If the issue was raised, I should it's definitely should be a camp. If the issue was not raised because nobody thought about it, then I don't believe it's a camp. Also, when we talk about interest rate risk management, yes, the annual report will tell you that, you know, they define what interest rate interest rate risk interest rate risk is, and they will tell you what needs to be done to manage this interest rate risk, which what happened? Interest rate risk, interest rate went up, bond, their bond portfolio went down, their bond HTM, which is not a big deal unless you have to look with it, which they had to. Now, let's look at some argument for and against camp starting with Mark Bowman, who's a former chief auditor at the PCAOB, who had a leading role in designing the new measure. And the reason it's cam is a new measure because it's fairly a new concept in the auditing report. So what he's saying, Silicon Valley banks unrealized losses and its bond portfolio, which is the HTM bonds, appear to meet every definition of a possible critical audit matter. He's saying it's definitely a critical audit matter because it meet every definition of it. Well, my question is, if SVB did not collapse, would Martin says the same thing? Was that issue raised during the audit? I believe that's the question we need to answer. Was the issue raised during the audit? If the answer is yes, then it is critical audit matter. If the issue was not raised by the auditor, did it not question it? The question is why not? We cannot ask them why not now because back then, you could not predict a bank run. Now also, we have the other point of view from Dennis McGowan, representative of the accounting industry, pushed back on suggestion that auditor should have sounded the alarm ahead of the crisis. This individual is the VP of professional practice at the Center for Audit Quality said accounting standards don't require companies to anticipate extremely remote. Now this was an extremely remote event happening and deciding whether they can classify those bonds as health to maturity. Well, again, because again, what is health to maturity? Intent and ability. Well, when they had the intent, they assumed they had the ability. Well, what happened is that was in the case because there was a bank run. The bank run was fueled by social media. Social media fueled the withdrawal from one bank. For example, auditor don't have a crystal ball to anticipate this kind of thing. Yes, if you're the auditor and I'm going to tell you, look, assume you had a bank run, can the bank survive? Well, that's a different story, but you don't have a crystal ball or you cannot anticipate extremely remote event. And based on that, you would put the you would write a camp. But again, if the issue was raised, that's the key point. And this is what we have to do. This is what it's going to, you know, investigation will eventually tell us if the issue was raised. And yes, KPMG that dropped the ball. If the issue was not raised, not at all. Now with the Wall Street Journal, look at other 10 banks. Okay. Auditors appear blind spot on the interplay of interest rate and liquidity risks isn't confined to Silicon Valley. Auditor for nine other US banks, most exposed to bond losses also did not flag this as an issue as they sign off of the financial statement for 2022. What the Wall Street Journal is saying, banks of similar profile to Silicon Valley, the auditor did not raise this issue as a camp because it's not a camp unless you assume something happening, which is a bank run. If you assume it's a bank run, everything becomes a camp matter of fact. Okay. The Journal reviewed the audit opinion for 10 small to mid-sized US banks that last year reported the highest losses on health to maturity securities as a proportion of their shareholder equity. Based on the data from this company, Silicon Valley ranked second on this list. None of the auditor included a critical audit matter related to the bank treatment of the bonds. Again, why not? Because the issue was not raised because the first thing in a chem is was the issue raised. Was it discussed? Instead, nine of the 10 reported the critical audit matter for estimate the losses for loans and other bad debt. Yes, because that's the risk that brought down banks in the 2008 financial crisis. Indeed, they were looking for red flags, but health to maturity losses were not a reason. Auditor did not report any critical audit matter for one of the banks the analysis found. Well, here we go. Do we have to have no rules for banks? Well, health to maturity, we have to assume that if you have a health to maturity, you could have a possible camp. Well, and if that's the case, is this going to trigger a bank run? Well, the opposite is if you're going to report this as a camp for every single audit that it loses its value as a camp. So if every bank says, well, since you have HTM securities and those HTM, they might have some losses and those losses are hitting. They are not reported. We're going to report it as a camp. In a single bank report this as a camp. The value of camp becomes a boilerplate. It loses its value because every bank says, OK, they're all cans or is reporting a camp will trigger a bank run as well. So it's a judgment based. So that's why when you are conducting an audit, you have to use your judgment. Now, let's take a look at the financial word because from the financial word, from the stock market perspective, this is who should pass a judgment on those type of investments. They were touted Silicon Valley Bank before collapse. So if we look at this, if we look at this video, I'm going to play it for a minute or two. So notice people were aware that there are some issues from their investment perspective, but the auditor did their job. The auditor reported those HTM as they're supposed to be. In conclusion, what I can say is this, passing an investment judgment because this is this was basically an investment judgment in a sense that you had a lousy investment. Why? You invested in long term bond. Are we supposed as auditor judge that investment or not judge that investment? Are we supposed to say, well, look, because you made a lousy investment. If you have a bank run, you could be in problem. And as a result, we're going to report this as a camp. Can we go this far? That's the question here because whether this is a lousy or a good investment that you made and whether, you know, SVB can survive or not as a company. It is a judgment made by investment analysts. That's why they look at this information and make their make the recommendation. And most, most analysts were recommending SVB as a buy. And I showed you just a second earlier. Jim Kramer was recommending this investment. Okay. Now, now Jim Kramer is not, you know, know it all. Obviously he was wrong. But the point is people knew that there was some issues going on and but the auditor's job is to report the numbers according to the applicable framework, which is gap. And they did that. They did their job. The question remained that the issue of a bank run was raised. And if that happens, you have to sell your HTM at a loss. And if that happens, you could go out of business. If that issue was raised, it should have been reported that was not raised. Well, I don't believe it's a camp. Once again, this, you know, this is this is my second video about Silicon Valley bank. But again, here from an auditing rather than accounting perspective in the first video, I, I explained the audit, the accounting part of it. And I am going to put the video in the, in the description about the accounting part of it. I hope you find it useful, helpful comment. Maybe I have missed something. Look at the article itself. And good luck. Stay safe. And if you're a CPA candidate, visit four had lectures. If you're an accounting student, visit four had lectures. Good luck.