Identifying and analyzing the risks of ‘risk-free’ securities

Interest rate increases result in unrealized losses for held-to-maturity debt security investments, but these losses do not appear in the financial statements (as long as there are no impairment losses). These losses appear only in the financial statement note disclosures. As a result, traditional liquidity and capital ratios may appear too favorable and distort investment decisions.

Furthermore, the risk-free designation for Treasury and Agency debt securities applies only to default risk. Many financial statement users rely too much on this risk-free default designation and should consider other risks.

Silicon Valley Bank was the first of three banks that failed in March 2023 and were seized by government regulators. All three were unable to repay depositors who withdrew their money in droves after rising interest rates devalued the banks’ investments in bonds, which banks had to sell to fund deposit withdrawals. Regulators intervened and depositors were saved. Equity investors weren’t.

The risks of debt securities designated risk-free can be revealed. Steps to thoroughly assess asset and equity values exist for companies holding held-to-maturity debt investments. Examples show how higher risks were hiding in plain sight last year, well before this year’s bank crisis occurred.

PERFORMING A THOROUGH FINANCIAL ANALYSIS

A key objective of financial reporting is to provide useful information for financial statement users to assess the nature, timing, and uncertainty of future cash flows to make investment decisions about providing resources to the reporting entity. By estimating future cash flows, users can assess both an entity’s liquidity (i.e., its ability to pay shortterm obligations) and the quality of its assets.

Assessments of financial soundness by financial statement users should have several levels of increasing granularity. Unfortunately, as this spring’s bank failures indicate, many financial statement users didn’t advance beyond cursory level 1; even fewer reach level 3 full financial analysis diligence.

• Level 1: Calculate financial ratios. These are well-known numerical calculations, such as a current ratio (current assets/current liabilities). Ratios are only the starting point as they are generally superficial. For entities holding bond investments, liquidity is measured by bond maturity and the ability to monetize a bond.
• Level 2: Identify what underlies the financial statement figures, which can come from financial statement note disclosures. Entities holding bond investments must disclose amounts by debt security type, carrying value, credit loss allowances, and maturity. For public companies, these disclosures add fair value and unrealized gains and losses.
• Level 3: Understand the economic nature of the different bond investments in level 2 to assess financial risk. Examples are credit risk, liquidity risk, value risk, interest rate risk, and concentration risk.

DEBT SECURITY ACCOUNTING BASICS

When assessing asset risk for companies owning debt instruments, it is necessary to understand what the carrying amount measurement represents and how changing fair values affects the financial statements. This is important because the accounting and financial impact may differ significantly for the same debt security. ASC Topic 320, Investments – Debt Securities, prescribes accounting for companies holding debt securities. Companies must classify debt security holdings into one of the following three categories:

• Trading: a debt security in which the company possesses the intent and ability of selling it in the near term. Although a trading security is typically classified as a current asset, a company with the intent and ability to hold a trading security for longer than 12 months classifies it as non-current asset.
• Held-to-maturity (HTM): a debt security in which the company possesses the intent and ability to hold the security until maturity.
• Amortized cost applies only if the company actually holds the security to maturity. This means that an amortized cost classification is restrictive because a positive affirmation must be justified for each debt security investment. The absence of any intent to sell is not justification.
• Available-for-sale (AFS): the residual category for a debt security not classified in either of the above categories.

To determine debt security classification, companies must evaluate their future operating and financing plans that would affect their intent and ability to hold the debt security to maturity or require selling before it matures. Examples of such plans may include: taking advantage of a potential business or investment opportunity, meeting an equity-based debt covenant, providing liquidity in an economic downturn, or meeting regulatory capital requirements. Companies determine debt security classification on the acquisition date and reassess it every subsequent reporting date. Thus, as facts and circumstances change, a company may no longer be able to justify HTM classification.

Each debt security classification has different accounting, measurement, financial statement presentation, and disclosure.

(See “Financial statement impact by classification,” below.) Interest income on held securities and realized gains and losses need to be reported in the income statement for all three types of debt securities. HTM securities have different reporting by adjusting interest income for premium or discount amortization and by adjusting the carrying value for the unamortized premium or discount carrying value.

DISCLOSURES THAT PROVIDE KEY RISK INFORMATION

U.S. GAAP requires debt security note disclosure by major security type, which is determined by the security’s nature and risk, and expands this disclosure for financial institutions (Topic 942, Financial Services – Depository and Lending).

Debt securities issued by Treasury and other U.S. government corporations and agencies are considered to be default-risk free. Too many financial statement users stop here. Unfortunately, these securities possess many other risks. For HTM debt securities, the entity operational business implications of amortized cost basis difference from fair value may be wrongly minimized by the financial statement user for U.S. Treasury and Agency securities due to over-reliance on their “risk free” designation.

U.S. GAAP disclosure requirements for AFS and HTM debt securities are more robust than for trading securities. (See “Disclosure for AFS and HTM debt instruments,” below.) (For simplification, this ignores additional disclosures for transfers between these categories.)

IMPLICATIONS OF RISING INTEREST RATES — FINANCIAL INSTITUTIONS

Prior to the March bank failures and significant stock price declines, financial risks impacting banks were hiding in plain sight for bank stakeholders such as government regulators, depositors, and equity and debt investors. Regulators have concerns about the liquidity of banks for depositors and borrowers and protecting societal interests. Investors want financial returns. All needed to consider the operating business implications and financial risks of rising interest rates.

The direct profitability impact from rising interest rates depends on how a bank manages its interest rate spread between the lower rates paid to depositors and higher lending rates. Focusing on interest rate spreads alone ignores other implications from rising interest rates.

Rising interest rates reduce the fair value of bank bond investments. The accounting for HTM investment can mask this devaluation impact of rising interest rates since HTM unrealized losses are only disclosed and not included in the measurement of the investment. As a result, in the case of SVB, significant portions of bank capital were an illusion, making traditional liquidity and capital ratios falsely appear favorable. According to SEC filings, banks incurred significant unrealized losses on their HTM bond investments at the end of 2022 compared with a year earlier, and SVB effectively had zero equity compared with two other banks that effectively had 20% lower equity. (See “Unrealized losses on HTM bond investments at year end,” below.)

AFS investment accounting has the same unrealized loss masking effect on income but does reduce equity as AOCI becomes a larger equity offset. That is, until banks sell HTM and AFS debt securities.

Why would banks sell HTM debt securities before maturity and recognize realized losses, when their continued intent must be to hold these bond investments to maturity? The reason is that depositors began withdrawing deposits to take advantage of significantly higher interest rates at other financial institutions.

The realized losses also result because most banks have not hedged their debt security investments for interest rate increases. (For more about interest rate hedging, see the author’s March 2023 Journal of Accountancy article, “Managing Interest Rate Risk with FASB’s New Hedging Flexibility.”)

Most bank stakeholders improperly focused almost totally on debt security default risk. U.S. Government securities are only risk free if held to maturity. While default risk was low due to U.S. Treasury and Agency debt investments disclosed in compliance with Topic 320, other risks should have been considered. These risks were also apparent from note disclosures:

• Interest rate risk — discussed above — bank interest rate models focused on income increasing. Their risk assessment underestimated or ignored the value loss on bond investments, plus banks were not hedging for interest rate risk.
• Concentration risk — banks became more dependent on deposits (bank liabilities) which increased from stimulus payments and from deposits in excess of the $250,000 federal insurance limit. Banks also shifted more assets into HTM, which didn’t have to record changes in fair value.
• Liquidity risk — banks were investing in longer-term U.S. government debt securities to get a higher interest rate, which created a maturity (duration) mismatch with deposits that are short term. This may also be named duration risk. Banks needed to sell longer-term debt investments at a realized loss to fund increased cash outflows from depositor withdraws.
• Bank stakeholders missed risks hiding in plain sight about bank asset and equity values. The recent bank failures and steep market value declines for all banks indicate many financial statement users would have assessed higher risks on bank future cash flows if they looked at disclosures beyond the financial statements.

About the author

Mark D. Mishler, CPA, CMA, MBA, is a fractional CFO and principal at CFO Resource Management in Morristown, N.J., and an adjunct professor of accounting, finance, and management at Seton Hall University in South Orange, N.J., and Rutgers University in New Brunswick,  N.J. To comment on this article or to suggest an idea for another article, contact Jeff Drew at Jeff.Drew@aicpa-cima.com.)

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Articles

“SEC increases transparency requirements for private, public securities,” JofA, May 3, 2023

“Managing interest rate risk with FASB’s new hedging flexibility,” JofA, March 1, 2023

“SEC adopts rule changes to reduce risks, proposes two other rules”, JofA, Feb. 15, 2023