Let's separate the facts from the fiction on the banking industry, the flawed audit process and the implosions of Silicon Valley Bank (SVB) and Signature Bank.
For many years, I have railed against the value and cited the potential harm of an accounting firm-conducted audit. The recent failures of SVB and Signature Bank have shed some light on this issue.
KPMG, a Big Four accounting firm, audited both SVB (by way of its parent, SVB Financial Group) and Signature. It was only 14 days in the case of SVB and 11 days in the case of Signature, after KPMG’s clean signed audits, when each bank collapsed.
KPMG never addressed SVB’s ability, or as it turned out inability, to hold debt securities to maturity. Also, KPMG made no mention of the large percentage of deposits that were uninsured at both SVB and Signature, making it more likely that depositors would withdraw their funds at the first sign of difficulty.
In addition, KPMG never directly addressed the existing troubles in the technology industry on which SVB was dependent. Further, KPMG never properly recognized that regulators had notified both SVB and Signature, in writing and in meetings, on multiple occasions over the years prior to their collapse, of various significant problems at both SVB and Signature.
These very problems later proved to be major contributing factors to the failure of both banks.
Lastly, KPMG did not adequately address the unrealized losses on SVB’s bond portfolio.
It can be argued that some and possibly all of these issues should have been addressed or more thoroughly discussed by KPMG under the “critical audit matters” standard set forth by the Public Company Accounting Oversight Board to which accounting firms adhere.
While KPMG will probably voice the usual arguments that its audits were for 2022 and signed prior to the collapse of each bank in March 2023, that management hid or did not adequately disclose relevant information, that companies are not required to foretell extremely remote possibilities in considering a held-to-maturity classification, that the circumstances that led to the collapse of both SVB and Signature could not be anticipated, that the impact of social media could not be determined and other similar arguments — there appears to be ample evidence that there was sufficient information available in 2022 to identify problems that were missed or at the very least not adequately addressed by KPMG.
Auditors are supposed to highlight issues and risks during the audit period, and arguably after a company closes its books and prior to the signing of an audit, which KPMG failed to do.
I have maintained for many years that a bad audit is worse than no audit at all because parties rely on the poor audit giving them a false sense of the facts. Parties make decisions based on audits. An inaccurate audit will probably result in poor decisions.
If no audit existed, at least parties making decisions would be aware of the limitations in the available information and not be misdirected by reliance on a faulty accounting firm conducted audit.
I have heard individuals in the accounting industry argue that there is an internal approval process at all accounting firms that must be followed and completed before an audit is signed and issued. That may be so, but this argument fails to recognize the inherent conflict between client companies and accounting firms in the audit process.
A specific accountant has the company relationship that impacts his or her compensation and the fees paid to the accounting firm. The accountant’s compensation and the accounting firm’s fees are contingent on the completion of a successful audit and the maintenance of good relations with the company for business in future years.
With so much on the line for the accountant as well as the accounting firm, I am confident that discussions will take place and every effort will be made on the part of all parties at the accounting firm to sign off on a positive audit. This dynamic results in the conflict.
Accounting Nuance Exploits
In the case of the banking industry, it is not only the bank-accounting firm relationship that is flawed, but also aspects of the process.
If a bank declares its debt investments as “available for sale,” it is required to value such debt investments at their fair value/market price, or “marked to market,” but if it declares its debt investments as “held-to-maturity,” it can reflect such debt investments at cost. In a declining market, this is above market price.
This allows banks to avoid showing a loss in value on their debt investments. In addition, banks can change the designation on debt investments at any time.
According to the Federal Deposit Insurance Corporation, U.S. banks classified 34% of their securities as “held-to-maturity” at the end of 2021 and 48% at the end of 2022. Obviously, banks took advantage of this nuance in the accounting process to make their financials look more favorable. The “held-to-maturity” issue is another gap in the audit process as it relates to the banking industry that creates a false sense of wealth and security.
Ultimately, all assets held by banks should be required to be marked to market.
In summation, we must consider the facts and not be fooled by the fiction.
And that’s my take.
Perry Kalajian is an attorney, consultant, and analyst with extensive experience in the areas of banking, finance, and restructuring. He possesses multiple degrees in each of the areas of business and law. Mr. Kalajian has had numerous appearances on Newsmax TV.
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