Silicon Valley Bank's collapse raises doubts over auditors' ability to identify risks

The collapse of Silicon Valley Bank in January 2022 has raised questions about the effectiveness of a measure introduced by the Public Company Accounting Oversight Board (PCAOB) in 2017 known as critical audit matters (CAMs). The new standard was meant to help investors decode risks and uncertainties hidden in financial statements by requiring auditors to record any critical audit matters when they sign off on a public company's books. Regulators define these as matters that have a significant impact on the financial statements and involve "especially challenging, subjective, or complex" judgments by the auditors.

When KPMG LLP gave Silicon Valley Bank a clean bill of health just 14 days before the lender collapsed, the Big Four audit firm flagged potential losses on loans as a critical audit matter. However, the audit opinion was silent on what actually brought down the bank - its unrealized bond losses and ability to hold them given a reliance on potentially flighty deposits.

Silicon Valley Bank's unrealized losses from its bond portfolio appear to "meet every definition of a possible critical audit matter," said Martin Baumann, a former chief auditor at the PCAOB who had a leading role in designing the new measure. The parent of Silicon Valley Bank, SVB Financial Group, had $91 billion of held-to-maturity bonds on its Dec. 31 balance sheet, which a footnote said had a fair value of just $76 billion. That $15 billion loss was big enough to wipe out most of the bank's total equity of $16 billion at year-end.

The latest banking crisis has exposed the gamble some banks took in betting heavily on long-term government bonds, which last year plunged in value as the Federal Reserve raised interest rates. Banks can keep these losses off their books by classifying their bondholdings as "held to maturity," or intended never to be sold, allowing them to be held at cost rather than fair value. However, accounting rules say banks can classify bonds as held to maturity only if they have both the intent and ability to hold on to them, rather than having to sell them to meet demands for withdrawals. For well-capitalized banks, that likely isn't a tough judgment call to make. But it is a much more nuanced issue for many of the lenders at the center of the latest banking crisis.

Unlike the biggest banks, smaller banks are largely reliant on deposits for funding, which can prove flighty in stressed times, calling into question a bank's ability to indefinitely hold long-term assets. The lack of liquidity due to potential deposit outflows has been identified as a critical audit matter that could have been highlighted in Silicon Valley Bank's audit. The judgment as to whether or not Silicon Valley Bank had the ability to hold these securities to maturity was certainly a complex question, it was material to investors, and it is hard to see how liquidity was not a matter for discussion with the audit committee, said Mr. Baumann, who is also a former senior partner at Big Four audit firm PricewaterhouseCoopers.

The collapse of Silicon Valley Bank has called into question the effectiveness of CAMs and auditors' ability to highlight key risks and uncertainties in a company's financial statements. The lack of a relevant critical audit matter and of a going concern are going to come up if it comes to litigation, said Jack Castonguay, an accounting professor at Hofstra University. He added that it was difficult to judge KPMG's audit without seeing the firm's work papers or knowing what risks it discussed with SVB's audit committee. Auditors' apparent blind spot on the interplay of interest-rate and liquidity risks isn't confined to Silicon Valley Bank. Auditors for nine other U.S. banks most exposed to bond losses also didn't flag these risks as