The following content is not a full transcript of Episode 11 of GAAP Chats. To hear the full audio click here:

Chris: Switzerland, known for cheese, chocolate, beautiful landscapes, the Alps, skiing, and also for fine precision-crafted (and very expensive) watches. Also known for its status as a neutral state and known for its banking industry. Swiss banks are regarded as some of the safest when it comes to privacy and keeping their clients’ identity hidden, with the exception of cases of terrorist threats, of course. But this week, one of those banking institutions, the 167-year old Credit Suisse, Switzerland's second largest bank, was all over the news as the latest to get caught in the evolving saga of turmoil in the banking industry. 

Welcome to GAAP Chats, the podcast dedicated to all things accounting brought to you by GAAP Dynamics. I'm your host, Chris Brundrett. Mike and I are switching places this week. He's on PTO, so I'm taking over host duties. With me today is Bob Loeffler, who you met last week when I was out. We hope you'll join us on our journey today as we share our passion for accounting and help change the way you train.

Bob, thanks for joining us again this week. And man, what a week it's been, at least in the banking world.

 Bob: It sure has, Chris. It's been quite the week in financial services. Obviously, the big news and thing that we've been hearing probably the most about over the past couple of weeks has been Silicon Valley Bank. But it really doesn't stop there. There's been other banks as well in the news. We had Silvergate Capital, which was a cryptocurrency focused bank. They announced that they're ceasing its operations and liquidating its assets after a run on the bank and then following Silicon Valley Bank, there was Signature Bank, which was seized by regulators amid fears that it would collapse after a run on the bank. So, obviously lots of fear in the market and that's causing these regional banking stocks to drop, and put these banks at risk. Now we're hearing other regional banks that are just kind of getting grouped into it with First Republic at risk and getting a lot of attention getting help now from some of the bigger banks. Stocks are volatile and craziness is ensuing.

Chris: It kind of came out of nowhere in a way. What caused all this?

Bob: There are a lot of things that are causing this. Of course, there's plenty of blame game going around as far as  who's responsible for this. I'm sure as the months pass and investigations are done, lots will be uncovered. At the end of the day, it probably comes down to just a few things that we're seeing. In the case of Silicon Valley and signature, It's really just a good old fashioned run on the bank. Banks are built on trust. When all of a sudden the people that are putting their trust in these banks and keeping their hard earned cash in the banks get nervous, they want to take their money out. When you have social media and Twitter and things like that going on, it seems like we're getting a really new phenomenon. You got electronic banking and you got social media that are giving you real-time information (or lack of real information, however you want to look at it). The point is it stirs up a frenzy and people are taking their money out immediately. Just electronically, boom, get my money out. What's funny is they're taking it out of these small regional banks and you gotta put your money somewhere and not just under your mattress. So they're going to these bigger banks. So the bigger banks don't seem to have an issue. But these regional banks are the ones that people are concerned about.

Chris: Bob, you're telling me that if I went to the bank today to get my money out, it's not just sitting in a shoe box somewhere? That’s kind of what the root of the problem is, right? I mean, these deposits have been invested. I mean, banks, of course, make loans, but they've also made investments. I heard in the news that in the case of SVB, for example, they had to sell investments in order to fund these deposits.I guess these investments were in a loss position which created issues. When there was this run and these investments were being sold, of course, my thought was, they must have been invested in some pretty risky stuff for it to be in this significant loss position.

Bob:  Yeah, I mean, that's kind of what you would think. But no, I mean, we're talking about very safe investments. I mean, banks, at their best, are just so boring. Banks should be boring. I would say that these banks are no exception. They're investing in U.S. Treasuries, some really basic mortgage-backed securities. They had safe investments. The problem is this frenzy, this run on the bank, where all of a sudden they needed to come up with the cash to pay off the depositors who wanted their money back. These investments were tied up in long-term investments. Really, what it comes down to, if you want to put fault in the way these banks were operating, it's a failure in asset-liability management where they weren't really looking at the durations.  They were investing in long-term securities. This goes back, you know, a couple of years ago from when the pandemic was going on. And now all of a sudden there was this need for short-term cash. The only way they could do that was sell these long-term securities. In this environment, this interest rate environment that we're in right now, if you've got fixed-rate assets at a low rate and now interest rates are going up, the fair value of those investments have dropped considerably. They've gone down. So as a result, they're taking massive losses for being forced to sell these investments and that was causing a lot of problems, too.

Chris: Further compounding this issue is these banks, particularly SVB and Silvergate capital, were concentrated in certain industries. Silvergate, as you mentioned it earlier, Bob, was crypto. It was a crypto focused bank. Silicon Valley Bank, surprise, surprise is the tech industry, right? Highly exposed to the tech industry. I guess it wasn't a problem at first, but, you know, during the tech boom of the pandemic, there was a lot of money going into Silicon Valley Bank. Hence they purchased these investments, as you mentioned, that at the time, interest rates were crazy low. These treasuries that they're in have a low interest rate. Well, now we're in a situation where both these industries, the tech industry and the crypto industry, have been having some trouble as of late. We're seeing deposit holders taking money out. Also, it's not just individual deposit holders. We had venture capital companies and others that had a lot of investment in these banks or deposits in these banks. So, now they're needing to pull money out for liquidity purposes as these industries are struggling. That combined with, as you mentioned, these investments being sold at sometimes a significant loss to fund the deposits. Then you get people involved and social media and everything else and the run on the bank occurred. So far, this seems pretty isolated to certain  industry specific regional banks.I think that's why President Biden this week clearly stated that our banking system overall is safe and secure. And of course, he stated that the FDIC is going to back these deposits and things like that. This does seem pretty isolated, right?

Bob: It seems like that was the case. But, then along came Credit Suisse. Now we're entering a different type of bank because, well, you can say Silicon Valley Bank and Silvergate are small-ish regional banks. You aren't going to say the same thing about Credit Suisse. Credit Suisse is a huge bank. They're one of these globally systemically important banks that we've identified. They've got $500 billion in assets. Now we're seeing concern over bigger banks. So that's really what we want to talk about here, right? 

Chris: So, a couple of days ago, Credit Suisse had a 24% drop in their share price. We'll talk about why. I guess it was last night the Swiss regulators said that they would pump some money and some capital into Credit Suisse, and that caused their stock price to come back up early today. But as of this recording, it's not looking good. It's back down again. So it's a rocky road, isn't it?

Bob: Yeah. Well, and once again, it's kind of this whole idea of volatility and uncertainty in financial institutions and the financial institutions that are at least viewed by the investing public as dangerous are the ones that seem to be suffering. Credit Suisse clearly is not necessarily seen at the moment by investors with a lot of confidence given their history. 

Chris:  What happened? What's going on that sort of caused this? I mean, obviously it certainly didn't help that we had these failures earlier in the week or over last weekend, you know, with these banks that we mentioned earlier. What happened to cause them to get dragged into this? 

Bob: I think what happened here is you had a bank that has had a number of issues over the years, but in recent years they have been saved by their big backer: The Saudi bank. The Saudi bank actually came out and announced that they have reached that limit as far as what investment they can make in Credit Suisse. They had a regulatory limit of, I think, 10% and they were up to the high 9%. Basically they came out and said, look, we're done as far as making additional capital infusions. That really freaked out the investors, and that's what kind of triggered all this.

Chris: And further compounding this issue was right about the same time this week, there was a delay in the release of Credit Suisse’s 2022 annual report due to, shall we say, last minute call from the SEC.

Bob: Yeah. And anytime you have a last minute delay caused by the SEC, that can't be good news. That's not something you want to hear.

Chris: Yeah, usually that's not good. And interestingly, the call from the SEC was actually related to prior period cash flow statements, which Credit Suisse has revised in its 2021 annual report. I guess the SEC was satisfied with the call because shortly after the bank did release its 2022 annual report.

Bob: Yep. So they got things all sorted I guess. But as a result of that call, management had to report a material weakness surrounding their internal controls over financial reporting. That unfortunately affects not only their 2022 financial statements, but also previous years.

Chris:  Right. Okay, and furthermore, PwC, who is Credit Suisse's auditor, issued an adverse opinion on the effectiveness of the bank's internal control over financial reporting as well. So now, of course, you know, when I start hearing these “adverse opinions” on internal control over financial reporting, the nerdy accountant in me and the former auditor in me gets intrigued. So, I did dig into Credit Suisse filings to try and see exactly what the issue was. Management's report on internal control over financial reporting did further state that “management did not design and maintain effective controls over the classification and presentation of the consolidated statement of cash flows, specifically control activities over the completeness and classification and presentation of non-cash items in the statement of cash flows.” 

This all stemmed from those revisions that we mentioned that were made to the cash flow statement in the 2021 annual report that the SEC was calling about.

Bob: All right, love it, Chris. So now we're getting down to accounting talk today, huh?

Chris: Oh, accounting talk. Even better than that, the good old statement of cash flows.

Bob: That is fantastic. So, I know you kept digging into this issue. Why don't you tell everybody what you found? Is this something that was complicated?

Chirs: It was sort of complicated, sort of not so, yeah. Let's break it down a little bit. I took a look at the 2021 annual report where they actually disclosed this revision that they made. That's what triggered the ineffective control that we just mentioned. There were actually two main issues, a few other little ones, too, but two main issues that were disclosed. The first was issues with respect to the netting treatment related to the presentation of a limited population of certain securities lending and borrowing activities. This issue caused the balance sheet and cash flow positions for both assets and liabilities relating to these activities to be understated. In addition, the bank's leverage exposure increased, which reduced the related leverage ratios by ten basis points. Unfortunately, the rest of the disclosure, which does provide amounts by which the various financial statement line items change, doesn't clearly highlight the specifics of the issue, or at least it didn't highlight it to me. Honestly, to the average reader of the financial statements, it probably sounds more like technical bullsh** jargon that no one understands.

Bob: Ah, the Christmas Vacation reference. Very nice.

Chris:  Well, thank you. Had to get that one in there. It seemed. Seemed perfect. But, seriously, it was difficult to kind of figure out what that issue was. I mean, we had sort of the highlight. Bob, I know you have an affinity for securities lending and borrowing arrangements, repurchase agreements,  and all that good stuff. So, thinking about what they said and the impacts on those line items, what are your thoughts? Can you shed some light on this?

Bob: So, obviously not being on the inside we don't know exactly what's going on. But based on the adjustments that were made and the things that were said in their disclosures, what I surmise from that is this is the securities lending issue is just a good old fashioned balance sheet netting issue that they ran into. Because,  balance sheet netting is, you know, not the most sexy topic, at least from an accounting training perspective. I don't get excited talking about balance sheet netting. When it comes to materiality this is probably one of the biggest issues that can affect your balance sheet at least. Certainly in the financial services world you see huge balance sheet netting that takes place. What we're seeing here is an issue surrounding securities lending, and repurchase agreements. First thing when it comes to balance sheet netting, the only time we can net in the balance sheet is when we have a situation where there are determinable amounts owed to each party in the transaction. We know we owe certain amounts to them, we have the right to offset. So there is some kind of master netting agreement in place. We have an agreement that says we are allowed to settle our obligations to each other, right, because we have a receivable and a payable and we're saying we have the ability to net that exposure to each other. It's enforceable by law, of course.

The key thing is that we have the intention to net, meaning even though we have the right to net, even though we have determinable amounts, when it comes down to it, we're actually going to settle this on a net basis. That's usually the one that fails for a lot of companies because it's just easier to to settle on a gross basis rather than worry about these net exposures. Therefore, a lot of times you don't get balance sheet netting, except in the case of derivatives and repurchase agreements. With derivatives and repurchase agreements, they have a little bit more lenient rules with regards to offset. The big thing is this intention to offset is not required. As a result, banks often will be netting their derivative exposures and their repurchase agreements. So, what I imagine happened here - by the way, we're talking about U.S. GAAP - I want to make sure that's clear, because IFRS doesn't have these loose netting agreements. But no, they're reporting under U.S. GAAP. So from reading this, what I'm thinking happened here is they probably had a portfolio of securities lending and borrowing arrangements that they somehow erroneously considered repurchase agreements, because they're very similar transactions. It really just comes down to “what's the purpose of that transaction?”

So, they might have been netting it as if they were repos when in reality they discovered that they were securities lending, and therefore we ended up having a balance sheet adjustment of 13 billion CHF. So, a large number there for just one isolated portfolio, as they like to explain it as. That resulted in the increase of both assets and liabilities of 13 billion CHF. On the statement of cash flow side, they also had a reclassification out of investing cash outflows and into financing cash outflows. What that tells me, too, is they treated it originally as if they were repurchase agreements, meaning I was making an investment. I was lending money on a short term basis on a collateralized basis, and I was just getting a return in investing cash flow. But, when they discovered these weren't repos, they weren't investing transactions, they were actually securities borrowing transactions, they also had to reclassify the statement of cash flows out of investing cash flows and into financing cash flows. That was an adjustment of 70 million CHF. So, that's kind of my best guess of what was going on with that first transaction. Who knows if that's really what was going on. But hey, it's a good opportunity to remind ourselves about the netting rules under U.S. GAAP. Chris, what about the second issue? Do you want to take us through that one?

Chris: Sure. Cash flow statement was impacted here. This second issue relates to what they refer to as “non-cash exchange rate movements”. That leads me to believe we’re talking about exchange rate movements for items that are still impacting or in the financial statements we don't have true transaction gains or losses here. We're dealing with remeasurement or translation of items in the financial statements. The disclosure states that the group also expanded the elimination of non-cash exchange rate movements related to certain operating, investing, and financing activities in the statement of cash flows. Then, of course, it goes on to disclose the amounts and the line items impacted. Again, like your issue, Bob, it's hard to know exactly what the issue is or was, but I have a pretty good feeling that it relates to a very common error that is made when dealing with foreign currency in the statement of cash flows. This issue has been widely publicized, but yet companies continually get it wrong. The Journal of Accountancy wrote an article about it a while back. I actually wrote a blog about it back in 2018.

Bob: Yeah, that blog is very famous within our company. That's the famous Plug the Flow blog. I believe it's one of our top five blogs of all time on our website.

Chris: It is. I don't know that it's because of the author, hopefully not because of the title. We are talking about  an accounting plug in the statement of cash flows. Hopefully it's been popular because it's a common pitfall, and a commonly misunderstood aspect in the accounting of the accounting literature.

Bob: So, why don't you tell us about this issue a little bit?

Chris: Yeah, absolutely. So, you know, the issue again, is a common one that occurs out there. It's not a new issue, because the underlying literature on foreign currency, which is ASC 830, has been around for longer than most of us have been in practice. But, you know, again, the issue continues to crop up. It's clearly stated in the literature, but it certainly continues to happen.

So let's get down to it. ASC Topic 830 prescribes the accounting for foreign currency within the statement of cash flows. It states that when a company has foreign operations, the foreign currency cash flows have to be translated into the reporting currency using the exchange rates in effect at the time of the cash flows. So, the same idea as the income statement. Of course, just like the income statement, an appropriately weighted average exchange rate for the period can be used if it gives you a substantially similar result. The statement of cash flows then must report the effect of the exchange rate changes on cash as a separate part of the reconciliation of the change in cash during the period. What that means is when the consolidated financial statements are prepared for a company that has foreign subsidiaries, the statement of cash flows has to be translated to the reporting currency, and the effect of the foreign exchange rate shown. 

Chris: That's what the literature says, but how do we go about doing that? Let me start with what usually goes wrong, and then we'll talk about how to do it right. 

The wrong way to do things: when preparing the consolidated statement of cash flows using the indirect method for a company with multiple foreign currencies, oftentimes financial statement preparers based on the consolidated balance sheets for the current and prior periods. The problem with this approach is that the consolidated balance sheets contain foreign currency balances that have been translated using a period end rate. That's what's required by the accounting guidance related to the balance sheet. However, as we said earlier, ASC 830 requires foreign currency cash flows to be translated using the exchange rate in effect at the time of the cash flows. The difference between that and the period end rate oftentimes is material. This effect of exchange rates on cash has been, you know, some company basically if they do it the wrong way, well, we'll have a line item in there that has this effect of exchange rates on cash being presented, that is required by the guidance, but it's not the right number. It's essentially a plug to make the statement of cash flows work. And this number should not be a plug. I've seen it where they'll bury this number in some other line item in the statement of cash flows. That's clearly wrong as well. Certainly this is an easy way to prepare the statement of cash flows, but it is the wrong way to prepare the statement of cash flows. 

Chris: So what is the right way to do it? Well, the right way to do it is if we have to look at properly translating and you have multiple foreign currencies or subsidiaries that use foreign currency, the right way to prepare it is you actually have to translate all of those individual statements of cash flows. You prepare the statement of cash flows for each of the subsidiaries, including those foreign subsidiaries. They're done in their functional currencies and then they are all translated using the appropriate rates. So , either rate in effect on the date of the cash flows, or the weighted average rate during the period is required by ASC 830. Once all those have been translated individually, then you combine those individual cash flow statements with elimination entries.  So it's like you're consolidating. It's a consolidation that's going on and that creates the consolidated statement of cash flows. So this takes a lot more effort, but this is what's required by the standard. Ultimately you will have a line item that is the effect of changes in exchange rates on cash flows. That number is actually a provable number. There's a formula if you go take a look at the blog or that Journal of Accountancy article, you’ll find it there. There's actually a formula that will prove that that number is accurate.

I remember many years ago, Bob, when I was in practice, it was a little trick by the partners on engagement teams that would say, okay, that cash flow statement is wrong. Why? Well, that number is wrong. That effective changes in exchange rates. They just did the proof. You know, that's kind of the story. 

Now, in no way do I think that Credit Suisse just started with their consolidated balance sheets and created a statement of cash flows. I don't think it was that egregious. Obviously, they know the rules. This is a pretty sophisticated organization. What probably has happened is that somewhere in that very complicated organizational structure, there were some foreign items being consolidated. Then the rates that were used ultimately in the translation weren't the right rates because things had been consolidated prior to preparing the statement of cash flows. I would guess that it was probably this issue. It's related to this issue with how to prepare these things, but it's probably buried pretty far deep down into their consolidation process.

Bob: Chris, I appreciate that and, you know, it's fun seeing you get all hot and excited when we start getting into this nerdy accounting stuff. But, you know, while I know you could probably keep going on and on about this, I think we have run out of time for our podcast today.

Chris: All right. Well, it was good, Bob, to get back into some discussion of accounting. It's fun when you have something that's in the news, it's hot off the press, and it relates to accounting. I mean, let's be honest, we don't get that all that often, right? Hopefully that was helpful for people to sort of understand some of these issues that are going on. We'll save more for another day. Bob, why don't you take us out?

Bob: Gladly. That's all for this episode of GAAP Chats, your source for all things accounting. Notes and resources from today's episode are linked in the description. As always, you can find us online at gaapdynamics.com and @gaapdynamics across social media. It's never too late to become a GAAPologist. Head over to our website and subscribe to our blog so that you're the first to know what's new with GAAP Dynamics.

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