A series of “why” questions at the dinner table served as the inspiration for today’s post exploring aspects of ASC 320, Debt Securities and recent events involving debt securities in the U.S. banking industry. Let me first set the scene…with a 2.5 year old running around, I’ve become no stranger to being asked “but why, Mommy,”; however I didn’t expect a series of “but why” questions from my husband! One evening at dinner, my husband asked what was going on with these banks and why it happened. (And once he said the magic “why” word, my daughter took the cue and chimed in asking “but why?” after every answer I gave him – it’s a good thing she’s cute!)
Why did the issues at Silicon Valley Bank happen?
If you haven’t heard, there have been some issues in the U.S. banking industry recently; this post will focus on issues at Silicon Valley Bank (SVB) and debt securities. A quick Google search will help you dive into the details regarding these failures, but I’ll try to quickly break it down for you. Simply put, SVB became insolvent and the banking regulators stepped in to protect the public. SVB’s insolvency was caused by a bank run – too many people wanted to withdraw their deposits at the bank and the bank didn’t have the funds. But why did all of these people want to withdraw their funds all at the same time? Well, that’s a bit more complicated.
Asset liability management (ALM)
Banks try to balance the timing of deposits (cash withdrawals) with their cash needs related to loans. They also try to match the timing and type of interest paid on deposits with interest received on loans or investments held by the bank. This concept is called asset liability management, or ALM. Said another way, asset liability management is a strategic management tool to manage interest rate and liquidity risks faced by banks and other financial institutions. Changing interest rates, the timing of withdrawals of deposits, and the prepayments of loans all affect the bank’s ALM strategy.
Over recent years, Silicon Valley Bank had purchased longer-term, higher-yielding debt securities when it had excess cash, specifically U.S. Treasury bonds and government-agency securities, and classified them as available for sale (AFS) debt securities. At the time of purchase, these securities yielded higher returns than shorter-term bonds, but the “caveat” was that these were longer-term bonds. This was all fine until interest rates started increasing in the U.S. which in turn resulted in the fair value of these bonds to start declining significantly. Fast forward to March 8, 2023 when SVB sold “substantially all” of its AFS portfolio (approximately $21 billion of securities), resulting in a loss of approximately $1.8 billion. But why did SVB sell these bonds knowing they would take such a large loss? Well, they needed cash and that cash was “tied up” in long-term bonds. This was announced in a press release – customers and large investors became leery of SVB’s situation and the bank run ensued, resulting in the closure of the bank by the regulators on March 10, 2023 (just 2 days after the press release announcement).
What about other banks? Why are we hearing they are “ok”?
So we know SVB was an ALM disaster. But other banks likely bought these same longer-term bonds – what does this mean for them? How are they managing the interest rate risk? Many banks in the U.S. hold these same longer-term bonds (check out this post for the details); however, they’ve made some accounting changes over the years to help “combat” the volatility due to the declining value of these bonds in their income statement. Essentially banks have transferred these bonds from the available for sale (AFS) classification to the held to maturity (HTM) classification. But why did they make these changes, and is this allowed under the accounting guidance?
ASC 320 Classification Reminders
ASC 320, Debt Securities contains the guidance for classification and measurement of debt securities (equity securities fall under the guidance of ASC 321). There are three classifications for debt securities under ASC 320: held to maturity, trading, and available for sale (of course, there is also the fair value option under ASC 825, but let’s leave that out of this post!). Debt investments are classified by management upon acquisition based on management’s intent.
- Held to maturity: HTM is to be used only if the bank has the positive intent and ability to hold those securities to maturity. There are some pretty strict rules found in ASC 320 for using the HTM classification, but the HTM classification comes with a major accounting “benefit.”
- Trading: This category is generally used when the bank has the intent of selling the investment within hours or days.
- Available for sale: This is the default category – if it isn’t classified as HTM or Trading, it is classified as AFS.
But why am I reminding you of these classifications under ASC 320? Because the classification drives the accounting treatment!
Measurement under ASC 320
Debt securities classified as Trading or AFS under ASC 320 are measured at fair value each reporting period. Any changes in the fair value of a trading security are recognized in net income and changes in the fair value of an AFS security (other than those associated with credit impairment) are recognized in other comprehensive income (OCI). Both of these classifications result in immediate recognition of the change in value in the bank’s income statement each reporting period. The HTM classification is where that accounting “benefit” I mentioned earlier appears.
HTM debt securities are measured at amortized cost. Any unrealized gains or losses associated with HTM securities (such as the decline in value due to rising interest rates) is not recognized in the income statement, rather it is tracked and disclosed in the footnotes only. Said another way, HTM is the only debt security classification where the volatility in the value of the security doesn’t impact the income statement! But why are the accounting rules written to allow the HTM classification this benefit? Well, think back to the intent of the HTM classification – these are securities the entity has the intent and ability to hold until maturity; this classification is not for debt securities that the bank plans to sell when cash is needed or to earn a quick return.
Transfers between classifications under ASC 320
ASC 320 permits transfers between the AFS, Trading, and HTM classifications with certain requirements. Let’s focus on what some banks have done over the years. As part of their ALM strategy, factoring in the realization that interest rates were trending upward, many banks decided to transfer securities from their AFS portfolio to the HTM classification. But why did they do this? To achieve the HTM classification accounting benefit!
Remember, when a security is classified as AFS it is measured at fair value each reporting period by recognizing any changes in the fair value of the security (that are not related to credit impairment) in OCI. The steps found in ASC 320-10-35-10 are shown below, but essentially the result is that the security is transferred out of the AFS portfolio (where unrealized gains/losses are recognized in OCI) and into the HTM portfolio resulting in only the tracking and disclosure of unrealized gains/losses (no recognition of gains/losses). It’s important to note that the strategy of transferring AFS securities to HTM classification was a good strategy when interest rates were beginning to rise; however, now that we “think” we are reaching the end of the interest rate hikes, such a reclassification would not be a smart strategy since the value of the securities has already declined and those losses have already been recognized.
Another point to highlight is that a bank may have reasons for transferring securities to the HTM classification besides avoiding the realization of unrealized gains and losses in the income statement (i.e., not everyone is “gaming” the system). An example of this could be a bank that, at the time of initial classification of an investment, may have wanted the option of selling a security in the future; however, due to the decline in value associated with changes in interest rates, the bank may now have changed their intention from AFS and plans to hold the security until it matures (HTM).
But why does ASC 320 permit transfers into HTM and allow banks to keep the changes in the value of debt securities from impacting the income statement? Well, unfortunately my answer is “because ASC 320 says so!” If this feels like a strategic loophole in ASC 320 to you, you’re in good company! Some people think the guidance found in ASC 320 should be changed to address the permissibility of these transfers and the measurement of HTM securities.
Banking industry training resources
Accounting for transactions in the banking industry can be quite interesting and can leave you asking but why? The GAAP Dynamics team has developed a Banking Industry Fundamentals eLearning course collection and an Advanced Banking Industry Fundamentals eLearning course collection covering the ins-and-outs of the banking world under U.S. GAAP.
About GAAP Dynamics
We’re a DIFFERENT type of accounting training firm. We don’t think of training as a “tick the box” exercise, but rather an opportunity to empower your people to help them make the right decisions at the right time. Whether it’s U.S. GAAP training, IFRS training, or audit training, we’ve helped thousands of professionals since 2001. Our clients include some of the largest accounting firms and companies in the world. As lifelong learners, we believe training is important. As CPAs, we believe great training is vital to doing your job well and maintaining the public trust. We want to help you understand complex accounting matters and we believe you deserve the best training in the world, regardless of whether you work for a large, multinational company or a small, regional accounting firm. We passionately create high-quality training that we would want to take. This means it is accurate, relevant, engaging, visually appealing, and fun. That’s our brand promise. Want to learn more about how GAAP Dynamics can help you? Let’s talk!
This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.