“On-chain accounting is the future.” That’s a line from a Coinbase article published on Friday, and it’s been bouncing around my head all weekend. As the dust from FTX begins to settle, the crypto industry is waking up to what we’ve always known: crypto needs solid accounting practices. The FTX fraud serves as proof that we are far from fulfilling that mandate. In our last issue, we covered what happened with FTX from a general perspective. This week, we’re digging into the specific accounting failures and how we can prevent them moving forward. “Calc”-you-later, 🧮 Trevor |
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FTX’s Accounting Failures |
I recently came across an article by a former Chairman of PwC Philippines in which he states: “‘Our profession is about the preservation of trust.’ Our real role is to protect what is true. As accountants, our real job is to be custodians of the truth.” As I explained in a recent LinkedIn post, we’ve shown a poor track record of “preserving trust” over the past few years:
While the accountants aren’t the most guilty party of the FTX scandal, it’s another black mark on our already tarnished reputation. As much as I wish it weren’t so, FTX was largely an accounting failure. The appointed restructuring CEO John Jay Ray III, who oversaw Enron’s bankruptcy proceedings, says so himself: “Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.” So, where did accounting fail, and where do we go from here?
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Keep in mind, I’m only referring to the related-party transactions that were documented— the ones sitting right under our noses the whole time. First, SBF and a few other insiders played simultaneous roles as liquidity providers, market makers, and traders for the firm. In fact, according to a recent CoinDesk article, for the years ended Dec. 31, 2021 and 2020, “liquidity provider, market making and trading exchange transactions with a related party together represented about 6% and 11% of total exchange transaction volume, […] respectively.” Second, SBF paid himself massive sums of money from licensing exchange software to FTX—$250.4 million for the year ended Dec. 31, 2021—to be exact. Third, audited financial statements disclose that FTX used related parties to manage currency and treasury management activities. Fourth, the company used the FTX FTT token as currency for acquisitions. For example, Bankman-Fried acquired trading app Blockfolio for an estimated $150 million in October 2021. Here’s the FTX Trading/Prager Metis audit report language related to that transaction: “The FTT receivable and liability are marked to market based on the quoted price for the FTT tokens at the reporting date. As of Dec. 31, 2021 and 2020, the receivable was $496.8 million and $44.6 million, respectively, and is presented as “receivable, related party” in the shareholders’ equity section on the consolidated balance sheets.”
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hed a now-deleted post back in June 2022 saying that it was “proud to support FTX US.” |
Both Prager Metis and Armanino have less-than-stellar track records with the PCAOB, and now, with John Ray Jay III, who says he has “substantial concerns as to the information presented in these audited financial statements” and that the audited financials can’t be trusted. I’m sure we could spend hours detailing every accounting failure that contributed to FTX’s fraud, but I’d rather refocus our energy on discussing a solution, which brings us to our next section. |
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Where Do We Go From Here?In an ironic twist, crypto brokers, lenders, and exchanges are scrambling to put their clients at ease by getting the blessing of an auditor. But the “audits” they are getting look mighty similar to the “audits” FTX received. You’ve probably heard talk of “proof-of-reserves” — a way to verify that a platform holds enough assets to match their users’ deposits. As I see it, this is our opportunity as accountants to either redeem ourselves as “custodians of the truth” or sit idly by as someone else (hopefully) solves the problem. Before you decide to quit your day job and make it your life’s mission to solve crypto’s accounting problem, know that there are no easy answers here. As with many other innovations within digital assets, bringing accounting transparency to the blockchain will require a massive coordinated effort. I’ll share my initial thoughts on the matter in hopes that more competent accountants (maybe even somebody reading this!) will put some brain power into a solution. Trust on a SpectrumBefore we can get into the nitty-gritty of how crypto companies can provide proof of reserves, you have to understand what crypto ideally seeks to be: a distributed, trustless system. The FTX fraud proves we are far from making this a reality—we trusted Sam Bankman-Fried, and he betrayed that trust. That said, accountants should understand that this is one of the foundational rules of the sandbox we play in. And I tread lightly here; full financial statement audits by independent third parties go a long way to establishing transparency, but even those are not enough on their own. After all, this approach still requires tremendous trust in the auditors. It’s helpful to think of trust as being on a spectrum. On one end, we have the more centralized traditional finance form of trust: trust companies to act in good faith and trust auditors to do their job right. On the other end, we have the more crypto-native approach of trusting mathematics, computer code, and node validators to do their job. Several techniques for establishing proof-of-reserve lie at different points on the spectrum, and each has pros and cons. Potential Paths to Proof-of-Reserves (PoR)Rather than reinvent the wheel, I’ll synthesize thoughts from two of the most prominent thinkers in the industry here: Vitalik Buterin, Co-founder of Ethereum, and Philip Martin, Chief Security Officer at Coinbase. I strongly recommend reading each of these articles. How do we go about establishing proof-of-solvency for crypto custodians? Here are a few techniques, in rough order from least desirable to most desirable:
There’s so much more that we could cover here, and I’m sure we will in future Triple Entry issues.
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