“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

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:

• Despite investors questioning WeWork’s poor financial performance and Adam Neumann’s antics, EY gave WeWork their blessing.
• Elizabeth Holmes’ trial revealed that at least three of the Big Four had provided services to Theranos during its run but never said a peep about the company’s unethical dealings.
• The SEC fined KPMG $50 million in 2019 for using stolen PCAOB inspection information to cheat on audit inspections.

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?

Failure #1: Related-party Ruckus

Perhaps the biggest red flag neither auditors nor investors caught was the sheer volume and audacity of related-party transactions FTX documented over the past few years. There are so many of them that I’m not sure where to start.

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.”

Failure #2: “A Complete Failure of Corporate Controls”

For goodness sake, the guy that led Enron’s bankruptcy proceedings basically came out and said that FTX was worse than Enron, and Enron was what ultimately led to Sarbanes Oxley and the internal control testing requirements we have now. Here’s another quote from our guy John Jay Ray:

“From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.”

Granted, FTX is a private company, so internal control audits weren’t necessarily required; however, it was large enough based on its combined revenue to not be exempt from providing an auditor’s report on internal controls. FTX’s internal control failures were so glaringly apparent that you’d have to try hard not to see them. And yet, neither the Armanino nor the Prager Metis audit reports provide an opinion on the internal controls over accounting and financial reporting.

From what I gathered from the FTX Chapter 11 Petitions and First Day Pleadings, FTX lacked internal controls of any kind, specifically:

• Each of the four business silos within FTX was controlled by Mr. Bankman-Fried
• “The FTX Group did not maintain centralized control of its cash. Cash management procedural failures included the absence of an accurate list of bank accounts and account signatories, as well as insufficient attention to the creditworthiness of banking partners around the world.”
• FTX had no type of employee management, not even a list of employees, terms of their agreements, or each employee’s status.
• FTX’s digital asset custody was entirely fraudulent. SBF and Gary Wang controlled all assets and used an unsecured group email account to share private keys. They also used “software to conceal the misuse of customer funds.”

Failure #3: Two Questionable Auditors

One of the first questions to naturally emerge in this scandal is, “who were the auditors?” There were two—apparently, having more auditors on a single engagement does not increase the quality of said audit. New York City-based firm Armanino performed the 2020 and 2021 FTX US audits, and — I kid you not — “Metaverse-based” Prager Metis, published a now-deleted post back in June 2022 saying that it was “proud to support FTX US.”