On November 11, 2022, the FTX group filed for Chapter 11 bankruptcy in the US. Incorporated in the Bahamas in 2019, FTX was a popular cryptocurrency exchange. The nosedive in crypto prices as well as a popular exchange going bust within three years of incorporation has worried the crypto community. They must be feeling that it makes more sense now to trust the BSE Sensex than the price of cryptos.

The reasons for the FTX collapse are all too familiar — a bad balance sheet, weak internal controls, auditors who may not have understood the world of cryptos, and innumerable high-value related party transactions. This drives home the point that irrespective of the industry, the reasons for corporate collapses are pretty much the same.

The  Financial Times put out the  balance sheet of FTX on the Net. It would be inappropriate to call it a balance-sheet — its just an Excel Sheet with a number of values. The sheet does not comply with the minimum requirement of a balance-sheet — the liabilities and assets do not balance.

The liabilities displayed in this sheet exceeded the assets many times over, indicating a highly leveraged financial position. Both the liabilities and the assets side of the sheet displayed ticker values. There were some bizarre notes in the sheet — one that states “all these are rough values and could be slightly off, there is also a change of typos, etc”.

Large and needless related party transactions also contributed to the fall of FTX. Certain related party entities were the initial liquidity providers and participated in majority of the market-making transactions at the inception of the exchange. Over time, other liquidity providers joined the exchange, and the percentage of trades involving related parties fell as a percentage of total revenue.

The related entities do trade for their own proprietary purposes on non-market making transactions. Liquidity provider, market making and trading exchange transactions with a related party represented about 6 per cent and 11 per cent of total exchange transaction volume for the years ended December 31, 2021 and 2020, respectively. Because the related parties were primarily market makers, which therefore generated negative commissions, net revenues (negative) for end-December 31, 2021 and 2020 were -$22 million and -$13.4 million, respectively, which represented about 2.2 per cent and 14.9 per cent of total exchange transaction revenue on an absolute basis.

Sub-standard auditors

To audit complex transactions such as cryptos, one would have thought that FTX would engage with the best auditors. However, they choose two small firms which had negative comments issued on their work by the Public Company Accounting Oversight Board (PCAOB).

In 2019, the PCAOB published its private comments about deficiencies in one of the firm’s overall quality-control processes related to its 2018 inspection because the firm hadn’t corrected the board within a year. This firm was also the auditor for Lottery.com and issued an opinion for 2021.

The lottery-sales start-up reported that it had overstated its available unrestricted cash balance by $30 million and improperly recognised revenue. There was substantial doubt about its ability to continue as a going concern. The audit firm resigned from its audit role this September, right before a class-action lawsuit was filed against Lottery.com’s executives.

The bankruptcy of FTX is bound to alert accounting regulators across the world to come out with guidelines on accounting for cryptos. Tax authorities are also bound to look at the tax aspects of these transactions. Auditors of crypto exchanges would put in cautionary paragraphs in their audit reports. Founders of crypto exchanges would be looking at these developments closely. Investors in cryptos would be looking for alternate investments that provide some stability and not rude shocks.

The writer is a chartered accountant

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