As a seasoned investor with over two decades of experience in various markets, I’ve seen my fair share of frauds and follies. However, nothing quite compares to the audaciousness of the FTX saga, where an auditor’s negligence seemed to have played as big a role as the founder’s chicanery.
Frauds don’t happen by accident – they require intent. In the rare instance that a fraud does occur, investors expect that the gatekeepers of fair financial reporting, the auditors, will be there to detect the fraud and protect their investment before it’s too late. But what happens when the gatekeepers don’t comply with the industry’s bare minimum standards of competency and quality? We get FTX’s bankruptcy and Prager Metis’ audit failure.
To clarify, it was primarily Sam Bankman-Fried (SBF), the founder of FTX, who orchestrated the fraud that led to the company’s bankruptcy. However, for this scheme to thrive and expand to such a significant extent, Prager Metis, the auditor, allegedly committed negligence-based fraud. The Securities and Exchange Commission (SEC) has levied misconduct charges against Prager Metis, which they have agreed to settle by paying $745,000.
According to auditing standards, auditors must have a thorough understanding of the entity they’re auditing and its operating environment. They should possess the necessary expertise and independence for the job, and be able to adequately staff the audit. These rules apply equally to first-time clients, small businesses, and large entities like a billion-dollar cryptocurrency exchange with associated trading firms.
Since its beginning, the blockchain and cryptocurrency sector has been marred by fraudulent activities, though instances of fraud appear to have decreased from 2018 levels. This field is inherently risky, demanding expert knowledge about conventional exchanges, blockchains, and investment tactics, as well as an in-depth understanding of how they intertwine. Regrettably, Prager Metis seemed to be lacking in this fundamental knowledge. They failed to recognize the potential risks associated with FTX’s trading division, Alameda Research, which were related parties. Moreover, they neglected to perform thorough checks to safeguard investors and customers.
In situations such as this, it’s often tempting to second-guess after the fact, claiming that any auditor or client could have been in the same position. However, in this case, the fault lies specifically with Prager Metis, as their audit fell short due to a lack of adherence to the basic standard for professional care. There were numerous warning signs that should have been heeded. FTX apparently managed its accounting records in Slack chat channels, personal messages, and QuickBooks. While QuickBooks might be suitable for a small business just getting off the ground, it is unacceptable for a billion-dollar currency exchange like FTX, and such a setup should have triggered alarms for the auditor. But it seemed to go unnoticed. Keeping records in Slack might have raised suspicions, but it appears they were not heeded either. The massive cash transfers between FTX and Alameda should have been a cause for concern and prompted further investigation into their relationship. Regrettably, this did not seem to happen.
The issues at hand aren’t just vague confusions or debatable matters. They were obvious potential problems that Prager Metis should have recognized, addressed, and investigated further to minimize the chance of incorrect statements. Unfortunately, as claimed by the SEC, Prager Metis didn’t exhibit enough doubt towards these risks, mainly because they seemed to lack the necessary expertise on crypto clients to meet auditing requirements.
Regardless of their involvement in cryptocurrency or blockchain, accounting firms should view actions by the SEC as red flags. While it’s tempting for accounting firms to dive into a promising, lucrative field like crypto due to increased capital inflows, they should proceed with caution. Rushing into a new technology and industry without proper knowledge, research, and experience could lead to costly mistakes. If accounting firms lack the capacity to learn quickly, it might be more prudent for them to observe and learn from early adopters rather than being pioneers themselves in this industry.
The SEC’s actions serve as a reminder to investors that regulators remain vigilant, stepping in when gatekeepers fall short of their duties. They continue to enforce penalties and implement quality control measures when companies violate standard auditing practices. As the industry prepares for stricter quality management standards, the SEC remains steadfast in its oversight role, scrutinizing even the independent auditors themselves.
Auditors of cryptocurrency exchanges, blockchain businesses, and related platforms should be well-informed about their industry and clients, as the SEC strongly advises. Meeting basic standards is just a starting point; auditors must delve deeper to grasp the unique risks associated with these new industries and clients. While this doesn’t guarantee the prevention of fraudulent activities, it significantly boosts the likelihood that such misconduct will be spotted before investors suffer substantial harm. This becomes much more achievable when the auditor possesses the necessary knowledge and skills to recognize potential hazards early on.
If a future auditor disregards the SEC’s warning, they should be prepared for prompt and firm penalties, sanctions, or actions to follow.
*Disclaimer: The opinions shared within this article belong solely to the author and may not align with those held by CoinDesk Inc., its management, or any of its associates.*
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2024-09-23 17:46