Auditors Reject Crypto After FTX, Misleading Reserve Estimates

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In a rush to reassure customers and markets, crypto exchanges like Kraken and Binance Holdings Ltd. in 2022 touted the tests provided by auditors of their reserves tests to show that customer deposits were safe.

But those snapshot reserve reports that don’t reflect fund volatility or outstanding obligations have failed to reassure jittery clients and regulators, including Securities and Exchange Commission Chairman Gary Gensler. Instead of offering a lifeline to crypto firms, the practice of collateral verification has sparked scrutiny from regulators and provided new ammunition for criticism from auditors.

Risk-averse auditors are now rethinking their relationship with crypto players after the risks of working with the industry were laid bare in bankruptcy filings for collapsed exchange FTX, whose founders face charges criminals.

Mazars Group, Marcum LLP and Armanino LLP said they would reconsider their work in the crypto industry after the implosion of FTX and a wave of bankruptcies, including bitcoin miner Core Scientific Inc., caused panic on the market. Pulling out of crypto could limit legal and reputational risk to companies that could undermine investor confidence in the work that auditors provide to their publicly traded clients.

But skepticism about reserve proof testing has raised questions about why some auditors have agreed to do this kind of work.

They wanted to participate in what was seen as the next hot industry, Poppy Alexander, a partner at Constantine Cannon LLP which represents SEC whistleblowers, said of the accounting firms. They wanted to touch what looked like gold.

Risky business

Stock exchanges and other players in an often opaque industry present a myriad of risks to auditors. For starters, many offshore companies operate beyond the reach of US regulators. Gaps in auditing and accounting standards, which do not address digital currencies or tokens, add to the challenges for auditors.

There’s a huge liability to that, said Kyle Welch, an assistant professor of accounting at George Washington University. As far as auditing goes, their name is on the line at the back of this book.

Many crypto companies are relatively young and are growing their accounting teams and implementing internal governance controls. Auditing firms assess this level of maturity when deciding to work with clients. They also consider the level of service they could provide and their ability to meet those needs, said Brian Neil Hoffman, partner at Holland & Hart LLP.

How companies make this calculation varies depending on the expertise of their staff, their risk appetite and their business objectives.

Audit industry giants Deloitte, Ernst & Young, KPMG and PwC have generally avoided providing assurance services to companies involved in crypto. Yet affiliates of these big four firms have at least a dozen audit clients listed on public exchanges around the world, including Coinbase Global Inc., WisdomTree Inc., Northern Data AG, and Bitfarms LTD/Canada. regulatory requirements that accompany a public listing.

US subsidiaries of Deloitte and EY did not respond to requests for comment; PwC and KPMG declined to comment.

Even outside of the crypto challenges, CPA firms were already facing increasing pressure from the SEC. The regulator has put auditors, critical guardians of the market, on notice to stick to its main mission: to question the accounting of companies and provide real control over management.

They won’t hesitate to open investigations or take action, Hoffman said of the SEC’s auditor oversight.

Proof of reserves reports also caught the attention of Gensler, who told Bloomberg News that asset snapshots were not enough to protect investors.

Marcum President and CEO Jeffrey Weiner said the company has raised its risk monitoring assessments to determine whether to take on new crypto clients and continue to work with existing clients. The company, which does not offer reserve proof reports, had not yet decided to exit the industry altogether. Most laypeople don’t understand what’s in and what’s not, Weiner said.

Flying colors

The way the market perceives the work of auditors and the possibility that the limits of this work can be misunderstood is another risk with crypto clients. The negative reactions could spill over and tarnish investor confidence in the work of auditors for their public company clients.

Crypto firms have asked auditors for help in demonstrating they have enough funds to cover depositors’ claims, promoting one-time snapshots to clients, even though they’re a far cry from traditional audits financial statements. These Proof of Reserve reports do not verify a company’s total financial health or assess its ability to continue operating in the coming months, or show the total liabilities of an exchange.

Crypto exchange Kraken touted next-generation auditing standards that showed how far the exchange exceeded the transparency offered by legacy financial firms, the company announced in February.

The Yield Apps website reported that the crypto-wealth platform passed a rigorous reserves audit with flying colors in January.

It is simply inaccurate to call it an audit, said Aaron Jacob, accounting solutions manager at TaxBit, a cryptocurrency software company. Companies have to think: what risks do we expose ourselves to if our client says that it is an audit and he tells the market something that is not?

The reports accounting firm Armanino wrote for Kraken and Yield App detailing its findings were more measured and technical than what their clients announced via press release. The firm, which analyzed the assets in a single day, said it was limited only to demonstrating that outstanding customer liabilities are adequately reserved by assets held by the two companies.

Armanino LLP, the firm that audited FTX US, a branch of collapsed crypto exchange FTX, previously told the Financial Times that it was halting its financial statement audits and no longer providing proof of reserve reports to companies in the industry. . Armanino did not respond to requests for comment.

Crypto exchange Binance Holdings Ltd. promoted its reserve evidence report as a sign of transparency, but is now downplaying the reports’ significance after negative publicity caused the auditor it hired, Mazars, to remove the report from its website and to cease offering proof of reserve reports. entirely.

A Proof of Reserves report is just the first of many steps exchanges are planning in the coming weeks as it aims to be more transparent about the health of the business and the safeguards it has, Binance said. in a press release.

Francine McKenna, a longtime critic of the auditing industry who teaches financial accounting at the Wharton School of Business, criticized auditing firms for selling these services to companies eager to allay market fears. She called the reports a number matching exercise.

They came up with this agreed-upon procedure report that didn’t fool anyone, McKenna said. Even the crypto-devoted are skeptical. They are worried. They worry about the disappearance of client assets; they worry about crashing stablecoins.

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