Why crypto needs to be overhauled

Cryptocurrency investors are finding that the limited “proof of reserve” audits touted by some crypto companies don’t offer much reassurance following the collapse of prominent crypto exchanges like FTX.

Still, other crypto companies have designated such audits, including Binance, Crypto.com, Kraken, and KuCoin. A handful of audit firms such as Armanino and Prager Metis offered this type of insurance in the past, at least until their former client FTX collapsed last November. Mazars, which provided evidence of reserve audits for Binance, Crypto.com and Kraken, has also allegedly stopped such work.

A proof of reserve audit is more like a limited form of security rather than a full audit and mainly checks whether the assets listed on the crypto exchange balance will be enough to balance the customers’ holdings. But when an exchange like FTX secretly moves client funds to a related entity like the Alameda Research arm, it’s harder for an auditor to detect such activity without performing a full audit.

The legal and reputational fallout from the meltdown of FTX and other prominent crypto exchanges is likely to discourage several major auditing firms from engaging in the crypto market, at least in terms of engagements limited to vouching for a proof of reserves.

“As far as proof of reserves, many of the big four audit firms have been reluctant to do any of these audits,” said Isaac Heller, CEO of Trullion, a New York-based company that develops accounting and auditing software. “Especially the proof of reserves engagement has been this middle ground. But it’s a bit vague in terms of how you engage, and what’s the expected outcome, so a lot of audit firms don’t do this proof of reserves.”

Of course, audit problems can be found outside the crypto industry as in the accounting scandal surrounding the German payment company Wirecard, whose former CEO has testified during a trial in a German courtroom.

“In the case of Wirecard having to verify a cash balance through a bank verification, that was not successful and that was something that was missed over a multi-year period,” Heller said. “It’s extreme, but this happens all the time within the audit practice because you have complex businesses, siled systems and multinational connections, and you have to audit everything. When you use the traditional sampling framework with legacy systems, and then you move to crypto, it’s even more difficult, because crypto has a high volume of transactions. It has systems that may be even newer or even unheard of by auditing firms.”

Crypto is a relatively new area, and auditing firms and standard setters such as the Financial Accounting Standards Board and the Public Company Accounting Oversight Board have been trying to learn more about it. The FASB has been working on a digital assets project that focuses on crypto and decided in October to use fair value measurement to appreciate it.

“Making a decision to move to fair value accounting has a big impact,” Heller said. “It goes from sort of an annual view of crypto hidden under intangibles to potentially a monthly view, which is very important and impactful when you have such a volatile asset class.”

FASB board member Christine Botosan discussed the project during a conference on accounting, governance and regulation of digital assets at New York University in January.

“As a standard setter, before we can write standards, we have to understand the economics,” she said. “You can’t write standards on what’s the most appropriate recognition, measurement or disclosure for a transaction without really understanding the economics. We’ve been able to move relatively quickly now that we’ve added the project, and it took us a while to decide to add the project. There were certainly people who wanted us to add the project much earlier than we did. But we’ve been able to move the project quickly since May 2022 because we’ve limited the project very narrowly, to things which can really only generate results in realized value through an exchange. And that provides, in my opinion, a very clear path to determine what the right measurement system is.”

The FASB was able to find an approach that seemed workable after hearing the demand from stakeholders for a digital asset project, and specifically cryptoassets.

“There were questions about whether or not it was a technologically feasible solution because we hadn’t limited the project narrowly enough,” Botosan said. “And so we were concerned about whether fair value would be the right metric to talk about tokens that give rights to underlying assets. Ultimately, where we ended up, and why I ultimately supported adding to the project, I felt that there was an ability to solve the project where we could come to a better solution than what the alternative solution was, which was the treatment as an intangible asset at historical cost with a depreciation problem. And I really felt that the economics of the types of assets that are the scope of our project is better reflected through fair value measurement with these gains and losses.”

Auditors will also have to wrestle with these questions, and they may also have to consider fair value if financial statement preparers use it for measurement.

“Generally, the traditional audit is in a retroactive, backward-looking world,” Heller said. “If crypto companies are privately held, they will be audited on an annual basis, or maybe just based on events and funding and things like that. Obviously, in the public markets, companies like Tesla with crypto will go through more quarterly and rigorous audits, but even at fair value, it’s just for the internal accounting standards. From an audit perspective, auditors aren’t necessarily equipped or accustomed to doing monthly audits with these firms, especially private companies.”

The blockchain is supposed to contain a distributed ledger of all crypto transactions and automatically capture them, but it still proves difficult to audit crypto.

“The funny thing about all of this is the nature of the blockchain,” Heller said. “An immutable full audit trail of transactions between all counterparties is the golden ticket that would reduce the need for auditing. Obviously, you still need to audit the companies in the blockchain and infrastructure. How do you audit a crypto company itself, which has its own internal controls and practice? That’s something we’re going to see play out over the years. It’s a big promise, but one that’s far from being fulfilled.”