The stunning meltdown of Sam Bankman-Fried’s FTX.com has revealed a black hole in the company’s financial reporting and accounting.
The crypto exchange—which said Friday that it had filed for Chapter 11 bankruptcy—is privately held, which means it does not have to share its financial statements with the public. Its website states that it completed a US GAAP audit for 2021 and “plans to undergo regular audits.” But it neither shared the name of its auditor nor published its audited financial statements. FTX didn’t respond to requests for that information.
Even if the company did share its audited financial results, however, the details might not answer key questions: What caused a gap between assets and liabilities at the company that Bloomberg News reported could be more than $6 billion? How much of that gap could be caused by an inflated valuation of the holdings of the exchange’s own crypto token, FTT?
“There is no transparency, there is no consistent valuation methodology, and there are no guiding rules or overarching frameworks to help folks in accounting and tax get a handle on these assets,” said Sean Stein Smith, chair of the Wall Street Blockchain Alliance’s accounting working group and an assistant economics professor at Lehman College in New York. “FTX is a poster child of how corporate governance failed, financial reporting failed, and the transparency and the auditability of the asset in question failed.”
US accounting rules do not directly address how companies recognize and measure their crypto holdings. In the absence of formal rules, companies largely treat cryptocurrencies as intangible assets, which means they record them at historical cost on the balance sheet and adjust them if the value declines. They are never able to record gains unless they sell their cryptocurrencies at a profit.
The lack of rules is particularly tricky for illiquid, thinly-traded tokens like FTT, a crypto asset created solely to be used within the FTX exchange, said Vivian Fang, accounting professor at the University of Minnesota Carlson School of Management. FTT tokens are similar to mall arcade tokens in that only the FTX platform accepts the tokens, but a customer could in theory sell them to someone who wants to use them for the same purpose, Fang said. The value of the FTX token has plunged this week to less than $3, from over $23 just a month ago.
The Financial Accounting Standards Board—the body that sets US accounting rules—is considering rules that would require publicly traded and privately held companies holding cryptocurrencies to report their coins at fair value, a measurement technique that would capture the ups and downs of the market. For assets like FTT, that will lead to big swings, Fang said.
“When we completely switch to fair value accounting, we have to understand the amount of volatility we might inject into some company balance sheets,” Fang said. " Some of them are so volatile because they’re so thinly traded and one trade could sway the price up or down by a lot.”
Adding to the confusion around FTX’s financial reporting: US authorities, including the Securities and Exchange Commission, the Commodity Futures Trading Commission, and the Department of Justice are investigating whether the firm properly handled customer funds, as well as its relationship with trading house Alameda Research, Bloomberg News has reported.
The lack of clear regulations in the crypto industry doesn’t help. Credit card customers, for example, receive pages of disclosures in their monthly statements about the risks involved in running up credit card bills because of regulations aimed at protecting consumers. Investors in crypto assets and in crypto companies have to rely on companies being as transparent as possible about their terms and conditions, their risks, and whether customer accounts are segregated from the company accounts, said Suzanne Morsfield, global head of accounting solutions at Lukka Inc., an enterprise crypto asset software and data provider.
“Private companies don’t have to disclose the same things as public companies—that is part of how our financial system works,” Morsfield said. “But investors that are engaging in the crypto space still need to have good information, as much as possible, about the risks they’re entering into.”