New-age firms fall due to old causes

The Public Company Accounting Oversight Board (PCAOB) in the United States took birth courtesy Enron and WorldCom. In India, the Companies Act, 2013, was promulgated thanks to Satyam and Sahara. The National Financial Reporting Authority (NFRA) was brought to life because of Punjab National Bank. What is obvious from the above is that whenever there is an accounting ‘accident’, new legislation is enacted.

Continuing with that trend, it has been reported that the Securities and Exchange Commission (SEC) in the US is looking closely at the work done by the auditors of crypto-mining companies after the collapse of FTX. Questions are being raised about whether audit firms have the necessary technical ability to audit such new-age companies. All of this has prompted at least one audit firm to give up audits of crypto-mining companies.

In India, the RBI has always treated cryptos with a fair degree of scepticism. The Companies Act already has a provision for companies to disclose their crypto transactions.

The collapse of FTX has prompted many of these reactions. However, though FTX was a new-age company, its collapse was triggered by age-old corporate governance lapses -- greedy promoters, diversion of funds to related parties, donating to political representatives, and a lack of internal controls over financial accounting and reporting.

The financial statements of crypto companies contain only a few new items – ‘Digital Assets’ appear on the balance sheet, the main source of revenue would be digital currency-mining and hosting, revenue and the digital currencies would be revalued at the end of every reporting period with the gains or losses hitting the profit or loss account.

Crypto-mining companies enter into contracts with mining pools and undertake the performance obligation of providing computing power and transaction verification services to the mining pool in exchange for non-cash consideration in the form of digital currencies. They measure the non-cash consideration received at the fair market value of the digital currencies received. Fair value is estimated on a daily basis as the quantity of digital currency received multiplied by the spot price on the day it was received, and subsequently measured as an intangible asset. Accounting standards across the world mandate testing of ‘Intangible Assets’ for impairment at least annually.

Regulators are concerned that crypto-mining companies do not have adequate reserves matching their assets. This is a tall ask since most of these companies are funded by private equity funds and the funding would be used for expenses and some investment in equipment. Most of these companies are not profitable and hence the classic accountant’s entry of transferring a portion of the profits to reserves every year would not be possible. Instead of worrying about proof of reserves, regulators should get assurances about proof of funding.

To audit complex transactions such as cryptos, one would have thought that FTX would engage with the best auditors. However, they chose two small firms that have had negative comments issued on their work by the PCAOB. In 2019, the PCAOB published its private comments about deficiencies in one of the firms’ 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 past September, right before a class-action lawsuit was filed against Lottery.com’s executives.

FTX chose these auditors who would toe their line without asking too many questions -- which suited their penchant for violating corporate governance norms. It would be futile to blame the inadequacy of accounting or auditing standards for governance lapses – the blame rests squarely on the auditors who did not follow them at all. At best, auditing standards can be amended to fortify internal controls over financial reporting.

All existing accounting and auditing standards would apply to crypto companies. However, considering the unique nature of their business, accounting regulators across the world would come out with some guidance on accounting and auditing such companies. It would not take much time or effort for auditors to understand the nuances of the business of crypto companies. Audit reports these days have enough space for auditors to tell it as it is. Corporate governance norms provide enough ammunition to companies to tread the right path. If companies collapse despite this, it could be only due to two reasons – deliberate flouting of governance and disclosure norms or sheer ignorance.