Accounting Regulation and Reform: FTX Collapse

Psychological Risk Factors

December 4, 2022

The Future Lawyer Weekly Briefing – W/C 6th December

December 6, 2022

Published by Shwetha Sivaraman at December 5, 2022

Article by Oscar Luck

Adam Smith envisioned a world in which the selfish interests of corporations and consumers would result in a fair equilibrium being reached. However, what he didn’t account for was the ability of corporate entities to defraud the people who rely on and invest in them, prodigious collapses resulting in bankruptcy and insolvent liquidation. To correct this default, government regulation has been implemented, in the form of accounting, to help minimise the risk of such events. With the recent collapse of the multi-billion dollar crypto exchange FTX, in addition to the innumerable instances of accounting failure, can it really be said that these mechanisms are working, and if not, what reforms are being made?

Accounting law

Currently, in the UK, unless exempt, all companies have to partake in a yearly audit. Here, an independent auditor is required to ‘obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditor’s report that includes the auditor’s opinion’. They have to attempt to identify the risk present of a misstatement, understand the internal control structure sufficiently for this purpose, evaluate the appropriateness of the firm’s accounting policies, judge the directors’ use of accounting, and evaluate the issued financial statements.

However, accountants are rarely held liable for failing to discover fraud as they are ‘watchdogs not bloodhounds’. Directors are not liable to any third party unless special circumstances arise, such as if they had made direct representations to the third party. If not, they are solely liable to the company. Indeed this is insufficient, as companies not only defraud themselves and their shareholders when conducting business in bad faith, but they also cause detriment to their customers, who place mistaken faith in their services based on a facade.

FTX collapse

Recently, FTX has been plastered over the news, with various accounting failures continually coming to light. Currently, a Chapter 11 bankruptcy is being processed, and it is in insolvent liquidation. The liquidators have managed to recover $740 million. However, the 50 biggest creditors alone are owed over $3 billion, meaning many debts will be unpayable. FTX used two accounting firms, Armanino LLP and Prayer Metis, neither of which noticed or reported the breaches of policy they were committing.

FTX’s finances were apparently ‘a complete failure of corporate controls’ – John J. Ray III, the new CEO of FTX. The firm had no complete list of customer accounts. The CEO, Sam Bankman-Fried, used consumer funds to purchase property for himself and his family in the Bahamas. Furthermore, the firm misappropriated consumer funds to support its subsidiaries, even though they still were the consumers’ property and thus could not be used in this way. If the finances were in such a bad state, it is clear that the accountants should have reported such misconduct to prevent the billions lost due to the malpractice.

Crypto accounting

The primary source of missing assets arose from an accounting sector that operates without official standards. Many companies hold vast positions in cryptocurrencies; Tesla had over $2 billion in bitcoin in 2021. This is potentially problematic, as cryptocurrencies are notoriously volatile and prone to collapse, as government bodies do not regulate them. FTX held crypto assets with a reported value of $5 billion. However, just a week after this statement was made, this value was reduced to barely 10% of the stated value, at $649 million.

When accepting liabilities is based upon a company’s asset value, having volatile assets is problematic for balancing the books. Regulation that standardises a method to deal with this volatility needs to be encouraged, informing those interacting with the company of the risk involved with such holdings.

FTX had major holdings in a cryptocurrency called FTT, that although publicly traded, is relatively limited in volume. This meant as soon as one firm started to dump the price, all others followed. Almost instantaneously, FTT was left with only 20% of its previous value; thus, FTX lost substantial asset value.

Having such volatile asset value creates risk for all forms of corporate transactions, from M&A to loans.

Accounting reform

Currently, accounting reform is in the works in the UK, with various measures attempting to solve the problem of monopolies, conflicts of interest and poor quality.

Within this legislation, a category of companies called Public Interest Entities has been created, including companies with more than 750 employees or annual turnover greater than £750 million. Most accounting reform is targeted at these companies; this was decided to be the most effective way to reduce the burden on smaller companies while also addressing the companies with the most to gain and the most to lose from fraudulent practices.

Within accounting, there are arguably monopolies, as the ‘big four’ undertake the majority of the work for important companies. In order to counter this, the government has proposed forcing PIEs hiring one of the ‘big four’ to also hire a smaller ‘challenger’ firm that will complete at least a third of the accountancy work needed.

A new audit regulator will be introduced, called the ARGA, that will have increased investigative and regulatory powers. It will have powers to enforce breaches of corporate codes and impose fines and sanctions. Additionally, there are plans to improve auditor training with professional bodies required to substantially improve training and skills to create a ‘more effective audit profession’.

These are just a few examples of the reforms proposed. But the act has yet to be passed, so they are still open to change.

Conclusion

The recent collapse of the FTX exchange should remind the government of the necessity of such regulation and the continual need to improve the accountancy profession to prevent such losses. However, it seems inevitable that similar events will continue to occur, as it is impossible to remove the incentive of corruption. Therefore, due diligence is required in every transaction, treating financial statements with scepticism in order to avoid unnecessary risk.