Why crypto needs to be audited

Cryptocurrency investors are finding that the limited “proof of reserves” audits touted by some crypto companies don’t provide much reassurance after the meltdowns of prominent crypto exchanges like FTX.

Nevertheless, other crypto companies have touted such audits, including Binance, Crypto.com, Kraken and KuCoin. A handful of auditing firms like Armanino and Prager Metis offered this type of assurance in the past, at least until their former client FTX’s collapse last November. Mazars, which provided proof of reserves audits for Binance, Crypto.com and Kraken, has also reportedly halted such work.

A proof of reserves audit is more like a limited form of assurance rather than a full audit and mainly checks to see whether the assets listed on the crypto exchange balance sheet would be enough to balance their customers’ holdings. But when an exchange like FTX is secretly shifting customer funds to a related entity like its Alameda Research arm, it’s more difficult for an auditor to spot such activity without doing a full audit.

The legal and reputational fallout from the meltdown of FTX and other prominent crypto exchanges is likely to discourage more major auditing firms from getting involved in the crypto market, at least when it comes to engagements limited to vouching for a proof of reserves. 

“As it relates to proof of reserves, a lot of Big Four audit firms have been unwilling to do some of these audits,” said Isaac Heller, CEO of Trullion, a New York-based company that develops accounting and auditing software. “Specifically the proof of reserves engagement has been this middle ground. But it’s a little bit vague in terms of how you engage, and what’s the expected outcome, so a lot of audit firms are not doing this proof of reserves work.”

Of course, auditing problems can be found outside the crypto industry as in the accounting scandal revolving around the German payment company Wirecard, whose former CEO has been testifying during a trial in a German courtroom.

“In the case of Wirecard needing to verify a cash balance through a bank confirmation, that was not successful, and it was something that was missed over a multiyear period,” said Heller. “That’s the extreme, but this happens all the time within the audit practice because you have complex businesses, siloed systems and multinational connections, and you have to audit it all. When you apply that traditional sampling framework with legacy systems, and then you move over into crypto, that’s even harder, because crypto has a high volume of transactions. It has systems that may be even newer or even unheard of to audit firms.”

Crypto is a relatively new area, and auditing firms and standard-setters like the Financial Accounting Standards Board and the Public Company Accounting Oversight Board have been trying to learn more about it. FASB has been working on a digital assets project that’s focusing on crypto and decided in October to use fair value measurement for valuing it. 

“Making a decision to move to fair value accounting has a big impact,” said Heller. “It’s going from kind of an annual view of crypto tucked in under intangible assets to potentially a monthly view, which is really important and impactful when you have such a volatile asset class.”

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

“As a standard setter, before we can write standards, we need to understand the economics,” she said. “You can’t write standards on what is 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 a while for us 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 scoped the project very narrowly, to things that really can only generate results in realized value through an exchange. And that, to my mind, provides a very clear path for determining what the appropriate measurement system is.”

FASB was able to find an approach that seemed feasible after hearing demand from its stakeholders for a digital assets project, and specifically crypto assets.

“There were questions about whether or not there was technologically a feasible solution, because we hadn’t scoped the project narrowly enough,” said Botosan. “And so we were worried about whether fair value would be the appropriate measurement basis for talking about tokens that provide rights to underlying assets. Ultimately, where we ended up, and why I ultimately supported adding the project, was I felt that there was an ability to solve the project where we could get to a better solution than what the alternative solution was, which was the treatment as an intangible asset at historical cost with an impairment problem. And I really felt that the economics of the types of assets that are scoped in our project are better reflected through fair value measurement with those gains and losses.”

Auditors will also need to contend with those questions and they too may need to take fair value into account if the financial statement preparers are using it for measurement. 

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

The blockchain is supposed to contain a distributed ledger of all crypto transactions and automatically capture them, yet it’s still proving to be difficult to audit crypto.

“The funny thing about this all is the nature of blockchain,” said Heller. “An immutable full audit trail of transactions between all counterparties is the golden ticket that would reduce the need for audit. Obviously, you would 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 practices? It’s something we’re going to have to see play out over the years. It’s a big promise, but one that’s far from being fulfilled.”