Commentary: FTX lesson No 1 – Don’t fall asleep in accounting class

Sam Bankman-Fried is a reminder that under the heading “boring but important”, basic bookkeeping tops the list, says Michelle Hanlon and Nemit Shroff for Bloomberg Opinion.

Commentary: FTX lesson No 1 - Don’t fall asleep in accounting class
Sam Bankman-Fried is seen in police custody on Dec 13, 2022 in the Bahamas, accused of committing one of the biggest financial frauds in US history. (Photo: AFP/Mario Duncanson)

CAMBRIDGE, Massachusetts: Investigations are underway into the stunning collapse of FTX and its sister company, Alameda Research. FTX-related case studies will be taught in business schools for years to come. Out of the tangled mess, one lesson already has become clear: The lack of a serious accounting system or even basic internal controls contributed to the company’s downfall.

As professors of accounting, it’s a continual challenge convincing students that our courses are important when they’re tempted by sexier-sounding classes with titles that include words like “innovation”, “artificial intelligence” or “fintech”. “Introduction to Financial Accounting” doesn’t pique the interest of the typical 20-year-old.

The FTX debacle has given us our best argument yet. It enshrines all the reasons a solid accounting system and well-structured internal controls are critical to a business and its investors, creditors, customers, suppliers and other stakeholders.

CONTROLS EVEN AT MINIMAL LEVEL MIGHT HAVE PREVENTED LARGE-SCALE MELTDOWN

Internal controls are the checks and balances a company puts in place to protect its assets, maintain integrity in its financial accounting systems and reporting processes, and to ensure compliance with company policies and applicable laws and regulations.

Publicly listed US companies need to have their internal controls reviewed by an independent auditor to ensure they’re doing the job. In addition, certain US financial institutions that maintain custody of customer assets must attest to their internal controls.

If FTX had implemented such controls even at a minimal level, many of the company’s deficiencies would have become known sooner and the large-scale meltdown might have been prevented.

FTX’s bankruptcy filing indicates that it had no in-house accounting department and failed to take even the most basic measures, such as segregating duties and establishing a system to keep track of accounts.

The sworn declaration from John Ray, the new chief executive officer of FTX and chief restructuring officer, indicates he is struggling to locate the company’s cash and crypto balances.

The filing also says corporate funds were used to purchase homes and other personal items for employees and advisors, that FTX used software to conceal the misuse of customer funds, and that there were other obvious shortcomings in standard accounting practices and internal control procedures.

When the person who previously supervised the bankruptcy proceedings of frauds as spectacular as Enron states that, “Never in my career have I seen such a complete failure of corporate controls,” one wonders how this could have been possible, especially at a company that raised a total of US$1.8 billion in funding over seven rounds, and was valued at US$32 billion in February.

On Monday, FTX co-founder Sam Bankman-Fried was arrested in the Bahamas and charged with eight criminal counts in the US.

WHERE DOES THE BLAME LIE

The FTX saga has led observers to cast blame in many directions: On regulators, FTX’s investors, its auditors, the CEO of Binance (Changpeng Zhao, or CZ, as he is known) and even FTX’s customers. But it seems clear to us that the blame for FTX’s collapse should fall squarely on the top management at FTX, not on its competitors or the industry as a whole.

It’s true that FTX’s investors should have demanded greater accountability, such as attestations of internal controls by both management and a reputable independent auditor. That they didn’t doesn’t mean that they’re responsible for FTX’s failure; it simply means they failed at their own due diligence.

One can only speculate why sophisticated investors didn’t do more to protect their investment. Perhaps the potential for large gains outweighed the risk of loss on a few investment decisions. Even so, investors would certainly have reduced their exposure by demanding some visibility into accounting safeguards.

Casting any blame on CZ, or any of FTX’s customers, is a red herring — at least based on what is known so far. CZ and FTX’s customers responded to the leaked disclosure of Alameda’s balance sheet as one would expect them to — they began to pull their money out once they learned about the substantial, previously unknown risks surrounding their investments.

Binance’s withdrawal of its funds and termination of its planned acquisition was not the cause of FTX’s failure, but rather a symptom of it.

Raw intelligence, academic accomplishments and professed altruism are no substitutes for financial accounting systems, internal controls and materially correct financial accounting statements. Nor are they legitimate reasons to make customers, competitors and the whole industry a scapegoat for internal failures.

Accounting classes may never sound thrilling to most young students and entrepreneurs, but FTX’s collapse proves the necessity of learning the principles of sound accounting for any business.

While it may not be the most exciting part of starting up a new company, entrepreneurs have been put on notice: You need to create a system for reliable accounting and be ready to vouch for appropriate internal controls.

Source: Bloomberg/aj