Photo credit: Erika P. Rodriguez/The New York Times

FTX: Latest example of auditor failing as financial guardians

Article published in the Philadelphia Business Journal on December 19, 2022.

Since 2001, the accounting firms responsible for auditing four high-profile companies have failed in their role as the guardians of those who rely on their audits.

FTX

Each day, more details emerge about the collapse of Bahamas-based FTX Trading Ltd, formerly led by 30 year-old CEO Sam Bankman-Fried. FTX was the third largest platform processing cryptocurrency transactions. Bankman-Fried also held a 90% equity position in Alameda Research, a hedge fund that traded in cryptocurrencies. 

Despite the illegality and a clear conflict of interest, Bankman-Fried transferred FTX client funds to Alameda, weakening the balance sheet of FTX. He also co-mingled both customer and company funds.

On Nov. 9, FTX suffered a liquidity crisis. The company declared bankruptcy on Nov. 11.

John Ray III, who oversaw the bankruptcy of Enron in October 2001, was appointed CEO of FTX to oversee its bankruptcy. Ray characterized FTX as having “a complete failure of corporate controls [and a] complete absence of trustworthy financial information.”  

Ray said, “From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.” 

On Dec. 12, the U.S. Securities and Exchange Commission charged Bankman-Fried with “orchestrating a years-long fraud to conceal from FTX’s investors the undisclosed diversion of FTX customers’ funds to Alameda Research LLC, his privately held crypto hedge fund,” among other charges. 

“Auditors are required to maintain a ‘professional skepticism’ of their clients, including errors and fraud,” said Robert Knechel, director of the Accounting and Auditing Center at the University of Florida.

In a statement to Bloomberg on Nov. 18, FTX auditor Prager Metis CPAs LLC said, “We believe the financial statements of FTX Trading Ltd. as of Dec. 31, 2021 were fairly stated and we stand behind our audit opinion.” Expect lawsuits.

Photo credit: Erika P. Rodriguez/The New York Times

Trump Organization

During a probe of The Trump Organization by the New York attorney general, Mazars USA, the company’s accounting firm, wrote a letter to the organization dated Feb. 4, 2022. That letter stated, “We write to advise that the statements of financial condition for Donald J. Trump for the years ending June 30, 2011—June 30, 2020 should no longer be relied upon.” 

Bankers relied on those audited statements to loan The Trump Organization money to expand their business. Insurance companies relied on those statements to insure Trump properties. Those statements were the basis of the company’s tax returns.

Did sizable audit fees paid by The Trump Organization incentivize Mazars, a small firm, to issue unreliable audit reports for 10 years rather than fire The Trump Organization as a client?

Madoff

Madoff Investment Securities was the largest Ponzi scheme ever perpetrated against investors. Some $65 billion in investor funds from approximately 4,800 clients were lost when the Ponzi scheme collapsed in December 2008. Only some of those funds were subsequently recovered.

CNN Money reports that the small firm of Friehling & Horowitz was the audit firm of Madoff Investment Securities. David Friehling admitted that his firm conducted cursory audits and pleaded guilty in November 2009 to a number of federal charges. 

Friehling failed the investors who put their trust in Madoff. It was no accident that Madoff used such a small three-person audit firm. As in the case of the Trump organization, were the significance of the fees paid by Madoff the incentive for Friehling to conduct only cursory audits? 

Enron

Through mergers and acquisitions, Enron became a rapidly growing diversified energy and commodities company with revenues in excess of $100 billion in 2000. Through the use of creative accounting and off balance sheet financing, the company appeared to be financially stronger than it really was. 

As a result of the fallout from Enron’s fraudulent practices becoming public, in October 2001, the company declared bankruptcy. 

Enron’s audit firm, Arthur Anderson, one of the big five accounting firms at the time, suffered huge damage to its reputation and disbanded. An outcome of the Enron scandal was the passage of the Sarbanes Oxley legislation, which tightened up accounting standards and whistle-blower protections at public companies.

Audit firms are the guardians that protect the investing public and those who rely on companies’ financial statements. It is imperative they have the capability to audit those companies and maintain their independence, especially when the fees received are a significant portion of the audit partner’s and audit firm’s income. They need to fire their client if they uncover a pattern of fraudulent practices.

 

Stan Silverman is founder and CEO of Silverman Leadership and author of “Be Different! The Key to Business and Career Success.” He is also a speaker, advisor and widely read nationally syndicated columnist on leadership. He can be reached at Stan@SilvermanLeadership.com.

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