How does a professional auditor analyze financial reports?
In this episode, host Nick Drakon, founder of Revelo Intel, speaks with Souvlaki, Head of Financial Reporting at Beethoven X, about experiences & misconceptions around auditing, Tether’s background, controversy, disclosures & reports, landscape post FTX collapse, proof-of-reserves & other disclosures investors need.
Read our notes below to learn more.
Beethoven X background
A decentralized exchange operating on the Balancer tech stack that runs on both Fantom and Optimism.
Souvlaki’s background
Spent a decade working at two of the Big Four auditing firms.
Another five years at one of the largest TradFi investment banks in the world.
Souvlaki’s experience in financial auditing & reporting
Did a variety of client scopes & industries across multiple locations.
Engagements vary from full scale audits to limited scope engagements.
Scope in the UK was more focused in banking & capital markets area, then has a more narrowed focus on liquidity, market risk & treasury space.
Moved into a treasury risk role in the banking space where he looks into what’s happening in the macro environment, future business pipeline items, setting appropriate controls in place & responding to risk as & when it happens.
First-hand experience in a volatile macro environment.
Misconceptions around auditing
The objective of an audit is to determine whether the numbers presented & the disclosures relating to them are free from material misstatement as a result of fraud or error.
Auditors don’t go into an entity & look at every single invoice or every single entry within the ledger, they look at things that are deemed material.
Material is depending on the nature of business whether it changes the perception.
When audits are performed, they are done based on risk factors.
Auditors would look at what’s the underlying environment that the company operates & what are the fields that they have, then, they’ll determine whether certain areas of financial reporting have a higher risk of fraud in them.
A forensic audit is done if there is a beyond reasonable doubt that there is something suspected happening within the organization.
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Tether’s background
Issuer of the $USDT stablecoin that has a simple business model where users & institutions give Tether fiat currency & in exchange, Tether will issue a stablecoin in 1:1 ratio.
They keep a certain amount of U.S. dollars liquid & available for redemptions at any time & invest the rest of it.
They went out of the risk curve & looked for higher yields that led to engaging in riskier activities than they would have otherwise & this produced controversies in the industry.
There have been questions if Tether is liquid enough to meet redemptions & if assets are appropriately valued.
One of the options available to companies like Tether is buying U.S. treasuries which is a risk-free environment.
In a zero-rate environment, they have options to lend money to private companies or buy corporate bonds around the world.
They potentially lent money to some obscure entities in China & the value of the paper that was lent out was unknown.
Tether announced on Nov. 10, 2022 that over the course of the year, they reduced their commercial paper exposure by $24B.
Within this year, they have been buying back commercial paper that was outstanding & have been replacing it with treasuries making it a more transparent & less risk balance sheet.
Tether’s reduction in commercial paper
In spite of everything that is happening, they are doing work in terms of risk management & re-aligning the strategies.
Created more confidence in what they are doing.
More sophisticated auditing firms are willing to work with them.
Tether’s limited assurance engagement
Limited Assurance Engagement is designed to get confirmation or assurance of something very specific & generally done in conjunction with management.
Tether doing this type of engagement is not a red flag.
Every holistic company or major corporation out there is only doing a full-scale audit once a year & a review engagement for half year interim numbers which is generally a result of listing numbers or any other regulator looking for those numbers.
Based on what happened to FTX, it is important to have an independent verification on the numbers.
Consolidated Reserves Report & red flags
CRR report is a consolidation of the assets that are backing the Tether tokens in issuance.
A fairly standard practice in a sense of looking at free from stereo statements & applying the concept of materiality.
There are defined procedures & mathematical equations behind how they do it.
Latest Tether’s CRR report states that no errors have been found.
Some of the things BDO has done to verify the report is going directly to banks to verify balances, independently verifying the amounts & information that Tether has told them.
Reconciling CRR pre-FTX collapse data
Things could have happened between the 30th of September & 10th of November that could have impacted the value of both the assets or liabilities within the CRR.
The FTX collapse happened after the CRR report was issued.
On November 17, Tether had an announcement that addressed some of the questions around what kind of exposure they had to FTX & Alameda.
In the asset category of the CRR on page 7 of the BDO report, it shows the breakdown of the cash or cash equivalents which are, U.S. treasury bills are around $40B which is the vast majority of the balance sheet, market funds of $7B cash, bank deposits of $6B, reverse repurchase agreements of $3B, corporate bonds of $3B, other investments & some secure loans.
The disclosures are overall looking solid.
There is an important indicator in the CRR report, page 4, that points to management key accounting policies stating the report is prepared using recognition & measurement principles of IFRS as issued by the ISB.
There’s no clear guidance of IFRS around disclosures for digital assets & liabilities.
Thoughts on Proof-of-Reserves
There is an interesting evolution in terms of where focus areas are, what people are looking at & what people deem important.
It is concerning there are no liabilities indicated in recent releases of proof-of-reserves.
The insolvency of an exchange is like the available cash & digital assets they own vs. what they owe to customers that are using the protocol.
The heat has calmed already a bit off from exchanges because they’ve made a commitment to do proof-of-reserves & we’ll see how long it takes for these liabilities to service themselves.
Currently not trusting any centralized exchange at this point & removed all the money from them including Binance.
The disclosures these centralized exchanges are going to be providing in these coming months is going to be a core component on where to do business.
Looking forward to seeing fully audited financial statements.
There’s an opportunity for someone like CZ from Binance to go & sit with the accounting standards board to determine a financial reporting framework of exchanges for the industry as a whole & create this framework for digital assets to operate in.
Looking forward to seeing how proof-of-reserves reporting evolves.
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