If cryptocurrencies and digital assets like bitcoin and NFTs (non-fungible tokens) have you scratching your head, you’re not alone. Sure, some of the confusion might come from the patently foreign vocabulary – blockchain, distributed ledgers, and smart contracts, to name a few – but not all of it.
As CFOs and CAOs are now discovering, there’s a whole new level of complexity lying just beneath crypto’s binary-coded surface, primarily around accounting for such digital assets. So join us as we discuss these asset types, how the accounting standards apply to them, and what it all means for your accounting team.
Crypto Isn’t a Passing Fad
We understand society’s spotlight can be fickle – think pet rocks, fidget spinners, dubstep, and 3-D movies. However, despite displaying enough recent volatility to dissuade even the most devout, forward-looking of souls, digital assets like cryptocurrencies don’t fit into that category.
In fact, although the current crypto rollercoaster is keeping many on the sidelines for the time being, the financial world has been far more welcoming to these assets than most people realize. To that point, massive firms like JP Morgan, Mastercard, and UBS have already sunk millions into the Ethereum network and infrastructure, the world’s second-largest virtual currency.
Even more astounding, the European Investment Bank (EIB) issued $121M in two-year digital bonds through Ethereum’s public blockchain network. And, of course, we don’t even have to mention how Bitcoin and NFTs are catnip to financial headline writers.
The point is, these digital assets and currencies aren’t a passing fad. Yes, calamities like FTX happen, and those occurrences make everyone hit pause for a moment to reassess – including the SEC, growing a bit more consistent with talk on stricter regulations around this asset type.
But for every FTX-type of crypto cage rattling, we’re still seeing decentralized finance (DeFi) trends, institutional investing, and the acceptance of crypto assets and stablecoins – crypto assets with values pegged to a fiat currency or commodity to minimize volatility – from customers for goods and services.
For any company thinking about dipping its toe into the crypto pool, though – whether now or when the waters calm a bit – you first need to have a solid handle on what you’re getting yourself into. And that starts with a basic understanding of these sometimes-digital-darlings.
What Are Digital Assets?
First and foremost, it's important to understand that digital asset is an extremely broad term. While most people associate crypto currency with digital asset, that's like using an Italian sub with pepperoncinis and a dash of vinegar and oil to represent all of sandwichdom. And that's just not fair.
In fact, digital assets are a wide-ranging class of assets that generally share a common characteristic – a reliance on blockchain technology. Now, given how most people's eyes glaze over when hearing blockchain, we'll leave some of our previous insights to catch you up to speed, if needed. But in a nutshell, digital assets use cryptography to verify and secure transactions on a ledger maintained by a decentralized network of participants. In other words, blockchain.
Diving in a bit further, you can basically break digital assets down between two main categories – fungible and non-fungible assets.
Fungible Assets
Fungible assets typically entitle the holder to a good or service from an identifiable party, like utility tokens, for instance. Alternatively, in the case of crypto assets, they can also serve purely as a medium of exchange. Note, however, that crypto assets cannot be issued by a governmental entity, serve as a contract between the holder and issuer, or be considered a security under the Securities Act.
Non-Fungible Assets
On the opposite side of the spectrum, non-fungible digital assets represent ownership of a digital or physical asset. Even a cursory following of the news over the last few years means you're at least somewhat familiar with NFTs of digital art, video clips, songs, or virtually anything else digital. They were everywhere for a while.
Accounting Guidance on Digital Assets
This is the point of the discussion where things get especially murky for a CFO or CAO looking for answers on digital asset and cryptocurrency accounting. Because, to put it bluntly, there really isn’t much – or more like any – corner of GAAP specific to them.
Let’s look at Tesla as an example. As you might remember, the company put $1.5B into bitcoin back in February 2021. Just two weeks later, Tesla’s crypto stake had grown to $2.5B, obviously a nice holding on paper. But that’s where the accounting issues begin since, not so long afterward, that very same bitcoin holding was $600M to $700M, burying the cost basis in an ocean of red. So how does anyone begin to sort through that bookkeeping disaster movie?
Well, we obviously can’t say exactly what it was like to be in Tesla’s accounting and financial reporting functions at the time. Further, there's nothing specific in US GAAP that speaks to digital assets directly. Thankfully, the AICPA has stepped in to fill the gap in GAAP – pun alert! – by forming a digital asset working group that published what has quickly become the non-authoritative gospel on accounting for cryptocurrencies and the like.
At this point, the AICPA practice aid is borderline indispensable with its discussion, assessment, and examples of different accounting and reporting questions around investing and holding digital assets. In fact, it even separates the discussion on accounting and reporting for non-investment and investment companies.
That said, while the practice aid provides a nuanced look at digital assets that companies probably won't find elsewhere, we're going to take the walk-before-you-run approach with these insights and stick to accounting issues with crypto assets for the time being.
Start With the Best-Fitting GAAP Framework
So let's start the conversation by determining exactly how to classify crypto assets on the balance sheet. Maybe as cash, cash equivalents, or a possible type of foreign currency, you ask? Nope. For an asset to be cash, it must be accepted as legal tender and backed by a government.
Likewise, cash equivalents must represent investments that are readily convertible to cash or have a near maturity that results in insignificant risk to the value. And an asset can’t be a foreign currency if it doesn’t represent cash.
Unfortunately, accounting for them as a plain ol’ investment or financial instrument is another swing and a miss. That’s because digital assets don’t represent a contract with a right or obligation to deliver or receive cash or some other type of financial instrument. And while crypto miners who intend on selling the assets might think of them as a type of inventory, digital assets usually don’t meet the definition under US GAAP since cryptography-based assets lack physical substance.
The Rise of Central Bank Digital Currencies (CBDCs)
All things considered, there’s a fair amount of financial report McGyvering around the accounting treatment for things like cryptocurrencies and digital tokens on the balance sheet. And it looks like it’s going to continue like that for the foreseeable future. However, one interesting development in this general area is the recent rise of central bank digital currencies (CBDCs). In 2021, China released the digital yuan, and many other countries – including the United States – are exploring the benefits and risks of CBDCs.
This doesn't mean, however, companies would classify a hypothetical digital US dollar – or any other CBDC – as cash because they’re still not legal tender or provide the holders any ownership interest or contractual rights to actual cash.
Still, a CBDC is a digital tokenized version of a nation's fiat currency, issued and regulated by the country's central-bank and, therefore, backed by the full faith and credit of the nation's government. So, yes, crypto assets like CBDC's are moving closer to financial instrument status under GAAP, but still have a ways to go.
Accounting for Crypto as an Intangible Asset
So where does that leave us? Most companies are classifying digital assets as a type of intangible asset, at least when they go out and purchase the asset themselves. Granted, this still isn’t a great fit, but it’s the best we have under the current standards since it provides the broadest definition. Specifically, digital assets:
- Lack physical substance, and;
- Are indefinite-lived as they have no prescribed life.
This means, in the case of a purchase or investment into a crypto currency, companies initially record digital assets at their acquisition cost and, thus, subject them to annual and trigger-based impairment tests. Needless to say, this opens up an entirely new can of financial accounting worms.
Given the constant volatility of these digital assets – and the fact that the impairment model for indefinite-lived intangible assets permits a write-down in value but no write-up for increases – the accounting outcomes can be hard for some to wrap their head around.
In fact, even a single day's significant decline in the value of a digital asset could warrant a trigger-based impairment test and possible impairment losses. That’s because, unlike some financial instruments, the impairment framework for intangible assets is not an other-than-temporary-impairment model.
Performing Impairment Tests on Digital Assets
Now that we know what we’re up against, it’s just a matter of following applicable guidance in ASC 350 – or industry specific exceptions like, for example, an investment company under ASC 946. In the case of a direct purchase under ASC 350, you begin by looking at the asset’s fair value and comparing it to its carrying value. If the fair value is less, then you have to write it down and take an impairment charge.
But as we mentioned earlier, you cannot recover any value for previous impairment charges taken under current US GAAP. Instead, you would only recognize any upside as a gain upon the sale of the intangible asset, and that’s just when the sale price exceeds the adjusted carrying value.
Crypto Received as Payment
As we said, some companies are now accepting crypto in exchange for goods or services. In such transactions, a company would follow the non-cash consideration under ASC 606-10-32-21. Here, the guidance states that when the customer promises consideration in something other than cash for the transaction price, a company measures the estimated fair value of the non-cash consideration at contract inception.
Yes, this may differ from when the crypto is actually received and, as we all know, volatility could swing values quickly and significantly. In this instance, there can be an embedded derivative associated with the contract that a company would need to evaluate and account for under the derivative guidance. So, yeah, there's a lot going on here.
Crypto Acquired in a Business Combination or Asset Acquisition
Given what you just read, you could probably use something a lot more straightforward right now. Thankfully, when it comes to crypto acquired in a business combination or asset acquisition, you follow the guidance in ASC 805. Therefore, you measure the crypto at its fair value for business combinations – or, in the case of an asset acquisition, its relative fair value – as of the acquisition date, and then treat it as an intangible.
Crypto Purchased through a Third Party Custodian
In many cases, entities hold their crypto assets either directly or indirectly through a third party. This type of arrangement can muddy ownership rights and responsibilities, making it important to distinguish between actually owning the asset and just having the right to obtain the crypto asset from the third party. As you might guess, the company only recognizes the asset on their financial statements if it has control over it.
Thus, when the situation arises, you must first look at the terms in the agreement, the laws governing the jurisdiction where the third party operates, and how it manages and stores the crypto assets. Once again, rather than occupying additional digital real estate by discussing this area, we recommend looking at the AICPA guide for common factors to think about when determining if you should recognize crypto assets held within a third-party digital wallet.
Operational Considerations for Crypto Assets
Of course, with such a Wild West feel to it, holding and accounting for crypto assets isn't just about your balance sheet, but your internal controls and processes as well. So on that note, we also have a few areas you'll want to keep in mind to ensure effective processes and control environment around crypto.
Controls over Digital Keys and Wallets
Blockchain transactions are either set in stone or extremely difficult to reverse. Or at least they should be. Therefore, once you send a transaction to a specific wallet address, you cannot adjust the blockchain entry unless the counterparty is actively involved.
In other words, erroneous or inappropriate digital asset transfers could very well lead to a permanent loss of digital assets. Put another way, without properly safeguarding the transfer, you might be throwing the crypto assets into a digital blackhole. And that's no bueno.
This makes your controls over initiation and authorization of transactions absolutely imperative, and the same goes for lost or stolen private keys that essentially lock you out of a crypto wallet. Therefore, private key security and understanding how they work are critical since anyone with key access can use or send your crypto assets.
Evaluating Third Parties
Obviously, you need to consider and understand any risk associated with using a third-party custodian to store digital assets. Keep in mind, a custodian may commingle assets from different customers into the same addresses while also maintaining its own off chain ledger. This can complicate verifying your specific assets and negate the entire purpose of using the blockchain in the first place.
To avoid such pitfalls, you should begin by obtaining and reviewing the service organization controls (SOC) reports. From there, you should focus on designing, implementing, and maintaining controls over information received from an exchange, not to mention controls over a custodian's safeguarding of your assets.
For example, you want to understand how a third party's controls relate to the generation and ongoing security of digital keys used in transactions. Similarly, does the custodian have sufficient customer on-boarding and due diligence procedures to avoid any potential legal or noncompliance issues down the road? These are the types of insights you need to safeguard your assets and business in general.
Transaction-Related Controls and Counterparty Risk
It's not just about controls outside of your business, however. In fact, your internal controls over transactions are just as important, if not more so. To that point, you want to establish appropriate authorization controls and segregate duties associated with the initiation of any crypto transactions.
Likewise, given the pseudo-anonymous nature of blockchain transactions, just determining the identity of a party you're transacting with could be a significant challenge. Naturally, this increases counterparty risk, making it crucial for you to establish policies, processes, and controls to assess such risk.
The Future of Accounting for Digital Assets
We've spent much of our time today discussing the unpredictability and lack of structure around crypto assets, particularly on the accounting rules front. However, in the good news department, there have been a few recent developments from the Financial Accounting Standards Board (FASB) on their digital asset project that, with time, can help shore up accounting for digital assets if and when a final ASU is issued.
May 2022 – The FASB added a project to address the recognition, measurement, presentation, and disclosure of particular digital assets in financial statements.
August 2022 – The board decided this project should apply to:
- Fungible digital assets currently accounted for as intangible assets under GAAP, likely applying to bitcoin and Ethereum as well
- All entities, including those subject to industry-specific guidance like broker-dealers, investment companies, and other financial services firms
October 2022 – The FASB decided to require fair value measurement for all in-scope crypto assets for all entities, also requiring crypto asset acquisition costs to be expensed as incurred unless industry-specific GAAP applies to such costs.
So that's something, right? Sure, the crypto paved road ahead is still pretty foggy but, being eternal optimists at Embark, we're encouraged by any movement in the right direction. Ultimately, a company must weigh the good versus the bad when looking at any digital or crypto asset integrations with operations.
Yes, it’s another financial asset class that allows you to further diversify and possibly recognize some serious gains when the stars align. However, even a team of battle-hardened in-house CPAs can find accounting for crypto to be messy and confusing, and the significant volatility only amplifies the mess on the financial statements.
Just remember, your technical accounting gurus here at Embark are always ready to step in whenever you need us, for digital assets like cryptocurrencies or anything else for that matter. It’s what we do.
