CRYPTOCURRENCY ACCOUNTING: A BIG CHALLENGE FOR ACCOUNTANTS

Digital assets—Pose big challenges for the accountants of the current era to show the financial positions of artificial and natural persons.

What is cryptocurrency?

Cryptocurrency is an intangible digital token that is recorded using a distributed ledger infrastructure, often referred to as a blockchain. These tokens provide various rights of use. For example, cryptocurrency is designed as a medium of exchange. Other digital tokens provide rights to the use of other assets or services or can represent ownership interests.

These tokens are owned by an entity that owns the key that lets it create a new entry in the ledger. Access to the ledger allows the re-assignment of the ownership of the token. These tokens are not stored on an entity’s IT system as the entity only stores the keys to the Blockchain (as opposed to the token itself). They represent specific amounts of digital resources that the entity has the right to control, and whose control can be reassigned to third parties.

Accounting for cryptocurrencies

There are many issues that accountants may encounter in practice for which no accounting standard currently exists; one example is cryptocurrencies. For example, as no accounting standard currently exists to explain how cryptocurrency should be accounted for, accountants have no alternative but to refer to existing accounting standards. International Accounting Standard (IAS?) 7,?Statement of Cash Flows, IAS 32,?Financial Instruments: Presentation?and International Financial Reporting Standard (IFRS?) 9,?Financial Instruments.

What accounting standards might be used to account for cryptocurrency?

At first, it might appear that cryptocurrency should be accounted for as cash because it is a form of digital money. However, cryptocurrencies cannot be considered equivalent to cash (currency) as defined in IAS 7 and IAS 32 because they cannot?readily?be exchanged for any good or service. Although an increasing number of entities are accepting digital currencies as payment, digital currencies are not yet widely accepted as a medium of exchange and do not represent legal tender. Entities may choose to accept digital currencies as a form of payment, but there is no requirement to do so.

IAS 7 defines cash equivalents as ‘short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value’. Thus, cryptocurrencies cannot be classified as cash equivalents because they are subject to significant price volatility. Therefore, it does not appear that digital currencies represent cash or cash equivalents that can be accounted for in accordance with IAS 7.

Intuitively, it might appear that cryptocurrency should be accounted for as a financial asset at fair value through profit or loss (FVTPL) in accordance with IFRS 9. However, it does not seem to meet the definition of a financial instrument either because it does not represent cash, an equity interest in an entity, or a contract establishing a right or obligation to deliver or receive cash or another financial instrument. Cryptocurrency is not a debt security, nor an equity security (although a digital asset could be in the form of an equity security) because it does not represent an ownership interest in an entity. Therefore, it appears cryptocurrency should not be accounted for as a financial asset.

However, digital currencies do appear to meet the definition of an intangible asset in accordance with IAS 38,?Intangible Assets. This standard defines an intangible asset as an identifiable non-monetary asset without physical substance. IAS 38 states that an asset is identifiable if it is separable or arises from contractual or other legal rights. An asset is separable if it is capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, identifiable asset or liability. This also corresponds?with IAS 21,?The Effects of Changes in Foreign Exchange Rates, which states that an essential feature of a non-monetary asset is the absence of a right to receive (or an obligation to deliver) a fixed or determinable number of units of currency. Thus, it appears that cryptocurrency meets the definition of an intangible asset in IAS 38 as it is capable of being separated from the holder and sold or transferred individually and, in accordance with IAS 21, it does not give the holder a right to receive a fixed or determinable number of units of currency.

Cryptocurrency holdings can be traded on an exchange and therefore, there is an expectation that the entity will receive an inflow of economic benefits. However, cryptocurrency is subject to major variations in value and therefore it is non-monetary in nature. Cryptocurrencies are a form of digital money and do not have physical substance. Therefore, the most appropriate classification is as an intangible asset.

IAS 38 allows intangible assets to be measured at cost or revaluation. Using the cost model, intangible assets are measured at cost on initial recognition and are subsequently measured at cost less accumulated amortization and impairment losses. Using the revaluation model, intangible assets can be carried at a revalued amount if there is an active market for them; however, this may not be the case for all cryptocurrencies. The same measurement model should be used for all assets in a particular asset class. If there are assets for which there is not an active market in a class of assets measured using the revaluation model, then these assets should be measured using the cost model.

IAS 38 states that a revaluation increase should be recognized in other comprehensive income and accumulated in equity. However, a revaluation increase should be recognized in profit or loss to the extent that it reverses a revaluation decrease of the same asset that was previously recognized in profit or loss. A revaluation loss should be recognized in profit or loss. However, the decrease shall be recognized in other comprehensive income to the extent of any credit balance in the revaluation surplus in respect of that asset. It is unusual for intangible assets to have active markets. However, cryptocurrencies are often traded on an exchange and therefore it may be possible to apply the revaluation model.

Where the revaluation model can be applied, IFRS 13,?Fair Value Measurement, should be used to determine the fair value of the cryptocurrency. IFRS 13 defines an active market, and judgment should be applied to determine whether an active market exists for particular cryptocurrencies. As there is daily trading of Bitcoin, it is easy to demonstrate that such a market exists. A quoted market price in an active market provides the most reliable evidence of fair value and is used without adjustment to measure fair value whenever available. In addition, the entity should determine the principal or most advantageous market for cryptocurrencies.

An entity will also need to assess whether the cryptocurrency’s useful life is finite or indefinite. An indefinite useful life is where there is no foreseeable limit to the period over which the asset is expected to generate net cash inflows for the entity. It appears that cryptocurrencies should be considered as having an indefinite life for the purposes of IAS 38. An intangible asset with an indefinite useful life is not amortized but must be tested annually for impairment.

In certain circumstances, and depending on an entity’s business model, it might be appropriate to account for cryptocurrencies in accordance with IAS 2,?Inventories, because IAS 2 applies to inventories of intangible assets. IAS 2 defines inventories as assets:

• held for sale in the ordinary course of business
• in the process of production for such sale, or
• in the form of materials or supplies to be consumed in the production process or in the rendering of services.

For example, an entity may hold cryptocurrencies for sale in the ordinary course of business and, if that is the case, then cryptocurrency could be treated as inventory. Normally, this would mean the recognition of inventories at a lower of cost and net realizable value. However, if the entity acts as a broker-trader of cryptocurrencies, then IAS 2 states that their inventories should be valued at fair value less costs to sell. This type of inventory is principally acquired with the purpose of selling in the near future and generating a profit from fluctuations in price or broker traders margin. Thus, this measurement method could only be applied in very narrow circumstances where the business model is to sell cryptocurrency in the near future with the purpose of generating a profit from fluctuations in price.

As there is so much judgment and uncertainty involved in the recognition and measurement of cryptocurrencies, a certain amount of disclosure is required to inform users in their economic decision-making. IAS 1,?Presentation of Financial Statements, requires an entity to disclose judgments that its management has made regarding its accounting for holdings of assets, in this case, cryptocurrencies if those are part of the judgments that had the most significant effect on the amounts recognized in the financial statements. Also IAS 10,?Events after the Reporting Period?requires an entity to disclose any material non-adjusting events. This would include whether changes in the fair value of cryptocurrency after the reporting period are of such significance that non-disclosure could influence the economic decisions that users of financial statements make on the basis of the financial statements.

So, accounting for cryptocurrencies is not as simple as it might first appear. As no IFRS standard currently exists, reference must be made to existing accounting standards (and perhaps even the Conceptual Framework of Financial Reporting).

All of the cryptocurrency’s wild swings would get captured by rules the Financial Accounting Standards Board is considering. But most significantly, assuming the market recovers, company financial statements would get to reflect crypto price rebounds, not just downturns as under current reporting.

It would be a long-awaited change for the crypto industry, accountants, and?investors?who complain about the current practice, where companies that hold cryptocurrencies like Bitcoin or Ether only get to report declines in value—never recoveries—unless they sell them.

“It kind of torpedoes the financial presentation and is very disconnected from what is happening economically,” Steve Soter, senior director of product marketing at Workiva Inc., said of the?current accepted accounting?for digital assets.

FASB has yet to plot the path it will take, but the board has talked about measuring cryptocurrency at?fair value, the price an asset fetches in an orderly market. To backers, who sent?hundreds of letters?to FASB last year urging it to take action, fair value measurement would capture the true market value of cryptocurrencies.

“Many of the folks who asked for fair value believe that’s a better reflection of the economics—up or down,” said Amy Park, partner at Deloitte & Touche LLP.

No part of the US accounting rulebook specifically spells out rules for cryptocurrency like Bitcoin and Ether. The American Institute of CPAs filled the gap in 2019 with guidance saying businesses that aren’t investment companies should account for their crypto stashes as intangible assets. This means companies record them at historical cost, watch out for signs of impairment, and mark down their holdings if the value declines. While AICPA guidance doesn’t carry the same weight as official rules, companies generally don’t deviate from it.

The board expects to discuss next steps as early as next month, a FASB spokesperson said.

What’s In, What’s Out

Three times since 2017, FASB has?rejected calls?to draw up official rules for crypto, arguing that only a few companies did more than dabble in the emerging space. Of the companies that did use crypto, many accepted digital currency as customer payments but immediately converted the currency to cash, the board said each time it got a request to address the issue.

The conversation changed once electric vehicle maker?Tesla Inc.?purchased $1.5 billion worth of Bitcoin in 2021 and enterprise software company?MicroStrategy Inc.?announced investing in Bitcoin as one of its main business strategies.

Direction from US market regulators changed, too. As late as November 2021, Securities and Exchange Commission acting Chief Accountant Paul Munter?warned?that setting rules for cryptoassets wouldn’t be a simple issue. By February, he told FASB that there was?opportunity for improvement.

Now FASB will have to figure out exactly what kind of crypto assets to focus on.

So far, the board is focusing only on exchange-traded assets, meaning the most common types of cryptocurrencies, like Bitcoin, which are actively traded and have easily determinable prices. Obscure coins held by a few owners? Not covered.

Similarly, non-fungible tokens, or NFTs—digital art and video clips that by their nature are unique and therefore trickier to value—aren’t expected to be captured by potential new rules. While the holder of one Bitcoin or Ether can look up the price of the coins at any given time, the holder of an individual cartoon-style image of a Taco Bell taco would have to dig deep to figure out the value. In addition, FASB isn’t expected to tackle stablecoins, many of which are classified as financial instruments and get a separate accounting treatment.

Setting the scope around what’s in and what’s out will be a challenge, said Scott Muir, partner at KPMG LLP.

“I don’t think anyone thinks it’ll be an easy exercise,” he said.

FASB could very well set some parameters around what is considered an exchange-traded asset and then offer examples—as in, perhaps, “‘Here’s how we’re thinking about parameters, but, for clarity, we mean things like Bitcoin and Ether’,” Muir said.

Whatever FASB drafts, it will have to be robust enough to prevent people from inflating their balance sheets because they sold one obscure coin once, FASB Chair Richard Jones said at a June meeting of the board’s Private Company Council.

“I can’t just invent a coin and convince you to buy one and mark the other million I have on my balance sheet to that price,” Jones said.

BIG QUESTIONS ARE HERE:

Will cryptocurrencies make accountants’ work more efficient, or more complex?

It could make earnings a lot simpler to track when it comes to using the public, distributed ledger that typically underpins a cryptocurrency.

However, let’s say you have a client who trades crypto across multiple exchanges and decentralised wallets. Everything is visible on the ledger – but you also need to track gas fees (a crypto term for transaction fees), plus fluctuations in the currency’s value. Crypto holdings can be extremely volatile – especially if a client isn’t converting their profits to a stablecoin such as USDC as they go.

Blockchain – the software behind cryptocurrencies – has the potential to revolutionise accounting, financial transactions and businesses. The transparency and speed of blockchain can make transactions – which often include copious amounts of paperwork, not to mention potential fraud and errors in public records – more efficient, safer and easier.

On that basis, blockchain has the scope to deliver many benefits for accountants, particularly in the fields of data reliability and financial statement audits.

Traditional accounting maintains and stores records in a centralised location – typically the database of an accounting software application. That model is based on a double-entry accounting system, whereby only the accountant or auditor has access to the ledger.

Blockchain, meanwhile, relies on a decentralised system. Data is accessible to all relevant parties via a triple-entry bookkeeping model – and in order to change any information, everyone’s permission is required. That enables the system to be more secure and trustworthy.

Could the role of auditor or bookkeeper become extinct, or change to absorb the shifts towards blockchain? Upskilling will be vital here – particularly to address the technological demands. For example, it is likely that blockchain will prompt auditors to shift from an analytical capacity to more of a programming and platform-designing role.

That said, the scalability of the tech at an acceptable cost is a concern – and it may take a while before blockchain is fully adopted into the accounting profession.

Should accountants advise their clients on any special risks and dangers as cryptocurrency use becomes more widespread? Or will very little change, and accountants will still follow traditional practices?

Until we receive more regulatory guidance, it is hard to assess how much will change. There are general risks – for example, cryptocurrencies’ volatile nature means that losses may occur, even if only temporarily. That would set the stage not just for an unfavourable accounting treatment of crypto-focused clients, but the potential for creating misleading information for readers of financial statements.

Counterparty risks in transactions involving cryptocurrencies – including loss of currency value, or transactions being associated with illicit activity or cyber theft – are still a concern. On top of that, there are reputational and sunk cost risks, plus instability around initial coin offerings, all of which impact cryptocurrency use. We may have to wait until use is more widespread before we receive stronger regulatory guidance.

Should accountants advise their clients on any special risks and dangers as cryptocurrency use becomes more widespread? Or will very little change, and accountants will still follow traditional practices?

There are significant potential risks, but they would stem mainly from accountants not understanding the security issues around mishandling crypto.

I know an accounting firm that was paid for its services in Ethereum (ETH) by a client that happened to be a crypto company. The financial director of the accounting firm asked the client to pay with a crypto wallet. However, the FD failed to disclose that the receiving address was on his?24-year-old son’s?wallet?– which was accessible via the son’s iPhone.

Complicating matters somewhat, the young man was buying NFTs via the wallet on his phone, and was eventually the victim of a phishing hack through a major NFT marketplace. Money was stolen. Misreading the situation, the FD rang the client, demanding to know whether they’d somehow reversed the transaction – which is impossible, by the way – before the client was able to use the public ledger to show that the FD’s son had carelessly used the same wallet that received clients’ monies to purchase NFTs.

When the client asked why the firm hadn’t exchanged the ETH sum to USD as soon as the payment had landed – rather than holding the ETH for 12 days – the FD explained: “We wanted to play with the market.” That’s a clear conflict of interest.

Such accounting firms have a huge lack of understanding of crypto. Yet they want new business – so they will try to show that they’re market leaders by accepting and dealing in crypto, too. Incidentally, the same firm now plans to start holding and storing millions of dollars in crypto for new clients. I wonder how that’s going to turn out without proper training and education.

If accountants want to be competitive on crypto while demonstrating best practices, they need to preserve their traditions while adopting new technologies such as blockchain. There is no stopping crypto – it’s either learn and help your clients with their crypto portfolios or get left behind. There’s a world of money to be made for accountants who are prepared to understand crypto, how to store it safely and how to maximize savings for clients.

Hence, Accounting for Cryptocurrency is posing a big challenge to Chartered Accountants Globally due to the emerging demand of the era for Digital Assets.

Note: The above-provided information is just for knowledge purposes, please consult a professional practitioner for the services.

TELL ME WHAT YOU THINK!

I'd love to hear your feedback, your thoughts and ideas for the ESG SUSTAINABLE BUSINESSES Newsletter and about this article. What you want to read is very important for me. Your Feedback is incredibly helpful. You can leave a review on Whatsapp at?00971564801733, [email protected]?or just leave a comment below.

KEEP ESG SUSTAINABLE:?Zahid Munir,?#Zahidmuniracca