The Rise of Digital Assets in Business

Bitcoin_Crypto currentcy - Scrubbed

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The Rise of Digital Assets in Business

Bitcoin_Crypto currentcy - Scrubbed

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Companies are beginning to set foot into unconventional investments, such as Bitcoin, and Ethereum, which are cryptocurrencies, a form of digital assets. With their tremendous potential for growth and unique portability and transparency, digital assets are an alluring venture. This can transform how financial markets operate, and investors interact with the traditional financial system. Also, as more companies embrace up-to-date and open technology, digital assets could become a more common medium of exchange and a streamlined, transparent, and cost-efficient form of value transfer.

Like all other investments, digital assets should conform to the broader investment strategy developed by companies. With the endless opportunities and possibilities in digital assets comes a wide variety of risks including the well-known volatile market for cryptocurrencies and NFTs, digital hacking, security breach, and theft (depending on how users store these assets); regulators continue to evaluate how to oversee the ever-evolving digital landscape. The rules of play are provisional, which makes risk assessment of digital assets critical. Digital asset investments will require constant and frequent monitoring of the market and several risk factors. The risk and liquidity of digital assets will also need to be evaluated and paralleled with the companies’ investment strategy.

As these innovative digital investments and currency forms are becoming more prevalent and interlinked with the regulated financial system, there’s an increasing likelihood that companies will come across digital assets in any way. Fundamental accounting and tax compliance with digital assets are challenging. However, the more we comprehend how digital assets work, the easier it will be to adhere to laws and regulations.

What is a Digital Asset?

There is currently no precise definition for this type of asset; however, we can refer to the executive order issued by US President Joe Biden last March 9, 2022, titled, “Ensuring Responsible Development of Digital Assets”. As outlined in the order, the term “Digital Assets” is the umbrella term that refers to all cryptography-based assets and other representations of value, regardless of the technology used, that are issued or represented in digital form through the use of distributed ledger or “blockchain” technology.

With the vast range of this topic, the most well-known forms of digital assets include: (a) Cryptocurrencies – such as Bitcoin, Ethereum, Tether, and Cardano; (b) NFTs – a unique and non-divisible token that allows for authentication to prove its legitimacy and ownership, usually associated with artworks, media files, documents, and even a unique item within an online game.; and (c) Asset-Backed Tokens – which derives their value on conventional physical assets, such as gold, oil and even real estate, which are “tokenized” and traded among users on the blockchain. Tokenization of these assets can help with asset liquidity problems and make them more accessible to a wider range of investors and users, at lower administrative costs.

Common Accounting Considerations

As we deal with digital assets, below are the common accounting questions regarding this type of asset:

How are these:

  • • Classified in the accounting records?
  • • Initially recognized and measured?
  • • Assessed for valuation and impairment?
  • • Derecognized?
 
To date, the US Generally Accepted Accounting Principles (“GAAP”), as represented by FASB Codification, has yet to provide specific guidance on accounting for digital assets. With this, publicly available information such as the American Institute of Certified Public Accountants Practice Aid titled, “Accounting for and Auditing of Digital Assets”, is used as a guide and reference in the meantime. The practice aid conclusion stated that the characteristics of digital assets meet the definition of indefinite-lived intangible assets and would generally be accounted for under Accounting Standards Codification or ASC 350, Intangibles—Goodwill and Other. 
 

In addition, when applying the existing US GAAP guidance by analogy, native digital assets generally do not meet the definitions of cash, inventory, or financial assets and are accounted for as an intangible assets. It emphasized that “digital” would not meet the definition of other asset classes within GAAP, as described in the following examples:

• Digital Assets will not meet the definition of cash and cash equivalents as they are not considered legal tender and are not backed by sovereign governments. 

• Digital Assets will not be financial assets as they do not represent a contractual right to receive cash or another financial instrument

• Digital Assets, though may be held for sale in the ordinary course of business, they are not tangible assets and therefore may not meet the definition of inventory.

However, the problem with digital assets that are accounted for as indefinite-lived intangible assets is that, it only captures negative volatility through impairment recognition. Note that under ASC 350, if an indefinite-lived intangible asset is impaired, an impairment loss is recognized, but any subsequent increase or recovery in value cannot be recognized until the asset is sold. As a result, this could be misleading to the users of financial statements and does not truly represent the economic nature of digital assets as these generally have actively traded markets. 

While there is no official accounting model yet that considers the proper way to reflect the substance, liquidity, and value of the digital assets that are aligned with the economic reality, other models may be more appropriate, depending on the circumstances. This can vary widely, and, therefore, the accounting framework to be applied under US GAAP needs to be considered on a case-by-case basis. The type of digital asset will also be a critical factor in terms of accounting and financial reporting under existing accounting rules. 

As the adoption of digital assets continues to soar, these issues will only become more prevalent and pervasive. Standard setters will continue to look into alternative and more refined approaches to accounting for digital assets to resolve practical problems and provide transparent financial reporting for users of financial statements. 

Recent Developments

With digital assets’ potential to transform the traditional financial system, the associated challenges are drawing considerable regulatory attention. To date, below are the relevant developments for the regulation of digital assets:

• On March 9, 2020, US President Joe Biden signed an executive order on “Ensuring Responsible Development of Digital Assets,” which includes cryptocurrency and other assets such as NFTs. The executive order shows the commitment of the White House to participate in the research on cryptocurrencies and engage departments across the government to collaborate in creating a framework that will regulate digital assets. It also outlines a “whole-of-government approach to addressing the risks and harnessing the potential benefits of digital assets and their underlying technology.”

Further, it serves as official recognition of the increasing impact of digital assets and the US federal government’s intention to regulate digital assets as a whole and cryptocurrencies, specifically.

• On March 31, 2020, the US SEC issued a Staff Accounting Bulletin (SAB) on accounting for the obligations to safeguard crypto assets that an entity such as a crypto exchange holds for users. It clarifies how the agency expects companies to apply existing accounting standards to digital assets. 

• On May 11, 2022, the FASB added a project to its technical plan to improve the accounting for and disclosure of certain digital assets. Previously, the FASB has received three agenda requests on digital assets since October 2020, all of which encourage the Board to address the financial reporting for digital assets.

• And more recently, the US Treasury Department issued a “Greenbook” that includes budget proposals to modernize various tax rules, including those for digital assets. Rules will change for treating securities loans as tax-free to have other asset classes and address income inclusion, provide for information reporting by certain financial institutions and digital asset brokers for purposes of exchange of information, and require reporting by certain taxpayers of foreign digital asset accounts. In addition, the plan would amend the mark-to-market rules for dealers and traders to include digital assets.

What’s Ahead?

As the digital asset landscape continues to evolve across various types of market participants, products, and technologies, companies and other stakeholders of all kinds must be able to properly reflect and disclose these digital assets in their financials and assess the overall impact of the risks involved in owning these types of assets when making decisions.

However, since digital assets are new and unique from other investments, the existing accounting models does not yet fully reflect these assets’ true nature and value in accounting and financial reporting.

Also,  companies must be aware that regulators are rapidly evolving their guidance on reporting, so the rules of engagement today may be different in the future.

Accordingly, accounting, assurance, and tax services for companies with digital assets have become more sophisticated and require professional advisors to understand the nature of those complexities. 

We’d love to help.

To ensure that all factors are considered in the pursuit of reliable financial reporting, effective and efficient operations, and compliance with law and regulations, our services can be scaled to accommodate your business needs. Our Technical Accounting* Group provides a thorough analysis on assessing the impact of complex and unusual accounting transactions.
 
E-mail us at knowledge@scrubbed.net for a full consultancy assessment.

Disclaimer: The information contained herein is general and is not intended to address the circumstances of any particular individual or entity. It is not intended to be relied upon as accounting, tax, or other professional services. Please refer to your advisors for specific advice. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.

*Disclaimer: Services being offered do not require a state license.

About the Author

Reinald John Maliberan is a supervisor of the Technical Accounting Group of Scrubbed. He assists companies in preparing technical memoranda and performs an extensive review of US GAAP financial statements (i.e., 10-Q and 10-K reports), note disclosures, and account reconciliations. Before joining Scrubbed, he has almost five years of professional experience with Ernst and Young (EY) Philippines handling financial statement audits for public and private companies.