Mind the GAAP (part 2)
The second part of the article will explore the options for accounting treatment of digital currencies. It is not possible to reach a unified solution on the matter because the cryptocurrencies are a new economic phenomenon.They have different business use and characteristics that makes them hard to define. The flagman currency Bitcoin is maintained by a community and has the strongest aspirations to become a recognised medium of exchange for peer-to-peer transactions. Its market capitalization, increasing liquidity and acceptance as cash equivalent defies many sceptics of its legitimate purpose. On the other side of the crypto spectrum is EOS – tokens which are not mined but issued by the company Block.one through the biggest ICO to date ($185m). EOS tokens do not have any rights and uses. They are traded but the agreement to buy them via the ICO says that they are “not an investment, currency, security, commodity, a swap on a currency, security, or commodity or any kind of financial instrument.” What did the subscribers then pay the $185m for?
By Stanjourdan – Own work, CC BY-SA 4.0, https://commons.wikimedia.org/w/index.php?curid=64570499
Taxonomy of money, based on “Central bank cryptocurrencies “by Morten Linnemann Bech and Rodney Garratt
The taxonomy diagram classifies cryptocurrencies as electronic, universally accessible, peer-to-peer money. They are held by companies as a medium of exchange, similar to cash; short-term speculative digital commodity; and long-term investment to benefit from its appreciation in value. In the absence of widely accepted authoritative guidance we will analyse the possible options to classify a cryptocurrency from the buyer point of view assuming that the buyer is an entity which applies a commonly recognised accounting principles framework (US GAAP, IFRS or UK GAAP.
Although Bitcoin and other popular currencies operates like a currency in some environments, they still do not have all the attributes of a real currency. Digital currencies do not have legal tender status in any jurisdiction and they are still not customarily used and accepted globally as a medium of exchange. Cryptocurrencies would not meet the definition of cash under any current GAAP.
Currently all cryptocurrencies are subject to significant risk of changes in their value. This volatility precludes them from being classified as cash equivalent.
A digital currency does not meet the definition of a financial instrument because it does not represent cash, an ownership interest in an entity, or a contractual right to receive either cash or cash equivalent. It is not also a debt or equity security.
This category is reserved only for land and buildings; therefore, this classification does not include the cryptocurrencies although many tax authorities treat them as property for capital gains purposes.
Digital currencies are identifiable non-monetary assets without physical substance. As such they meet the technical definition in US GAAP, IFRS and UK GAAP. However, the scope of IAS 38 and its US/UK equivalents excludes from its scope assets held for sale in the ordinary course of business. These standards deal with assets that are held for production or administrative purposes similar to fixed assets employed by the business to generate future economic cash flows. They do not provide distinction between assets held for own use or consumption and those held for investment purposes. In addition, if the cryptocurrencies are intangible assets held for trading or for capital gains, they would not fully fit into the accounting valuation model (cost or revaluation through other comprehensive income) prescribed for other intangible assets like patents, license rights, software, brands, customer lists and other. The Australian Bitcoin Group Limited is in the business of mining Bitcoin and recognises in its financial statements Bitcoins as indefinite life instangible assets. The cryptocurrency is initially measured at cost and subsequently at fair value by reference to quoted price in an active Bitcoin market. Increases and subsequent decreases in the carrying value of Bitcoins are credited to/against a revaluation surplus in equity. Initial decreases are recognised in profit and loss. The realised gains on disposal of Bitcoins are recycled from revaluation surplus to retained earnings.
Inventories are assets held for sale in the ordinary course of business. They are measured at the lower of cost and estimated selling price less costs to complete and sell. The selling costs for digital currencies are not expected to be material, therefore treating cryptos as inventories would not allow upward revaluation. Such an accounting model would not provide relevant information about the current value of the cryptocurrencies. It can also be argued that, unlike commodities, under US GAAP digital currencies do not represent tangible personal property and should not be accounted for as inventory. Can they be treated as digital commodity then? In the US GAAP Master Glossary, a commodity is defined as product whose units are interchangeable, is traded on an active market where customers are not readily identifiable, and is immediately marketable at quoted prices. This definition does not exclude intangible products. In accordance with IAS 2 ‘Inventories’ commodity trader-brokers are required to measure their assets at fair value less costs to sell, with changes in fair value recognised in profit and loss. If we assume that digital currencies are viewed as digital commodities all entities that trade with them for a profit would be categorized as commodity trader-brokers and then IAS 2 would apply.
An example of the commodity treatment is the company DigitalX Limited. It is a broker-trader of Bitcoin and has adopted its own accounting policy on Bitcoin holdings. The latter are measured at fair value less costs to sell with any changes going through the profit and loss. Bitcoin inventory fair value measurement is a Level 1 fair value as it is based on quoted (unadjusted) market price in active market for identical assets. The annual report further discloses management’s judgment to treat Bitcoin as commodity notwithstanding that it does not have physical substance.
None of the current GAAPs has an authoritative definition of investment. According to Investopedia “An investment is an asset or item that is purchased with the hope that it will generate income or will appreciate in the future.” This is a very broad definition which includes intangible assets like digital currencies, emission rights, mineral rights and water rights held for investment purposes. Unfortunately, there is no accounting standard that deals with such investments and it is not on the current agenda of FASB and IFRS. In December 2017 the Accounting Standard Board of Japan published an Exposure Draft which prescribes the accounting for digital currencies as an independent category of assets that should be measured at market value. Back in December 2016 the Australian Accounting Standards Board issued a paper on digital currencies and noted the gap in the IFRS literature. The authors drew attention to the superseded IAS 25 Accounting for investments which gave a broader definition for investments that would cover digital currencies. Similarly, IAS 25 allowed for investments to be measured at fair value through profit and loss which we believe is the most appropriate measurement basis for cryptocurrencies if the recognition criteria are met.
The growing number of ICOs for new cryptocurrency ventures by start-ups indicate that if a coin or token is an “investment contract” (i.e., an investment of money with a reasonable expectation of profit based significantly on the entrepreneurial or managerial efforts of others), it can be deemed and accounted for as an investment.
Lack of clear guidance in GAAPs on definition and accounting for digital currencies
The appropriate accounting treatment will depend on certain facts and circumstances
The most common use of cryptocurrencies will be as commodity or investment and measurement at fair value with movements reflected in profit or loss would provide the most useful information to investors
Standard setters have to develop a new accounting standard on blockchain, ICO and digital currencies to fill the GAP.