Its not uncommon in the world of finance for accountants to encounter challenges related to an evolving discipline for which no accounting standard would have explicitly existed earlier. One example is in the manner how the world of tokens or cryptocurrencies is evolving as no accounting standard currently exists to explain how this asset class should be accounted. In such situations historically, accountants have had no other alternative but to refer to existing accounting standards in underpinning the rules of accounting related to real, nominal, and personal classification of accounts based on fundamental utility, which the asset is being subjected to. In this article we will try to establish with valid reasoning as what accounting rules must apply to specific business events in dealing with cryptos while we analyze the below four financial reporting challenges related to such assets:

1. Ascertaining the appropriate balance sheet classification of cryptos.

2. Determining if cryptos should be carried at fair value or cost subjected to impairment testing.

3. Establishing if gains or losses should be recognized, or not recognized at all until sold.

4. Selecting the most appropriate price information while valuing this asset class.

And in dealing with these questions, we shall primarily be referring to the International Accounting Standard (IAS) 7 and IAS 32 for balance sheet classification of cryptos. Plus, IAS 2 and IAS 38 for their valuation.

Before we continue, let's do a short recap on two important concepts. What defines Crypto Assets and Single Entity principle in accounting.

Crypto assets are intangible digital tokens which are recorded using distributed ledger infrastructure, referred to as blockchain, providing various rights of use. For example, cryptocurrencies are designed as a medium of exchange use case on distributed ledger. Other digital tokens (eg securities tokens) may represent ownership interest or there could be tokens providing rights to the use of other assets or services.

One of the fundamental tenets of accounting is “Single Entity”, and a single entity is an operating unit for which financial information is reported. For accounting purpose, a single entity is a separate legal entity compared to an individual or a group of individuals who may own the entity. And therefore, to be able to use an accounting lens on cryptos, its of utmost importance that we are able to assign an entity relationship to ownership of the tokens and in doing so, separate out the frameworks which create the assets from ownership of such asset.

Bearing in mind the above principle, and how Crypto Assets are created by systems or frameworks that generates keys which lets them find an entry to the distributed ledger we must be able to distinguish the purpose for which the token is being put to use, as we start to discuss on what accounting standards might be used to account for cryptocurrencies.

Determining the appropriate balance sheet classification of cryptos as per IAS 32 and IAS 7.

Is it Cash or Cash Equivalent? - At first, it might appear that cryptocurrencies should be accounted as cash or cash equivalents because it is claimed to be a form of digital money. However, cryptocurrencies cannot be considered equivalent to ‘cash as currency’ because of two underlying reasons as defined under IAS 32 and IAS 7.

1. Referring to IAS 32 for the description of cash - It observes that cash is expected to be readily used as a medium of exchange. However, no crypto asset can be readily exchanged for any good or service. Even though one can argue that an increasing number of entities have started accepting digital currencies as payment, however digital currencies are not yet readily accepted as a medium of exchange as they do not represent legal tender. In other words, entities may decide to, or nor decide to accept digital currencies as a form of payment, as there is no obligation to do so as it is in the case of legal tenders.

2. 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’. Going by this requirement to be met, Cryptocurrencies can’t be classified as cash equivalents because they are subjected to significant price volatility. Therefore, it does not appear that digital tokens (even cryptocurrencies) represent cash or cash equivalents that can be accounted for in accordance with IAS 7.

Or is it a Financial Asset? Intuitively, it might as well appear that cryptocurrencies could be accounted for as a financial asset at fair value in accordance with IFRS 9. However, it does not seem to meet the definition of a financial instrument either, because it does not represent an equity interest in an entity, or a contract establishing a right or obligation to deliver or receive cash in exchange. In other words, cryptocurrencies are neither a debt security, nor an equity instrument (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, its quite clear that cryptocurrencies should not be accounted for as a financial asset.

So where does it find its place in a Balance Sheet? Digital currencies, within their current scope, meet the definition of an intangible asset in accordance with IAS 38 standards outlined for Intangibles. 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 or exchanged, either individually or together with a related contract, identifiable asset or liability. Thus, cryptocurrencies meet the definition of an intangible asset in IAS 38 as it is capable of being separated from the holder and sold or transferred individually.

Determining whether cryptos should be carried at fair value or historical cost subjected to impairment testing in accordance with IAS 38 or IAS 2

IAS 38 allows intangible assets to be measured at cost or revaluation.

• Using the cost model - Intangible assets are measured at cost of acquisition, and are subsequently measured at cost less accumulated amortization or impairment losses.

• Using the revaluation model - Intangible assets can be carried at a revalued amount if there is an active market for them. In other words, it implies that If there are assets for which there is not an active market, then these assets should be measured using the cost model and not the revaluation model. 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 revaluation model where there is activ trading and that msrket place xan be considered as active under IFRS 13 (Fair Value Measurement), which defines an active market. However its not necessary that if daily trading exists, it is an active marketplace. An active market must also provide the most reliable evidence of fair value.

There are two more important implications of IAS 38 as we shall see when we analyze three different use cases for holding cryptocurrencies and how they would be treated in the books of accounts:

1. IAS 38 states that a revaluation loss should be recognized in P&L. However, a revaluation increase should be recognized in P&L to the extent that it reverses a revaluation decrease of the same asset that was previously recognized in profit or loss.

2. IAS 38 also prescribes that an entity will need to assess whether the cryptocurrency’s useful life in its balance sheet is finite or indefinite. And an intangible asset with an indefinite useful life is not amortized but must be impaired.

IAS 2 on the other hand, depending on an entity’s business model, allows for cryptocurrencies to be treated as Inventories, because IAS 2 applies to inventories of intangible assets. It defines inventories as assets held for sale in the ordinary course of business in the form of materials to be consumed in the production process or in their business of rendering 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 that the recognition of inventories must happen at the lower of cost or net realizable value less costs to sell. This type of inventory is principally acquired with the purpose of trading in the near future and generating a profit from price luctuations.

Considering the above existing accounting principles prescribed under the international accounting standards, lets now analyze 3 independent use cases based on uniqueness of business models as accounting for cryptocurrencies by holders largely depends on the purpose of holding such assets:

CASE 1 – If Held for Trading by Cryptocurrency Dealers, in which case IAS 2, inventory principle must be applied, which would mean that the recognition of inventories must be at the lower of cost and net realizable value. This principle will mostly apply for funds investing in cryptos.

CASE 2 – If held for any other purpose by an entity for capital appreciation, then IAS 38 rule for intangible assets must be applied, in which case the holder will have a choice to either use cost model or revaluation model based on existence of active market for the asset.

However irrespective, if we are using the cost model or revaluation model, the interesting fact is that entities investing in cryptos , shall not be able to adjust the assets value upward for any subsequent increases in their asset’s prices notionally. In other words, gains (if any) shall not be recorded until realized upon sale. So now we know why Tesla sold its holding of cryptos before results during early 2021. Contrary to the popular belief of Musk trying to influence prices in the secondary market the real reason was that Tesla wouldn’t have recognized gain on the value of its holding unless some were sold. However, it would be able to recognize a loss if the crypto fell below the price at which they purchased its allocation over the accounting period, even if the tokens are not sold.

CASE 3 – Unfortunately IFRS or IAS doesn’t prescribe any rule for the Miners of cryptos specifically. In which case what must be considered are the cashflows originating from crypto mining activities which essentially is a service that a miner is making to a blockchain framework against which he is rewarded with fees and tokens.

• Accounting for Fees as Reward – Since this fee is paid by the system and not by a counterparty to a contract (which is not enforceable) therefore IFRS 15 doesn’t apply. Instead, this fee as reward in the form of cryptocurrencies will be credited to P&L and correspondingly Intangible Asset will be debited.

• Accounting for Transaction Fees – Since Transaction fees can be clearly attributed as coming from a customer (node) within the chain and not by the system itself, therefore contract can be applied and IFRS 15 will allow for crediting P&L and correspondingly debiting Intangible Assets.

• Accounting for Expenses incurred in mining – Since not all mining expenses lead to rewards (as there are failed attempts to mine too) and therefore such expenses should not be capitalized but debited to P&L.

Summary:

Accounting for cryptocurrencies is not as simple as it might first appear. Therefore it must be understood that in the presence of so much of ambiguity and absence of clearly identifiable rules of accounting for this asset class, a certain amount of disclosure must be made in the reports to inform stakeholders about the rationale of exercising accounting choices as mandated by IAS 1 - Presentation of Financial Statements.