Classification and valuation issues with crypto-assets

Wim Maas

Crypto-assets are a new asset class. It might trouble many accountants in practice. The question is how to classify certain crypto-assets. While some guidance has been provided by parties like the standard setters, the SEC and the IRS, many complications still remain. This article tries to provide some insight in the difficulties in classification of this new asset class and reviews what we already know.

Accounting for cryptocurrencies

The correct classification of cryptocurrencies like Bitcoin and Ether is the first problem to tackle. The current accounting standards do not (yet) give any explicit guidance on the issue. The AASB, however, published a comprehensive review of the problem in which they concluded that:

Cryptocurrencies can NOT be considered cash or cash equivalents.

The reason is they lack general acceptance as a method of payment, acceptance as legal tender (except in Switzerland and Japan) or backing by a central bank. They are also not equivalent to cash since most markets are typically illiquid and prices are volatile. One thing to note is that even though cryptocurrencies are not cash equivalents now, that doesn’t mean they cannot become cash equivalents in the future.

“Cryptocurrencies are not cash, nor are they cash equivalents”

Cryptocurrencies are not financial instruments.

IAS 32 on financial instruments clearly states there should be a contractual relationship between entities, which is not the case. The same answer has been provided by the SEC. For a transaction to be a deemed an “investment contract” according to the Securities Act of 1933 it should comply with the so-called Howey test. This test refers to a Supreme Court case ruling in 1946. Basically a transaction is an investment contract if all points below apply:

  1. It is an investment
  2. There is an expectation of profits from the investment
  3. The investment of money is in a common enterprise
  4. Any profit comes from the efforts of a promoter or third party

Due to the non-applicability of the third and fourth criteria, bitcoin and similar cryptocurrencies cannot be seen as a security or investment contract. There is no ‘common enterprise’ in a decentralized network. Also, there is no ‘third party effort’ to speak of because the maintenance and development of the Bitcoin network is distributed to a large and continuously changing and open group of network peers. Sources within the SEC have also indicated that Ether, the second biggest cryptocurrency by market cap (currently $12 billion compared to bitcoin’s $70 billion), is also not a security. This can however be disputed. Again note the fact that if an asset does not classify as a security it does not mean it cannot become a security in the future.

Cryptocurrencies are intangible assets. Unless they are held for sale in the ordinary course of business, in which case they are inventory.

The standard that does capture cryptocurrencies depends on the purpose with which the entity holds the cryptocurrency. If the purpose is to sell them in the ordinary course of business they would classify as “inventory” under IAS 2. If this is not the case, then they should be accounted for as “intangible assets”. IAS 38 prescribes that these are “an identifiable non-monetary asset without physical substance”, a definition in which cryptocurrencies seem to fit perfectly. However intuitively, the first measurement of these assets should be at cost. Subsequent measurement could be at cost (IAS 36) or fair value (IFRS 13).

Accounting for crypto-tokens

Some other crypto-assets have more purposes and/or attributes than currencies, we call these crypto-tokens (the difference with currencies can be read here). The measurement of these might follow a different method. Most tokens derive their value of off the efforts of a team of developers or a company, making the Howey test’s criterion 4 apply. Criterion 3 might also apply, however this might be tougher to say.

Most of the time a token (the investment vehicle) is used to access a product or future product. A clear definition of these so-called utility tokens is lacking, and their diversity has created quite a few dilemmas for regulatory bodies. Guidance by the SEC confirms that whether or not a particular transaction involves the offer of a security depends on the circumstances. The SEC has already deemed multiple crypto-tokens as unregistered securities in recent law-suits. So, chances are that crypto-tokens should follow the standards of financial instruments.

For a token to be considered a financial instrument according to IAS 32 there should be a contract that gives rise to a financial asset on the one side and a financial liability on the other. It is hard to say whether this is the case. If the token gives the contractual right to a residual interest in the net assets of a particular company, it is of course considered a “financial (equity) instrument”. However, most of the time tokens issued in ICOs entitle the holder to underlying goods or services provided by an identifiable counter-party (usually in the future). In this case there is no financial asset, because the future benefit is not a right to cash or another financial asset. Classification of these crypto tokens purely held to access a future product would comply with the standards of “intangible assets”. Again however, If the purpose is to sell them in the ordinary course of business they would classify as “inventory” under IAS 2. A token can however be somewhere in between the “residual interest”-token and the “future product”-token, making classification an individual fit thing.

SAFT agreements

One way to prevent uncertainty for the issuer of and the investor in a token project is to instead come to a so-called Simple Agreement for Future Tokens (SAFT). A SAFT is a registered security that is sold to accredited investors even before the tokens are created or the product is ready. There is now a contractual agreement between issuer and investor to transfer tokens in the future. The classification of this contract will most probably follow the accounting for the tokens promised in the contract, so: back to start.

Gains are taxed as capital gains

Officially, bitcoin and other cryptocurrencies are not currencies in the US (only in Japan and Switzerland this is the case). The IRS classifies them as ‘intangible property’. This means that every transaction herein is subject to capital gains tax. In other words, for everything you buy with bitcoin you have to calculate the capital gains on that transaction. Due to the cumbersome nature of this, tax exemption for small transactions have been proposed. Unfortunately for cryptocurrency users, these were not included in the December tax Bill presented by House of Representatives and the Senate.

To make things worse, the new tax bill got rid of the option of a so-called 1031 like-kind exchange when exchanging one cryptocurrency for another. In March this year the IRS issued a notice that warns users and investors that any gains and losses upon sale, purchase or trade must be reported. Penalties after tax evasion could include a prison term of up to three years and a fine of up to $250,000. Pressure to comply increased when the IRS ordered one of the biggest exchanges in the US to hand over information on its users. Conclusion: Report all gains in your tax returns.

I hope this article was helpful. For further reading about the classification of crypto-assets, take a look at this review by EY from August 2018.


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