Breaking Down Bitcoin
The topic of Bitcoin can be confusing and controversial. Bitcoin is still in the development stage, and some people are skeptical that it will survive. However, the use of Bitcoin is prevalent enough today that accounting professionals should be aware of what it is, how to account for it and some of its most important implications.
What It Is
Although the symbol commonly used for Bitcoin is an image of a coin, a “bitcoin” is not a physical token. It is a unit of virtual “cryptocurrency” that is transacted electronically using encryption technology. It can be exchanged for fiat currencies (legal tender) or used to pay for goods and services. Bitcoin is not backed by any commodity, government or bank. It derives its value by relying entirely upon the mutual trust and acceptance of its users. It was purportedly created with the intention of making centralized banking obsolete by allowing direct payer-to-payer transactions, requiring lower fees and providing faster transaction times. However, eliminating a central bank also has the effect of circumventing measures put in place to prevent illegal activities, such as identification and reporting requirements. As a result, it has been criticized for being an instrument of criminals and for posing a threat to global security. In addition, its complexity has made it difficult for users to understand and properly handle their accounts, making it vulnerable to theft. Those who suffer losses from theft or the failure of a Bitcoin exchange have no recourse because the U.S. government does not regulate Bitcoin.
How It Works
To transact in bitcoins, you must have a software “wallet” accessed by pairs of electronic keys. “Hot” wallets can be maintained on a cryptocurrency exchange via the internet, while “cold” storage wallets are more safely maintained offline. The public key is like your payment address while your private key allows you to access your bitcoin. Public keys are meant to be used only once, so transactions are not easily traceable back to the individual. “Miners” are people who compete to process blocks of bitcoin transactions in exchange for fees and rewards of new bit-coins. The protocol limits the total creation of new bitcoins to 21 million, making it inherently deflationary. It also regulates their rate of introduction by halving the number of new bitcoins created with each block verification every four years.
Bitcoin transactions are recorded in a blockchain, a digital ledger described as “distributed” because transactions are public and everyone in the worldwide network has a synchronized copy of it. An algorithm takes transaction information and encrypts it into a standard-length output known as a hash. The hash of a new block of transactions always contains the hash of the previous block, thus “chaining” the blocks together and making the chain very difficult to alter. A block must be validated by a miner who has successfully completed the security procedure called the proof-of-work. The blockchain ledger is an important advancement with the potential to be used beyond applications like Bitcoin because of its ability to maintain a high level of data integrity. Due to the unique way bitcoin is transacted, special audit techniques are required, and auditors should be given additional training.
In general, businesses have been slow to accept bitcoin as a form of payment, which has limited its ability to scale as a form of currency. However, it has gained popularity as a speculative asset traded by investors. The IRS has determined that bitcoin should be treated like property, subject to capital gain or loss treatment. Bitcoin held for resale would incur ordinary gains or losses. Bitcoin exchanged for goods or services should be measured by its fair market value in USD at the date of the transaction and treated as any other form of payment. Therefore, bitcoin given as compensation is subject to employment taxes and is reportable on a W-2 or 1099. Failure to comply with tax laws will have taxpayers facing penalties, though, predictably, the lack of government regulation over cryptocurrencies like Bitcoin has resulted in widespread tax avoidance. Should regulation occur in the future, it is likely to lessen Bitcoin’s market volatility, but also its appeal.
It is clear that Bitcoin has the potential to have a substantial impact. Although the future of Bitcoin is unknown, its innovativeness warrants our attention.
This article appeared in the November/December 2018 issue of New Jersey CPA magazine. Read the full issue.