The Wild West: Accounting for Distributed Ledgers and Crypto Assets
When it comes adopting distributed ledger and crypto asset technologies, one common reason why companies have hesitated is the lack of adequate regulatory guidance. Securities and Exchange Commission (SEC) Chair Gary Gensler complained that, “Right now, we just don’t have enough investor protection in crypto. Frankly, at this time, it’s more like the Wild West.”
As of May 2021, 31 states had pending legislation relating to crypto assets and blockchain concerns including California which has called for the formation of a working group to study the potential uses, risks and benefits of blockchain technology (A.B. 2658). California has also authorized its corporations to utilize blockchain ledgers to record stockholder activity (S.B. 838). Similarly, on the federal level there is a pronounced deficiency in authoritative accounting and auditing guidance. For example, there are no Financial Accounting Standards Board (FASB) Accounting Standards Codifications (ASCs) relating to digital assets, and FASB recently rejected a proposed agenda item to discuss accounting standards for cryptocurrencies. Instead, legislation at the federal level has been more focused on raising revenues by, for example, including (as of the time of this writing) provisions in the infrastructure bill to vastly increase cryptocurrency brokers’ tax reporting requirements. Since auditors are required to understand a client’s compliance with applicable regulatory requirements, this can be vexing. What is an auditor to do? Fortunately, there is some important guidance that accounting professionals can refer to.
Receiving Crypto Assets
An AICPA Practice Aid issued in June 2021 advised that crypto assets (e.g., bitcoin) received in exchange for cash should be recorded at their cost and accounted for as an indefinite lived intangible asset (FASB ASC 350-30) and not as cash, a cash equivalent, foreign currency or financial instrument. The crypto asset should not be amortized but must be tested for impairment at least annually or more frequently if the facts and circumstances (FASB ASC 350-30-35) suggest that it is more likely than not that the asset is impaired even if the impairment is believed to be temporary in nature. If a company repurchases a crypto asset for a lower price than the carrying value of its preexisting crypto assets, this suggests that an impairment charge is necessary. Once an impairment has occurred, a write down is required for the amount by which the crypto asset’s fair value exceeds its carrying value. Impairment write downs cannot be subsequently reversed, even if the crypto asset recoups its value. Accordingly, recognition of unrealized gains on crypto assets are deferred until the time of sale, but impairment rules essentially require that losses in value be recognized much more timely.
Receiving Crypto Payments
The accounting treatment differs for crypto assets received in a sale. If the crypto asset is contemporaneously received from a customer in exchange for goods and services provided in the ordinary course of trade or business, the transaction should be recognized at the fair value of the crypto asset at the time of contract inception (ASC 606). Subsequent changes to the value of the crypto asset would not affect the transaction price (ASC 606-10-32-23). In the event that the crypto asset is not received contemporaneously with the exchange of goods or services, but at a later point in time, an assessment must be made as to whether the crypto asset constitutes a derivative or a hybrid instrument containing an embedded derivative (FASB ASC 815).
Selling Digital Assets
Accounting for the sale of a digital asset to a customer for fiat currency requires the recognition of revenue at the time the transfer constitutes a sale (FASB ASC 606). If the sale is not to a customer in the ordinary course of business, then the transaction should be accounted for as a derecognition of a nonfinancial asset (ASC 610-20) or as a nonmonetary transaction (ASC 845). Gains or losses should be recognized as appropriate. In circumstances where only a portion of the digital asset is sold, it may not be feasible to employ specific identification to determine the cost basis. Therefore, since digital assets are fungible and can be split into fractional units, a reasonable and rational method should be used for purposes of establishing the cost basis.
Treatment for cryptocurrency sales differs depending on whether the sale is part of an entity’s ongoing major or central operations. In cases where cryptocurrency is sold to a customer for a fiat currency such as the U.S. dollar, revenue is recognized when control of the cryptocurrency has been transferred and the transaction is considered a sale under FASB ASC 606. However, if the transaction is not with the customer, then the sale should be accounted for as a gain/loss from the derecognition of a nonfinancial asset (ASC 610-20) or, if applicable, under ASC 845 as a nonmonetary transaction. For purposes of determining cost basis, entities might find it difficult to identify which specific units of the digital asset were sold particularly since they are fungible and can be divided into smaller fractional units. Therefore, a reasonable and rational method (e.g., FIFO) can be utilized for determining the cost basis.
Because virtual currencies (cryptocurrencies are a specific type of virtual currency that uses cryptography) do not have legal tender status, the IRS does not recognize them as “real” currencies. Instead, crypto-currencies such as Bitcoin are treated as property for tax purposes. If they are received in exchange for good or services, then the fair market value of the virtual currency becomes its basis and must also be included in the recipient’s gross income. Subsequent sales will give rise to capital gains or losses, assuming they were capital assets in the taxpayer’s hands. Otherwise, the gains or losses will be ordinary income. Notice 2014-21 and Revenue Ruling 2019-24 provide tax guidance for more complex virtual currency transactions.
One area that remains active relates to disclosure. In March 2021, the IRS announced that taxpayers who purchase virtual currency with real (fiat) currency do not need to answer ‘yes’ on Form 1040 Box 3, which asks whether the taxpayer acquired any financial interest in a virtual currency. At the time of this writing, the U.S. Infrastructure and Jobs Act (approved by the Senate but awaiting passage in the House of Representatives) includes an expanded definition of “brokers” required to provide reporting information on cryptocurrency transactions. The provisions are intended to generate additional tax revenue and, if passed by the House, would take effect in 2023.
Hopefully, the next year brings more regulatory clarity. With the advent of a regulatory framework, standardization and greater adoption is likely to follow.
Dr. Ethan Kinory is an assistant professor of accounting at Rutgers School of Business-Camden.
This article appeared in the Winter 2021/22 issue of New Jersey CPA magazine. Read the full issue.