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【AppWorks Selection】How should blockchain startups account for the cryptocurrency they hold on their financial statements?

2020/12/14

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This article is authorized and reprinted from AppWorks, written by Jiyong Yu, an analyst at AppWorks.

At the end of 2018, AppWorks partner Andy Tsai wrote a special article titled "When ICO Meets Accounting: Accounting Concepts Blockchain Startups Need to Know," analyzing how blockchain startups that raised funds through the issuance of cryptocurrencies during the prevalent ICO Initial Coin Offering craze at that time should recognize to comply with accounting rules.

Two years have passed. Although ICOs are no longer a novelty, the cryptocurrency trading market continues to thrive. According to data from CoinMarketCap, there are currently nearly 4,000 cryptocurrencies globally that can be tracked and statistically recorded, compared to 617 at the beginning of 2017, a sixfold increase. The global cryptocurrency market capitalization recently surpassed $570 billion. In October of this year, leading online payment platform PayPal announced the launch of services in the U.S. for buying, selling, or holding cryptocurrencies in digital payment form; in December, credit card institution Visa also announced a partnership with Circle to add USDC as a settlement option in its global payment network. This shift eliminates the need for traditional check or wire transfer methods in future financial flows, significantly shaking up the current international financial ecosystem. The impact of Blockchain's development on the business, technology, and social aspects of the human world is undeniable. Since the second half of 2018, when AppWorks Accelerator began limiting recruitment to startups in two fields, AI/IoT and Blockchain/DeFi, it has accumulated over 30 outstanding blockchain startups from across Greater Southeast Asia, ASEAN + Taiwan.

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In 2020, the global investment market, under the policy catalyst of the era of printing money, reflects investors seemingly fleeing from fiat currencies vulnerable to inflation and turning to assets that can preserve value. Examples include precious metals like gold, silver, and in recent years, Bitcoin and other cryptocurrencies that have gained significant exposure in the hedging asset market. In 2020, with the emergence of innovative protocols like DeFi Decentralized Finance on Uniswap, the issuance of various governance tokens, and the public's fervor for liquidity mining, have further boosted the trading volume of the cryptocurrency market.

For startups holding cryptocurrencies or operating services related to cryptocurrencies, how to recognize and express them in accounting and financial practices is a crucial issue for blockchain entrepreneurs.

Since the beginning of this year, the trend of buying and investing in cryptocurrencies has continued to heat up, and the diverse range of cryptocurrency application features introduced by blockchain startups, from basic payments to lending, voting rights, and even equity recognition symbols, have multiplied. However, in the past few years, the International Financial Reporting Standards IFRSs adopted by over 160 countries have not been revised to address how cryptocurrencies should be recognized in financial statements and still adhere to outdated rules. This has caused considerable confusion for startups, companies, and venture capitalists regarding the recognition and expression of cryptocurrencies in financial statements. Therefore, through this article, I hope to provide some insights and analysis on the accounting recognition direction for cryptocurrency holders, supplemented with practical aspects in light of the current International Financial Reporting Standards. For simplicity, unless otherwise stated, the cryptocurrencies mentioned in this article include both Coins and Tokens, with companies encompassing startups.

What Accounting Category Should Companies' Cryptocurrency Holdings Belong To? The "Rule" Still Remains Undefined

Although the International Financial Reporting Interpretations Committee has discussed issues related to the recognition of cryptocurrencies in 2018 and 2019, the current decision does not introduce new publications or additional items for any virtual assets or cryptocurrencies. Instead, existing accounting standards or publications are applied to the recognition of cryptocurrencies. So, under current rules, in which category can cryptocurrencies be recognized in financial statements? According to the committee's decision, cryptocurrencies should be applicable to two asset categories: inventory and intangible assets.

Inventory: If a company holds cryptocurrencies primarily for sale, and trading cryptocurrencies is part of its day-to-day business operations for sale in the normal course of business, in accordance with International Accounting Standard 2 (IAS 2), companies should appropriately represent cryptocurrencies as inventory in financial statements.

What constitutes day-to-day business operations? In simple terms, it refers to a company's core business or how it generates its main revenue. For example, if a company like National Electronics generates its main revenue from selling various electronic products, the various electronic products it owns would be considered inventory rather than fixed assets or other asset categories. Similarly, if a company holds various cryptocurrencies for the purpose of selling them to earn price differentials and the income from selling cryptocurrencies is the main source of revenue, then the company can recognize the held cryptocurrencies as inventory. For example, funds or investment companies specializing in cryptocurrency investments may have cryptocurrencies that fit the definition of inventory.

If the held cryptocurrencies are classified under the inventory category, how should the value of cryptocurrencies be determined? Generally, the value of inventory is determined by the lower of cost or net realizable value, which means the cost and the estimate of the selling price of the inventory minus disposal costs, such as sales expenses and transaction taxes, are compared, and the lower figure is recognized. However, there is an exception: if a company holds cryptocurrencies with the intention of selling them in the short term and expects to profit from significant price fluctuations, the above valuation method does not apply. Instead, the exception rule for commodity brokers - traders under IAS 2 paragraph 5 is applied, where the fluctuation of the inventory value is recognized in the income statement. Given the current level of price volatility and trading in the cryptocurrency market, there is a good chance that the valuation method under this exception will be considered by regulatory authorities, which means that the financial performance of the holder will be significantly affected by cryptocurrency market price fluctuations.

However, if a company holds cryptocurrencies for long-term investment purposes expecting appreciation, or the held cryptocurrencies are used as vouchers for future services from the counterparty, or the company's main business activities are not related to trading cryptocurrencies at all, but rather engaging in short-term trading of cryptocurrencies, it does not meet the current criteria for inventory recognition.

Intangible Assets: If a company holds cryptocurrencies and does not meet the inventory recognition criteria, then it must follow International Accounting Standard 38 (IAS 38) to express cryptocurrencies as intangible assets. For example, in the financial reports of RIOT BLOCKCHAIN, listed on the Nasdaq in the United States, engaged in cryptocurrency mining operations and cryptocurrency exchanges, the held cryptocurrencies are recognized as intangible assets.

If cryptocurrencies are classified as intangible assets, there are two valuation methods: cost or revaluation model. If a company chooses to value cryptocurrencies using the cost method, as cryptocurrencies are not expected to have a definite useful life, the measurement of cryptocurrencies under the cost method is based on the purchase cost minus accumulated impairment losses, without deducting amortization costs. The other method is to use the revaluation model for measurement. Under the revaluation model, the fair value of cryptocurrencies - essentially the market price - minus accumulated impairment losses is used. When the fair value exceeds the cost, the profit is recognized in other comprehensive income and not directly in the income statement; conversely, impairment losses are recognized in the income statement. It is worth noting that the Financial Supervisory Commission of Taiwan has not allowed the revaluation model for intangible assets in the preparation of financial statements for issuers, adopting the International Financial Reporting Standards version. This was one of the areas where Taiwan did not fully converge with international standards when aligning with IFRS, so publicly traded companies in Taiwan or their subsidiaries can only use the cost method if they acquire cryptocurrencies and recognize them as intangible assets.

Many Unresolved Issues Remain

Many entrepreneurs may wonder if cryptocurrency can truly reflect its economic substance solely by using two accounting categories, inventory and intangible assets. From my understanding, the classification of the above two accounting categories mainly depends on the intent of the cryptocurrency holder and whether the company's main business activities are highly related to buying and selling cryptocurrencies. However, the diversity of cryptocurrency functions makes accounting judgment and treatment more complex, requiring more research and discussions to determine the accounting treatment. Therefore, after the International Financial Reporting Interpretations Committee issued accounting treatment decisions for cryptocurrencies, it received 23 letters from various countries, including South Korea, opposing the finalization of cryptocurrency accounting treatment.

In addition to the lack of strict definitions for cryptocurrencies by the International Financial Reporting Interpretations Committee, the diversity of Tokens is another reason why there is no definitive answer in the short term: for example, the economic substance of cryptocurrencies is similar to money in part, as long as both parties agree, goods or services can be exchanged through cryptocurrency; or when a user holds Utility Tokens such as those issued by Turnkey Jet, the economic substance is more like advance payments or partially applicable to money; even Governance Tokens like Uni, COMP, etc., give holders functions similar to voting rights or governance rights. Therefore, simply relying on the holder's intention for a basic binary classification on financial statements seems hasty. Thus, under the current IFRS framework, it is challenging to have a perfect discourse that can be applied to cryptocurrency recognition.

In response to this situation, an interesting example is Japan's approach. Since Japan does not mandate the use of IFRS for publicly traded companies, the Accounting Standards Board of Japan (ASBJ) has established accounting treatment standards and financial statement audit standards for cryptocurrencies, considering cryptocurrencies as a new type of asset rather than belonging to any category such as inventory, financial assets, intangible assets, etc. The Accounting Research and Development Foundation of Taiwan has also advised the International Financial Reporting Interpretations Committee to issue new publications on accounting treatment for cryptocurrencies in the future or to revise existing accounting rules to better reflect the economic substance of cryptocurrencies.

Conclusion

In the foreseeable future, as blockchain technology continues to accelerate, cryptocurrency transactions and their significance will increase, and with the continuous evolution of cryptocurrency functions, there is a chance to disrupt existing financial and investment markets. For startups and companies, how to account for cryptocurrencies is a pressing issue that the International Financial Reporting Interpretations Committee and regulators around the world must face. Based on current practices in various countries, the main reliance is still on existing accounting standard frameworks to find appropriate measurement and recognition methods and to provide subjective interpretations. However, the diversity of cryptocurrency functions still presents many ambiguities within the current accounting framework, affecting the presentation of financial statements and information dissemination.

Unfortunately, in the meetings held by the International Financial Reporting Interpretations Committee in 2020, the accounting treatment of cryptocurrencies was not included in the agenda. Until IFRS issues further specific guidance or amendments, how regulators in various countries will account for cryptocurrencies under existing accounting rules or express this type of asset through new classifications and rules will only become clearer over time.

Before that happens, if blockchain entrepreneurs have any questions about accounting treatment for cryptocurrencies, they are welcome to discuss with us.

Author Bio

Yung-Yu Chi, Analyst at AppWorks

Responsible for investment and fund management. Prior to joining AppWorks, worked in the audit department of Ernst & Young for nearly two years, participating in financial statement audit cases across multiple industries. Graduated from the Department of Accountancy at National Taiwan University, serving as Director of Activities in the NTU Student Association and Public Relations Officer of the Department of Accountancy Society during student years. Enjoys tasting food, baseball, and mystery series. Aspires to be a rational yet passionate and warm venture capital analyst.