Digital Asset Accounting Changes
Updates to existing report standards for digital assets could increase corporate adoption
Anyone who knows me knows that I am not an accounting enthusiast. However, occasionally something in the accounting world captures my attention because of its effect on the investing world. And, if you want to be a savvy investor, you have to speak a little accounting, sadly.
Recently, an accounting standards body proposed updates to accounting practices for digital assets. The proposed changes are going to make it a lot easier for CFOs of publicly traded companies to accurately report on their digital assets. This may have the effect of attracting corporations to treasury and investment strategies that include digital assets.
Because the digital asset markets are relatively small compared to other markets like public equities, bonds, and real estate, increased corporate interest in digital assets could significantly influence token prices. It only takes one or two large corporations announcing initial investment in digital tokens to drive the next frenzy.
First, some context…
There are a few companies that have cryptocurrency on their balance sheets already. Famously, Tesla Inc. bought around $1.5 billion of Bitcoin in 2021 and claimed that it would accept payment for its vehicles in Bitcoin. After facing some backlash regarding the energy efficiency of the Bitcoin network, Musk and company reversed course a few weeks later. They went on to sell most of the Bitcoin, but Tesla still retains over $100 million worth of the asset in its treasury and has not been expressly transparent about its plans for it. Musk’s interest has seemed to shift towards Dogecoin lately, and he’s likely holding the Bitcoin to pursue some future tax savings strategy.
Perhaps equally famously, MicroStrategy, Inc.’s CEO and majority shareholder, Michael Saylor, also executed a Bitcoin buying strategy in 2021. In MicroStrategy’s case, their executive team has made a commitment to hold onto their billions of dollars worth of Bitcoin as an investment. The company is also making strategic investments in the Bitcoin layer 2 network, Lightning. A layer 2 network on the blockchain is a secondary protocol or framework built on top of an existing blockchain network, which is designed to improve the scalability, speed, and efficiency of blockchain transactions.
MicroStrategy’s Bitcoins investments are controversial and heavily scrutinized by their investors, naysayers, and the media. Saylor seems convinced that Bitcoin is the only digital asset that can be classified as a commodity and is therefore exempt from the regulatory scrutiny of the SEC.
Before choosing to invest in Bitcoin, Saylor and his team searched the world for appropriate stores of value for the hundreds of millions of dollars that their enterprise SaaS company had generated. Their search was initiated because they could not find the appropriate investment vehicles for their cash which was being debased at a rate that outpaced the yield that would be returned to them from traditional investments like bonds.
Saylor has been operating MicroStrategy since 1989 which is quite an achievement given all of the turnover in software in the last 34 years. Most software companies started in 1989 do not exist today for lack of discipline and adaptability, among other things. Saylor has competed against Microsoft, the Big 4 consultancies, and other corporate powerhouses and has been successful in carving out a nice piece of the market. He’s seen a few cycles, and he knows a thing or two about digital transformation. He wrote a book about the mobile wave that revolutionized human interaction with technology.
Though they are publicly traded companies, Tesla and MicroStrategy have every right to hold Bitcoin as a treasury reserve asset. However, they have to comply with US generally accepted accounting principles and standards and report audited financial results on a quarterly basis that accurately reflect the health of their businesses and the usability of their assets. Additionally, material holdings of digital assets and reporting on those assets can impact the profitability of the company when it comes time to calculate accounting metrics at the bottom of the income statement. If you take a massive loss on your digital asset investments, then you have to disclose this information to shareholders. That disclosure may affect the public’s perception about the health of the business which could drive the stock price down.
What’s the recent accounting change?
The Financial Accounting Standards Board (FASB) recently published a draft on its proposed accounting rules on how corporations should report cryptocurrency holdings. In an Accounting Standards Update, FASB proposed that fair value accounting be used for reporting on cryptocurrencies. Currently, corporates report on their crypto holdings using indefinite-lived intangible accounting practices. Indefinite intangible accounting is useful when a company is trying to report on assets that provide value for a business on an unlimited timeline with any end date. Typically this type of accounting is used for trademarks, patents, and goodwill.
Implementing this type of accounting is costly. Assets have to be frequently assessed for impairment which requires a ton of research by accounting teams. This is called cost-less impairment accounting and requires a good bit of modeling in order to complete it accurately. Determining the cost at the acquisition date of the asset and spreading that cost overtime can be complex.
While FASB is solving for some of the feedback that they heard from corporations on the dealings with crypto, FASB is also adding in extra disclosures to help investors and regulators understand the composition of a corporation's crypto portfolio. Current accounting standards for cryptocurrencies do not require the corporation to disclose information about the types of cryptocurrencies that a corporation may hold. FASB’s draft proposal helps clarify this requirement and will serve to protect investors. Of course, these disclosures come at a time when the cryptocurrency and digital asset industry has been suffering from fraud.
Importantly, Bitcoin and Ethereum would be covered in the FASB proposal but non-fungible tokens or NFTs would not be reported on using fair value accounting practices.
This proposed accounting update requires entities to expense transaction costs related to acquiring a crypto asset unless industry-specific guidance says otherwise. It also requires that crypto assets be presented separately from other intangible assets on the balance sheet and income statement. Additionally, if crypto assets are quickly converted to cash, they must be classified as cash flows from operating activities.
What is FASB?
FASB is a private, non-profit organization that establishes accounting and financial reporting standards for public and private companies in the United States. Its mission is to improve financial reporting by providing clear and concise guidance that enables users of financial statements to make informed decisions. When they make changes to accounting practices corporations take note.
FASB’s standards are known as Generally Accepted Accounting Principles (GAAP), which provide a framework for financial reporting that is consistent and transparent. GAAP compliance is required for public companies in the US, and many private companies also follow GAAP standards for consistency and credibility.
FASB regularly updates its standards to reflect changes in the accounting industry and to address emerging issues. It also works closely with other standard-setting bodies around the world to ensure consistency and comparability across different jurisdictions.
What is fair value accounting?
Fair value accounting is a method of valuing assets and liabilities based on their current market value, or what they would be worth if sold in an orderly transaction between market participants. This approach contrasts with historical cost accounting, which values assets and liabilities based on their original cost.
Fair value accounting is used to provide more relevant and accurate financial information, especially for assets and liabilities that are traded frequently in active markets. It is widely used in the financial industry, particularly for investments, derivatives, and other financial instruments. However, fair value accounting can be more subjective and can lead to greater volatility in financial statements.
It’s not perfect, but fair value accounting is a significantly more accurate way to report on digital assets when compared to the current intangible asset accounting method.
How does this affect the marketplace for digital assets?
If the proposed changes are approved and implemented we may witness additional corporations invest in digital assets. The proposed FASB change is not a magic bullet for CFOs who want to accurately report on crypto assets. These assets come with a ton of volatility, and reporting on their price changes is a costly accounting practice no matter which way you slice it.
Additionally, It’s going to take a lot more adoption from the largest and most respected corporations before medium and small sized companies look to invest in the digital asset space. If a tech giant looking to position themselves as a payment network or bank (hint: Apple, Inc.) decides to start to accumulate tokens then we could see an arms race to acquire more digital assets.
The amount of activity, otherwise known as trading volume, in digital asset marketplaces is still relatively light compared to traditional markets. As we have witnessed, it doesn’t take much in terms of selling or buying pressure to move even the most popular or most valuable assets. Corporations devoting even small portions of their research and development spend on tokens could significantly affect the prices of digital assets in the short term.
Of course, corporations in the US will watch the behavior of regulators closely over the next year to determine if they will receive favorable treatment if they decide to hold these assets. The return on investment for digital assets is low if there is a high probability that the assets are unregistered securities or the exchanges they used to purchase the assets are operating illegally.
An increasing amount of young people are buying digital assets and thinking about the asset class as not only a call option on the future adoption of the technology but also a store of value and hedge against the other forms of currency. Tokens held in digital wallets represent a target for corporations who are looking to maximize profitability and entrench themselves with the digitally savvy consumer of tomorrow.
Stakeholders are encouraged to submit comments on the proposed changes by no later than early June 2023. Positive news on this front could spur short term price action to the upside for an industry that is currently in the midst of a bear market.