Whether you view Bitcoin as a modern-day tulip bulb mania bubble or an unstoppable development in finance, one thing is certain – there is an increasing tendency for these assets to be held beyond just specialist funds or cryptocurrency ‘miners’.
US business intelligence company MicroStrategy owns digital assets reported at $1.1bn in its balance sheet at 31 December 2020. Then a subsequent earnings release announced that the market value of its holdings was $2.3bn at 27 January 2021. The company’s commitment to the asset is such that it says Bitcoin is now its “primary treasury reserve” and that it intends to “invest additional excess cash flows in Bitcoin”.
But exactly what type of asset is a cryptocurrency and how should changes in its value be reflected in profit and loss, and when?
Accounting was not designed for cryptocurrencies
Cryptocurrencies do not fit into the current accounting framework very well. There is no accounting standard dedicated to this asset under IFRS or US GAAP, and the existing standards were clearly not written with crypto assets in mind.
The most obvious answer is that a cryptocurrency is simply another currency and should be accounted for in the same way as any foreign currency cash balance. This would mean reporting the cryptocurrency at its equivalent (current) value in the company’s reporting currency. Changes in value would generally appear as currency gains or losses in profit and loss.
The problem is that cryptocurrencies are not regarded as a currency for accounting purposes. They are not considered legal tender, are not issued or backed by a government or state, and are not directly related to setting prices for goods and services.
Nor does a cryptocurrency meet the definition of a ‘cash equivalent’. While these assets may be readily convertible into cash, to be regarded as a cash equivalent they must also have ‘insignificant risk of changes in value’; not something that cryptocurrencies are currently known for.
If a cryptocurrency is not cash, then maybe it is some other type of financial asset? However, cryptocurrencies do not give contractual rights to any flows and the only way to realise value is to sell the asset to another party. There is no interest, dividends, right to repayment or any other cash flow that characterises a financial asset. This means that IFRS 9 Financial Instruments does not apply, which is unfortunate because its accounting would produce a good answer.
The only remaining options when using existing IFRS or US GAAP is to report cryptocurrency as either inventory or an intangible non-current asset. Cryptocurrencies meet the accounting definition of an indefinite life intangible non-current asset. This applies in all cases under US GAAP and in most cases under IFRS where some holdings may qualify as inventory.
Intangible asset accounting, and why it does not work for cryptocurrencies
Intangible assets are reported at amortised cost, although because cryptocurrencies have an indefinite life, there is no annual amortisation expense. If their value is impaired, they would be written down below their purchase price and an expense reported. When a cryptocurrency is sold, the difference between the sale amount and the balance sheet carrying value on the date of sale is reported in profit and loss.
A key difference between IFRS and US GAAP is the treatment of the reversals of past impairments. Under IFRS, if the price of a previously impaired cryptocurrency asset was to subsequently recover, a gain is recognised. This is not the case under US GAAP, where the asset would be reported at the lowest amount it was impaired to since the date of purchase.
In the case of IFRS (but not US GAAP) an upward revaluation is permitted for some intangibles (cryptocurrencies would likely qualify if they are traded in an active market), but the revaluation gain would be reported in OCI and not profit and loss. Furthermore, these revaluation gains remain in OCI even when the asset is sold and the gain realised. This would make the revaluation approach unattractive for most companies.
A cost-based approach to accounting for cryptocurrency holdings does not provide investors with relevant information. The historical purchase price is likely to be completely irrelevant within days, given the price volatility of these assets, and the gain on sale useless in measuring performance. In addition, the historical cost approach enables the company to time sales to realise profit when it suits them. Even measuring the realised profit is difficult because cryptocurrencies are a fungible asset. If only part of a holding is sold, then some sort of allocation rule needs to be applied (FIFO, LIFO, etc.) to work out the cost of that sale. The allocations, and hence the profit, are arbitrary.
An investor view
Cryptocurrencies should be reported at their current fair value in the balance sheet, with changes in value reported in profit and loss. This should apply irrespective of why the asset is held or the intention regarding their trading or timing of realisation. They should be a separate category of investments with appropriate disclosure of the nature of the holdings, the business rationale for the investment and information about their price volatility, transferability and liquidity.
In cases where there is limited liquidity, and there is also significant uncertainty about the value of the asset or whether it can be realised, the asset should be reported at zero in the balance sheet. There is a difference between a ‘level 3’ valuation of a financial instrument under the fair value measurement hierarchy and putting a price on a cryptocurrency with limited transferability. In the case of financial assets, there are fundamental value drivers, flows and comparable assets to inform any valuation. This is not the case for a cryptocurrency.
A fair value through profit and loss approach means unrealised gains are recognised in profit and loss, which some might regard as not ‘prudent’ accounting. The price volatility of cryptocurrencies would also make reported profit extremely volatile and driven by, potentially, random and irrational price movements. However, a fair value approach, supported by relevant disclosure, is the most useful and investors are perfectly capable of interpreting the value changes correctly.
Is there any chance that the IASB or FASB will make changes?
Unfortunately, it seems, not any time soon. The US standard-setter, FASB, recently debated cryptocurrency accounting, but has decided, for now, not to do anything to change US GAAP. Nor is the International Accounting Standards Board (IASB) currently looking at the issue, although I understand that this topic may feature in its next agenda consultation. The current inaction could be due to the limited investment in cryptocurrencies by companies in the past. But if the current trend continues, this may not be sustainable.
A simple change to IFRS that would greatly enhance the relevance of financial statements would be to scope cryptocurrencies into IFRS 9. This would produce accounting at fair value through profit and loss, due to the asset failing the ‘solely payment of principal and interest’ test needed to apply amortised cost measurement.
About the author
Steve Cooper is a member of ICAEW’s Financial Reporting Committee and a former IASB Board Member.
A longer version of this article was previously published on his investor-focused blog The Footnotes Analyst (footnotesanalyst.com<).
