The Financial Education & Research Foundation (FERF) spoke with Deloitte’s Principal, Risk and Financial Advisory Practice Tim Davis, Deloitte Partner, US Audit & Assurance Blockchain & Digital Assets Partner Amy Park, and Deloitte Partner, Global & US Tax Blockchain & Digital Assets Leader Rob Massey about the accounting and tax considerations when a company invests in cryptocurrencies or chooses to use it in its business.
FERF: Given that different cryptocurrencies carry different risks, how do financial executives decide which ones we want to be associated with and which ones to avoid?
Tim Davis: Each type of coin represents a unique value proposition. Typically, each coin is associated with a particular use case or problem that the coin system is trying to address. This needs to be understood and evaluated. Beyond the value proposition, companies should consider how the coin system plans to execute those plans and the risks associated with that plan. This can include the experience of the leadership team, funding strategies, key partnerships, and evidence of market validation. There are legal and regulatory risks associated with how the coin plans to be licensed; how they plan to remain in compliance with Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) rules; and how they plan to organize funding rounds. The funding mechanism and how the sale of the token is marketed can be a significant indicator as to whether the coin is considered a security by securities regulators and this may require companies to employ legal counsel to assist in evaluating. The technical architecture and consensus mechanism of the coin also needs to be evaluated for security and stability risks. These are some of the more important areas of coin due diligence.
FERF: What are the key accounting and tax capabilities that their systems need to accommodate to account for crypto?
Amy Park: Companies need to have systems and processes in place to keep track of digital assets purchased and the price they were purchased for in order to evaluates the assets for potential impairment (see Question 3 for details). Further, tracking the carrying amounts (cost less impairment) of digital assets will be important when calculating any gains when the digital assets are sold. Companies can follow different policies for cost allocation, such as first-in-first out or specific identification, as long as the policy is systematic and rational.
Rob Massey: Similar to accounting, from a tax perspective, companies need to have systems and processes in place to track the cost basis, associated transaction fees, and historical impairment associated with each asset or tranche. Some companies have different basis tracking or lot relief methods for tax purposes than for accounting purposes, so additional tracking or process may be required for those differences.
FERF: What are the key accounting and tax considerations when a company invests in cryptocurrencies or chooses to use it in its business?
Park: US GAAP doesn’t provide specific guidance for the treatment of digital assets, and, to date, the Financial Accounting Standards Board (FASB) has decided not to add a project on accounting for cryptocurrencies. As a result, a company must apply and interpret existing GAAP rules for digital asset transactions. On the investment side, the accounting will be driven primarily by what the company is investing in as not all crypto assets are treated equal. If a company is not required to apply specialized industry GAAP, then the accounting for an investment in certain digital assets, like bitcoin, will be as an “indefinite-lived intangible asset.” Indefinite-lived intangible assets are accounted for at cost, subject to subsequent impairment, as appropriate. That means that when the asset is impaired (i.e., when the price decreases), the company must write down the value on its books. However, the converse is not true, the value of the asset cannot be written up when, and if, the price goes up or a previously written-down asset subsequently recovers.
Absent the ability to mark up the value of a company’s digital asset holdings, if the company believes fair value to be more reflective of the economics of its investment, it has the flexibility to provide disclosures that it believes are meaningful to its investors.
When companies use digital assets that are accounted for as intangibles for business transactions, such as paying vendors, these transactions will require a different accounting treatment, which is more complex. That is a consequence of the intangible asset (a nonfinancial asset) now being used as a financial asset yet required to apply nonfinancial asset accounting rules. Companies will need to think about the transaction price that will determine the amount of revenue that will be recognized when a good or service is sold to a customer in exchange for digital asset consideration. Companies may also have to consider how to account for the variability in the price of the digital asset, oftentimes as a derivative instrument, if exposed to such variability. In scenarios where companies are using a digital asset as payment for a service or expenditure, the payment for the service is recognized as an expense but the transaction is also resulting in monetization of the digital asset with a carrying amount that likely will be less than the fair value at that date. This monetization results in a realized gain on the digital asset as a result of payment for an expense incurred and paid with the digital asset. Disclosures will obviously be key in helping investors really understand the use of the digital assets .
Massey: In the US, cryptocurrency is considered general property for tax purposes and is not tied to nor dependent upon the accounting rules. For tax purposes, gain or loss is normally recognized only when cryptocurrency is sold or exchanged. There are two tax accounting methods which are available for basis tracking: Specific Identification (ID) and First In, First Out (FIFO). Specific ID can be used by a company to choose which asset or tranche it is accessing if the assets or tranches are segregated into different wallets or addresses. This segregation is necessary given the fungible nature of cryptocurrency. Without segregation, companies should use the FIFO method. It is common for investors to develop wallet structures to house different tranches of their digital cryptocurrency with different cost bases and holding periods.
From a tax standpoint, cryptocurrency held for investment purposes is normally deemed a capital asset. In corporate solution, capital losses can only be used to offset capital gains. So, while a company may mark down to fair value for accounting purposes, tax does not follow that methodology. Companies which impair cryptocurrency for accounting purposes need to evaluate their sources of income to see if they have any capital gains income when evaluating the need for a valuation allowance on the deferred tax asset (DTA).
When a company uses cryptocurrency in business transactions, such as fund transfers, paying vendors, or employees, it should be segregated into separate wallets to maintain a clear distinction between the cryptocurrency which is used in the operation of the business (which may be deemed “ordinary” property) and the cryptocurrency held for investment ( which may be deemed a “capital asset”). Any cryptocurrency used in the business will generate a gain or loss recognition event for tax purposes as its basis will likely be different than the fair market value at the time of use. This creates a barter transaction each time it is used in exchange for goods or services. Companies that use cryptocurrency instead of fiat currency for business transactions need to create robust tracking of the cryptocurrency to adequately capture all of the gain or loss transactions. Further, they need to bolster other processes impacted by the use of cryptocurrency like payroll – having a system to determine the valuation of crypto used to report on Forms W-2 and withhold and remit payroll taxes. Most tax agencies around the world don’t take cryptocurrency as a form of tax which means the company needs a process to capture deemed withholding taxes in cryptocurrency, convert to fiat, and remit the appropriate amounts of payroll tax. Similar considerations are needed for payments to vendors and calculating and remitting sales tax. This can become very complex and may require significant enhancements to existing processes in the business.
FERF: How do we think about the decision to self-custody vs. Use a custodian?
Davis: Companies should weigh the risk trade off associated with either option. Self-custody may be suitable if a company is unable to find a custodian that meets their needs and believes they can institute sufficient controls over cybersecurity, segregation of duties, and transaction authorization. This is a high bar and for that reason we see most companies electing to use a third-party custodian. That said, custodians have risks that need to be understood and regularly monitored. The typical way companies will understand and be provided assurance over the internal controls at custodians is via a SOC report. This provides independent verification as to what controls exist and whether they are effectively designed and operated. A good SOC report will address risks specific to digital asset custody such as cryptographic key management. Custodians should have world class controls and cybersecurity over their digital assets and companies may need a qualified advisor to help them evaluate the responses to RFPs to separate minimally acceptable from world-class. The other piece of advice is to evaluate the whole picture of risk associated with the custodian’s business. i.e., if the custodian were to maintain strong controls, yet were to go bankrupt, any digital assets held in omnibus accounts could be subject to receivership and hence be at risk of recovery.
FERF: What are the considerations as we select vendors to support key functions like custody?
Davis: It is important that custodians can house tranches of cryptocurrency in different addresses or wallets to allow proper segregation for tax basis tracking purposes. Sufficient user access permissions to allow for segregation of duties is another key consideration. A minimal segregation would typically be between the ability to initiate a transaction and approve a transaction. This would prevent an initiator from approving his or her own transaction and vice versa.
Cybersecurity controls that assist customers in preventing or detecting scams or unauthorized transactions are also important. These can include controls to ensure the customer’s identity, geographic location, and that key message fields such as destination address do not get interfered with through browser malware or a man-in-the-middle attack.
Key reconciliation controls to ensure the accuracy of customer statements that tie the digital asset records to the blockchain and to customer statements is an important, as well as sufficient, pricing detail, such as intra-day lows that may be necessary to support impairment accounting.
FERF: Which risk factors should preparers consider disclosing in public filings?
Davis: Considerations will vary based on specific circumstances. Among some of the key considerations, but not limited to, are the newness of digital assets and limited operating history; regulatory uncertainty with digital assets; the reality that most markets are relatively new and unregulated, and may be subject to fraud and manipulation, and the simple fact that digital assets can be a highly volatile asset class.
Another concern is that blockchain transactions can be irrevocable and without any central authority that can be appealed to. There’s the potential loss of private key material, which can result in permanent loss of the asset, and internet disruptions as a result of technical failure or governmental actions, which can lead to assets being inaccessible or lost.
It’s important to remember: permissionless digital assets protocols are governed by consensus and those protocols are subject to constant change. Such change can lead to vulnerabilities being introduced to these protocols which may result in assets being lost or inaccessible. The regulation of digital assets is evolving and can change rapidly. This can lead to them being banned in certain jurisdictions or regulated in such a way that they may lose some or all their value. And digital assets are subject to risks of loss or manipulation if they have inadequate cybersecurity and cryptography. This can result from inadequate design or from advances in the strength of attack vectors.
Finally, there are liquidity considerations, including the ability or potential inability to monetize a digital asset if a company cannot find a willing buyer or sell for its entire investment. And the impact on future cash flows resulting from investments in digital assets is unpredictable.
FERF: Which areas of regulation and compliance should companies pay particular attention to?
Davis: Regulations and compliance will vary by entity and jurisdiction, but some common examples to be aware of include the determination on whether the digital asset is a security; compliance with anti-money laundering, OFAC, and counter-terrorist financing regulations; prevention of insider trading or market manipulation; and determining the tax treatment of the digital asset on behalf of all stakeholders in a transaction flow.
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