In the previous post, I discussed accounting treatment and relevant accounting standards concerning cryptographic assets. So far, we have seen cryptographic assets fitting into the definition of intangible assets and inventories for both the US GAAP and IFRS. Let’s do a quick recap here.
Source: AICPA, PwC
For the accountants, finding the right place to put cryptographic assets on the book is just the beginning. As shown in the above table, entities are required to conduct subsequent measurements annually to determine whether an adjusting entry to the carrying value is required.
Here Comes the Fun Part: Subsequent Measurement
By definition, under both US GAAP and IFRS, fair value means the price that would be received to sell an asset (or paid to transfer a liability) in an orderly transaction between market participants at the measurement date (FASB ASC 820 and IFRS 13). But in practice, it is more complicated than it sounds. According to PwC, fair values are divided into three hierarchy levels:
- Level 1: Quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date
- Level 2: Observable inputs other than Level 1 inputs
- Level 3: Unobservable inputs
One thing to note here is that despite having an active market, the quoted prices of a cryptographic asset have to be in fiat to be considered as Level 1 input. For example, if a cryptographic asset is only quoted in BTC or ETH on the exchanges, there is no direct conversion to fiat and thus these quotes can only be treated as Level 2 inputs. Although the definition of an active market does not explicitly refer to fiat currency, the presumption is that to qualify as a Level 1 fair value measurement, the transactions should be measured in fiat currencies (PwC 2018).
Valuation for cryptographic assets that fit into Level 1 is relatively straightforward. Having the Level 1 status presumes that an active market exists for that cryptographic asset at the valuation date. By definition, an active market is one in which transactions take place with sufficient frequency and volume to provide pricing information on an ongoing basis. Although judgment is required to determine whether the frequency and volume are sufficient, given the conditions we are seeing in the markets, major cryptographic assets such as Bitcoin and Ethereum should qualify. However, unlike other assets such as securities that are being traded on a single exchange, people find cryptographic assets being traded in dozens of exchanges and each of those markets might have different quotes at the measurement date. In this case, for accounting purposes, the entities are required to determine a principal market, which is the market with the greatest volume and level of activity that the entities can access. However, entities might find themselves in situations where there are multiple markets with similar levels of activity. In case of a tie, the default will be to locate the most advantageous market to which the entities have access with the highest activity levels.
On the other hand, many cryptographic assets will not have an active market as defined by US GAAP and IFRS, which means they may fall into Level 2 or Level 3 in the fair value hierarchy. In these cases, they will need to be valued using valuation techniques. In most cases, the market approach will be the most appropriate technique to use for cryptographic asset valuation. It is expected that the cost approach or the income approach will be rare in practice. After all, it is still best to hire a 3rd party professional appraiser if you find yourself in this kind of situation to avoid qualified opinions from auditors.
We Have to Face the Fragmented Market
There are probably more than 500 cryptocurrency exchanges in the world. The volatility we have seen in the crypto market also led to less arbitrage. That being said, cryptographic assets are traded in a very fragmented market. Although a principal market or the most advantageous market selected after reasonable judgment and effort in searching can most likely be accepted for financial reporting purposes, we cannot be certain that the principal market selected comes with the highest frequency or volume because the search most likely will not be exhaustive in practice. Earlier in May, S&P Dow Jones announced the launch of the S&P Bitcoin Index, S&P Ethereum Index, and S&P Crypto Mega Cap Index, and S&P is collaborating with Lukka, a crypto market data solutions company. Lukka has developed a fair market value methodology for cryptocurrencies. In its methodology, Lukka tries to solve the problem of identifying a principal or the most advantageous market in the fragmented crypto market. The methodology uses qualitative factors such as level of exchange oversight, microstructure efficiency, transparency, data integrity, alongside quantitative data such as volume and frequency of trades to determine a cryptographic asset’s principal market. Then the executed prices of such principal markets are assigned as the cryptographic asset’s fair market value. Besides the adoption of S&P Dow Jones, we have also seen other big names such as IHS Markit, CPA.com, and RSM adopting Lukka’s methodology. Cryptographic assets live in a decentralized and data-heavy world. It will be interesting to see how our accounting practices catch up.
Here comes the end of this post. I hope the post has been helpful to those struggling with this topic. There are many professional materials consulted when constructing this post. They are great resources to study if one wants to deep dive into these issues. Again, the post represents my personal discussion concerning accounting standards for cryptographic assets and should not be treated as guidance. Have fun building valuation models!
Bibliography
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Beigman, E., Brennan, G., Hsieh, S.F., & Sannella, A. (n.d.). Fair Value in Fragmented Markets: Cryptocurrency Valuation for Financial Reporting.
Congress of the United States House of Representatives. (2021). Congressional Letter to Chair Jones.
Corporates investing in crypto. Deloitte United States. (2021, May 11). https://www2.deloitte.com/us/en/pages/audit/articles/corporates-investing-in-crypto.html.
Cryptocurrency: The Top Things You Need To Know. BDO. (2019, January).
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How Many Cryptocurrency Exchanges Are there? Cryptimi. (2021, April 1). https://www.cryptimi.com/guides/how-many-cryptocurrency-exchanges-are-there#:~:text=We%20estimated%20504%20cryptocurrency%20exchanges,in%20their%20start%2Dup%20period.
IFRS. (n.d.). Holdings of Cryptocurrencies — Agenda decision to finalise. IFRS® Interpretations Committee Meeting.
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PwC. (2019, December). In depth A look at current financial reporting issues.
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Thomson Reuters. (2021, May 4). S&P Dow Jones brings bitcoin, ethereum to Wall St with cryptocurrency indexes. Reuters. https://www.reuters.com/technology/sp-dow-jones-indices-launches-crypto-indices-2021-05-04/.
