4 Key Challenges of Digital Assets Accounting

1. Tracking cost basis, fair value, and book value by lot

Since cryptocurrencies are taxed similar to traditional stocks and other forms of property, companies must carefully track all of their individual purchases and the cost basis of those assets. Each purchase event is often referred to as a lot. In financial markets, a lot is the number of units bought on an exchange. In the case of digital assets, it refers to the amount of the asset that’s being purchased, and the price and total cost at which it was purchased.

For example, if a company buys 1 bitcoin (BTC) for $35,000 on March 15, and then buys another 1 BTC for $40,000 on April 15, those transactions must be tracked as separate lots.

According to the American Institute of Certified Public Accountants’ (AICPA) digital asset practice aid, companies shouldn’t aggregate the same type of asset together to simplify the accounting—for example, when determining potential impairment charges as discussed further below.

What challenge does tracking by lot present for digital assets accounting?

When companies are regularly transacting in digital assets, the number of purchases becomes difficult to track at the lot level, similar to buying futures. The dates of purchase and sale, cost basis, and transaction size for each digital asset in your portfolio must be tracked and compared.

Additionally, both fair value and book value must be tracked by lot in order to account for impairment events, embedded derivatives, and borrowing activities as described in the sections below.

However, traditional enterprise resource planning (ERP) systems aren’t equipped to deal with digital assets. Finance and accounting departments often manage their holdings and transactions via manual reports, like an Excel spreadsheet, which is very inefficient and subject to human error.

What is cost basis? 

Cost basis is the original value or purchase price of an asset. Keeping track of cost basis allows you to calculate your capital gains and losses for tax purposes, and understand the tax liability of your transactions.

For more information on cost basis methods, please see our Cryptocurrency Tax Guide.

What is fair value? 

Fair value is a rational estimate of an asset’s market price. It needs to be tracked so a company can present a complete picture of its estimated worth to stakeholders and investors.

What is book value? 

Book value is the value at which an asset is held on a company’s balance sheet. For digital assets, the book value is a combination of cost basis—original purchase price—and any impairment adjustments to date.

2. Accounting for impairment events and impairment testing

In a previous article, we discussed how digital assets accounting follows the intangible asset model, and companies don’t get to record the fair value of their assets on financial statements that follow US GAAP. The intangible assets model also presents the following challenges:

• Monitoring assets for potential impairment events

• Recording impairment losses when necessary

• Tracking an assets book value, including the impact of any impairment

What is impairment? 

Impairment is intended to measure and account for the reduction of an asset’s value. For digital assets that are traded on exchanges, and for which there is a known market price, impairment analysis is tied to the price fluctuations of the underlying asset.

In the event an impairment occurs and a write-down is necessary, this reduction is permanent. The asset’s value is written down on your balance sheet, and a corresponding loss is recognized on the income statement.

How does a company test for impairment? 

To test for impairment, a company will compare the purchase price—the cost basis—of the asset, with the current market value of the asset. If, at any point in the reporting period, the price of the underlying asset drops below its purchase price, you have to reduce your holding amount to the lowest point during the period.

For example, if a company purchased 1 ether (ETH) for $3,000 on April 15, they would need to monitor the constantly fluctuating ETH price to test for impairment, and determine if the price of 1 ETH ever dips below their cost basis.

If the price, at any point in time, were to fall below $3,000, the company would need to write-down the value of their asset to the lowest point within the reporting period, along with a corresponding loss recognized in earnings.

Because prices are constantly changing, companies must perform this impairment analysis regularly, at least every reporting period.

Does a company need to test for impairment at the individual lot level? 

Yes, this analysis is complicated by the fact that impairment testing should be performed at the individual lot level. In other words, companies assess each individual lot and write-down that lot to its lowest value since the time of purchase.

Companies shouldn’t simply take their aggregate total asset balance at the end of the period and write-down the value to the lowest price point experienced within the period; lots can be purchased at any point in time, and it wouldn’t be correct to write a lot down to a market value that occurred prior to its purchase.

The AICPA addressed this issue in their practice aid, Accounting for and Auditing of Digital Assets, in Question 7, and offered the following non-authoritative guidance:

"[B]ecause entities usually have the ability to sell or otherwise dispose of each unit (or a divisible fraction of a unit) of a digital asset separately from any other units, entities will generally reach the determination that the individual unit (or a divisible fraction of a unit) represents the unit of account for impairment testing purposes. To perform impairment testing, entities should track the carrying values of their individual digital assets (or a divisible fraction of an individual unit)."

What challenges do impairment events present for digital assets accounting?  

Again, the volume of transactions taking place becomes difficult to track. Price points must be followed closely for each unique instance of every asset. The journal entry for the difference between purchase point and low point must be recorded in the ledger, which can be done at an aggregated level.

As long as the company holds the asset, the asset must undergo continual impairment testing until it’s sold.

3. Recording embedded derivatives  

If a company agrees to receive crypto or other digital assets in exchange for goods and services, it’s generally understood contracts will be subject to Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers.

What’s less understood, and under-appreciated, is companies could also be subject to FASB Topic 815, Derivatives and Hedging, to determine if the contract contains an embedded derivative, especially when revenue is paid for on account.

What is a derivative? 

Before we discuss embedded derivatives, let’s cover the definition of a derivative. A derivative is a financial contract where the value of the contract is tied to the value, or price fluctuation, of an underlying asset.

Derivatives are a common way for companies to:

• Manage market risk

• Create synthetic exposure in order to achieve desired outcomes

• Participate in market speculation, which is far less common for businesses

What is an embedded derivative? 

An embedded derivative exists when a broader contact has a derivative-like feature embedded within it. FASB Topic 815 defines an embedded derivative as “implicit or explicit terms that affect some or all of the cash flows or the values of other exchanges required by a contract in a manner similar to a derivative instrument.”

For example, if a company sells goods or services in exchange for digital assets, and that company allows customers to pay on account, then the company could have a digital asset receivable on their balance sheet that will be settled at some point in the future.

As the market price of that digital asset changes in value, the ultimate value the company realizes will also change. As a result, companies have to record an embedded derivative that reflects the underlying change of value in the digital asset.

Example of an embedded derivative 

To further illustrate this concept, consider the following hypothetical scenario. Please note: while the FASB hasn’t yet issued authoritative guidance, the below scenario illustrates an outcome consistent with current AICPA guidelines.

Contract inception:

• Entity A provides goods and services to Entity B in exchange for 1 BTC to be paid in 2 months. Assume the current price of BTC is $50,000.

• Entity A records revenue on its books in the amount of $50,000 with a corresponding account receivable.

• Entity A performs an analysis and determines the receivable contains an embedded derivative that needs to be bifurcated and separately measured through earnings.

1 month later, at the end of the quarter:

• Assume the price of BTC changed to $55,000. As a result of the bifurcated embedded derivative, Entity A will adjust the carrying value of the embedded derivative on its books to $5,000 with an offsetting gain flowing through earnings.

• Entity A maintains the $50,000 receivable on its books.

2 months post-contract inception, at maturity:

• When Entity B delivers 1 BTC to Entity A, assume the price of BTC is now $60,000.

• Entity A will adjust the forward contract to $10,000, with a corresponding $5,000 gain to earnings within the period, bringing the total gain to be $10,000.

• Entity A would then close out the forward contract and receivable balance with the offsetting entry to BTC.

What challenges do embedded derivatives present for digital assets accounting? 

The complexities of introducing derivative guidance to digital assets accounting is clear and can become a significant challenge for companies.

In this case, the receivable stays on the ledger; gains and losses are recognized according to the fluctuating price of the digital asset as tracked by the embedded derivative, which must be recorded separately and tracked at fair value.

This results in two separate entries on the ledger; both necessary for the accounting to be accurate, but each tracked by different measures even though they’re related to the same transaction.

4. Crypto Borrowing Activities 

Accounting for crypto borrowing activities is particularly challenging.

For example, if a company borrows 1 BTC, the asset is added to the balance sheet. It must be tracked as an intangible asset, then assessed for market changes to account for impairment.

In addition to the asset, a liability must also be recorded to represent the obligation to pay back, at a future date, the 1 BTC that was borrowed. The significant difference, however, is how a company accounts for the liability.

Unlike the asset, cryptocurrency-denominated liabilities aren’t accounted for using intangible asset guidance because they’re liabilities, not assets. Rather, the crypto liability is accounted for at fair value; changes in the fair value flow through earnings via the creation of a derivative contract that reflects the value of the underlying liability.

What challenges do crypto borrowing activities present for digital assets accounting?

If the fair value of the borrowed underlying asset goes up, then the liability will also increase. Likewise, if the fair value were to decrease, the liability will decrease as well.

This difference between how crypto assets and liabilities are treated for accounting purposes creates a meaningful challenge for companies, and also for users of financial statements.

When assets are held at cost, but liabilities fluctuate according to fair value changes, this creates a mismatch in the balance sheet; this mismatch could lead to net equity outcomes that aren’t aligned with economic realities.

To illustrate this, if you borrowed 1 BTC at $30,000 but the fair value of 1 BTC rises to $50,000, your balance sheet will reflect an asset worth $30,000. Meanwhile, the liability is recorded at $50,000—when the embedded derivative is factored in—and the ledger shows a $20,000 negative equity hit.

Therefore, it becomes much more difficult to explain to stakeholders and potential investors what’s happening with the business. Often companies will use non-GAAP disclosures and fair value statements to provide investors with insights into how their business is actually performing.

How TaxBit can help

Due to the complexity, volume, and rapid growth of crypto transactions, you’ll want to seek out and leverage technology to help you with your digital asset reporting.

TaxBit’s enterprise software combines the expertise of a specialized accounting firm and the efficiency of cutting-edge technology to automate your crypto reporting needs.

Contact us today to schedule a custom demonstration tailored for your business.