Recognition and Measurement of Crypto-Assets

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1		Voicu D. Dragomir	--	2135	2023-08-21 09:16:44	\|
2	format correction	Dean Liu	Meta information modification	2135	2023-08-22 02:24:27	\|

This entry is adapted from the peer-reviewed paper 10.3390/fintech2030031

The Markets in Crypto-Assets (MiCa) Regulation of the European Union is the first comprehensive piece of legislation that seeks to protect the interests of investors in the crypto-assets sector. Although the market value of crypto-assets is significant at world level, there is a lack of clear regulatory guidelines regarding the recognition, measurement, and presentation of crypto-assets in the financial statements of investors. Considering that not all digital assets are the same, retail holders need to take into account the characteristics, rights, and obligations associated with the crypto-assets they purchase to determine the appropriate accounting method.

crypto-assets classification accounting recognition

1. Introduction

Crypto-assets are digital assets created on the basis of the distributed ledger technology (DLT) to validate and secure transactions ^[1]. They can be traded in real time while producing an immutable trace of trading activity ^[2]. The technology can be implemented in a centralized or decentralized crypto-exchange, depending on how crypto wallets are handled. This technology can serve a multitude of purposes, from the creation and trading of cryptocurrencies to automating contracts, issuing security-like digital tokens, guaranteeing the stable price of certain assets, or attaching a certificate of authenticity to digital art. In the legal sense, crypto-assets are “digital representations of value or rights that have potential to bring significant benefits to market participants” ^[3] (para. (2)). The DLT has led to the creation of a “blockchain ecosystem” ^[4], in which the interests of crypto issuers, investors, intermediaries, auditors, creditors, regulators, and policy-makers should converge.

Crypto-assets fulfill three distinctive economic functions: (a) serving as a means of exchange; (b) providing investment value (akin to classical art or securities); and (c) conferring economic benefits related to the participation in network arrangements and the consumption of network products and services ^[5]. One possible classification would be according to their liquidity. Crypto-assets can be created to be a medium of exchange on the dedicated blockchain, with or without monetary claims against the issuer (these would be called “coins”), or to be a digital representation of rights in connection to assets, organizations, or events in the “real world” (these would be called “tokens”). Irrespective of their type, crypto-assets are powered by the DLT and rely on cryptography to verify and secure transactions on a ledger, so that their value is attributed by market participants ^[3] (para. 2).

Currently, there are no generally accepted standards for the recognition and measurement of crypto-assets ^[6]. Several countries have adopted regulations regarding cryptocurrencies, but the MiCa Regulation is the most comprehensive piece of legislation in this domain ^[7]. However, it does not address the recognition and measurement of crypto-assets. This is an opportunity for researchers to investigate the best solutions for increasing the usefulness of financial information pertaining to crypto-assets, especially for holders and investors (who are the vast majority of participants in the blockchain ecosystem). The IFRS Foundation, which has issued standards applied in numerous countries, has allowed companies to use professional judgment, leading to potential manipulations of earnings and financial accounts ^[8]^[9]. The strictly regulated financial reporting of crypto-assets would enhance investor confidence, reduce market risk, and promote the correct assessment of tax implications of crypto-assets.

2. The Distributed Ledger Technology (DLT)

“The blockchain is a technology used for structuring transactional data” ^[10]. It includes several nodes that store the distributed ledger. The nodes form a network where the blockchain database is located. The data stored in the database are distributed towards all the nodes of the network without needing a centralized validation ^[11]. The data in the ledger are replicated and synchronized in nodes in real time. The chain of blocks in the distributed ledger is maintained by the participants ^[12]. The database can be accessed by anyone (when it is public) or only by some specified users (when it is private). The use of the DLT in the financial industry was explored by many market participants, including crypto-assets issuers.

The blockchain technology involves the existence of three key elements ^[13]:

Data: in the case of crypto-assets, the blocks that are stored on the distributed ledgers
Network: all the nodes that work together to reach consensus
Logic: the “smart contracts” used in transactions.

The blockchain technology has a few characteristics that solve the ownership, authenticity, and provenance issues ^[13]:

It is decentralized: there is no central unit that validates the transactions. They are validated by the network nodes.
It is immutable: in any system, the stored data are susceptible to being manipulated or modified. The node consensus makes the smart contracts immutable.
It is secure: the data stored in the ledger are secured by cryptographically hashing each block.

Two protocols are relevant for blockchain technology: (1) the proof-of-work (PoW) and (2) the proof-of-stake (PoS) ^[12]. In the PoW paradigm, the digital assets are created by the mining process, which means solving a conceptual graphic algorithm called hash. After a miner generates a new block, it will broadcast the block to the network for validation. In the PoS paradigm, network participants use smart contracts that put their digital assets at stake to operate network nodes and become validators. Just as the PoW miners receive the digital assets that they mined, the users in the PoS network receive digital assets as a reward for validating new transactions and completed blocks ^[12]. However, the PoS users do not always receive digital assets as a reward. They can receive, for example, lower fees for transactions. The mechanism for rewarding participants in a PoS network is dependent on the fact that validators are also stakeholders in the system ^[14].

To access their own digital assets and perform transactions in the blockchain network, each participant uses an alpha-numeric key, called a private key. This private key is stored in a hardware or software device called digital wallet ^[12]. Each wallet is secured by public and private keys and can interact with many blockchain networks, enabling its owner to send and receive crypto-assets ^[5]. A wallet can send and receive crypto-assets without the need for transactions to be recorded by a third party, making the transaction anonymous to anyone other than the involved parties. Each transaction is accepted by the centralized network and each new block has to comply with the cryptographic rules ^[15]. When a participant makes a transaction in the blockchain network, the transaction is broadcasted and the nodes that manage the network validate it ^[16]. The signature produced by the private key of a user represents his or her acceptance for the DLT to record the change of ownership. The miners or validators who approve this transaction receive digital assets as a fee.

Bitcoin implements the PoW protocols. The miners resolve cryptographic problems (which become more complex from one coin to the next) that are easily verifiable. Each cryptographic solution becomes a new block in the blockchain network ^[17]. Each new block has a reference to the previously created block, thus forming the chain, which gives the name of the technology.

The Ethereum platform (ETH) has adopted a token standard that implements an application programming interface (API) for tokens related to smart contracts. Through this API, the supply of fungible tokens can be tracked on the blockchain, and the smart contract can be executed by transferring tokens from one account to another. In contrast, the ERC-721 is a standard for non-fungible tokens ^[18]. In this case, smart contracts have a unique pair consisting of a contract identifier and a token identifier, similar to a file with an attached certificate of authenticity ^[19].

3. Accounting Options for the Recognition of Crypto-Assets

The definition of crypto-assets considered in the present article is based on the MiCa Regulation: “crypto-asset means a digital representation of a value or of a right that is able to be transferred and stored electronically using distributed ledger technology or similar technology” ^[3] (art. 3.1 (5)). This very broad definition suggests that crypto-assets can appear in different forms, including that of financial instruments ^[20]. However, the MiCa Regulation is not applicable to crypto-assets that may be qualified as financial instruments, deposits, funds (cash), insurance products, pension products, and social security schemes ^[3] (art. 2.4). Furthermore, the MiCa Regulation does not apply to non-fungible tokens of any sort ^[3] (art. 2.3).

EFRAG ^[5] enumerates the criteria for the recognition of crypto-assets in the statement of financial position. These criteria are referenced to the IFRS Conceptual Framework ^[21]. The following discussion is from the holder’s perspective. As such, crypto-assets can be recognized as assets because they:

Are a present economic resource controlled by the entity. Crypto-assets are a digital representation of value or contractual rights created and stored on the DLT network ^[5]. Cryptocurrencies and e-money tokens are the most compelling examples because they are similar to a means of exchange. Other crypto-assets correspond to the contractual right to exchange economic resources with another entity on favorable terms (e.g., asset-referenced tokens) or rights to intellectual property (e.g., non-fungible tokens).
Have the potential to produce economic benefits. The Conceptual framework specifies that future economic benefits do not need to be certain ^[21] (art. 4.14). The volatility and risks associated with crypto-assets do not affect their potential to yield economic benefits ^[22]. Cryptocurrencies can be sold for cash or other crypto-assets, while certain tokens can be used to receive cash or avoid cash outflows. Security tokens (which can be assimilated to ordinary stocks and bonds) can produce cash inflows through potential dividends, interest, or other capital gains.
Are controlled by the holder entity. This is demonstrated by the holder’s ability to command the use of the crypto-asset and obtain the economic benefits that may flow from it. When the crypto-asset is stored separately on a device owned by the holder (in a “cold wallet”), control is easily demonstrated ^[23]. However, when crypto-assets are stored in a “hot wallet” managed by a centralized exchange, the holder cannot precisely demonstrate the ability to prevent other parties from directing the use of the respective crypto-assets and obtaining economic benefits from them. For this reason, wallet providers (i.e., crypto-exchanges) may be required to ensure that user holdings of crypto-assets are kept separate from the entity’s own crypto-assets ^[24]. In other words, the client’s wallet address should be different from the custodian’s wallet address, to meet the definition of control.
Have a value that can be measured reliably. From the perspective of the holder, the purchase cost is easy to identify and can be recorded in accounting. Fair value accounting can be used for potential impairment ^[12].

The IFRS provides several accounting options for recognizing crypto-assets in the statement of financial position. The following enumeration is relevant for holders (not issuers, credit institutions, depositors, or intermediaries). According to the principle of representing the substance of contractual rights and obligations derived from owning crypto-assets ^[21], the financial statements should present a true and fair view of the entity’s economic resources and transactions. Therefore, crypto-assets can be recognized as:

Cash, only applicable to e-money tokens and central bank digital currencies (CBDCs). With very few exceptions, cryptocurrencies are not accepted as legal tender, and therefore they do not fall in the legal category of cash or funds. In the European Union, cash is “defined as comprising four categories: currency, bearer-negotiable instruments, commodities used as highly-liquid stores of value and certain types of prepaid cards” ^[25] (para. (13)). Some authors consider that cryptocurrencies should be recorded as “foreign currencies” in the financial statements ^[15].
Cash equivalents, if the respective crypto-assets meet the criteria of short-term, highly liquid investments that are readily convertible to known amounts of cash, which are subject to an insignificant risk of changes in value ^[26]. While the most significant cryptocurrencies are highly liquid investments and readily convertible to cash, the criterion of insignificant risk of changes in value is seldom met.
Financial instruments, if the respective crypto-assets bear ownership interest in an entity (i.e., equity) or represent contracts that impose the right to receive cash or other financial instruments from a third party ^[12]. Security tokens meet the definition of equity or debt instruments but are not covered by the MiCa Regulation. Additionally, tokens that encapsulate a contractual right to receive cash or a financial asset (e.g., equity) can be considered financial instruments ^[27] (IAS 32, art. 11).
Inventories, when the respective crypto-assets are held for sale in the ordinary course of business ^[28]. IAS 2 (Inventories) was not designed to encompass crypto-assets (or non-physical assets, more generally), but the definition does not contradict the nature of crypto-assets if they are assimilated with merchandise. On the other hand, this definition excludes the investment purpose associated with some types of crypto-assets, such as security tokens.
Prepayments, as in the case of some categories of tokens (i.e., utility, hybrid, and DeFi tokens). Prepaid expenses are usually recorded under current receivables ^[29].
Intangible assets of indefinite duration, without physical substance ^[30]. Intangible assets are long-term assets, either to be amortized or without a limited useful life (such as non-fungible tokens). They are usually listed in the “non-current” section of the financial statements, although the purpose of crypto-assets may contradict this classification, as they could be transformed into other assets in the short term ^[17].

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Voicu D. Dragomir

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Table of Contents

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1. Introduction

2. The Distributed Ledger Technology (DLT)

3. Accounting Options for the Recognition of Crypto-Assets

References