From Blockchain to Balance Sheet: Navigating the Financial Reporting and Audit of Digital Assets
Cryptocurrencies are increasingly gaining popularity within corporations, whether for long term investments, short term gains or used as a method of transaction. As their use increases it creates more challenges for the accounting profession to apply existing accounting standards to a fast-evolving and highly complex asset class.
Examples of digital assets:
This article provides an overview of cryptocurrency accounting under the current standards and addresses the accounting treatment of a variety of digital assets, with the goal of better understanding how these assets are recognized, measured and disclosed.
Accounting for digital assets
A common misconception when accounting for cryptocurrencies is that they should be treated as cash or cash equivalents. However, since cryptocurrencies are subject to significant risk due to their change in value, they do not meet the definition of cash equivalents in accordance with IAS7. Additionally, cryptocurrencies do not meet the criteria to be classified under financial instruments, as they do not represent cash, an equity interest in entity, or a contract establishing a right or obligation to deliver or receive cash or another financial instrument.
If cryptocurrencies do not meet the requirements of IAS 7 and IFRS 9, where does this leave us?
Initial recognition
Classification depends on the purpose for which the asset is held. In 2019, the IFRS interpretations Committee released guidance by confirming the decision that cryptocurrencies should generally fall under IAS 38 (intangible assets), unless they are held for sale in the ordinary course of business, in which case they are to fall under IAS 2 (inventories). Initial recognition requires the entity to have control over the asset (e.g., access to private keys) and to be able to reliably measure its cost.
Subsequent – IAS 38
IAS 38 allows intangible assets to be measured at cost or revaluation. Using the revaluation model, assets can be revalued to their fair value only if there is an active market. If there is no active market, then the company has no choice but to measure the assets at cost. Should the revaluation model be applied, any revaluation gains are to be recognised in other comprehensive income.
Subsequent measurement – IAS 2
Typically, inventories held in the ordinary course of business are recognised at the lower of cost and net realisable value, in line with IAS 2. However, if the entity acts as a broker-trader of digital assets, then IAS 2 states that their inventories should be valued at fair value less costs to sell, with any gains or losses being recognised in profit or loss.
Auditing digital assets
As aforementioned, considering the increase in digital assets within corporations, the following step-by-step guide has been designed to assist in identifying, classifying, and auditing digital assets.
Step 1: Understanding the nature of the digital asset
First, we must obtain details regarding the digital asset from management, most notably:
- What is the name of the token/cryptocurrency
- On what blockchain is this asset traded
- What rights are available with this asset, for example upon redemption
request:
- Acquisition documents such as platform agreements/contracts
- Blockchain Transaction Details
- White Paper and Technical Documentation
- Wallet Statements for the year
- Information regarding whether the asset is a long-term investment or held for resale in the normal course of business.
Step 2: Determine the applicable accounting standard
This depends on the intentions of management. One would need to consider whether the assets are being held for investment or trading purposes.
- Should the assets be held for investment purposes, then these need to be accounted for in accordance with IAS 38 Intangible assets
- Should the assets be held for trading purposes (held for resale in the ordinary course of business), then these would need to be treated in line with IAS 2 Inventory
Auditors must challenge managements’ business model by looking at the frequency of trades. If there are regular trades in place, this would indicate that the assets are being held for trading purposes and therefore should be treated in line with IAS 2.
Step 3: Valuation of the digital asset
IAS 38
Under IAS 38 we measure the asset at cost less any impairment, unless the asset is traded in an active market, in which case the asset can be valued at fair value less any depreciation and impairment losses.
If an active market does exist, then the auditor should agree the fair value of that asset with the price per active market as per Level 1 inputs under IFRS 13. Furthermore, the auditor should also review the valuation date and the reliability of the source of information used for the valuation.
For impairment, we need to identify several impairment indicators such as differences in market price as at reporting date and carrying amount, loss of access to private key, any news regarding the exchange platform that may affect its liquidity. Considering how volatile digital assets can be, an auditor should also look at the market price post year end, given in some cases there can be major price declines, and a disclosure should be considered.
IAS 2
On the other hand, under IAS 2, assets are valued at lower of cost and net realisable value. To determine the net realisable value, we need to understand if the asset is traded in an active market where it can be traded regularly. If we are dealing with popular cryptocurrencies, stable coins and utility tokens, this is usually the case. We then use the quoted market price at the applicable reporting date on that platform. We then adjust by accounting for any transaction fees that will be charged upon withdrawal, such as platform fees (which can be identified based on the platform) and gas fees, which are small transaction fees that are paid when trading crypto.
Step 4: Performing audit and verification procedures.
Confirming existence and ownership:
In order to confirm existence and ownership, the auditor would firstly need to obtain the wallet address from the client. The wallet address is a unique code made up of letters and numbers which identifies a wallet on the blockchain where crypto can be sent or received. Once the address is obtained from the client, the auditor can make use of a blockchain explorer to confirm the existence of the address. The blockchain explorer can also be used to confirm the balance held at any specific date and can also show all transactions made within that wallet similar to a bank statement.
Verify control over wallets
To verify control over the wallets, the auditor should carry out an exercise whereby the client signs a message or transaction through the private wallet key. These can be made free of charge. Cold wallets should be inspected physically by observing the access procedures and confirming the ability to recover access. In cases where digital assets are held by a custodian, it is imperative that third party confirmations are obtained by the auditor.
Review of internal control procedures
This can be achieved through understanding access rights to the private key management. Auditors must also understand the relevant controls surrounding segregation of duties and assess to determine if such controls are effective. This process is vital to determine whether control risk is higher due to poor segregation of duties or poor internal control procedures, which are crucial for reducing the risk of a material misstatement.
As cryptocurrencies and other digital assets become more relevant in corporations, critically assessing the asset class, valuation and controls surrounding the digital asset is vital in ensuring transparency and clarity in financial reporting. Each type of digital asset covered can often pose unique and complex issues and risks.
Until clear global accounting standards are published, it is imperative that auditors apply professional scepticism and judgment, while also adhering to IFRSs and IASB guidance as discussed above.
This article is provided for informational purposes only and should not be construed as professional advice. Readers are encouraged to seek appropriate guidance tailored to their specific circumstances.
