Crypto accounting and decrypting digital assets

As CFOs and CAOs are now discovering, there's a whole new level of complexity with cryptocurrencies and digital assets beyond volatility. Specifically, GAAP doesn't yet provide guidance on crypto accounting, leaving many accounting teams in the dark. 

Using Tesla's massive crypto investment as an example, the company put $1.5B into Bitcoin back in February 2021. Just two weeks later, Tesla's stake had grown to $2.5B, only to fall to $600 million to $700 million soon thereafter, burying the cost basis in an ocean of red. Although the company has divested most of its Bitcoin holdings at this point, the investment might still present a significant challenge to Tesla's accountants.

Thankfully for companies like Tesla and the many others in a similar predicament, the American Institute of CPAs has filled the crypto guidance void in U.S. GAAP with its digital asset working group, publishing what has quickly become the non-authoritative gospel on accounting for cryptocurrencies and the like.

At this point, the AICPA practice aid is virtually indispensable with its discussion, assessment and examples of different accounting and reporting questions on investing and holding digital assets, even separating its insights between non-investment and investment companies.

Searching for an asset classification

From a practical perspective, while classifying crypto assets as cash, cash equivalents or a type of foreign currency might make some sense, an asset can only be cash if it's accepted as legal tender and backed by a government.

Likewise, cash equivalents must represent investments that are readily convertible to cash or have a near maturity that results in insignificant risk to the value. And an asset can't be a foreign currency if it doesn't represent cash.

Unfortunately, you can't account for them as a regular investment or financial instrument, either. In these instances, digital assets don't represent a contract with a right or an obligation to deliver or receive cash or some other type of financial instrument.

Further, while crypto miners intent on selling the assets might think of them as a type of inventory, digital assets usually don't meet the definition for inventory since cryptography-based assets lack physical substance.

Accounting for crypto as an intangible asset

Most companies classify digital assets as a type of intangible asset, at least when purchasing and holding the asset themselves. Although this still isn't a perfect fit, it's the best CFOs and CAOs have under the current standards since, like crypto, intangible assets lack physical substance and have no prescribed lifespan.

Therefore, companies initially record purchases or investments of digital assets at their acquisition cost, and thus subject them to annual and trigger-based impairment tests. Needless to say, this opens up an entirely new can of financial accounting worms.

Given the constant volatility of these digital assets — and the fact that the impairment model for indefinite-lived intangible assets permits a write-down in value but no write-up — the accounting outcomes can be hard for some to understand and anticipate.

As we've seen recently, even a single day of volatility could warrant a trigger-based impairment test and possible impairment losses for a digital asset. And unlike some financial instruments, the impairment framework for intangible assets is not an other-than-temporary-impairment model.

Operational considerations for crypto assets

Of course, with such an unregulated feel to it, holding and accounting for crypto assets isn't just about the balance sheet, but internal controls and processes as well. To that point, there are certain best practices a company should keep in mind to ensure an effective control environment and processes regarding crypto holdings.

1. Controls over digital keys and wallets. Blockchain transactions are either set in stone or extremely difficult to reverse. Therefore, once you send a transaction to a specific wallet address, you cannot adjust the blockchain entry unless the counterparty is actively involved.

In other words, erroneous or inappropriate digital asset transfers could very well lead to a permanent loss of digital assets. This makes controls over initiation and authorization of transactions imperative, extending to controls protecting against lost or stolen private keys that essentially lock you out of a crypto wallet.

2. Evaluating third parties. Companies must consider and understand any risk associated with using a third-party custodian to store digital assets. Keep in mind that a custodian may commingle assets from different customers into the same addresses while also maintaining its own off-chain ledger. This can complicate verifying specific assets, possibly even negating the entire purpose of using the blockchain in the first place.

To avoid such pitfalls, companies should begin by obtaining and reviewing the service organization controls (SOC) reports. From there, focus can shift to designing, implementing and maintaining controls over information received from an exchange, along with controls over a custodian's safeguarding of a company's assets.

For example, finance leaders must understand how a third party's controls relate to the generation and ongoing security of digital keys used in transactions. Similarly, a custodian must have sufficient customer onboarding and due diligence procedures to avoid any potential legal or noncompliance issues down the road.

Although crypto and other digital assets represent an additional asset class for balance sheet diversification, a crypto investment obviously poses significant potential risks. Besides volatility, a company must also consider the lack of accounting guidance and necessary controls before jumping into the crypto pool.