The Parliamentary Standing Committee on Finance recently convened a meeting on cryptocurrencies which has attracted a lot of interest as well as concern in various quarters about their investment potential and risks. The Prime Minister also cautioned that cryptocurrencies may end up in the wrong hands and urged for more international co-operation.
Cryptocurrencies have emerged as alternative currencies / investment avenues and are being considered by many as the currency of the future. Cryptocurrencies such as Bitcoins, Ethereum and many others are being considered for a variety of purposes such as a means of exchange, a medium to access blockchain-related products and raising funds for an entity developing activities in these areas. Many large international companies such as Paypal, Tesla, Starbucks, Rakuten, Coca Cola, Burger King and Whole Foods now accept cryptocurrency transactions.
Since the last few months, the Covid-19 pandemic has catapulted the growth of contactless transactions and the growth of cryptocurrencies in India. The crypto culture is fast picking up in India. Many companies all over the world have started accepting or investing in virtual currencies. Concurrently, a new crypto-asset issuance wave has been visible in the start-up world for the purpose of fund-raising. Further, the appreciation in the value of cryptocurrencies (e.g., Bitcoin price has increased more than five times at the time of writing this article as compared to the price in January, 2020) and the price volatility has attracted the interest of investors. These developments have also sparked the interest of regulators around the world.
Cryptocurrencies are not controlled or regulated by a government. Regulators around the world have been concerned about cryptocurrencies. The Reserve Bank of India (RBI) has been concerned about investors’ protection and the anonymity of the transactions.
HOW DO CRYPTOCURRENCIES FUNCTION?
Cryptographic instruments work on the principles of cryptography, i.e., a method of protecting information and communications through the use of codes so that only those for whom the information is intended can read and process it. Crypto assets represent transferable digital illustrations that prohibit any duplication. These are based on the blockchain or distributed ledger technology that facilitates the transfer of cryptographic assets.
Cryptocurrencies are not backed by any sovereign promise as is the case with real currencies. However, digital assets are backed by something. Bitcoin, for example, is backed by the electricity that goes into validating and generating transactions on the network. Gold-backed cryptocurrencies also exist. And some are backed by US dollars.
Governments around the world (including India) have generally adopted a cautious evolution of regulatory approach towards cryptocurrencies. Some countries such as China have banned cryptocurrency, while others like El Salvador have welcomed them into the formal payments system.
It is believed that it is impossible to duplicate the transactions or involve counterfeit currency in the cryptocurrency mechanism. Many cryptocurrencies are decentralised networks based on blockchain technology; it is a list of records that is growing all the time. These are known as blocks that link and secure each type of cryptocurrency. Then there is a single network called mining in which all the funds are kept. In other words, the process by which the cryptocurrency is validated is called mining.
Transactions on public, permission-less blockchains such as the Bitcoin blockchain can be viewed by anyone. The ledger records ownership of Bitcoins and all transactions that have occurred upon it. One can track an activity to particular addresses and addresses to individuals or parties involved in the blockchain. Whenever a transfer is made, this public record is used to verify availability of funds. A new transaction is encoded into the ledger through the mining process. The ledger is virtually undisputable. These features minimise the risk of fraud or manipulation in participant-to-participant transactions on the blockchain itself. The distributed ledger technology has many possible uses that go beyond cryptocurrencies.
FINANCIAL REPORTING PERSPECTIVES
Cryptocurrencies have diverse features with a broad variety of features and bespoke nature. Further, these are emerging at rapid speed. Several new cryptocurrencies have emerged and today there is widespread talk about blockchain technology and cryptoassets.
These factors make it difficult to draw general conclusions on the accounting treatment. To determine which accounting standard applies to cryptocurrencies and assessing the related accounting issues it would be important to understand their characteristics and the intended use for which they are being held by the user. Similar types of cryptographic assets may be accounted for in a similar way.
CLASSIFICATION FOR THE PURPOSE OF ACCOUNTING
Since the emergence of cryptocurrencies is a new phenomenon, there is no specific guidance from accounting standard-setters and pronouncements that deal with the accounting of such assets from the holder’s perspective. Accounting for cryptocurrencies may potentially fall in a variety of different accounting standards. One must consider the purpose of holding the cryptocurrency to determine the accounting model.
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Classification
of cryptocurrencies held for own account
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Rationale
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Classification as cash or cash currency
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• No. Since these are not legal tender and are generally not
issued or backed by any sovereign / government; cryptocurrencies do not
directly affect the prices of goods / services
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Classification as financial
instrument
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• No. A cryptocurrency does not give
the holder a contractual right to receive cash or another financial asset.
Also, cryptocurrencies do not come into existence as a result of a
contractual relationship. Moreover, cryptocurrencies do not provide the
holder with a residual interest in the assets of an entity after deducting
all of its liabilities.
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(continued)
Therefore, currently the cryptocurrencies do not meet the
definition of a financial asset
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Classification as property, plant
& equipment
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• No. Since cryptocurrencies are not
tangible items
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Classification as inventories
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• Maybe. AS 2 / Ind AS 2 do not require inventories to be in
physical form, but inventory should consist of assets that are held for sale
in the ordinary course of business. Where cryptocurrencies are for sale in
the ordinary course of business (for example, in case of entities actively
trading in cryptocurrencies), inventory classification would be appropriate;
inventories are measured at the lower of cost and net realisable value
• It must be noted that Ind AS 2 scopes out commodity broker-traders
who measure their inventories at fair value less costs to sell. When such
inventories are measured at fair value less costs to sell, changes in fair
value less costs to sell are recognised in profit or loss in the period of
the change
• On the other hand, where cryptocurrencies are held for
investment / capital appreciation purposes over an extended period, the
definition of inventory would not be met
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Classification as intangible assets
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• Yes. If a cryptocurrency does not
meet the definition of inventories as stated above, it is likely that the
definition of an intangible asset under AS 26 / Ind AS 38 would be met since
it is an identifiable non-monetary resource controlled by an entity as a
result of past events and from which future economic benefits are expected to
flow to the entity with no physical form
• Purchased intangible assets are
initially recognised at cost
• AS 26 Amortisation of
Intangibles is based on the rebuttable presumption that the useful life
of intangibles will not exceed ten years. Under Ind AS 38, the useful life of
an intangible can be assessed as finite or indefinite. Where the useful life
is assessed as finite, such useful life is
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(continued)
determined based on management’s estimate, reviewed at least
annually. An intangible can be assessed to have an indefinite useful life if
there is no foreseeable limit over which it is expected to generate economic
benefits for the company. Ind AS 38 gives an accounting policy choice of cost
or revaluation method for intangible assets but requires the existence of an
active market if the revaluation method is to be used
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DEVELOPMENT FROM INTERNATIONAL STANDARD-SETTING BODIES
Internationally, the Accounting Standards Advisory Forum (ASAF), an IFRS Foundation advisory forum, discussed digital currencies at a meeting in December, 2016. The debate was focused on the classification of a cryptographic asset from the holder’s perspective. Conversations have continued in various accounting standards boards, but no formal guidance has been issued by the International Accounting Standards Board (IASB).
In July, 2018, the IASB requested the IFRS Interpretations Committee to consider guidance for the accounting of transactions involving cryptocurrencies. In June, 2019, the Committee concluded that IAS 2 Inventories applies to such assets where they are held for sale in the ordinary course of business. If IAS 2 is not applicable, an entity applies IAS 38 Intangible Assets to holdings of cryptocurrencies.
The Australian Accounting Standards Board (AASB) had put together a discussion paper on digital currencies.
On the other hand, the Accounting Standards Board of Japan (ASBJ) has issued an exposure draft for public comment on accounting for virtual currencies. In addition, the IASB discussed certain features of transactions involving digital currencies during its meeting in January, 2018 and will discuss in future whether to commence a research project in this area. The discussion paper concluded that, currently, digital currencies should not be considered as cash or cash equivalents since digital currency lacks broad acceptance as a means of exchange as it is not issued by a central bank. A digital currency is not a financial instrument, as defined in IAS 32, since there is no contractual relationship that results in a financial asset for one party and a financial liability for another.
A digital currency may meet the definition of intangible assets, as defined in IAS 38 or Ind AS 38, because a digital currency is an identifiable non-monetary asset without physical substance. The discussion paper stated that it is not necessarily clear how ‘held in the ordinary course of business’ should be interpreted in the context of digital currencies more broadly. For example, it is not necessarily clear whether entities that accept digital currencies as a means of payment should be considered to hold them for sale in the ordinary course of business. IAS 2 does not apply to the measurement of inventories held by commodity broker-traders who measure their inventories at fair value less costs to sell and recognise changes in fair value less costs to sell in profit or loss in the period of the change.
FAIR VALUATION
Valuation of cryptocurrencies would be required to be determined in several situations, for example:
*In order to determine the net realisable value under AS 2 / Ind AS 2 or to determine fair value less costs to sell if the broker-trader exception is applied under Ind AS 2;
*In order to determine the revaluation amount under Ind AS 38 when classified as an intangible asset;
*For the purpose of purchase price allocation under business combination under Ind AS 103 when acquired through an acquisition.
Ind AS 113 Fair Value Measurement defines fair value as the price that would be received on selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. There is a three-level hierarchy for fair value determination as follows:
Level 1: quoted active market price for identical assets or liabilities;
Level 2: observable inputs other than Level 1 inputs; and
Level 3: unobservable inputs.
Many large traditional shares with an average turnover rate on the Bombay Stock Exchange or the National Stock Exchange are generally considered to be traded in an active market if there are sufficient active trading days within a given period. Data available from CoinMarketCap1 (‘CMC’) for November, 2021 shows that the top five cryptographic assets with the highest market capitalisation have high percentages of average daily turnover ratios (in certain cases up to 50%) with active daily trading. Bitcoin, for example, has a daily trading volume in excess of US $30 billion since the past few months. Looking solely at these statistics, it may be possible to conclude that certain cryptocurrencies have an active market.
Currently, for the other cryptocurrencies, it would be difficult to get a Level 1 valuation for cryptocurrencies as an active market as defined under Ind AS 113 would not be available, although there may be observable inputs that can be used to value these assets. However, the manner and speed at which the cryptocurrencies are evolving, it seems that the fair value hierarchy may keep changing between Level 1, Level 2 and Level 3.
Given the complex nature of cryptocurrencies and relative lack of depth in the market, determining the valuation would not be a straightforward exercise. This is particularly so given the high volatility of prices and the large geographic market dynamics driving the prices. It may be noted that the time at which an entity determines the value of the cryptocurrencies might need careful consideration since the crypto markets may be trading 24/7. For instance,
*Is the valuation time 11:59 PM at the end of 31st March?
*How is the valuation time determined in case of foreign subsidiaries with different time zones?
*Whether the inputs underlying the valuation have been adequately reviewed / challenged given the circumstances existing at the time of closure of business hours?
Ind AS 113 requires the principal market to be determined based on the greatest volume and level of activity for the relevant item. For cryptocurrencies, while CMC includes data from several exchanges, many exchanges serve regional markets only and might not be accessible to entities / individuals in India. Ind AS 113 states that if there is no clear principal market, an entity shall determine fair value with reference to the most advantageous market within the group of active markets to which it has access with the highest activity levels. An entity need not undertake an exhaustive search of all possible markets to identify the principal market but it shall take into account all information that is reasonably available.
Another aspect to be considered for the purpose of determination of fair valuation of cryptocurrencies is whether the cryptocurrencies can be readily exchanged for a ‘real’ currency such as USD or INR. Ind AS 113 requires a Level 1 fair value input to be quoted (with) prices (unadjusted) in active markets for identical assets / liabilities that the entity can access at the measurement date. Certain cryptocurrencies are exchanged for other cryptocurrencies rather than being exchanged for real currencies. Crypto-to-crypto exchange rates are priced based on an implicit conversion of the cryptographic asset into real currencies.
Under Ind AS 113 it can be said that an active market for a cryptocurrency would exist only when crypto-to-real currency rates are published by reliable sources. It would be difficult to classify crypto-to-crypto exchange rates as an active market (and therefore Level 1 fair value). Further, the valuation would also have to be adjusted for illiquidity factors due to the lack of a ready market and the derivation of the prices based on a crypto-to-crypto exchange rate and a secondary crypto-to-real currency exchange.
Due to the factors discussed above, most of the cryptocurrencies will not have an active market and, therefore, they will need to be valued using a valuation technique. The appropriate valuation technique should consider how a market participant would determine the fair value of the cryptocurrency being measured.
Generally, the market approach will be the most appropriate technique for cryptocurrencies. The cost approach or the income approach is likely to be rare in practice. Since cryptocurrency markets are still emerging and not very matured, inputs and information based on discrete / bilateral transactions outside an active market may have to be used. For example, in April, 2021 there was a big crash in Bitcoin prices, reportedly due to tweets about the US regulators’ decision on cracking down on financial institutions for money laundering using cryptocurrencies. Based on CMC website data at the time of writing this article, it does appear that broker quotes are not widely used in this sector as yet. The cryptocurrency market is evolving rapidly and so valuation techniques are also likely to evolve.
FINAL REMARKS
Due to the large diversity in the features of various cryptocurrencies, the pace of innovation and the regulatory developments associated with cryptocurrencies, the facts and circumstances of each individual case will differ. This makes it difficult to determine the appropriate accounting treatment and acceptable valuation technique. And given the increasing acceptance of cryptocurrencies around the world, it is a matter of time before the accounting standard-setters around the world and in India come out with standards / application guidance for cryptocurrencies.
