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Cryptoassets: The Accountant’s Manual
I. Language of Cryptocurrency
Cryptocurrencies, utility tokens, and security tokens.
A blockchain is a digital, decentralized ledger consisting of a series of blocks.
A block is simply a group of cryptocurrency transactions that have been verified.
Blockchain technology.
As a concept, Bitcoin is capitalized, and as the unit of currency, bitcoin is used in lowercase.
Consensus Mechanism.
The process of encoding and decoding information is used to verify and secure transactions on the blockchain.
Distributed ledger.
Note: Blockchain is a distributed ledger created to keep track of all bitcoin transactions.
Double-spending.
Initial coin offering (ICO).
Hashing involves taking plain text and converting it to a fixed size hash value by a hash function.
It ensures the integrity of the message as the hash value on both the sender’s and receiver’s sides should match if the message is unaltered.
Peer to peer.
A consensus mechanism is used to validate transactions recorded on certain blockchains are based upon a user’s proof of stake (how many units they have) in the blockchain.
A consensus mechanism is used to validate transactions recorded on certain blockchains generally require the production of proof of complex cryptographic computations and large amounts of computing power in order to validate transactions.
II. Defining Money In A Modern Economy
Barter system.
Double coincidence of wants.
- The likelihood of double coincidence of wants is small.
- No common measure (unit) of the value of goods and services in which exchange ratios can be expressed.
Currency is unstable or unavailable for conducting commerce.
Example: Popular in the 1930s during the Great Depression due to a lack of money.
Increase the efficiency of an economy by reducing transactions costs.
Medieval and early renaissance Italy in 1400AC.
In Great Britain 1816.
On blockchain in 2009.
- Medium of Exchange.
- Unit of Account.
- Store of Value.
- Standard of Deferred Payment.
Medium of exchange.
Because money functions as a common measure of value across the economy, allowing the value of goods and services to be expressed in an understandable way for comparison.
Store of value.
Standard of Deferred Payment.
- Commodity money.
- Representative money.
- Fiat money.
Commodity money.
In times of economic turmoil, such as severe economic depressions or hyperinflation.
Note: Commodity money has intrinsic value because the value comes from a commodity or an underlying asset.
Representative money and fiat money.
Representative money.
Examples of representative money: Tobacco certificate, gold certificate, silver certificate, and checks.
A digital representation of value that can be digitally traded and functions as a medium of exchange, unit of account, or store of value. Virtual tokens or coins may represent other rights as well.
Fiat digital currency and virtual currency.
Paypal, Venmo, Google Wallet, or online banking.
Because digital currencies exist outside of a specific virtual environment.
- Issued and usually controlled by its developers.
- Used and accepted among the members of a specific virtual community.
- Generally does not have legal tender status in any jurisdiction.
- Non-Convertible (Closed) Virtual Schemes.
- Unidirectional Virtual Currencies.
- Convertible (Bidirectional) Virtual Currencies.
Non-Convertible (Closed) Virtual Schemes.
- Currencies are purchased using fiat currencies at a specific exchange rate or earned by participating in activities.
- The purchased currency can be subsequently used to buy virtual goods and services.
- May not convert back to fiat currency, and trading with other users is not allowed.
Convertible (Bidirectional) Virtual Currencies.
The International Monetary Fund (IMF).
because the distributed consensus system is secured by strong cryptography.
- A medium of exchange;
- A unit of account;
- A store of value, but do not have legal tender status (when tendered to a creditor, are a valid and legal offer of payment) in any jurisdiction.
Because they are not issued by a federal government or backed by a central bank.
The cryptocurrency uses a distributed ledger technology running on peer-to-peer network records and tracks all activity.
- Intended to constitute a peer-to-peer alternative to government-issued legal tender.
- Used as a general-purpose medium of exchange (independent of any central bank).
- Secured by a mechanism known as cryptography.
- Can be converted into legal tender and vice versa.
III. Decoding Money Of The Future
- Blockchain is Bitcoin.
- Blockchain is just a storage mechanism.
- Cryptocurrencies are not secure.
- Blockchain’s only application is cryptocurrencies.
- Cryptocurrency and blockchain are for technology and finance people only.
- Coins and tokens are the same things.
- Cryptocurrencies have no real-world value.
- All tokens are securities.
- Tokens are not regulated.
- All crypto transactions are anonymous and untraceable.
- Right-click on Sum of Related Item Amount at the designated cell in the Pivot Table.
- Select Summarize Values By.
- Click on Average.
- After the Average is created then format the cell by Right-click on Average of Related Item Amount at the designated cell.
- Select Number Format.
- Select Currency… 0 decimal places.
Because it is a list of records (blocks) linked to form a chain.
- Distributed Ledger enables a decentralized exchange of trusted data.
- Cryptography enforces the authentication and confidentiality of transactions.
- Consensus mechanism ensures the correct sequencing of transactions on a blockchain.
- Decentralized Infrastructure.
- Immutability and Enhanced Security.
- A Self-Regulating Ecosystem.
In a blockchain approach, every participant received a copy of the database or distributed ledger whereas in the traditional approach database was controlled by central and third-party trust.
It uses cryptographic tools to keep the information secure by controlling the ownership of, and/or the right to access, the information on the ledger.
- Provide more business opportunities in areas where governing authority and intermediaries exist.
- Generate trust, security, and transparency among people and entities that do not necessarily know each other.
- Cost-saving by eliminating separate reconciliation efforts on ledgers.
- Enhances transparency by allowing participants in the network to access the history of transactions or confirm new transactions (every change on the chain is viewable and traceable).
Immutability.
Cryptography.
Hashing process.
Consensus mechanism.
Consensus mechanism.
Consensus mechanism.
Fixed-length 32-byte.
- Because the hashing process of a new block always includes meta-data from the previous block’s hash output.
- If attempted, the subsequent blocks in the chain would reject the attempted modification since their hashes would not be valid.
Hashing process.
Cryptography.
Cryptography.
Asymmetric cryptography.
- Serve the purpose in a similar fashion as an account number.
- Made available to everyone on the network to serve as an address on the blockchain network to receive cryptocurrency.
- To verify a digital signature validating the identity of the sender.
- Determines the destination of a cryptocurrency payment.
1, 3, or bc1.
- Serve the purpose in a similar fashion as PIN or password to an account.
- Use to create a digital signature for a transaction.
- Link to the owner and known only to the parties involved in a transaction.
- Prevents the transaction from being altered by anybody once it has been issued.
- Grants a cryptocurrency user ownership of the funds on a given address and allow users to access their cryptocurrency.
Cryptocurrency wallets.
- Stores private and public keys used for cryptocurrency transactions.
- Interacts with various blockchains to enable users to send and receive cryptocurrency.
- Monitor users’ balances in each cryptocurrency resulting from the various transactions.
Hot and cold wallets.
- Hot wallets are connected to the Internet, while cold wallets are kept offline.
- Funds stored in a hot wallet are more accessible in comparison to funds in a cold wallet.
- Hot wallets are more vulnerable to hacking and phishing.
Hardware wallet and paper wallet.
Paper wallet.
Because a private key is similar to a dollar bill, If they are lost, they cannot be recovered; the funds are forever lost. The holders will lose the ability to sell or transfer the crypto funds attached to those keys.
It may transfer the auditing process into a quick, efficient, and cost-effective procedure, enhance regulatory compliance with improved transparency and bring more trust and integrity to the data businesses use and share every day.
Achieve decentralized consensus about the validity of a common database, stored in multiple locations.
Require multiple-system participants to independently verify and authenticate transactions occurring on blockchain.
The transaction will be considered invalid.
Consensus mechanism.
Ownership of the cryptocurrency; and sufficiency of cryptocurrency in the spender’s account.
The spender of cryptocurrency needs to prove ownership of the private key.
Every transaction is verified against the spender’s account (“public key”) in the public ledger.
Permissionless (public) and permissioned (private).
Permissionless (public).
Permissioned (private).
Proof of Work (PoW)and Proof of Stake (PoS).
Proof of Work (PoW).
To validate transactions and to confirm transactions before they can be accepted by network participants.
- Verify the legitimacy of a transaction by solving a mathematical puzzle, which is called a hash function.
- Release newly-created cryptocurrencies (e.g. bitcoin) to reward the first miner who generates a new block as a “block reward”.
Because such an alteration would require re-mining all subsequent blocks. It also makes it difficult for a user or pool of users to monopolize the network’s computing power as the machinery and power required to complete the hash functions are expensive.
A 51% attack, or majority attack.
Proof of Stake (PoS).
Eos, Dash, and Tron.
Efficiency in smaller transactions by combining all parts of a securities trade across several days and intermediaries into one transaction, saving up to $12 billion annually.
Reduce the number of checkpoints, need for repeated validation/authentication.
Financial service, security, banking, government, healthcare, education, intellectual property, international fund transfers, philanthropy, and hospitality.
Alternative.
Cryptocurrency.
Altcoins.
- Coins that are built based on Bitcoin’s original open-source protocol, with a number of changes to its underlying codes. Example: Namecoins and Litecoins.
- Altcoins have their own protocol and distributed ledger instead of using Bitcoin’s open-source protocol.
Examples: Ether operates and functions on the Ethereum blockchain and ripple operates and functions on the XRP blockchain
- Tied to public-open blockchain; anyone can join and participate in the network;
- Operate on their own blockchains, independently of any other platform, meaning that they exist on their own ledgers as further explained below.
- Could be sent, received, or mined/forged.
- Not meant to perform any functions beyond acting as money.
They are equivalent to money.
Bitcoin, Ethereum, Binance Coin, Cardano, and Tether.
A coin is a means of payment while a token has wider functionality.
Ethereum and NEO blockchain platforms.
Currency, digital assets, and digital rights.
Utility Tokens and Security Tokens.
- Simply application tokens or user tokens.
- Users receive some definable benefits.
- The common benefit is access to a particular system or access to products and services offered by a company now or in the future.
- No profits guaranteed.
- No relationship between the token’s value and the company’s valuation.
- Unregulated token sales.
Because utility tokens do not give holders ownership of a company’s platform or assets.
- Meet the Howey Test.
- Share the same qualities as typical stocks should be classified as securities.
- Represent assets such as participation in physical companies or earnings streams or an entitlement to dividends or interest payments.
- Security tokens are analogous to equities.
- Ownership of assets.
- Investors expect a profit.
- The token’s value is connected directly to the company’s valuation.
- Heavily regulated.
Note: Subject to federal regulation under the Securities Act of 1933 (Securities Act) and the Securities Exchange Act of 1934 (Exchange Act). Requires registration with SEC when security tokens are issued.
Because no personal information is shared and identifying data is encrypted, each user has a public address that theoretically could be traced back to an IP address or exchange account (through proper network analysis).
The transaction can be traced to the person or entity using a combination of procedures that includes identifying the destination of the transaction through the public ledger.
Monero, Dash, or Zcash.
By using the concepts of stealth addresses and ring confidential transactions.
Allow and require the sender to create random one-time addresses for every transaction on behalf of the recipient.
- Unlinkable to the original public address.
- Unlinkable to any other one-time address.
- Only the recipient can link all their payments together.
- Only the recipient can derive the secret key associated with the one-time address.
Transactions are un-linkable; only the sender and recipient can determine where a payment was sent.
Ring confidential transactions.
Coinbase, Cashapp, Bisq, and Binance.
Crypto ATM machines.
25,959.
85% located in the U.S., and 6.8% in Canada.
Because they know that such payments are typically not reversible.
IV. Scoping the Crypto Market
- Supply and demand is the key determinant of cryptocurrency prices; no single party (government or otherwise) regulates its use.
- The value can change by the hour; high volatility. For example, an investment that may be worth thousands of U.S. dollars today might be worth only hundreds tomorrow.
- The system is not operated by a central authority (not centrally controlled), its state is maintained through distributed consensus.
- Transactions and balances are recorded on distributed digital ledgers (blockchains).
- Transfers can be done with minimal processing fees without the need for a trusted third party, allowing users to avoid the steep fees charged by traditional financial institutions.
- Transactions are irreversible; once the participant provides confirmation, the transaction is initiated and no one is able to stop that transaction.
- Personal data security is enabled by public-private key cryptography.
- Ownership of cryptocurrency units can be proved exclusively cryptographically.
- The use of cryptography provides a mechanism for securely encoding the rules of a cryptocurrency system (e.g. prevents “double-spending”, resists counterfeiting).
Benefits
- May reduce the risk of identity theft.
- Has immunity to conventional inflationary pressures and sovereign risk.
- Gives potential access to financial instruments for those who are unbanked.
- Might have lower transaction costs for merchants.
- Settles almost immediately.
- Provides irrevocability and finality.
- Is accessible to anyone with access to a computer or smartphone.
- Contains security features that are created through digital signatures and cryptography.
- Useful in countries where the social or political climate may lead to distrust of local currencies or there is a high degree of connectivity to the Internet.
- Opportunities in areas like notary services and tracking asset ownership.
Risks
- May allow for a level of anonymity that can lead to criminal activity.
- Can require a lot of computing power and electrical energy to complete a transaction because the calculations that assure trust between unfamiliar parties are rigorous.
- Has no central authority providing a natural bridge to the currency and no guarantee of value.
- Many provide no recourse for owners who lose money through fraud, exchange collapse, or simple transaction errors and lost “passwords”.
- Is treated differently than other currencies by regulatory bodies. For example, in the U.S., bitcoin and other virtual currencies will be taxed like property, not currency.
- Faces an uncertain legal status. Regulations are still forming and inconsistent and some nations are attempting to outright ban the use of virtual currency.
- Is not ubiquitous.
21 million.
Note: Due to these limits or artificial scarcity, bitcoin is inherently resistant to inflation.
Satoshi Nakamoto.
Overstock.com
All bitcoins are estimated to be mined around 2140.
Vitalik Buterin.
“A set of promises, specified in digital form, including protocols within which the parties perform on the other promises.”
Smart contracts.
Ripple works with banks and allows sending money.
Ripple runs on a permissioned blockchain.
V. Meeting Financial Reporting Requirements
Under U.S. GAAP, an item that meets the definition of an asset is recognized when its cost or value can be measured reliably.
Because cryptocurrencies not backed by a government are generally not accepted as legal tender, therefore, they are not cash.
Cryptocurrencies are not investments that are either 1) readily convertible to cash or 2) so near their maturity that they have insignificant risk, therefore, they are not cash equivalent.
Because they do not represent the contractual right to receive or exchange cash or a financial instrument.
- Because they don’t meet the definition of tangible personal property.
Indefinite-lived intangible asset.
Note: No amortization due to indefinite-lived but subject to an annual impairment test.
Fundamental
- It is an entity that does both of the following:
- Obtains funds from one or more investors and provides the investor(s) with investment management services.
- Commits to its investor(s) that its business purpose and only substantive activities are investing the funds solely for returns from capital appreciation, investment income, or both.
- The entity or its affiliates do not derive strategic or operating benefits from investments other than capital appreciation or investment income.
Typical
- Holds multiple investments.
- Has multiple investors.
- Investors include external or unrelated parties.
- Ownership interests are equity or partnership interests.
- Investments are managed on a fair value basis.
At fair value through profits or losses.
- Held as an “other investment” by an investment company in the scope of ASC 946.
or
- Held by an entity that is not an ASC 946 investment company as an intangible asset when fair value measurement is required.
The entity needs to identify its principal market or in the absence of a principal market, the most advantageous market.
Note: The principle market usually has the greatest volume and level of activities to access the cryptocurrency.
- Description of the cryptocurrency and its important characteristics and the purpose of holding it (e.g.,investing, buying goods and services).
- The quantity of the cryptocurrency held at year-end.
- Applicable accounting policies (e.g., measurement basis).
- Information on the market risk associated with the cryptocurrency (e.g., historical volatility).
- The risks associated with holding cryptocurrencies.
- The company does not have sufficient controls over cryptocurrency transactions.
- The cryptocurrency wallet (if applicable) has not been accounted for.
- The company loses a private key and can no longer access the related cryptocurrency.
- An unauthorized party gains access to the company’s private key and steals its cryptocurrency.
- The company misrepresents ownership of a private key and the related cryptocurrency.
- The company sends cryptocurrency to an incorrect address and it cannot be recovered. A feature common to all blockchains is that once a transaction is confirmed on a blockchain, it is irreversible. This feature may result in an entity losing cryptocurrency if it is sent to an incorrect address.
- The company enters into and records a cryptocurrency transaction with a related party that cannot be identified due to the potential anonymity of parties to blockchain transactions.
- There are significant delays in processing cryptocurrency transactions at the end of a period.
- Events or conditions make it difficult to determine the value at which a cryptocurrency should be recorded for financial reporting purposes.
- How does the entity evidence that cryptoassets (e.g. cryptocurrencies, security tokens) are secure and that private keys have not been compromised?
- How does the entity evidence its ownership of cryptoassets?
- If third-party custodians are used, how is the entity confident that the custodian has the appropriate controls in place?
- Given the potential anonymity of blockchain participants, how does the entity ensure all related-party transactions are identified, accounted for, and reported?
- How does the entity ensure crypto transactions are measured at an appropriate value
- How does the entity ensure that all crypto transactions are captured and appropriately reflected in the financial statements and footnotes?
- Has the entity evaluated whether its engagement with crypto creates additional risks of material misstatement (including fraud risks) and designed and implemented controls to mitigate those risks?
- How does the entity ensure compliance with all relevant laws and regulations?
VI. Examining Regulation Of Cryptoassets
Initial coins offering (ICO).
Time or capital on the amount of funds raised.
Because they can bypass the rigorous and regulated capital-raising process required by venture capitalists or banks.
CoinMarketCap.
DAO Report known as Decentralized Autonomous Organization.
The SEC concluded that those who offer and sell securities in the U.S. are required to comply with federal securities laws, regardless of whether those securities are purchased with virtual currencies or distributed with blockchain technology.
Howey Test.
For determining whether certain transactions qualify as “investment contracts or implication of the investment contract or transaction is a type of security.
- The transaction is an investment of money;
- The investment of money is in a common enterprise; and
- There is a reasonable expectation of profits derived from the efforts of a promoter or third party.
- Do the token holders provide funding for the company’s capital and receive a portion of the profits?
- Does the fundraising effort of the ICO entail investment in the project where profits are generated entirely from the effort of individuals other than the creators or founders of the project?
both initial sales by an issuer and subsequent resales by holders in the secondary market.
File a registration statement with the SEC containing a variety of information about the issuer and its business.
or
Conduct the offering pursuant to a specific exemption from registration.
- Regulation D for private placements to “accredited investors”.
- Regulation A for public offerings of securities < $50 million in any one-year period.
- Regulations S for offshore sales.
Antifraud provisions of the Securities Act and the Exchange Act.
Notice of Sale of Securities.
- Each purchaser must be an accredited investor.
- Purchasers’ accredited investor status must be verified.
- The issuer must not be subject to disqualifications.
- The issuer must file a Form D to report the sale.
- Individuals who have a net worth of over $1 million or have made over $200,000 per year in income for the last two years with the expectation of earning at least that amount in the current year.
- Companies that have over $5 million in assets.
- SEC expanded lists effective on December 8, 2020.
Examples: individuals holding certain certifications, designations, or credentials (initially Series 7, 65, or 82 licenses administered by FINRA)
The notice must be filed within 15 days after the first sale of securities in the offering.
Lead to fines, investors getting their money back, and even criminal charges.
- To correct a material mistake of fact or error in the previously filed notice, as soon as practicable after discovery of the mistake or error.
- To reflect a change in the information provided in the previously filed notice, except as provided below, as soon as practicable after the change.
- Annually, on or before the first anniversary of the most recent previously filed notice, if the offering is continuing at that time.
Form 1-A and known as the Regulation A Offering Statement.
Up to $50 million in investment.
- Part I – serves as a notice of certain basic information about the issuer and its proposed offering, which also helps to confirm the availability of the exemption.
- Part II- contains an “offering circular”; a primary disclosure document that is the equivalent to a prospectus.
- Part III – requires issuers to file certain documents as exhibits to the offering statement. Examples of exhibits include underwriting agreement, charter and by-laws, instrument defining the rights of security holders, voting trust agreement, and material contracts.
- Each offer and sale is made in an “offshore transaction”; and
- No “directed selling efforts” are made in the U.S.
- Cryptocurrencies are property, not currency.
- Every cryptocurrency transaction has tax consequences that may result in a tax liability.
- Cryptocurrencies received as payment for goods and services are reportable as taxable income.
- Wages paid in cryptocurrency are subject to withholding to the same extent as wages paid in dollars.
- Gains/losses on the sale or exchange of cryptocurrencies held as capital assets are generally recognized as capital gains or losses subject to limitations on the deductibility of losses.
- Capital gains/losses must be calculated based on the cost basis of the cryptocurrency.
- The value of a transaction is determined by the fair market value on that day.
- Miners must report receipt of cryptocurrency as income.
- Record keeping is the individual’s responsibility.
- The date of purchase.
- The cost.
- The date of sale, exchange, or disposal.
- The sale price.
- Relevant fair market value information.
- Giving virtual currency as a gift (the recipient inherits the cost basis adjusted for any gift taxes the donor paid when determining if there is a gain or disposition; In determining if there is a loss, the lower of the donor’s basis or the fair market value of the cryptocurrency when it was received is used as the basis; the gift tax still applies).
- Donating virtual currency to a tax-exempt non-profit or charity.
- Transferring virtual currency between wallets.
- Buying virtual currencies with fiat currency.