As the use of digital assets proliferates and regulatory bodies continue to chart that new territory, auditing and accounting for those assets presents fresh challenges. Many cases involving distributed ledgers and cryptocurrencies require thoughtful examination of basic considerations within traditional audit and accounting frameworks, while other instances call for new standards and practices.
The IRS, Securities and Exchange Commission, American Institute of Certified Public Accountants and other groups continue to issue guidance on digital assets. But at this relatively early stage, uncertainty lingers around some elemental issues, such as which rules to follow, jurisdiction of regulators and even the nomenclature by which to refer to such assets. “It’s going to take some time for everybody to get on the same page here,” said Jay Schulman, principal at RSM and the firm’s national leader of blockchain and digital assets.
In the absence of definitive answers to questions about auditing, accounting and taxation of digital assets, asking the right questions is helpful to understanding these new challenges and adapting to them. Here are some important issues to consider:
Reliability and relevance of the ledger
A ledger, such as a blockchain, might include information that is internal or external to the entity being audited. That consideration triggers questions that will require the auditor to judge the ledger’s relevance and reliability: What information is going into the blockchain? What is coming out? What are the controls around the blockchain? For a ledger capturing transactions, what external parties are contributing to it, and how reliable are their processes?
Rights and custody
An auditor must carry out certain procedures to determine an entity’s rights and obligations over a wallet address, said Mark Murray, who specializes in financial services and digital assets as a senior manager in RSM’s National Professional Standards Group. Keep in mind that some wallets are anonymous. “If you think about it from a fraud perspective, what prevents anyone from booking the balances within that wallet on multiple statement entities and providing that wallet address to every auditor who is looking at the separate financial statements?” Murray said. “Can the entity that’s under audit provide sufficient evidence that they actually have the right to control or move the assets that are in the wallet?”
Auditors also need to ask whether an entity has exclusive custody of a digital asset or if it uses a third-party provider? There are cybersecurity risks involved in both scenarios. Similar questions and risks apply to the use of third-party trading platforms.
Off-chain support: If, for example, a company purchased a product by moving bitcoin, the bitcoin transfer could be seen on the blockchain. But that doesn’t necessarily provide audit evidence about the purchased product, including whether the product actually was delivered. “One needs to understand if there is a manual process between information that’s flowing from the blockchain into the financial statements, and what does that process look like?” Murray said. “And is that subject to human error, fraud? These are all types of concerns auditors might have.”
The AICPA’s digital asset working group published a practice aid in December 2019. It clarified that entities will classify digital assets as indefinite-life intangibles. That means they are going to be recorded at their initial fair value but not adjusted to fair value thereafter. Instead, the assets will be tested for impairment.
If, for example, a company purchases a tangible good from another company in exchange for a digital asset, with no variable considerations, it can be assumed the transaction is within the scope of the revenue standard ASC 606. Thus, the assets will be measured as of the contract inception date. That value will be used to record the revenue upon transfer of the good.
Beyond that, entities will have to consider how to identify and track impairment indicators for these assets, as well as how to determine fair value when measuring an impairment. Then, as entities use the digital assets for subsequent transactions, they must consider policies, procedures and controls regarding tracking the assets in and out of wallets and how they will maintain cost bases.
These issues and others require attention and thought as the use of digital assets moves toward ubiquity. The ecosystem of digital assets is evolving, and so are the questions and challenges within.
Whereas the accounting bodies have been slow to issue authoritative guidance, the IRS has been more vocal as to how it wants individuals and companies to treat digital assets for tax purposes. In 2014, the IRS published Notice 2014-21, which stated that, “[f]or federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency.”1 In October 2019, the IRS published Revenue Ruling 2019-24 and an updated FAQ on virtual currency transactions. The new guidance provided explanations on the taxation of hard forks and airdrops, and provided details on the accounting and calculation of gains and losses on virtual currency transactions.
The IRS’ classification of digital assets as general property creates multiple potentials for a capital gain, or loss, for a taxpayer. Whether a digital asset is exchanged for a durable good, contributed to a partnership, or used to pay network fees, the taxpayer must generally calculate capital gain on each transaction.
Considering the continued uncertainty surrounding the taxation of digital assets, many taxpayers take a conservative approach to digital asset tax reporting. Those transacting in digital currency should consult the proper professionals to ensure they understand the tax outcome of conducting or participating in an offering.