# Bitcoin: The financial reporting challenge for investors

Whether you view Bitcoin as a modern-day tulip bulb mania bubble, that will inevitably burst, or an unstoppable development in finance, one thing is certain, companies are increasingly purchasing this asset. But how do Bitcoin and other cryptocurrencies affect reported financial position and performance metrics?

There are no accounting rules dedicated to cryptocurrencies. Under current US GAAP and, usually under IFRS, intangible asset accounting is applied.  We use the reporting by MicroStrategy to illustrate why this does not provide the right information for investors and explain how you should include cryptocurrency assets in your analysis.

Tesla and Elon Musk may have attracted the headlines for the recent purchase of $1.5bn of Bitcoin, but it is not the first mainstream corporate to invest heavily in cryptocurrency. US business intelligence company MicroStrategy owns digital assets reported at$1.1bn in its balance sheet at 31 December 2020, and in its recent earnings release announced that the market value of its holdings at 27 January 2021 was \$2.3bn. Its commitment to the asset is such that it says Bitcoin is now their “primary treasury reserve” and that it intends to “invest additional excess cash flows in Bitcoin”.

##### MicroStrategy Q4 2020 earnings release extracts

Whatever you may think about the merits of companies investing in Bitcoin and other cryptocurrencies, it is clear that there is an increasing tendency for these assets to be held beyond just specialist funds or cryptocurrency ‘miners’. But exactly what type of asset is a cryptocurrency and how should changes in their value be reflected in profit and loss, and when? Furthermore, how should you analyse companies which hold Bitcoin and other cryptocurrencies?

## Accounting was not designed for cryptocurrencies

Cryptocurrencies do not fit into the current accounting framework very well. There is no accounting standard dedicated to this asset under either IFRS or US GAAP, and the existing standards were clearly not written with crypto assets in mind.

The most obvious answer is that a cryptocurrency is simply another currency and should be accounted for in the same way as any foreign currency cash balance. This would mean reporting the cryptocurrency at its equivalent (current) value in the company’s reporting currency. It would also mean including cryptocurrency holdings as part of cash in the balance sheet and ‘cash and cash equivalents’ in the cash flow statement. This would not result in any entries in the cash flow statement for purchases or sales of cryptocurrency, in the same way that moving cash from one bank account to another is not a cash flow. Changes in the value of cryptocurrency, when expressed in the reporting currency, would generally appear as currency gains or losses in profit and loss.1Accounting for foreign currency is not quite this simple. Financial reporting is based on a concept of functional currency. For each reporting entity in a group a functional currency is identified, reflecting “the currency of the primary economic environment in which an entity operates” (IAS 21). Any currency holdings that are not the functional currency are translated into that currency at the exchange rate at the balance sheet date, with gains and losses reported in profit and loss. In the consolidation process, subsidiaries that have a functional currency different from that of the parent are converted into the parent’s functional currency, but this time exchange differences are reported in OCI. Usually, the consolidated financial statements are presented in the parent’s functional currency – but not always. If the presentation currency is different, every figure in the functional currency consolidated financial statements is converted into the presentation currency, but no further gains and losses arise.

The problem is that cryptocurrencies are not regarded as a currency for accounting purposes. This is because they are not considered legal tender, are not issued or backed by a government or state, and are not directly related to setting prices for goods and services.

Nor does a cryptocurrency meet the definition of a ‘cash equivalent’. While these assets may be readily convertible into cash, to be regarded as a cash equivalent they must also have “insignificant risk of changes in value”; not something that cryptocurrencies are currently known for!

If a cryptocurrency is not cash, then maybe it is some other type of financial asset? However, cryptocurrencies do not give contractual rights to any flows and the only way to realise value is to sell the asset to another party. There is no interest, dividends, right to repayment or any other cash flow that characterises a financial asset. This means that the accounting standards that specify how financial assets are measured (amortised cost of fair value), and how gains and losses are reported, do not apply. This is unfortunate as we think that, at least under IFRS, financial instrument accounting would produce a good answer.

The only remaining options when using existing IFRS and US GAAP is to report cryptocurrency as either inventory, a commodity or some type of intangible fixed asset. The answer is that cryptocurrencies meet the accounting definition of indefinite life intangible fixed assets. This applies in all cases under US GAAP and in most cases under IFRS – some holdings may qualify as inventory, which we explain below.

## Intangible asset accounting and why it does not work for cryptocurrencies

Intangible assets are defined as “identifiable non-monetary assets without physical substance” (IAS 38). This broad definition seems to encompass cryptocurrencies and hence, in the absence of specific rules, this appears to be the most logical classification.

Intangible assets are reported at amortised cost, although, because cryptocurrencies have an indefinite life there is no annual amortisation expense. If their value is impaired, they would be written down below their purchase price, and an expense reported in profit and loss. When a cryptocurrency is sold the difference between the sale amount and the balance sheet carrying value on the date of sale is reported in profit and loss.

A key difference between IFRS and US GAAP is the treatment of the reversals of past impairments. Under IFRS, if the price of a previously impaired cryptocurrency asset were to subsequently recover, a gain is recognised. This is not the case under US GAAP, where the asset would be reported at the lowest amount it was impaired to since the date of purchase.

In the case of IFRS (but not US GAAP) an upward revaluation is permitted for some intangibles (cryptocurrencies would likely qualify if they are traded in an active market), but the revaluation gain would be reported in OCI and not profit and loss. Furthermore, these revaluation gains remain in OCI even when the asset is sold and the gain realised. This would make the revaluation approach unattractive for most companies.

##### Intangible asset accounting for cryptocurrencies under IFRS and US GAAP

We do not think that a cost-based approach to accounting for cryptocurrency holdings provides investors with relevant information. The historical purchase price is likely to be completely irrelevant within days, given the price volatility of these assets, and the gain on sale useless in measuring performance.  In addition, the historical cost approach enables the company to time sales to realise profit when it suits them. Even measuring the realised profit is difficult because cryptocurrencies are a fungible asset. If only part of a holding is sold then some sort of allocation rule needs to be applied (FIFO, LIFO, etc.) to work out the cost of that sale. The allocations, and hence the profit, are arbitrary.

Not only is the profit on sale arbitrary but there are also different ways to calculate an impairment loss. MicroStrategy takes a very conservative approach and writes down their holding of Bitcoin to the lowest price it has traded at any time since the asset was purchased. This seems to us to produce unhelpful results. If, for example, the value of the holding increased over an accounting period but, on just one day dipped below the opening value, then a loss would be reported.2This would not apply under IFRS considering the requirement to reverse impairments. But of what interest is that loss to investors?

### Inventory accounting may apply under IFRS

Under IFRS it is possible that cryptocurrencies could be classified as inventory if they are held for resale. However, this only applies if they are “held for sale or consumption in the ordinary course of business”. It is difficult to see how this applies to cryptocurrency held for investment or treasury purposes.

Some argue that a cryptocurrency is closer to a commodity such as gold. After all, Bitcoin has been described by some as the “new gold” and of course the process by which new Bitcoin is created is called ‘mining’. However, analogising to commodities is a stretch, considering that all recognised commodities have a physical form, which is not the case for cryptocurrency held in an electronic wallet. Under IFRS, commodities held by a broker-trader may be reported at fair value (less costs to sell) with changes in value included in profit and loss.

Canadian (and hence IFRS reporting) financial services innovator Galaxy Digital Holdings has applied this approach, although it also acknowledges the lack of specific guidance.

##### Galaxy Digital Holdings accounting for digital assets

One interesting aspect of the Galaxy Digital Holdings approach is that, where a digital asset is not actively traded, the assets are valued based upon “quoted prices of similar assets or based on unobservable inputs”. We think it is much more difficult to use a comparable asset, or to find fundamental valuation inputs, to value cryptocurrencies that are not actively traded than it is for, say, ‘level 3’ financial assets. We wonder how, for example, ‘Dogecoin’ can have any relevance in valuing say ‘Polkadot’, or what the ‘unobservable inputs’ might be.

## Our view

We think that cryptocurrencies should be reported at their current fair value in the balance sheet, with changes in value reported in profit and loss. This should apply irrespective of why the asset is held or the intention regarding their trading or timing of realisation. We do not think cryptocurrencies should be reported as cash given the limited ability to use them in exchange transactions (although conceivably that could change). They should be a separate category of investments with appropriate disclosure of the nature of the holdings, the business rationale for the investment and information about their price volatility, transferability and liquidity.

In cases where there is limited liquidity, and there is significant uncertainty about the value of the asset or whether it can be realised then, in our view, the asset should be reported at zero in the balance sheet. We think there is a difference between a ‘level 3’ valuation of a financial instrument and putting a price on a cryptocurrency with limited transferability. In the case of financial assets there are fundamental value drivers, flows and comparable assets to inform any valuation. This is not the case for a cryptocurrency.

A fair value through profit and loss approach means that unrealised gains are recognised in profit and loss, which some might regard as not ‘prudent’ accounting. The price volatility of cryptocurrencies would also make reported profit extremely volatile and driven by, potentially, random and irrational price movements. However, we believe a fair value approach, supported by relevant disclosure, is the most useful and that investors are perfectly capable of interpreting the value changes correctly. We do not agree that companies should only report realised profits or that unrealised gains arising from investment assets should be excluded from profit and loss.

### Is there any chance that the IASB or FASB will make changes?

Unfortunately, it seems, not anytime soon. The FASB recently debated cryptocurrency accounting but has decided, for now, not to do anything to change US GAAP. Nor is the IASB currently looking at the issue, although we understand that this topic may feature in their next agenda consultation. The current inaction could be due to the limited investment in cryptocurrencies by companies in the past. But if the current trend continues this may not be sustainable.

In our view, a simple change to IFRS that would greatly enhance the relevance of financial statements would be to scope cryptocurrencies into IFRS 9. We believe that this would produce our preferred accounting of fair value through profit and loss, due to the asset failing the ‘solely payment of principal and interest’ test needed to apply amortised cost measurement.

## Non-GAAP measures

The volatile nature of the gains and losses from holding cryptocurrency, whether it is impairments and gains on sale for MicroStrategy or the fair value changes for Galaxy Digital Holdings, make this a prime candidate for exclusion from non-GAAP performance metrics. Unsurprisingly, this is exactly what we see for MicroStrategy.

##### MicroStrategy non-GAAP operating profit

Clearly the gains and losses from cryptocurrency holdings should be disaggregated and presented separately, given their nature and, in the case of MicroStrategy, their materiality to the overall result. In addition, as we explain above, we do not believe the figures presented under intangible asset accounting are meaningful for investors. However, as a matter of principle we do not believe that excluding volatile gains and losses is the best approach (nor do we think that share-based compensation should ever be excluded).3For more about non-GAAP measures and disaggregation see Don’t rely on APMs, disaggregate IFRS – GlaxoSmithKline. We discuss share-based compensation and why it should not be excluded from performance metrics used in equity analysis and valuation in Dot-com bubble accounting still going strong – Tesla.

## Insights for investors

• There are no accounting standards specific to cryptocurrencies and you may see different accounting applied in practice. The most likely is intangible asset accounting and measurement at cost less impairment.
• In our view intangible asset accounting is not suitable. Impairments and gains on sale may not be comparable and are not measures of performance that matter for investors.
• Remember that intangible asset accounting differs under IFRS and US GAAP.
• Regard cryptocurrency assets as, in effect, financial investments. Include their fair value in your analysis but take note of the risks, price volatility and particularly whether there is an active market.
• If no active market exists for a cryptocurrency you should probably not include it in your valuation, even if reported in the balance sheet. Beware of companies quoting ‘level 3’ values in this situation.

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