Accounting for Cryptocurrencies: Answering Questions You Might Have About Cryptocurrency Accounting

Let’s face it: cryptocurrencies have been a buzz for quite a long time. While not everyone understands their purpose and how they work, many use cryptocurrencies in their business transactions (and the tendency seems to grow). At this point, CPAs and accountants need to embrace this unique class of digital assets to answer the demand for cryptocurrency accounting. And that’s not that easy. With the absence of specific accounting standards and the volatile nature of these currencies, accountants must grasp the complexities involved in their recognition, measurement, and reporting. 

I wanted to explore the current state of accounting for cryptocurrencies, shedding light on key challenges and considerations in treating them and reporting crypto transactions in financial statements. I also asked Irene Wachsler, a CPA and Crypto/Digital Currency Expert, to help me clarify some points, so I’ll be sharing some insights from her.

Irene Wachsler, CPA, CTRS

Irene is a CPA and Crypto/Digital Expert helping her clients organize their finances, make sense of their numbers, and handle taxes efficiently, including cryptocurrency taxation and problem-solving.

Now, here’s a quick look at what you’ll read about:

1. What are cryptocurrencies?

2. Why is cryptocurrency accounting more challenging than traditional accounting?

3. What are the regulations for cryptocurrency and digital assets accounting?

4. How to account for cryptocurrency

5. Does tax preparation differ a lot with cryptocurrency involved?

What are cryptocurrencies?

Before we get to cryptocurrency accounting, I believe it might be good to know what cryptocurrency is. 

So, in a nutshell, cryptocurrency is a digital or virtual currency that uses cryptography for secure transactions and controlled creation of new units. Think of cryptocurrencies as digital tokens representing value, just like physical coins or banknotes, but existing solely in the digital environment.

People use cryptocurrencies for various reasons. Some see them as investments, hoping their value will increase over time. Others use them for online transactions or for transferring money internationally without involving banks and their associated fees. Cryptocurrencies also enable the creation of smart contracts – self-executing contracts with predefined conditions.

What’s the technology behind cryptocurrency?

Unlike traditional currencies issued by governments and regulated by central banks, cryptocurrencies operate on decentralized technology called blockchain. Let’s break it down a bit, as it’s interesting.

You can compare blockchain to a super secure digital ledger. Imagine a giant, unchangeable, and transparent book that records every transaction ever made with a cryptocurrency. But instead of being stored in one place, this digital book is duplicated and distributed across many computers worldwide.

Each page in this book is a block, and all these blocks are linked in a chain, hence the name blockchain. The magic is that once a block gets filled with transactions, it’s sealed with a digital lock, making it almost impossible to tamper with. Every time a new transaction happens, it’s like adding a new page to this book, and the network of computers agrees on its accuracy.

So, when someone says they mined a cryptocurrency, they actually helped verify and record transactions by solving complex mathematical puzzles. The process maintains the integrity of the blockchain and rewards miners with new cryptocurrency units.

And it comes with benefits.

First, cheating becomes incredibly difficult since changing a block requires changing all the previous blocks. Second, it’s decentralized, so no single entity has all the power, which boosts security and trust, and also means no one can create more cryptocurrency out of thin air.

The perspectives on using blockchain technology in various industries are amazing, accounting included. But this is worth a whole new story, so let’s not stop at it right now.

Bitcoin and other popular cryptocurrencies

Let’s get back to cryptocurrencies and look at the most popular options on today’s digital currency market.

• Bitcoin (BTC)
  Bitcoin is the pioneer and most recognized cryptocurrency. It laid the foundation for others and is often called digital gold. People use it for investment and as a form of digital money.
  
• Ethereum (ETH)
  Beyond just being a currency, Ethereum lies behind the concept of smart contracts. It’s like a platform for building applications that automatically executes agreements without intermediaries.
  
• Binance Coin (BNB)
  Initially created for a specific exchange, BNB has expanded its use for various purposes within the Binance ecosystem, including trading fee discounts and participating in token sales. Consider exploring a binance review for valuable insights.
  
• Cardano (ADA)
  Known for its focus on research-driven development, Cardano aims to create a more sustainable and scalable blockchain. It emphasizes academic rigor in its design.
  
• Solana (SOL)
  Praised for its speed and scalability, Solana aims at fast handling of a high volume of transactions. It’s gaining attention for its potential use in decentralized applications.
  
• XRP (XRP)
  Developed by Ripple, XRP focuses on enabling fast and low-cost cross-border transactions. It’s often associated with the financial industry for its potential in remittances.
  
• Polkadot (DOT)
  Polkadot is designed to connect various blockchains, allowing them to work together and share information, which could lead to more efficient and interconnected networks.
  
• Dogecoin (DOGE)
  Started as a meme, Dogecoin eventually gained popularity. It’s known for its fun and friendly community. However, it’s important to note that, being a joke, it carries higher volatility.

These are just a few examples of cryptocurrencies. Crypto market is constantly evolving, and new projects emerge frequently. So, for CPAs who offer crypto accounting among their services, it might be a bit of a hussle to keep an eye on the cryptocurrency landscape.

Why is cryptocurrency accounting more challenging than traditional accounting?

Should emerging cryptocurrencies be the only hardship accountants face, we won’t be sitting here right now, as there would’ve been nothing to discuss. But in fact, there are more challenges that make crypto and traditional accounting different.

Irene Wachsler: 

“Price fluctuations for cryptocurrencies make it challenging to keep the accounting records accurate in determining the Fair Market Value of these crypto assets. This, in turn, makes financial reporting challenging – especially if one has to audit or rely on these financial statements.”

Volatile nature of cryptocurrency values

Cryptocurrencies feature extreme price volatility. Unlike traditional currencies that tend to have relatively stable values, cryptocurrencies can experience rapid and significant fluctuations within short timeframes. This inherent volatility poses a significant challenge for accurately valuing and recording transactions. The value of a cryptocurrency asset can change dramatically between the time of the transaction and the subsequent reconciliation, impacting financial reporting and balance sheets.

Lack of standardized accounting principles

In traditional finance, well-established frameworks like Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) provide a common language for recording and reporting financial transactions. However, the decentralized nature of cryptocurrencies has resulted in the absence of universally accepted accounting principles. As a result, individuals and businesses often resort to varied accounting practices, leading to inconsistencies and challenges when comparing financial statements across the cryptocurrency landscape. (We’ll get back to this later on.)

Transaction volume and automation

Cryptocurrencies operate on blockchain networks that process a high volume of transactions per second. The sheer quantity of these transactions can overwhelm traditional manual and semi-automated accounting methods. At this point, specialized accounting software capable of handling the rapid pace and volume of cryptocurrency transactions is required to accurately record and categorize financial activities in real-time.

Security and safeguarding digital assets

The digital nature of cryptocurrencies exposes them to hacking and cyberattacks, leading to the potential loss of valuable assets. Security is a big concern in cryptocurrency accounting, requiring solid measures to safeguard digital holdings. This introduces an additional layer of complexity, as accountants and financial professionals must ensure the secure storage and management of cryptocurrency assets while maintaining accurate records.

What are the regulations for cryptocurrency and digital assets accounting?

As mentioned above, one of the biggest challenges cryptocurrency accounting comes with is the lack of commonly approved regulations for treating digital assets – they don’t fall into traditional frameworks. 

I was wondering, doing my research, why cryptocurrency regulations are so vague.

Here’s what Irene has to say:

“Most cryptocurrencies are decentralized, so no central bank or government controls the supply of coins/tokens on the market. This makes it very challenging for any government to regulate. 

The Securities and Exchange Commission (SEC) has started taking steps by claiming that various cryptocurrency offerings, such as Ripple, are investment securities and, therefore, must register with the SEC and adhere to SEC regulations. Also, since cryptocurrency can be used as a medium to purchase/exchange for goods and services, the US Department of Treasury is trying to assess how to regulate some of these transactions. 

And the States are getting involved because each state has its banking regulations – some stricter than others. When I evaluate banking services for a cryptocurrency (or any online bank), I make sure that the bank is registered to do business in The State of New York because New York has the most strict regulations.”

As you can see, regulations in the cryptocurrency space are still evolving, which is pretty logical considering that cryptocurrencies are a relatively new concept. This uncertainty causes a good deal of trouble for businesses and accountants. At this point, businesses that operate with cryptocurrencies need to work closely with accounting professionals who are well-versed in this area. Staying updated on regulatory changes is equally vital to ensure compliance with tax laws and financial reporting requirements.

How to account for cryptocurrency: a quick look at crypto bookkeeping and financial statements

Seeing how contradictory cryptocurrency grounds are – its recognition, vague regulations, super volatility – I wondered how finance folks handle bookkeeping and accounting with cryptocurrency involved. No surprise here: it requires effort and understanding the context, as many depend on the nature and purpose of cryptocurrency within an organization.

Irene Wachsler

“Accounting treats cryptocurrency as investments. That’s fine if the company or individual’s goal is to hold onto them and/or trade them, similar to one would do with stocks or mutual funds. However, if the cryptocurrency is used to purchase goods and services, then I think this should be treated as cash, similar to how foreign currencies are treated.”

So, let’s look at the typical ways cryptocurrency transactions are treated in financial statements, and what determines this or that way.

Classification

Cryptocurrencies can be classified in multiple ways, such as intangible assets, inventory, or cash equivalents.

Intangible assets

Cryptocurrencies are often classified as intangible assets, particularly when held for investment purposes. Similar to other intangibles, like patents or trademarks, their value comes from the benefits they provide. As a rule, they are initially recorded at cost and subsequently measured at either cost or fair value, depending on the accounting standards followed.

For example, consider a scenario where a technology company, let’s call it Tech Guys Inc., purchases a substantial amount of Ethereum, intending to benefit from potential capital appreciation. The company believes that over time, the value of Ethereum will increase, resulting in a potential gain. In this case, the Ethereum holdings are akin to other investment assets like stocks or bonds. The company will record the initial purchase of Ethereum at its cost, and subsequent changes in its value will be reflected on the income statement. If the value of Ethereum increases, Tech Guys Inc. might report a gain, but if the value decreases, a loss will be recognized.

Inventory

In some cases, cryptocurrencies might be classified as inventory. This is especially relevant for businesses actively involved in mining or trading cryptocurrencies. Similar to other inventory items, these assets are recognized at the lower of cost or net realizable value. The challenge here lies in determining the appropriate cost basis for cryptocurrencies, considering factors like mining costs and market fluctuations.

Picture a mining company called CryptoMine Ltd. This company is actively involved in getting Bitcoin using computer processes. The Bitcoin they get from mining is considered inventory because CryptoMine’s business is all about making new units of this cryptocurrency. It’s similar to a manufacturing company that keeps the materials and stuff they produce in their inventory. CryptoMine keeps track of its Bitcoin inventory by looking at the cost, including the costs of mining, like electricity and computer hardware maintenance. They also look at how much Bitcoin could be sold for now – its current market value. If the value drops significantly, CryptoMine might have to say they lost some value in their Bitcoin inventory.

Cash equivalents

Cryptocurrencies can also be treated as cash equivalents when they exhibit characteristics of highly liquid investments with minimal risk of value changes. This classification is often applied to stablecoins or other cryptocurrencies with a fixed value pegged to a stable asset like a traditional currency.

For instance, consider a global ecommerce platform named ShopGlobal Ltd. that accepts stablecoins like USDC (USD Coin) as a form of payment. These stablecoins are pegged to the US dollar, maintaining a fixed value. ShopGlobal holds a significant amount of USDC in its wallet, ensuring that it can quickly process refunds, payouts, and transactions without being exposed to the volatility of other cryptocurrencies. In this case, the stablecoins function as cash equivalents since they are readily convertible to traditional currency and have a stable value. ShopGlobal will record these stablecoins on its balance sheet at their fair value, and any fluctuations in value will be reflected in the income statement.

Criteria for classification

The classification largely depends, as mentioned, on how a company acquired cryptocurrency and the intent behind it. The predominant activity of the organization is also considered.

Investment Intent

If the primary objective is to hold cryptocurrencies for potential capital appreciation, it makes sense to classify them as intangible assets. Their value fluctuations can be reflected in the income statement, potentially impacting a company’s profitability.

Operational activities

Organizations engaged in mining, trading, or using cryptocurrencies for day-to-day transactions might classify them as inventory. This aligns with the principle of recording assets intended for sale or consumption during regular business operations.

Liquidity and stability

When cryptocurrencies are used as cash equivalents, assessing their liquidity and stability is a critical criterion. Stablecoins, designed to minimize value fluctuations, are more likely to fit into this classification frame.

Treatment in financial statements

As you can see from the examples above, cryptocurrency’s classification influences how they get reflected in financial statements. Let’s just put it together in a more structured way.

• Cryptocurrencies as intangible assets are initially recorded at cost (i.e., the price they were bought for). Later on, their value is adjusted by subtracting amortization over time (if any) and losses due to value drops. Any increase in value after a drop is considered income. But if their value goes down, that loss is recognized right away.

• Cryptocurrencies classified as inventory are recorded at the lower of cost or net realizable value. The cost includes direct expenses (like mining costs) and an appropriate portion of overhead expenses. Any reduction in value is recognized as an expense.

• Cryptocurrencies serving as cash equivalents are measured at their fair value. Changes in their value might impact the income statement, reflecting gains or losses.

Does tax preparation differ a lot with cryptocurrency involved?

Just like accounting for cryptocurrencies, tax preparation looks significantly different when cryptocurrency is involved. The reasons are pretty much the same – the decentralized nature of cryptocurrencies, value fluctuations, and evolving regulatory environment. Let’s break it down real quick.

Determining the tax implications of cryptocurrency transactions can be challenging. Each action – whether buying, selling, trading, or using cryptocurrencies – may trigger a taxable event, and accurately valuing these assets at any given time is crucial. Cryptocurrencies’ high volatility requires careful tracking of transaction dates, prices, and associated fees, which can be daunting for individuals and businesses.

Reporting requirements for cryptocurrencies are distinct from traditional assets. Many tax authorities now demand explicit disclosure of cryptocurrency holdings and transactions, sometimes requiring separate forms or schedules. Additionally, issues such as cross-border transactions, international regulations, and complex tax implications for activities like mining and staking add layers of complexity that don’t exist with traditional assets.

Finally, the potential for errors or misunderstandings in cryptocurrency tax reporting can have serious consequences, ranging from audits to penalties for underreporting. As a result, specialized expertise is often necessary to ensure accurate compliance.

Final word: Will we see more crypto-related accounting services?

Today, there’s a notable demand for cryptocurrency accounting expertise. The unique characteristics of cryptocurrencies, such as their decentralized nature, rapid price fluctuations, and evolving regulatory environment, create complexities that traditional accounting methods may not fully address. Businesses and individuals engaging in crypto transactions seek specialized help to accurately track and report their activities, ensuring compliance with tax regulations and transparent financial reporting.

Moreover, the increasing mainstream acceptance of cryptocurrencies, the emergence of decentralized finance (DeFi) platforms, and the integration of blockchain technology into various industries have amplified the need for professionals who can navigate this intricate landscape. As the crypto space continues to expand, it’s safe to say that the demand for dedicated cryptocurrency accounting services is likely to grow significantly.