Cryptocurrency Accounting for Investment Companies
Cryptocurrency Accounting for Investment Companies
2 in a 3 part series
Accounting for Digital Assets When Specialized Industry Guidance Applies
Does Specialized Guidance Apply to the Entity?
ASC 946 applies to investment companies; this includes entities that are regulated under the Investment Company Act of 1940 or entities that possess the fundamental characteristics of an investment company, as described in the guidance (ASC 946-10-15-6):
– It is an entity that does both of the following:Obtains funds from one or more investors and provides investment management services; andCommits to its investors that its business purpose and substantive activities are investing funds solely for a return.
– It is an entity that does not obtain or have an objective of obtaining returns or benefits from an investee that are not normally attributable to ownership interests or that are other than capital appreciation or investment income.
It’s important to note that in the context of digital assets, any investment company would be focused solely on investing in digital assets for anticipated return. Engagement in tangentially related activities – such as mining activities to establish cryptocurrency – may be enough to preclude treatment as an investment company
Alternatively, the application ASC 940 Financial Services – Brokers and Dealers may affect the accounting treatment of digital assets.
In both cases, the guidance included here is not exhaustive and the effects are more significant than just the treatment of digital assets. Entities should apply judgment to determine the appropriate accounting standards applicable to its operations.
Digital Assets Under Specialized Guidance
Under ASC 946, the investment company needs to determine the nature of its digital asset holdings: whether they represent debt securities, equity securities, or an other investment. It should apply the appropriate guidance based on that distinction. Investments held by investment companies are initially recorded at the transaction price, inclusive of any commissions or other charges that are part of the transaction. Subsequently, the digital assets should be generally marked to fair value with changes in fair value recognized as gain or loss in the income statement.
Under ASC 940, treatment depends on whether the purchase and sale of digital assets is undertaken on behalf of a customer. When an entity is acting as an agent for a customer, the transaction should not be recorded on the entity’s books, though it may recognize commission income earned through the transaction. If the entity is purchasing and selling digital assets as part of its own trading portfolio, the digital assets will generally be measured at fair value.
Measuring at Fair Value
In generally (GAAP), fair value is based on the exchange of an asset or liability in an orderly transaction between market participants in either (1) the principal market for the asset or, if there is no principal market, (2) the most advantageous market for the asset or liability.
There are several active markets on which digital assets can be traded. Entities will have to evaluate the markets to determine the principal or most advantageous market. GAAP defines the principal market as the market with the greatest volume and level of activity for the asset that the reporting entity can access. If there are restrictions precluding an entity from accessing a market, it would be inappropriate to consider that market the principal market for valuation purposes.
It is assumed that the market used by the entity for its transaction is the principal market, unless there is evidence to the contrary. When determining the appropriate market for valuation purposes, management should exercise careful judgment and evaluate the quality and reliability of information reviewed. The price from the principal market (even if it is not the most advantageous market) should be used to record the fair value of the digital assets on an entity’s books.
For financial reporting purposes, an entity will need to determine what level of the fair value measurement framework the digital asset fits into. If the principal market is active, it can be considered a Level 1 asset for recording purposes. If the market is not active, or based on bid-ask spreads, management will need to exercise judgment to determine the appropriate level. Level 2 or 3 treatment may be appropriate, and management should follow the guidance within ASC 820, Fair Value Measurement.
Some entities have invested heavily in digital assets, and an election to liquidate their holdings may be sufficient to move the market. If this is the case, there is no adjustment to the fair value of the digital assets for reporting purposes. Fair value is just a product of the quantity held and the price per unit; it is inappropriate to apply a discount due to the size of holdings.
Many digital asset markets operate continuously, and don’t have a traditional market close. Entities should develop a cut-off time that it will exercise for reporting purposes. For instance, this may be based on the close of the business day at the entity, based on when other markets closed, or just based on a fixed time. Entities should document this decision and apply the convention consistently.
Some entities that apply specialized accounting can account for digital assets at fair value, though it is not without its complexity. Entities need to exercise judgment to ensure the assets are treated and reported properly. It’s important to note that guidance is changing rapidly, with the SEC issuing its perspective and FASB working on a project to issue authoritative guidance.
[SEC Staff Accounting Bulletin No. 121] Provides guidance to companies who hold crypto assets for users of their platforms