Introduction

Blockchain, Cryptocurrency, and Bitcoin had remained buzzwords for over a decade since they burst onto the world stage on October 21, 2008, when a whitepaper that envisioned a new way to transfer value over the internet appeared on an obscure online mailing list. 

The paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System” proposed a radically new form of electronic money that would be distributed over a decentralised network. Its creator was a mysterious figure who went by the name Satoshi Nakamoto; unfortunately, no one knows who Satoshi is; he has remained anonymous. 

Blockchain, Cryptocurrency, and Bitcoin, even though related, are not the same and cannot be used interchangeably. Let us attempt to define the three terminologies as clearly as possible. Blockchain is a technology for storing and transmitting information in a transparent, secure manner and operates without a central control body. By extension, a Blockchain constitutes a database containing the history of all the exchanges carried out between its users since its creation. On the other hand, Cryptocurrency is a digital or virtual currency secured by cryptography, making it nearly impossible to counterfeit or double-spend, and Bitcoin is the first and most popular Cryptocurrency.

Traditionally, the bank has long served as an intermediary (or agent) between buyers and sellers of good and services such that when payment is to be made, the buyer sends money to the bank, which in turn sends it to the seller. Here, the bank can be trusted as an intermediary even when both parties do not trust each other. However, if we take away the bank, how would two parties who do not trust each other carry out a transaction? Cryptocurrency was designed to solve this problem by providing a trusted and decentralised platform where assets can be transferred between two parties. It is an electronic cash system that transfers value through the internet and does not have a government, an enterprise or a foundation controlling the technology. The dream was to create a virtual world where money flows as freely as information.

We can further illustrate the peer-to-peer transmission of information using a historical practice common among ancient Europeans. It was a way of sending mails or any sensitive information securely and reliably. It works as follows: Mr A wishes to send a mail containing sensitive information to Mr B in another city but wants to ensure that the information is secured and cannot be accessed by anyone else apart from the receiver. Mr A puts the mail in a mailbox, padlocks it and sends it to Mr B through an agent without providing the key to the box. Upon receipt by Mr B, he realises the box is locked; he then puts a second padlock and sends the mailbox back to Mr A. When Mr A (the initial sender of the mail) receives the box, he opens his padlock with his key and sends it back to Mr B. Mr B receives the mailbox for the second time, and this time, he can now open the box with his key and access the information in the box. This strategy ensured that no third party could intercept the information being sent across from one person to the other. The cryptographic technology works on a similar principle as described above, however, the difference is that there is neither an agent nor an intermediary; information is passed across the internet from peer-to-peer. The use of padlock on mailboxes can also be likened to Cryptography’s state-of-the-art encryption technology.

The most popular Cryptocurrency is Bitcoin and was first to appear in July 2009. Since then, different types of Cryptocurrencies have emerged, such as Ethereum, Ripple, Litecoin, XRP etc. We must apply caution with the word “currency” that appear in CCryptocurrency because Cryptocurrency does not have the characteristics of a regular currency as described in IAS 32: Financial Instrument Presentation. It is highly volatile, deflationary and cannot be used as a measurement basis in the financial statement. However, it functions as a medium and means of payment and is gradually gaining acceptability. For example, Uber’s CEO Dara Khosrowshahi said in February that the company is open to the idea of accepting Bitcoin as a payment. In addition, the other Big 4 accounting firms are following EY’s lead in accepting Bitcoin as payment for professional services rendered.

Digital currency has enjoyed increased adoption and gone through all the phases of disruptive technology. I see a continuous evolution when I look ahead.  It has come from proof of concept to use cases and to the production stage. The technology has experienced both a bullish and bearish market; the next phase is how to scale the technology properly, embed security into it and have something that works for the public’s interest. In fact, there are reports about companies that gained increased patronage only by rebranding their corporate name to include the word “Blockchain”. This shows how much the subject has gained significance in the past few years. This year, Elon Musk, the CEO of Tesla, invested a whopping $1.5 billion in Cryptocurrency, and this singular action pushed up the market value by 20%. In addition, Bloomberg reported on May 11 2021, that the combined market value of all Cryptocurrencies had entered $2.48 trillion, up from less than $1 trillion at the beginning of the year. Therefore, given the increasing popularity of Cryptocurrency and its acceptance, it becomes imperative for accountants and financial reporters to be aware of the accounting and financial implications of having Cryptocurrency in the financial statements. For financial reporters, we need to be aware of the accounting standards around Cryptocurrency relating to its recognition and presentation while financial analyst should be aware of the strategic impact of Cryptocurrency on the income statement and balance sheet.

How does Cryptocurrency Work?

To understand how to account for Cryptocurrency in line with IFRS provision, we must understand the transactions and their unique characteristics. Today, Cryptocurrency has become a global phenomenon known by many but understood by few. In 2021, we can hardly find a major financial institution, accounting firm, software company or government that has not researched Cryptocurrency or started a Blockchain project. However, despite the noise and press releases, many people still fail to understand the basic concept of this technology. Here, I will explain how Cryptocurrency works using Bitcoin as an example. It is instructive to know that it is impossible to account for a transaction or event about which we have little or no understanding. 

Bitcoin is the first, most popular and most valuable Cryptocurrency. The participants in a Bitcoin transaction form a network of computers, also called the nodes. To receive digital cash, every participant needs a payment network with an account, balances and transactions. One major problem every network aims to solve is to prevent double spending, that is, to prevent one entity from spending the same amount twice. Traditionally, a central server keeps records of balances; however, a server is not required to perform this action in a decentralised network. Instead, every participant within the network ratifies every transaction. Thus, each peer on the network has the complete list of all transactions to check if future transactions are valid or an attempt to double-spend. The question then would be how could these participants (or nodes) keep a consensus of the records if one peer on the network disagrees about one single balance? Then everything breaks. Hence, the need for an absolute consensus. However, nobody knew the solution to obtain an absolute consensus from all participants on a network until Satoshi proved it possible, and Cryptocurrencies are a vital part of the solution. 

Let us consider a practical illustration: Ade wants to send 20 Bitcoins to Ola; he must first send a broadcast message to all the computers (or nodes) connected to the network saying, “I want to send 20 Bitcoin to Ola”. Every node within the network will know the message is coming from Ade because of his unique password, and since they are all connected to the current database, they can confirm he has 20 bitcoins to send. This is a standard peer-to-peer technology, and nothing special is happening at this point other than confirmation of transactions by a network of nodes. There are thousands of similar transaction going on at the same time globally. Within the cryptocurrency network, a special set of participants known as “Miners”, scattered worldwide, are responsible for confirming transactions. Every miner competes to solve a cryptographic puzzle, and after finding a solution, they then receive payment by the system in the form of a cryptocurrency (i.e., Bitcoins). In this way, a network of these independent actors is economically incentivised to maintain the legitimacy of the transaction history. Miners perform two significant services: First, they aggregate new transactions such as Ade’s and include them in blocks; secondly, they create blocks, verify them, and update the ledger (i.e., Blockchain). For this job, miners are rewarded with bitcoins: For the first service, they receive Transaction Fees, while for the second, they receive the Block Reward. We would talk more about the accounting for miner’s transaction fees and block reward later in this article. Anybody can be a miner; they only need computation power to qualify for the task. In a nutshell, cryptocurrencies are the key to the complex digital cash problems that Satoshi solved; that is, to maintain integrity and consensus across independent and potentially malicious actors. 

Characteristics of Cryptocurrency

1. No Central Authority (Decentralised): Traditional fiat currencies such as the dollar, euro, and pounds sterling have central authorities and banks that control the financial system. However, transactions processed and validated by a distributed, open network owned by no one in bitcoin cryptocurrencies. Usually, there is a network of nodes (i.e. computer systems) across the globe that verifies the transaction and add it to the open distributed ledger known as the Blockchain. 

• Reliability: With Cryptocurrency, there is no point of failure as in central systems, and this is due to the decentralised ledger technology, which by design results in the very high availability of the services and guard against loss of data.

• Irreversible and Immutable: Due to the decentralised consensus mechanism and validation by each network of nodes applied within the Blockchain, participants cannot make changes to the deal already consummated.

• Scarcity and Limited Supply: Traditional fiat currency is usually controlled by the central banks, which uses different economic policies to manage currency liquidity within an economy. Hence, the central banks can issue or print currencies when there is scarcity. However, with Cryptocurrency, no individual or group of individuals can unilaterally exert significant influence over cryptocurrency supply without the sanction of the majority.

• Security. The integrity and security of transactions are ensured by state-of-the-art encryption, and volunteers work together to encrypt every transaction on the platform.

• Stability. A single participant to the network cannot alter or destabilise the system as all contributors to the Blockchain jointly approve the release of a new block.

Accounting for Cryptocurrency

Based on all that has been said, Cryptocurrency cannot be classified as a currency or cash and cash equivalent in line with IAS 8, and neither does it fit the definition of financial instrument in line with IFRS 9. Hence, we would look at relevant IFRS standards, conceptual framework and the interpretation issued by the International Financial Reporting Interpretation Committee (IFRIC). The Interpretations Committee published an agenda decision on treatment of Cryptocurrency at its meeting in June 2019. Note, we would consider how to account for Cryptocurrency from two perspectives: the motive for holding Cryptocurrency and transaction relating to Miners.

1. From the Holders’ Perspective:  Cryptocurrencies, even though it is not a financial asset, it is similar in terms of investors’ motives for holding financial assets: The business model for financial assets according to IFRS 9 are “Hold to collect” and “hold to collect and sell”. In the same manner, there are two motives why holders buy Cryptocurrency, and it is either to hold it for capital appreciation or to trade with it, but are not involved in mining it. Therefore, the treatment of Cryptocurrency depends on the purpose of holding it, for trading or for other purposes. We would agree with the guidance of IFRIC that Cryptocurrency is an asset because it meets the definition of an asset in line with the conceptual framework; it is separable, i.e., it can be sold separately to someone else and future economic benefits will accrue to the holder.

• Held for trading: If Cryptocurrency is held for trading by holders or dealers, the provision of IAS 2: Inventory applies, especially paragraph 3b, which guides the commodity brokers. Cryptocurrency should be treated as an asset (inventory) and measured the lower of cost and net the realiseable value. The below is the suggested accounting entry to be passed.

Debit: Inventory

Credit: Bank or any other mode of payment

• Other purposes: If Cryptocurrency is held for other purposes, such as capital appreciation, storage of value, or others, it should be treated as Intangible assets, and IAS 38: Intangible assets will apply. IFRIC has concluded that Cryptocurrency is an Intangible Asset because it is an identifiable non-monetary asset without physical substance. In this case, Cryptocurrency is measured at cost at initial recognition and subsequently using the cost model or revaluation model. In addition, most cryptocurrencies have an indefinite economic useful life, and as a result, no amortisation expense is charged, but we must test the asset for impairment at least at every reporting period. The below is the suggested accounting entry to be passed.

Debit: Intangible Asset

Credit: Bank or any other mode of payment

• From the perspective of the Miners: The Miners receive cryptocurrencies either as a block reward or transaction fees depending on the service they perform within the network. Unfortunately, from its 2019 meeting the IFRIC was quiet on accounting treatment for Cryptocurrency relating to miners. However, we would look at the relevant IFRS standard and guidance from the IFRS conceptual framework for financial reporting.

• Accounting for Block Reward: To create valid blocks, the miner must “guess” the correct proof of work or the hash. It is not possible to derive it, it is always guessed through trying and failing and only one out of multiple attempts is successful. It requires a lot of computational strength and resources. From this explanation, we see that the miners are not mining actually (i.e., mining does not relate to natural resources) but providing a service. Furthermore, we may be quick to think that IFRS 15: Revenue from contract with a customer would apply; this would be wrong because the block reward obtained by the miners is paid by the system algorithm and not by any customer. When the miner makes a successful guess and has the correct hash to validate the block, the system creates some cryptocurrency for the Miner and includes it into the block. IFRS 15 will not apply to this situation because for Revenue to be recognised; there must be a valid contract between the seller or provider of service and the customer. In this case, there is no valid contract; hence, no customer and no revenue can be recognised. Another argument could be that the network is the customer, and the contract is implied; however, this argument will not fly because of enforceability. Remember that IFRS 15 defined contracts as agreements between two or more parties to provide goods or services that creates enforceable rights and obligations. In this case, no right or obligation to be enforced, which further shows that IFRS 15 would not apply. In the absence of any existing IFRS guidance on how block reward should be recognised, we would adopt the conceptual framework to recognise it as an income in the statement of profit or loss. It would be recognised as income because we can match the income with the related expense, and the block reward results in a change in the asset’s value (i.e., intangible asset or inventory, depending on the motive for holding the Cryptocurrency). The below is the suggested accounting entry to be passed.

Debit – Intangible Assets (or Inventory)

Credit – Block Reward (Profit or Loss)

• Accounting for transaction fees: Transaction fees are earned by miners to include the transaction into the block and validate it. In this situation, the individual for which service was rendered can be identified. Unlike in block reword, transaction fees are paid by the originator of the transaction and not by the system algorithm. Here, we can identify the customer as the originator of the transaction or the person who made the transaction. In this scenario, the contract is implied, and the transaction will not happen without paying that fee. Therefore, in this situation, the provision of IFRS 15 will apply as as the miner becomes entitled to the fee. The below is the suggested accounting entry to be passed.

Debit – Intangible Assets (or Inventory)

Credit – Revenue (Profit or Loss)

• Accounting for the expenses incurred by Miners: Miners incur high expenses while arriving at a proof of work by using lots of computational strength such as computer, electricity etc. They complete with other miners to solve an algorithm first. Therefore, they have both successful and unsuccessful attempts. Since there is an element of lottery embedded in the miners work, it difficult, if not impossible, to separate cost attributable to successful attempts from those attributable to unsuccessful attempts. Moreover, miners provide service and do not develop Intangible assets; therefore, failing the criteria to be capitalised as internally developed intangible assets in line with IAS 39. Therefore, expenses incurred by miners will be expensed in the profit or loss statement. In addition, if a miner is not a single individual but in a pool of miners, IFRS 11: Joint arrangement will apply (this would be treated under a different topic). The below is the suggested accounting entry to be passed.

Debit – Profit or loss

Credit – Bank or other mode of payment

Conclusion

Some years ago, Cryptocurrency was only used to pay for petty items such as a glass of coffee at coffee shops. Now, its popularity and market value have risen astronomically to the extent that corporate organisations and high-net-worth individuals use it as a store of value. Moreover, the application of Cryptographic technology (or Blockchain) is no longer limited to digital coins but now permeates largely every sector of society. From capital market to healthcare, insurance, banking, audit and government, more and more use cases of the technology continue to emerge. Hence, it becomes imperative for accountants, auditors, financial reporters, and analysts to have proper grasp its accounting implications and treatments.

Furthermore, as plausible as the idea of Cryptocurrency and Blockchain technology appears, it is not without significant drawbacks and certain areas where due care should be exercised. Issues relating to cybersecurity, fraud, finance of terrorism, and ascertaining transaction source need further consideration. Undoubtedly, Blockchain and Cryptocurrency remain a major disruptive technology of the 21st century and the world will continue to see more of its application in the future.