February 2022
AOGB Professional Services Group
Authored by:
Harry Ho, Managing Partner
Amedeo Montonati, Associate Director
The interest related to crypto-assets and general defined Digital Assets kept to further increase and spread globally in 2021. Driving from past years considerations there are now additional and more detailed developments that need to be taken into consideration. In this article we will highlight the most common practices for accounting, auditing and taxation in relation to Digital Assets.
INTRODUCTION AND MARKET UPDATE
Digital Assets related topics have generated a tremendous amount of interest and during the year of 2021.
While there has been an explosion for the price of Bitcoin from US$29K in the beginning of the year to an all-time high of US$ 65K in mid-April 2021, Ethereum has performed even better in the same year, starting 2021 at US$731 and reached all-time high in November 2021.
Many governments are discussing on how to develop a regulatory regime for Digital Assets, at the same time these governments continue to work on their own central bank digital currencies: The United Kingdom and Europe are currently working on developing a new regulatory regime; the United States and Singapore on the opposite side are relying on the current regulatory regime and guidelines. El Salvador meanwhile officially adopted Bitcoin as legal tender.
In relation to Hong Kong, the Securities and Futures Commission (the “SFC”) issued a position paper in November 2019 to set out a licensing framework for platforms which offer trading of securities-type tokens (“voluntary opt-in regime”). In particular, the voluntary opt-in regime is applicable to only platforms that offer trading services of at least one token with securities features involved. As of 2021, there have only been a few cryptocurrency trading entities which can obtain licenses approved by the SFC.
The above outlook indicates a solid trend with multiple jurisdictions working on applicable regulatory regimes and practical guidelines on Digital Assets.
ACCOUNTING IMPLICATION AND UPDATE
There are not many specific accounting standards issued by jurisdictional accounting bodies for Digital Assets up until early 2022. Accounting firms around the globe have been trying to assess possible classifications of Digital Assets under accounting standards. Major players in the industry have been directing their assessment mainly under the General Accepted Accounting Principles (the “US GAAP “) and the International Financial Reporting Standards (the “IFRS”) to which respectively reporting practices are set by the Financial Accounting Standards Board (the “FASB“) and by the International Accounting Standards Board (the “IASB “) respectively.
In this article we want to focus on the applicability of the IFRS to assess Digital Assets being internationally recognised and since theoretical framework and principles of the IFRS leave more room for interpretation (which might require detailed disclosures on financial statements).
The IFRS Interpretations Committee (“IFRS IC”) issued an agenda decision on the accounting for cryptocurrencies (a subset of Digital Assets) in June 2019, specifying they are not financial assets but in the scope of International Accounting Standard 2 (“IAS 2”) Inventories or International Accounting Standards 38 (“IAS 38”) Intangible Assets. The agenda decision also provided guidance on relevant disclosure requirements.
Furthermore the IFRS IC defined a cryptocurrency as a crypto-asset with all of the following characteristics: “a) a digital or virtual currency recorded on a distributed ledger that uses cryptography for security, b) not issued by a jurisdictional authority or other party, and c) does not give rise to a contract between the holder and another party”.
Despite the indication of the IFRS IC the International Accounting Standards Board (IASB or the Board) has not added crypto-assets to its standard-setting agenda at this stage but it is still continuing to monitor the development of crypto-assets and their significance for IFRS reporters.
Digital Assets have diverse terms and conditions, and the purpose for holding them also differs among holders. Hence, holders of a crypto-asset will need to evaluate their own facts and circumstances in order to determine which accounting classification and measurement under current IFRS should be applied. Such determination and
assessment should serve the purpose to rule out accounting classification under which might get a wrong classification.
In this article, due to the amount of information, we will touch base only the two of most commonly used standards as briefly mentioned above: IAS 2 Inventories and IAS 38 Intangible Assets. Please be reminded that a detailed and assessed rule out of all the other standards is required.
IAS 2 Inventories
IAS 2 does not require or imply the inventory to be tangible. Also IAS 2 does not apply to financial instruments. In fact Inventories under IAS 2 include assets held for sale in the ordinary course of business, assets in the production process for sale in the ordinary course of business and materials or supplies that are consumed in production.
Digital Assets could be held for the scope of sale as per scope of business, for example by a trading entity. Whether Digital Assets are held for sale in the ordinary course of business would depend on the specific facts and circumstances of the holder.
Unfortunately estimating and valuating the selling costs for Digital Assets classified as inventory may present difficulties as the selling costs can fluctuate significantly depending on the market value and trend.
IAS 38 Intangible Assets
IAS 38 states an intangible asset to be “a resource controlled by an entity as a result of past events; and from which future economic benefits are expected to flow to the entity”. Furthermore the IASB defines an intangible asset as an asset which is held and controlled by an entity, lacks physical substance but can be identifiable and will generate a possible economic benefit.
For such definitions and classification, Digital Assets usually meet the criteria of the IAS 38 to be classified as intangible assets, however a detailed assessment of the scope and practice of a business should be done in order not to misclassify those assets.
Generically speaking, crypto-assets do not have defined useful life, and they will not undergo amortisation. Instead, crypto-assets should be assessed for impairment tests during a financial year.
Intangible assets usually are initially measured at cost. The cost of acquiring crypto-assets would typically include the purchase price and transaction costs. Under IAS 38 there are two subsequent measurement approaches that can be applied as an accounting policy choice to each class of intangible asset: The Cost model and the Revaluation Model.
The above guidelines provide brief insights on how to classify Digital Assets, it is important for Digital Assets holders or traders to kick start discussions with auditors on the accounting treatments on Digital Assets.
AUDIT IMPLICATION AND UPDATE
It is becoming common for financial statements to show material cryptocurrency balances and to reflect the results of cryptocurrency transactions. Management for corporations involving in Digital Assets business has now come to the concern of conducting audits for the business.
While the market is searching for auditors specialising in digital assets, the market has little or no experience with cryptocurrencies and digital assets’ audits. Currently audit firms are exploring the nature, timing and extent of audit procedures on digital assets, the audit practice is evolving with more experience gained.
Along the development of Digital Assets market, we have noted that different accounting bodies, like Chartered Professional Accountants Canada, American Institute of Certified Public Accountants and the Chartered Institute of Management Accountants have issued different publications to provide us with insights on auditing of digital assets. For example, below are the keys areas that auditors should pay attention to:
Assessing the integrity and business substance of the corporations which involve Digital Assets related business
Obtaining an understanding of the entity's information system for cryptocurrency transactions and exchanges
Identifying and assessing risks of material misstatements in financial statements related to cryptocurrency transactions and cryptocurrency balances
Confirming the custody of digital assets
Assessing the accounting classification of digital assets
Verifying the valuation of different cryptocurrencies
Other considerations include but not limited to:
Liabilities resulting from agreements to pay amounts owing using a cryptocurrency
Controls related to the infrastructure supporting a blockchain technology, such as the hardware and software used in operating a node
Getting to know the key audit focus for corporation management is always important to ensure smooth audit process and avoid qualified audit opinions.
The corporation’ management needs to understand how auditors obtain sufficient appropriate audit evidence regarding the validity and occurrence of the business activities via Digital Assets platforms and prepare adequate documentary evidence to satisfy auditors about the validity of transactions.
TAXATION IMPLICATION AND UPDATE
axation is one of key considerations when transacting digital assets. Management should take into consideration of the potential tax costs on any transactions related to digital assets. In some countries whereby tax rules treat Digital Assets as ordinary property, buying and selling cryptocurrencies to realize a gain may be subject to capital gain tax. Some countries may treat the digital assets as payment of currencies or personal wealth and the gain may be assessed like appreciation of the currencies/private assets and subject to other types of tax instead of capital gain tax.
During past few years, it has been seen most countries stepped up their efforts to formulate and issue specific tax regulations to provide more guidance of tax implications on different types of Digital Assets transactions. Having said that, while the governments are trying to fit the Digital Assets into the existing tax laws and regulations instead of creating another set of tax rules governing digital assets, there are still too many details to be clarified. As a result, it is foreseeable that arguments and contentious issues surrounding Digital Assets transactions between tax authorities and taxpayers would arise.
Hong Kong as an international financial centre is trying to progressively setting some guidelines. It issued DIPN 39 in 2020 to provide some general principle applied to the various forms of cryptocurrencies transactions. DIPN 39 generally classified different forms of cryptocurrencies and provides that different scenarios of cryptocurrencies transaction should follow the general charging provisions in the Inland Revenue Ordinance. For example, the same principles would need to be followed to argue the gain on disposal of cryptocurrencies to be a capital gain in nature (as opposed to trading gain) in order to avoid paying Hong Kong profits tax. If any employees receive crypto assets from employers as employment remuneration, it should be subject to salaries tax similar to equity compensation calculated at a fair market valuation of the crypto assets. Some other scenarios are also provided in DIPN 39 for taxpayers’ reference.
However, Hong Kong has not practically fully implemented solid progress on taxation regulations of the Digital Assets since the issuance of DIPN 39. It remains to be seen how the tax regulations in Hong Kong would develop and evolve over time. From a pure tax point of view, it would be still reasonable to say Hong Kong may be still viewed as one of ideal jurisdictions to conduct crypto assets transactions given it has no capital gain tax, no indirect tax (VAT or GST, etc.), limited withholding tax and territorial taxation system.
DISCLAIMER: this article was prepared by AOGB Professional Services Group Limited (“AOGB”) as non-authoritative guidance. AOGB and the authors do not accept any responsibility or liability that might occur directly or indirectly as a consequence of the use, application or reliance on this material.
REFERENCES
1. WIRE, B., 2022. Global Digital Asset Management Market Report 2021: Growing Era of Digital Content Across all Industries is Contributing to Growth - Forecast to 2026 - ResearchAndMarkets.com. [online]
2. Businesswire.com. Available at: <https://www.businesswire.com/news/home/20220105005647/en/Global-Digital-Asset-ManagementMarket-Report-2021-Growing-Era-of-Digital-Content-Across-all-Industries-is-Contributing-to-Growth-Forecast-to-2026---ResearchAndMarkets.com.
3. The Conversation. 2022. After a big year for cryptocurrencies, what's on the horizon in 2022?. [online] Available at: <https://theconversation.com/after-a-big-year-for-cryptocurrencies-whats-on-the-horizonin-2022-172733.
4. Cpacanada.ca. 2022. Audit considerations related to cryptocurrency assets and transactions. [online] Available at: <https://www.cpacanada.ca/en/business-and-accounting-resources/audit-andassurance/canadian-auditing-standards cas/publications/cryptocurrency-audit-considerations.
5. IFRIC Update June 2019 IASB website, https://www.ifrs.org/news-and-events/updates/ifricupdates/june2019.