Crypto accounting for Exchanges in Web3

1. Crypto Accounting for Exchanges in Web3 The Complete Guide

Web3 is the decentralized iteration of the internet largely based on the blockchain technology and token-based economies. It largely aims at user privacy and transparency, thereby eliminating any reliance of intermediaries or third parties. Crypto assets are facilitators of the decentralization process and equal access. Crypto accounting for Exchanges in Web3 Crypto assets are products of interaction between technology and finance. Since it is a developing asset class, their transactions are nuanced too. They are not just limited to trade and exchange, but also expands to other transactions like mining, staking, lending, borrowing, airdrops, forks, NFT creation/trading, and so on.

Web3, being the forerunner in emerging new technologies, changes literally everything everywhere, including the field of traditional accounting. As the crypto asset market has grown extraordinarily, there is a need to have a proper crypto bookkeeping system to ensure transparency and ease in record keeping. Crypto accounting for Exchanges in Web3 The lacunae in specific accounting standards applicable to transacting crypto assets escalated the issue to the US accounting standard-setters, the Financial Accounting Standards Board (‘FASB’). This gap raises crucial questions like how do crypto exchanges recognize, value or record transactions of crypto assets? The FTX collapse is the ideal example to highlight the absolute lack of adequate regulations to govern the business of crypto exchanges. It has become crucial for crypto exchanges to share their financials with their customers in the most transparent manner possible.

A. Transaction Recording

Just like a traditional bank, managing user deposits, withdrawals and executions is the most important role of crypto exchanges for safeguarding customer funds and providing a transparent picture of net deposits. Exchanges are the recipient of uncountable order placements like market order, limit orders, trigger orders, etc. Binance, for instance, exchange has a daily trading volume of over $76 billion. This demands for a robust order management system which implies that these orders need to be recorded accurately in the books of accounts.

Crypto exchanges have various sources of fees from investors like transaction fees, withdrawal fees, service charges etc. It is crucial for these exchanges to understand the characterization and nature of such charges and thereafter apply the correct crypto accounting treatment Crypto accounting for Exchanges in Web3.

B. Liquidity Management Crypto accounting for Exchanges in Web3

The concept of liquidity in crypto market is even Crypto accounting for Exchanges in Web3 more relevant because excessive price spillage is not desirable. Ideally, there should be ease in converting crypto assets into cash without substantially impacting its market price. Maintaining liquidity ratios for crypto exchanges is essential due to various reasons. Liquidity in crypto market is a big contributor to price stability and in securing investor trust. A number of large order buy or sell orders can cause massive price fluctuations which is undesirable.

Liquidity management for crypto Crypto accounting for Exchanges in Web3 exchanges is extremely challenging owing to the market volatility, chances of market manipulation in absence of regulation, and other regulatory considerations. Any crypto exchange is successful based on its liquidity management. But how are they to maintain liquidity levels in the most volatile environment? Just like the stock market, there could be crypto traders or institutions that continuously buy and sell crypto assets and gain from the bid-ask spread. Ultimately, for crypto exchanges, market depth needs to be added in their order books.

Most importantly, it is critical for crypto exchanges to Crypto accounting for Exchanges in Web3 save themselves from bankruptcies owing to a liquidity crisis. Investor trust is an implicit advantage.

C. Regulatory Compliance

The regulation of crypto exchanges and platforms is continuously evolving. As an overview, registration and compliance requirements depend upon the product being traded. For instance, the crypto platform could require registration with the Commodity Futures Trading Commission (‘CFTC’) if the platform is trading certain commodities other than virtual currencies. The need to be registered with the Securities and Exchange Commission (‘SEC’) if the products traded are securities. Other platforms may possibly have to be registered solely with federal and state money transmitter licensing requirement (this is the case with most crypto exchanges). Compliance is needed with the Bank Secrecy Act including KYC norms and anti-money laundering compliances. Most importantly, the financial reporting standards need to be adhered to including financial crime enforcement network. Overall, there continues to be deficiencies in regulation of crypto exchanges that are subject matter of debates.

With the ever evolving and mostly add-on regulations, crypto exchanges need to stay atop and dynamically move ahead with he regulatory landscape in the US. Subject experts like crypto CPAs are updated with the evolving classification issues, legal uncertainties, and compliance procedures. Similarly, crypto tax accountants Crypto accounting for Exchanges in Web3 are also best equipped in handling crypto tax applicable on different transactions involving crypto assets.

D. Asset Reconciliation

Asset safety has been a matter of concern when it comes to crypto exchanges. It is vital for crypto exchanges to offer protections for a healthy investor protective regime. This includes ensuring appropriate bookkeeping or ledgering of assets and disclosures to protect against misuse or misallocation of customer assets. The exchanges must regularly reconcile customer’s trading balances against cash and digital assets. Further, it is also important to segregate independent assets of an exchanges from the customer’s assets.

Consolidating crypto assets in a single dataset through reconciliation will help in payment of taxes. The generalized high level key steps of this important process is the following:

Ø Step 1: Gathering all data from a crypto bookkeeping software and creation of a master dataset.

Ø Step 2: Ensuring accuracy of reported transactions (especially for crypto tax purposes) and pulling out any missing data

Ø Step 3: Reconciling transfers such as withdrawals and deposits including segregating self-transfers

Ø Step 4: reviewing unmatched transfers that were not categorized or matched properly.

Ø Step 5: Verifying final dataset by conducting a thorough review of it

Ø Step 6: Generating final and accurate report

Asset reconciliation helps in retaining customer trust, being transparent and playing safe during an audit. Early detections may completely prevent large scale discrepancies and overall collapse of the crypto exchange.

E. Impairment

Accounting Standard Codification (‘ASC’) 350 deals with accounting of intangible assets with indefinite useful lives. Crypto assets have no foreseeable limitation on the period of time over which it is expected to contribute to the cash flows of the reporting entity. Under ASC 350 for record keeping of such assets, the FASB has adopted a cost-less impairment model. Under this model, in the beginning, the asset’s value is recorded at its historical cost: the price at which it was acquired. Whenever it is observed that the value of the asset has gone below the historical cost, the same is recorded. Although it is required to test the price annually, a more frequent evaluation occurs due to high market volatility. The drawback here is that only the losses can be recorded. Any increase in the crypto asset’s value from its historical cost can be recorded only if the same assets are not transferred to someone else. Therefore, crypto exchanges have not been able to record any upward movement in the value of the crypto assets Crypto accounting for Exchanges in Web3.

It is challenging because the price shoots up and down drastically within a short span of time, which becomes complex and time-consuming for companies to keep a record of all such transactions.

F. Security and Custody

The security of crypto assets remains vulnerable. Breaches like hacking, phishing, and other cyberattacks may lead to loss of crypto assets. The extent of losses needs to be accurately accounted for. Similarly, loss of private keys making digital wallets inaccessible is a common problem. It may lead to omission in reporting such crypto assets. Such losses can be prevented by using crypto accounting software that utilize API integrations for downloading all necessary data from wallets and exchanges.

Following the complicated chain of custody of a crypto asset in a blockchain in order to de-recognize such crypto asset in the crypto currency accounting records is another challenge.

G. Classification of Crypto Assets

Crypto assets are a type of native digital asset that is directly transacted from peer to peer. All crypto assets are protected through encryption, and all the information or any crypto asset transaction is safely stored in a digital database.

At first glance, crypto assets may be considered cash or cash equivalent because they are a kind of digital currency used as a medium of exchange. Although, according to the US Accounting Standards, for it to be treated as cash or cash equivalent, crypto assets have to be backed by the government and possess characteristics like an option for demand deposits held with depository financial institutions, short term investment prospective with high liquidity.

Besides cash and cash equivalent, assets can also be identified as inventory, financial instruments, and intangible assets. The main reason for not considering crypto assets as inventory is because the latter considers physical, tangible assets for sale in the ordinary course of business, whereas crypto assets lack physical substance. Moving on to the following subset, financial instruments include cash, a contract creating an obligation to deliver or receive, or any ownership interest. However, these digital assets do not give rise to a contract between the holder and another party by creating an obligation to deliver-receive cash or any other kind of financial instrument or be recognized as a security. So, they cannot be considered financial instruments, leaving them to be classified under the default subset of intangible assets.

Interestingly, this subset includes trademarks, copyrights, and brands. These assets are rarely exchanged, unlike crypto assets. Further, clubbing crypto assets with such intangible assets as a single line item to be recorded in the balance sheet further blurs the picture for the investors. Ultimately, careful examination must be undertaken with respect to unique characteristics of various crypto assets as well as their impact on financial statements. In other words, the accounting regulations applicable to ‘Intangible Assets’ may not be adequately suitable to crypto assets.

Another important inadequacy of current accounting Crypto accounting for Exchanges in Web3 standards to treatment of changing classifications of crypto assets. For example, a crypto asset initially classified as a utility token might later be considered an investment. The lack of guidance on when and how these changes should be made can lead to misclassifications and errors in financial statements.

H. Misrepresentation of the value

For the accounting of crypto assets, the revaluation model is adopted. It does not represent the actual value of the assets, which are recognised as indefinite-lived intangible assets. It takes any loss caused by its historical cost into account, but it does not permit the companies to record any gain unless it is not transferred to a third party. Therefore, by doing this, the true nature of the asset is not highlighted, and it affects negatively on the financial health of the company. This instead acts as a deterrent for companies and investors to dwell in this field.

This model creates hindrance even when determining the Crypto accounting for Exchanges in Web3 unit of account for assessing impairment. This is problematic for businesses that deal heavily with digital assets. When transacting, they sell each unit separately, which is then subjected to this model assessment.

I. Inconsistent Accounting Guidelines

As mentioned before, there is no globally accepted accounting standard specifically tailored for crypto assets. Thus, it allows the companies to adopt various accounting practices, affecting how revenue and loss are recognised. Companies can use approaches like Last in First Out (LIFO) or First in First Out (FIFO) to value crypto assets. For example, in times of inflation, if the company adopts the LIFO approach, the profit decreases with the increase in product cost, and the total income also reduces and vice versa in the case of FIFO.

The absence of a proper costing methodology allows companies to experiment with all sorts of accounting methods.

FASB to the rescue!

Over the years, several CPAs and US Crypto accounting for Exchanges in Web3 Congress members have persuaded the FASB to create customized accounting standards and/or release clear guidance on interpretational issues. The FASB has endeavoured to develop standards that appropriately reflect the economics of a crypto transaction. Stay tuned for our upcoming blog on decoding the new Accounting Standard Update (‘ASU’) on crypto asset accounting proposed by the FASB Crypto accounting for Exchanges in Web3!

This piece primarily focuses on a few accounting considerations  Crypto accounting for Exchanges in Web3 of crypto assets under the current accounting standards. Owing to the complexity of crypto transactions, it is essential Crypto accounting for Exchanges in Web3 to seek assistance from Crypto CPAs like us to manage your crypto assets! Contact us today to schedule a chat for any accounting / crypto tax related query.