Blockchain Accounting & Cryptocurrency: What Controllers and CFOs Need to Know
The rise in cryptocurrency investment has led to the proliferation of an entirely new asset class. Unique to the crypto market is regulatory uncertainty, price volatility, high values raised in short periods of time, and a variety of tokens and token mechanisms. However, cryptocurrencies are still beholden to traditional accounting requirements and regulatory standards, creating a challenge for accountants and accounting services that are asked to fit a new asset class into a legacy system.
The following is a guest post about blockchain accounting by our friends at Balanc3, an enterprise-grade solution for companies that hold, trade, or invest in crypto markets.
Broadly speaking, there are three main issues companies and accountants are struggling to address when it comes to blockchain accounting:
- Structuring of wallets. The classification and tracking of the different kinds of crypto wallets a company may own.
- Determining capital gains and losses. Keeping track of the movements and trades of tokens between wallets.
- Chart of accounts. Fitting a new taxonomy of blockchain accounting labels into traditional accounting services.
Together, these three challenges encompass the largest hurdle of crypto adoption among legacy accounting services. These issues are explored further below:
Currently, token companies adhere to legacy accounting firms’ standard processes by organizing separate wallets into either token sale, cold storage, or hot wallets.
A designated token sale smart contract will accept funds from the participants and transfer them to a cold storage wallet. Usually, the cold storage wallet is a “multisig” wallet that contains the bulk of the raised funds and requires multiple signatures to move funds. To increase liquidity, the company sends funds from the cold storage wallet to a hot wallet in order to cover company expenses, including payroll, legal, and marketing. In some cases, multiple hot wallets are used to separate and categorize payments based on the expense, i.e. a hot wallet solely for payroll expenses.
As you might imagine, keeping track of multiple cryptocurrency wallets and ensuring proper internal controls around the transfer of funds can be extremely challenging, if not impossible, using a manual process.
Capital Gains and Losses
Many token companies are registered in countries that treat cryptocurrencies as assets or property, including the US, UK, Canada, Israel, Singapore, and Australia. These countries levy taxes depending on a variety of factors, including holding periods. Token companies registered in these areas must take into consideration how to track their “inventory” and the resulting capital gains or losses, which could be spread across multiple cryptoassets, blockchains, and wallets.
There are numerous inventory methods to calculate gains or losses on the disposition of cryptocurrencies; the most common one has been coined “FIFO by Address.” This is a similar concept as FIFO, or First-In-First-Out, in which the most recently sold cryptocurrencies use the historical price of the oldest incoming cryptocurrencies.
Two primary qualities differ FIFO from FIFO by Address. First, FIFO by Address does not coincide with a realized event when cryptocurrencies are transferred between addresses that are owned/controlled by the company. Second, with FIFO by Address, it is a choice out of which wallet to dispose of an asset and calculate FIFO within that wallet. These two qualities allow token companies to track the cost basis only as far back is it goes within their internal wallets and choose from which wallet to sell. As an example, a token company that has theoretically created thousands of wallets, each with its own unique purpose, could strategically pick the wallets with the highest cost basis when they choose to sell.
Tracking inventory manually can be a nightmare. But solutions such as Balanc3 have been developed to bring accountants sweet dreams by automatically monitoring and recording transfers between, into, and out of wallets, providing companies with complete clarity into their capital gains and losses – both on a company level and down to a wallet-specific and asset-specific level. In a theoretical case of a company creating thousands of wallets that are trading asynchronously, Balanc3 would record the price at which every asset was sold and purchased and from or into which wallet, enhancing traceability, reducing the opportunity for corruption, and providing transparency for regulators and stakeholders.
Chart of Accounts
Crypto-assets and crypto wallets have given rise to a new taxonomy of transactions and their purposes. As a result, new names for the Chart of Accounts have emerged as token companies respond to blockchain accounting challenges. The most commonly used Chart of Accounts on the Ethereum network is “Gas Fee Expenses” to refer to associated fees on the blockchain. Consensus does not exist around how to approach token sales. However, token companies have classified funds raised through crowdsales as “Sales Revenue,” “Deferred Revenue,” or “ICO Revenue,”as a sub-account of “Revenue.”
Sales Revenue accounts create income taxes against immediately-recognized funds raised upon receipt. Deferred revenue, on the other hand, can defer the recognition of taxable income for about a year while expenses accrue to offset taxable income. The classification of funds raised through token sales have been determined on a case-by-case basis, often on accounting advice from professionals. Other Charts of Accounts commonly used in blockchain accounting classify newly-created wallets undergoing testing, which are classified to the receiving wallet as “Test Revenue” and from the sending wallet as “Testing Expense.”
Looking Ahead: Improving the Financial Process
The financial process currently required by token companies to manage their assets can be demonstrated in three steps — each of which is error-prone, untrustworthy, and manipulatable.
The first step in an accounting process is to obtain records of all blockchain transactions for every address for every token. For tokens on Ethereum, this requires downloading all transactions one by one for each address and token from a block-explorer such as Etherscan.io. Block explorers are slow and laborious. They require the user to repeatedly return to the platform to download transactions by time period until all records are obtained. The same process must occur if the Token Company holds any other coins on blockchains, including Bitcoin or Bitcoin Cash.
The second step of the current financial process requires manually organizing all the exported transaction data into an Excel spreadsheet for further accounting and analysis. The information needed to be recorded is extensive, including: to/from addresses, wallet ID, asset amount, asset type, historical exchange price, transaction hash, realized gain/loss, unrealized gain/loss, movement across internally-owned wallets, and the classifications or chart of accounts. Each of these data columns in Excel requires continuous maintenance; historical exchange prices must be fetched and maintained and the classification of transactions must be manually monitored, as no chart of accounts standardization exists.
Lastly, only once the data is pulled and organized, including historical prices of incoming and outgoing transfers across all addresses and split by asset, then an inventory method is chosen to calculate realized and unrealized gains can be determined. This final point is necessary for Token Companies to track tax liability and understand potential future tax liabilities from moving assets.
All in all, there are multiple pain points throughout the financial process that are time consuming, error-prone, repetitious, and manipulable. Moreover, the current processes in place are neither scalable nor maintainable for continuous business operations. This is where an opportunity lies for services and companies to bridge the gap between crypto and legacy accounting.
We hope you enjoyed this guest post by Balanc3, an enterprise-grade crypto accounting solution providing transparency, security, reliability, and clarity as innovative financial markets struggle to accommodate to general accounting practices (while also establishing new ones).
Balanc3 operates by monitoring transactions on the Ethereum blockchain occurring with a company’s cryptoassets – i.e. monitoring the transactions to and from an entity’s wallets and exchange accounts. The platform records the prices at which assets were traded and allows transactions and wallets to be classified to provide more nuance to larger portfolios. Equally as important, Balanc3 bridges the legacy financial world with the blockchain financial world by allowing data to be formatted into traditional spreadsheets and reports.
Learn more about Balanc3 at https://www.balanc3.net/.