Professionals involved in the crypto asset space understand that regulation and oversight of the industry are amorphous. With the barrage of recent activity, it can be difficult to keep up with new guidance and regulatory enforcement actions. This article summarizes the following major developments around the financial reporting of crypto assets over the past year:
- The SEC's issuance of SAB No.121 to require crypto exchanges to better account for and disclose their obligations to safeguard customer crypto assets;
- The SEC's reopening of the comment period for the proposed amendments to Exchange Act Rule 3b-16 as it relates to broadening the definition of "exchange;"
- The SEC's continued focus on enforcement in the crypto asset space;
- The FASB's introduction of a technical agenda item that would require entities to account for crypto assets at fair value each reporting period;
- The PCAOB's concerns with Proof of Reserve Reports and their 2023 inspection priorities which include the review of audits of entities with material crypto assets; and
- Congress' introduction of bills to regulate the crypto asset space.
The SEC issued SAB No. 121 – Accounting for Obligations to Safeguard Crypto Assets an Entity Holds for Platform Users
On April 11, 2022, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No.121 (SAB No.121) to provide interpretive guidance for entities, such as cryptocurrency exchange platforms, that provide custody of crypto assets for third parties. In addition to providing users with the ability to transact in crypto assets, these entities may safeguard third-party crypto assets and maintain the cryptographic key information necessary to access such assets. A common misconception is that crypto assets held in a wallet at an exchange are directly owned and controlled by the user (and rightfully so when the user's wallet shows a balance of crypto assets). In the world of cryptocurrency, however, it is possession of the "private key," or cryptographic key, that represents ownership of a wallet and the corresponding crypto assets within. Since the exchanges maintain the cryptographic keys on behalf of their users, they effectively control the underlying crypto assets. As such, in the case of an adverse event such as fraud, theft, or bankruptcy at the exchange, a user's crypto assets are vulnerable to being lost.
Due to an increase in the number of entities that provide crypto asset custodial services, the SEC released SAB No.121 to help public companies address the increased technological, legal, and regulatory risks for the benefit of their investors.
The SEC highlights several changes it expects public companies to implement no later than their first interim or annual period ending after June 15, 2022, with a retrospective application as of the beginning of the fiscal year to which the interim or annual period relates. The key changes featured by the SEC relate to (i) recording an asset and liability for the crypto assets safeguarded by an exchange on behalf of third parties and (ii) disclosing the nature and amount of crypto assets held for platform users.
Requirement to Record an Asset and Liability for Crypto Assets Safeguarded
From the SEC's point of view, the ability of users to obtain benefits from the crypto assets safeguarded by exchanges is dependent on the entity's efforts to protect the assets and the associated cryptographic key information from loss, theft, or other misuses. Due to this responsibility, the SEC believes that these entities should present a liability on their balance sheet to reflect their obligation to safeguard the crypto assets held for their platform users. Further, the SEC believes these entities should also present a distinct asset on their balance sheet representing the value of the crypto assets held for its platform users. The SEC stated that the asset and liability should be measured at initial recognition and each reporting date at the fair value.
Requirement to Disclose the Nature and Amount of Crypto Assets Safeguarded
In addition to requiring entities to record an asset and liability for the crypto assets held for platform users, the SEC believes entities should include clear disclosures of the nature and amount of safeguarded crypto assets in their notes to the financial statements. The SEC provided the following disclosure guidance:
- Entities should make a separate disclosure for each significant crypto asset;
- Entities should disclose vulnerabilities due to any concentrations in specific crypto assets;
- Entities should include disclosure regarding fair value measurements;
- Entities should consider disclosure about who specifically holds the cryptographic key information, maintains the internal recordkeeping of those assets, and is obligated to secure the assets and protect them from loss or theft;
- Entities should disclose the potential impact that the destruction, loss, theft, compromise, or unavailability of the cryptographic key information would have on the ongoing business, financial condition, operating results, and cash flows of the entity; and
- Entities should disclose any risk-mitigation steps they have put in place related to the crypto assets held for platform users, such as insurance coverage.
As an example of compliance with the new accounting and disclosure requirements, Coinbase Global, Inc. (Coinbase) recorded in its Q1 2022 Form 10-Q a "[c]ustomer custodial funds" current asset in the amount of $10.02 billion and a "[c]ustodial funds due to customers" current liability in the amount of $9.74 billion. Coinbase also recorded several risk disclosures related to the crypto assets it held for platform users, including the following statement, among others:
The theft, loss, or destruction of private keys required to access any crypto assets held in custody for our own account or for our customers may be irreversible. If we are unable to access our private keys or if we experience a hack or other data loss relating to our ability to access any crypto assets, it could cause regulatory scrutiny, reputational harm, and other losses.1
The SEC Proposed Amendments to Exchange Act Rule 3b-16 and Focuses Enforcement on the Crypto Asset Industry
In a press release on April 14, 2023, the SEC reopened the comment period and provided supplementary information on proposed amendments to the definition of "exchange" under Exchange Act Rule 3b-16. The SEC's reopening of the comment period also included supplemental information and economic analysis regarding other systems or mechanisms of trading securities that would be newly included in the definition of "exchange" under Exchange Act Rule 3b-16. In other words, the supplemental information would result in a broader definition of "exchange" such that more entities would be required to comply with the rule. The reopening is intended to allow interested parties the opportunity to review and provide comments on the proposed changes in consideration of the new supplemental information.
In addition to amending its rules to keep up with the evolving crypto-asset landscape, the SEC has recently focused significant attention on the enforcement of the crypto-asset industry. In 2022, the SEC brought a total of 30 crypto-related enforcement actions, an increase of more than 50% from the prior year.2 Through April 2023, the SEC has already announced 13 actions against crypto-related entities, which is on pace to eclipse the number of enforcement actions brought in 2022.3 These actions taken by the SEC, when combined with statements from SEC chair Gary Gensler that "the runway is getting shorter" for crypto companies to register and/or comply with the agency, demonstrates the SEC's focus on regulating the crypto asset space. This sentiment is further evidenced by the SEC's nearly doubling of the number of personnel in their Crypto Assets and Cyber Unit in May of 2022.4
The FASB Introduced a Technical Agenda Item – Accounting for and Disclosure of Crypto Assets
On December 15, 2021, the Financial Accounting Standards Board (FASB) chair Rich Jones added a project to the FASB technical agenda titled "Accounting for and Disclosure of Crypto Assets." This technical agenda item is considered a "Recognition & Measurement" project, which involves determining whether, and at what amount, to include certain items on the face of the financial statements. After board deliberations were completed, this agenda item entered the exposure draft stage in which a proposed Accounting Standards Update (ASU) was issued on March 23, 2023.5 Once the comment period is completed on June 6, 2023, the FASB board will deliberate again and then issue a final and complete ASU.
According to the Proposed ASU, the amendments would apply to crypto assets that meet all of the following criteria:
- Meet the definition of intangible assets as defined in the Codification Master Glossary;6
- Do not provide the asset holder with enforceable rights to, or claims on, underlying goods, services, or other assets;
- Are created or reside on a distributed ledger based on blockchain technology;
- Are secured through cryptography;
- Are fungible; and
- Are not created or issued by the reporting entity or its related parties.
The proposed ASU would require entities to subsequently measure crypto assets that meet those criteria at fair value with changes recognized in net income each reporting period. Also, entities would be required to recognize transaction costs to acquire crypto assets, such as commissions, as expenses when incurred.
Crypto assets, and the change in their fair value, would be required to be presented separately from other intangible assets, and changes in those other intangible assets, on the entity's balance sheet and income statement, respectively. Finally, the proposed ASU would require entities holding crypto assets to make several disclosures, such as (i) the name, cost basis, fair value, and number of units of each significant crypto asset held and (ii) the activity in each reporting period with respect to crypto assets, including additions, dispositions, gains and losses, and descriptions of the activities that resulted in such additions and dispositions.
While U.S. General Accepted Accounting Principals (GAAP) does not currently address how to account for crypto assets, most public companies that hold crypto assets have accounted for them as indefinite-lived intangible assets under ASC 350.7 Under this standard, entities are required to record intangible assets at cost and then must test them for impairment at least annually or more frequently if events or changes in circumstances indicate that it is more likely than not that they are impaired. In other words, crypto assets are currently recorded as assets at cost and then can only subsequently be lowered, and never raised. If the price of a crypto asset goes back up, nothing can be done to recover that value. For these reasons, and due to the extreme volatility of prices in this space, the intangible assets recorded on public companies' balance sheets are typically not representative of the current value of their crypto assets held.
If this project becomes a standard in the future, companies would be required to measure the fair value of their crypto assets using the fair value hierarchy included in ASC 820-10-35, as follows:
- Level 1 Inputs: Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date, such as a major token with large volumes of transactions at centralized cryptocurrency exchanges like Coinbase. If more than one active market exists for an asset, the principal market with the greatest volume and level of activity should be used as the Level 1 input.
- Level 2 Inputs: Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, such as tokens with extremely low trading volumes at decentralized exchanges like Uniswap or tokens that are not available for trading on decentralized or centralized exchanges but have been offered through Simple Agreements for Future Tokens (SAFTs) or other agreements.
- Level 3 Inputs: Unobservable inputs for the asset or liability.
Generally, ASC 820 gives priority to observable inputs over unobservable inputs. Also, the industry is constantly evolving, so crypto assets previously valued using Level 2 or Level 3 inputs might eventually become traded in an active market and require Level 1 inputs.
The FASB Board indicated they will consider the presentation, disclosure, and transition at a future meeting.
The PCAOB Issued an Investor Advisory Concerning Proof of Reserve Reports and Identified 2023 Priorities
On March 8, 2023, the Public Company Accounting Oversight Board (PCAOB), which is responsible for overseeing the audits of public companies, issued an investor advisory with a clear warning for investors whose crypto assets are held with exchanges: "[p]roof of reserve reports are inherently limited, and customers should exercise extreme caution when relying on them to conclude that there are sufficient assets to meet customer liabilities."8 Proof of reserve reports (PoR Reports) are the results of a third-party review of a crypto entity and they are designed to show whether the crypto entity has sufficient funds to back all customer deposits. In other words, PoR Reports purport to give customers assurance that their funds held at the crypto entity are safe and could be withdrawn at any time.
The PCAOB alleges that the PoR Reports claim to provide crypto asset verification, but are severely limited because (i) they do not address the crypto entities' liabilities, which could evidence whether crypto entities have borrowed crypto assets to make them appear to have reserves, and (ii) they are based on crypto assets held at a particular point in time, so crypto assets could theoretically be used, lent, or otherwise become unavailable immediately following the issuance of the PoR Report. The PCAOB makes it clear in their news release that PoR Reports are not equivalent or more rigorous than an audit and they are not conducted in accordance with PCOAB auditing standards, even if reported by PCAOB-registered audit firms.
In April of 2023, the PCAOB issued their "Staff Priorities for 2023 Inspections" report and specifically identified digital assets as a key focus.9 In the report, the PCAOB states that "[a]udit firms may not have staff with the expertise to identify and assess risks related to digital assets and may not appropriately tailor their audit procedures to address these risks." The PCAOB noted that they will be selecting 2022 fiscal year-end audits of identified public companies and broker-dealers with material digital assets.
Bills and Resolutions Relating to Crypto Assets Currently in the Legislative Process
The virtual asset space has garnered a lot of attention over the past few years and has resulted in lawmakers introducing bills and resolutions to ensure crypto assets and other digital assets are appropriately regulated.
On June 7, 2022, the Lummis-Gillibrand Responsible Financial Innovation Act bill was introduced in the Senate.10 This bill will aim to (i) provide definitions for key terms in the digital asset space, (ii) provide legal clarity around the distinction between digital assets that are commodities and those that are securities, (iii) grant jurisdiction to certain government regulators over the digital asset space, and (iv) require higher standards of disclosure for certain providers of digital assets. Following the Terra-Luna collapse, this bill will also aim to prioritize the regulation of stablecoins, including placing a universal ban on all algorithmic stablecoins and determining who can issue stablecoins and what kinds of reserves would be required.11
In March 2023, Lummis stated at the Milken Institute Future of Digital Assets Symposium that a revised Lummis-Gillibrand bill would be presented to the Senate in mid-April 2023.12 However, as of early May, a revised bill has not been presented.
Other bills have also been introduced to Congress that could have an impact on the financial reporting of crypto assets. Similar to the Lummis-Gillibrand Bill, the Digital Commodities Consumer Protection Act of 2022 bill13 aims to provide clarity for regulatory oversight of the industry. Specifically, the Digital Commodities Bill would provide the Commodity Futures Trading Commission (CFTC) with the authority to regulate the trading of digital commodities. This bill would set a uniform national standard and enable the CFTC to more proactively respond to emerging risks in the crypto asset space.
In addition, Representative Patrick McHenry (R-N.C.), chair of the House Financial Services Committee, stated at Consensus 2023 that the U.S. House Financial Services Committee and House Agriculture Committee will be putting together crypto-related legislature in the "next two months."14 As of the date of this publication, none of the above bills have been voted on in Congress.
1. Coinbase Global, Inc., Q1 2022 Form 10-Q, p. 84.
2. Asmakov, A. (2023, January 18). Nearly Half of SEC Crypto Enforcement Actions in 2022 Were Against ICOs. Decrypt. https://decrypt.co/119448/nearly-half-sec-crypto-enforcement-actions-2022-were-against-icos
3. Sinclair, S. (2023, May 3). SEC Crypto Enforcements on Track to Eclipse 2022. Blockworks. https://blockworks.co/news/sec-crypto-enforcement
4. U.S. Securities and Exchange Commission. (2022, May 3). SEC Nearly Doubles Size of Enforcement's Crypto Assets and Cyber Unit. https://www.sec.gov/news/press-release/2022-78
5. FASB Exposure Draft, Proposed Accounting Standards
Update, Intangibles – Goodwill and Other – Crypto
Assets (Subtopic 350-60), Accounting for and Disclosure of Crypto
6. According to the FASB Master Glossary, intangible assets are assets (not including financial assets) other than goodwill that lack physical substance.
7. FASB ASC 350, Intangibles – Goodwill and Other
8. Public Company Accounting Oversight Board. (2023, March 8). Investor Advocate: Exercise Caution With Third-Party Verification/Proof of Reserve Reports. https://pcaobus.org/news-events/news-releases/news-release-detail/investor-advisory-exercise-caution-with-third-party-verification-proof-of-reserve-reports
9. Public Company Accounting Oversight Board. (2023, April). Spotlight: Staff Priorities for 2023 Inspections. https://assets.pcaobus.org/pcaob-dev/docs/default-source/documents/priorities-spotlight.pdf?sfvrsn=5c104095_2
10. U.S. Congress. (n.d.). S.4356 - Lummis-Gillibrand Responsible Financial Innovation Act. Retrieved May 4, 2023, from https://www.congress.gov/bill/117th-congress/senate-bill/4356/actions.
11. Wagner, C. (2023, March 2). Gillibrand, Lummis Plan Revamped Crypto Bill for April. Blockworks. https://blockworks.co/news/gillibrand-lummis-revamped-crypto-bill
12. DeGregorio, M. (2023, March 21). FinTech in Focus — March 21, 2023: Future of Digital Assets Symposium Insights and Community Resilience. Milken Institute. https://milkeninstitute.org/article/fintech-focus-digital-assets-symposium
13. U.S. Congress. (n.d.). H.R.8950 - Digital Commodities Consumer Protection Act of 2022. Retrieved May 4, 2023, from https://www.congress.gov/bill/117th-congress/house-bill/8950/text?r=16&s=1
14. Singh, A. (2023, April 28). U.S. House Will Have Crypto Bill in 2 Months: Rep. McHenry. CoinDesk. https://www.coindesk.com/policy/2023/04/28/us-house-will-have-crypto-bill-in-2-months-mchenry/
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