What Are The Accounting Implications?
As different forms of crypto tokenization enter the marketplace and intersect with real-world physical assets, getting the accounting and reporting correct will only become more important.
There has been no shortage of conversation and analysis around the various trends and developments as it connects to how the crypto economy and existing fiat economy can become better integrated. Decentralized finance (DeFi), non-fungible tokens (NFTs), and the overall trend to try and embed digital assets into a blockchain are trends that continue virtually unabated. An important issue that can be overlooked in the excitement (and potential frothiness) in these markets is the fact that, as these new crypto applications develop and expand, is that new and complicated questions are being raised with regards to the accounting and reporting of these cryptoassets.
Accounting and financial reporting, not always the hottest or most buzzworthy of topics, continues to become complicated and generate numerous unanswered questions. Setting aside the “usual” accounting issues with regards to cryptoassets – valuation, accounting standards, tax issues – the rise of NFTs and DeFi continue to create new and more nuanced questions. This does not even touch on the multitude of issues that need to be understood and addressed by market participants as they pertain to smart contracts, a blockchain-enabled method of automating certain parts of certain transactions.
Let’s take a look at some of the issues that will invariably crop up as tokenization (in whatever form) seeks to better integrate crypto economics with existing physical assets.
How are these tokens to be treated? Cryptocurrencies have been surrounded by a whirlwind of accounting and tax ambiguity since they first became a topic of mainstream conversation, but tokenizing real world assets creates a whole new set of issues. Tokenizing, or creating a NFT associated with a digital asset, video, or crypto collectible creates a situation where the asset valuation can be volatile and logically might be accounted for at fair-market-value.
Tokenizing or linking an NFT to physical assets such as commercial real estate adds an extra layer to this conversation. While the argument can, and has, been made that cryptoassets should be marked-to-market to accurately reflect current valuation, should this same treatment apply to tokens connected to real estate, which is traditionally held at cost under Generally Accepted Accounting Principles (GAAP)?
What about earnings? Prior to the growth of DeFi and NFT applications, the importance of income associated with cryptoassets was of minimal importance. With the continuing growth of items such as block rewards, liquidity mining, and yield farming (just to name a few), the question should be asked as to how these additional inflows should be treated? Treating income as income sounds like a relatively straight forward matter, but DeFi can create additional complications.
If, for example, the block rewards or other forms of inflows to asset holders takes the form of tokens or coins, how should these be treated? Should they be classified as ordinary income, classified and taxed as property (like crypto are as per the IRS), and what about governance tokens? In other words, does it ultimately matter what the specifics are of these DeFi earnings and flows are, or does it make more sense to treat the sector uniformly?
Traceability. Returning to the NFT sector for a moment, how is going to be possible to verify and connect the ownership of physical assets with the ownership of these tokens? On the surface this should be a straight forward matter since these NFTs are, in turn, supported and underpinned by blockchains that are able to be examined by any interested party.
Where it becomes more interesting, however, is when these NFTs are seeking to be linked to physical assets. For instance, if the underlying asset changes hands, goes into default, or otherwise has a change in corporate ownership, what is the impact of these changes on the valuation of NFTs? This same situation can also take place with real-world intangible assets, such as those that generate royalties or other annuity-like payments if these assets change ownership or come out from under legal protection (like a patent).
All of these questions remain unanswered with no crypto-specific authoritative accounting guidance at this point, and that is not necessarily a bad thing. Shaking out the truly innovative and viable ideas from potentially frothy bubbles is a necessary part of the price discovery and free market process. That said, it should be noted that these accounting and reporting issues, while not as high profile to most market participants, are going to be increasingly important as these sectors develop and expand.