Q&A: Fair Value Accounting

The following is a Q&A with our Chief Finance Officer, Edward McGee.

1. What is FASB? What’s its role in protecting investors and the economy?

Any experienced investor who has spent enough time reading quarterly reports will have come across the concept of US GAAP, or Generally Accepted Accounting Principles. FASB, or The Financial Accounting Standards Board, is ultimately who these principles are “generally accepted” by.

Through a formal review and deliberation process, they assess the needs of corporations, investors, and the general public, and issue and maintain standards in the form of the Accounting Standards Codification. They release documents laying out what’s reportable as income and what’s not, and when to recognize such income. The recent “Revenue Recognition” update was a significant project that took years to develop and implement. The US GAAP standards and codification are critical to issuers and investors alike, so that when an investor or another industry participant looks at the financial statements of an entity, they know what to look for, what they’re looking at, that such standards are consistently applied, and allows for comparability between enterprises.

It’s hard to overstate the impact that these kinds of standards have on every CFO’s job:  This is the rulebook that finance professionals and accountants have to abide by, and it is the basis for a common language to be used by management of these organizations, as well as key stakeholders. They are recognized by the US Securities and Exchange Commission, state boards of accountancy, and other professional organizations as the designated accounting standard setter for public and private companies.

2. How have the FASB rules historically approached bitcoin or crypto as an asset class?

While there are longstanding standards for more traditional assets, like stocks and bonds, up until this point there has been little specific guidance on accounting for digital assets. As a result, companies have treated them as “intangible assets,” a broad category that includes things like proprietary software, trademarks, and customer email lists. Broker dealers and investment companies are able to recognize digital assets at fair value for both price appreciation and depreciation.  For everyone else, the best practice has been to report the value of one of these assets as its cost of acquisition, unless a company receives signals that its value has dropped, in which case the book value is written down to a lower prevailing value of the asset. Meanwhile, gains can only be reported once the asset is sold.

Since many of the other assets in this category are relatively illiquid and difficult to value, you can see how it would make sense to act conservatively. However, it makes less sense for volatile, liquid digital assets, like bitcoin and ethereum. Currently, organizations are creating bespoke practices as to how to adjust the carrying value over the period they hold the asset. However, this is directionally only being applied to mark the asset at a lower carrying value given appreciated assets are effectively ‘captured’ at cost for corporate enterprises.

Some companies are basing the book value of digital assets on their lowest price in any given period which leads to US GAAP reporting that does not accurately capture their performance and does not accurately reflect where the organization has taken steps to manage this price risk. For example, if a corporate entity identifies a financial instrument to hedge price increases of the digital asset, this could create a scenario where the price appreciation of the asset isn’t reflected as unrealized gains because US GAAP for intangible assets won’t allow for the mark up in value. Meanwhile, a financial instrument used to economically hedge the risk results in unrealized losses being captured in that same income statement; so there is a mismatch which can create issues for companies that hold or trade digital assets and force investors to look to Non-GAAP disclosures to understand their impact on operations.

From time to time, FASB iterates on the standards they set. In July 2021, FASB invited public comments on what kinds of issues the board should address in the near future. According to accounting giant KPMG, “Of the more than 500 comment letters received by FASB, over 400 solely commented on the accounting for crypto assets.” That led to a formal project with the goal of setting standards for “crypto assets” defined as having the following characteristics:

1. Meet the definition of an intangible asset.
2. Do not provide the asset holder with enforceable rights to, or claims on, underlying goods, services, or other assets.
3. Are created or reside on a distributed ledger or “blockchain.”
4. Are secured through cryptography.
5. Are fungible.

This excludes NFTs, some stablecoins, and digital assets which could fall under existing rules for securities and contracts, but it provided a strong starting point.

3. There was recently an update to FASB’s approach to crypto. Can you explain what changed?

On October 12th 2022, FASB voted to require fair value accounting for digital assets. This is a welcome change that I and the Grayscale team have long advocated for, alongside other crypto-native firms, banks, broker dealers, and accounting firms. Under this standard, the book value of relevant assets would reflect their common market value, and fluctuate accordingly across reporting periods. This would bring standards for crypto accounting in line with standards for stocks, bonds, and other financial instruments.

While this vote is a very significant step, it does not mean that this rule comes into effect immediately. Next, the board is expected to open the matter to public comment, redeliberate the proposal while considering input from stakeholders, and only then issue a final Accounting Standards Update.

4. What’s the impact here? Do you expect this will have any implications for how corporations or entities are thinking about or approaching crypto moving forward?

It’s incredibly encouraging to see this reaction from FASB after receiving overwhelming commentary from crypto-native firms, banks, broker dealers, corporate enterprises, accounting firms – all of whom support fair-value accounting.

Codifying these standards will inform what type of disclosures and risks CFOs include in financial statements. The resolution would also allow CFO’s to manage volatility risk, such that there would no longer be a mismatch between the movements in value of digital assets compared to financial instruments used to hedge, or lock in, gains on the assets. Because the scope is not limited solely to bitcoin, but also encompasses a broader set of digital assets, the resolution could prompt more interest in education, research, and eventual adoption of other assets for corporate enterprises.

With the growing number of large institutions and public companies that are either investing in digital assets or investing in entities that hold digital assets, the accounting issues are only going to become more pervasive. As we’ve seen, accounting standards aren’t the only area where investors are eager for rulemakers to move more quickly. This move will hopefully provide more clarity for other regulators, legislators, and various departments of the government as they navigate this new industry.

I’m confident this decision will help anchor the conversations around digital assets with more certainty around how they are presented within financial statements. Consistency and comparability are the basic principles of US GAAP, and this change would clearly further those goals.