Suppose an advisor’s client is tempted to invest money in an entity that, in turn, holds non-fungible tokens as a significant part of its business, or simply is considering such an investment. Should the adviser (who may well be tasked with due diligence as to such an entity) be concerned with the specifics of how the entity treats these transactions on its books?
We are thinking here specifically of financial accounting and presentation; and will here set tax issues aside.
The answer to the above question is an emphatic: yes. There is a developing set of best practices for the treatment of NFTs, and digital assets more generally. Even where they have no legal/regulatory force, if an entity blatantly ignores the developing best practices in this space, it may be a consequence of ignorance, or even worse it may be an effort to obfuscate important facts.
A Consensus View on what NFTs Are
The general rule is that crypto assets, including NFTs, should be treated on the books as “indefinite-lived intangible assets,” akin to trademarks, perpetual franchises, and an entity’s goodwill.
This rule has been arrived at chiefly by process of elimination. Cryptos and NFTs are not cash (legal tender). Nor are they cash equivalents (which would typically be backed by a sovereign, maturity date, low volatility instruments). Nor are they financial instruments, as they represent neither an ownership interest in an entity nor a contractual right to receive cash or another financial instrument.
They are, then, intangible assets, and since they don’t have a fixed span of life (like a patent) they are indefinite-lived intangible assets.
If an advisor’s client is invested in an entity that holds and/or does business in NFTs, the client (and so of course the adviser) will be interested in whether the entity is using the best practices in accounting for those entities.
The Financial Accounting Standards Board has not yet issued standards specific to NFTs. Probably the most authoritative issuance on “best practices” yet has come from the American Institute of Certified Public Accountants (AICPA). Their guidance is here: Accounting and Auditing Digital Assets With AICPA’s help, the following material covers a life-cycle: standards for the purchase of a digital asset, for dealing with the impairment of its value while it is on the books, and for its sale.
Balance Sheets and the Purchase Price
In some situations there will be a question as to whether a certain NFT ought to be on the entity’s balance sheet at all. Perhaps it is not the entity’s asset, but the asset of a third-party hosted wallet provider? In general, the distinction that matters is control. For example, if the wallet provider has the right, under regulation or contract terms, to sell, transfer, loan, encumber, or pledge the deposited digital asset for its own purposes without depositor consent or notice, then one may conclude that the NFT belongs on the wallet provider’s balance sheet, not on that of the depositor.
Assuming that the depositing entity has retained control, and has decided to put the asset on its balance sheet: how does it do so? One simple-seeming rule: when an entity buys an NFT it will presumably enter that entity on its books (and register that addition to its balance sheet) with a valuation at the cash purchase price where applicable.
But the AICPA asks this question: assume the entity at issue engages in barter? It provides services in return for the NFTs. Assume, to be specific, that the services are within the course of its trade (its “ordinary activities”) for a digital asset that will be held in its own account and not through a custodian. How shall it determine the value for those assets? First, it should seek to estimate fair value given the notions of recognition and metrics at the time of contract inception. As a back-up though, if the value proves not estimable in that way, the entity should measure the noncash consideration by reference to the stand-alone selling price of the goods or services it promised to the customer. (“What would we have expected to sell these services for if we had not opted for the barter?”)
Presume that the asset is on the books: now what? Its value changes over time. Perhaps fewer people will be interested in Picasso’s ceramics next year than were this year. What impact does that have on the value of an NFT of which Picasso’s ceramics are an underlying?
Looking for Impairments
As noted above, the accounting classification for this variety of property is an “indefinite-lived intangible asset.” That means among much else that it is not subject to amortization and that it should be tested for impairment annually, or more often than that if events or changes in circumstances make it more likely or not there has been an impairment.
Paragraphs 18B and 18C in FASB ASC 350-30-35 provide examples of relevant facts and circumstances that should be assessed to determine if it is more likely than not that an indefinite-lived intangible asset is impaired. There are a lot of them, including: changes in management, key personnel, strategy, or customers, the contemplation of bankruptcy or litigation, industry and market considerations, legislative action, expected changes in distribution channels, and macroeconomic considerations.
Probably the most commonly germane point is the market in identical or near-identical NFT. The tokens are definitionally unique, but if the other Bored Apes are selling for less this year than they were selling for last year, then it is reasonable to consider whether the value of the Bored Ape on XYZ Ltd’s books has been impaired.
Likewise, if there is an underlying asset, then a sustained change in the value of the underlying asset may make a reconsideration of the value of the NFT appropriate.
Accounting for a Sale
How an entity should account for the sale of a digital asset on its books is another matter. Assuming that the rules and algorithms allow it to transfer the asset to another party in return for the fiat currency of a sovereign state, proper accounting treatment varies depending on whether the sale is to a customer or non-customer. If the buyer is a customer, the entity should present the sale as revenue for the period in which control changed hands. If the counter-party is not a customer, though, the transaction may be either a “gain or loss from the derecognition of non-financial assets.” In such a case, the gain or loss is measured by whether the consideration for the asset is greater or less than the carrying value, and it is treated as net, outside of value.