Experts weigh in on cryptocurrencies

David Lyford-Smith, Peter Drummond, Peter Mandich and John Liver discuss how cryptocurrencies work and why they pose such a dilemma for accountants, auditors and regulators.

David Lyford Smith, technical manager at the IT Faculty

Almost since the creation of the web there have been attempts to make a digital currency, an online equivalentCryptocurrencies to cash that’s as easy to use and as universal as banknotes and coins are. Of course, by using trusted parties such as banks or digital natives like PayPal, we have been able to buy and sell things online for a quarter of a century, but the direct peer-to-peer equivalent – the cash of the internet age – was not so easy to find.

The complexities arose from the security problem; how do I know I will receive the money that the other party says I will without deferring to a bank for confirmation? The cryptocurrency revolution purports to have the answer.

How they work

Bitcoin, the first cryptocurrency, was the invention of an unknown programmer who used the pseudonym Satoshi Nakamoto. Using the underlying technology of blockchain, they created a system allowing users to send digital tokens (bitcoins) to each other without needing to rely on trust. Blockchain is a decentralised ledger that keeps a record of all transactions that take place across a peer-to-peer network. The technology allows the transfer of tokens to be validated by members of the token network – a system of consensus – without the need for a centralised third party. The trustworthiness of the token itself is derived from cryptography, ie, computer-based security algorithms. This system of consensus, backed by complex computer security, ensures that no one is able to misrepresent their assets or hijack the flow of information.

Since the launch of Bitcoin in January 2009, many other cryptocurrencies have sprung up, almost all based on blockchain, but many with their own models for how inflation, new transactions and other details should work. Bitcoin remains the largest and best-known of them, but around 2,000 other cryptocurrencies of varying popularity also exist: Litecoin, Ethereum, Zcash and Ripple to name but a few. 

There are generally two methods of obtaining cryptocurrencies:

  • purchasing tokens directly from the counterparty or through an unregulated exchange. Some companies seek funding through initial coin offerings (ICOs) in which units of a new cryptocurrencyare sold to fund the venture; and
  • creating tokens through a process called mining. ‘Miners’ are rewarded with cryptocurrency for solving complex mathematical problems that result in the addition of a ‘block’ to the blockchain. 

Gathering momentum

As Bitcoin’s reputation for being the potential future of online payments began to grow, so did its valuation. It has had its problems (including governance crises and criminal use) but its value began gathering momentum and in 2017 this turned into a meteoric rise, from around $950 per bitcoin to nearly $20,000. Since reaching this pinnacle the value has fallen back, under increasing scepticism and rumours of tightening regulation, to around $8,000 at the time of writing. While a far cry from their peak, Bitcoin and other cryptocurrencies such as Ethereum and Ripple have still seen a tenfold increase since the start of 2017.

With more companies holding large amounts of cryptocurrencies and accepting them as payment for services, the question of how to account for these ‘currencies’ is increasingly common. While they are designed to mimic the functionality of cash, cryptocurrencies still lack many of the key features and the correct treatment is not immediately clear.

Peter Drummond, technical manager in the Financial Reporting Faculty

The accounting perspective

As there are currently no specific accounting requirements for cryptocurrencies in either IFRS or UK GAAP, we need to work by analogy to comparable standards and refer to the conceptual frameworks for financial reporting. 

It is generally accepted that cryptocurrencies cannot be classified as cash or even as a ‘cash equivalent’: nor can they be another type of financial asset because the holder has no contractual right to receive cash or another financial asset. So a key question is where they fit in the entity’s business model. Are they held for sale in the ordinary course of business so as to be classified as inventory? If not, the default classification for cryptocurrencies would seem to be as an intangible. 

Of course classification drives measurement. The most appropriate measurement basis would seem to be at fair value through profit or loss. However, inventories are generally measured at cost (or net selling price if lower) and a cost-based measurement is generally also applied to intangibles. A fair value or revaluation approach would be permitted for intangibles, if an active market exists. But, even under this model, valuation movements must be taken to other comprehensive income rather than profit.

One certainty is that clear disclosures will need to be made whenever cryptocurrency transactions are material to an entity.

Peter Mandich, manager in the Audit & Assurance Faculty

The auditing perspective

We are used to clients trading in stocks and shares and have developed audit techniques to assess the occurrence of increasingly ‘virtual’ stock market transactions, as well as the existence and valuation of the resultant investment assets. Why should auditing cryptocurrencies be any different? Although stock markets are well-established and strictly regulated to protect investors from the risk posed by unscrupulous issuers, the same cannot yet be said of cryptocurrency markets. 

Auditors will need techniques to verify the existence of these digital assets. In established markets, assets can be vouched by trustworthy counterparties but what is the equivalent in the virtual world of cryptocurrency, an issue compounded by their cross-jurisdictional nature?

Auditors should be alert to risks relating to the completeness and accuracy of transactions. In the absence of established market regulation, they will need to consider the effectiveness of the organisation’s internal controls over the generation and recording of the transactions. This also needs considering in the context of their assessment of the integrity and reliability of the cryptocurrency markets. The materiality of transactions and balances to the financial statements will also need consideration. How these assets and changes in value are accounted for and disclosed is a whole other set of risks that the auditor will need to respond to.

John Liver, financial services partner at EY

The regulatory perspective

To date the regulatory response to the emergence of cryptocurrencies has largely been jurisdictional, ranging from ignoring ICOs to banning them altogether. Regulators tend to intervene if and when there are signs of material consumer harm or law-breaking in areas including currency control, securities, anti money laundering, tax and/or personal data. On the other hand there is also, in some countries, a sense that cryptocurrencies may present innovative opportunities which should not be lost.

Given the level of uncertainty, especially in the context of regulation, it is no surprise that cryptocurrencies tend to be regarded as a less effective alternative to traditional currencies. As an asset class which falls outside current investor protection regulation, some commentators have taken the view that for the time being only more sophisticated investors should engage in cryptocurrencies. 

We are watching developments in this area very closely, including how the regulatory community and governments around the world are responding. In late 2017 we published the results of our research into this area – EY research: initial coin offerings (ICOs) December 2017. In the UK, HM Treasury has announced a taskforce involving the Bank of England and Financial Conduct Authority to explore the risks of cryptoassets and the potential benefits of the underlying distributed ledger technology.