Current State Of Affairs: Financial Reporting And Regulation Of Crypto Assets – Fin Tech

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.

Footnotes

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
Assets. https://www.fasb.org/Page/ShowPdf?path=Prop+ASU%E2%80%94Intangibles%E2%80%94Goodwill+and+Other%E2%80%94Crypto+Assets+%28Subtopic+350-60%29%E2%80%94Accounting+for+and+Disclosure+of+Crypto+Assets.pdf&title=Proposed+Accounting+Standards+Update%E2%80

%94Intangibles%E2%80%94Goodwill+and+Other%E2%80%94Crypto+Assets+%28Subtopic+350-60%29%E2%80%94Accounting+for+and+Disclosure+of+Crypto+Assets&acceptedDisclaimer=true&Submit=.

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/

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.