CRYPTO: Valuation of crypto (in the context of IFRS 13)

Updates on previous article (CRYPTO: Accounting for non-monetary asset?)

Philippine Interpretations Committee (PIC) Q&A, February 2019
The Philippine Interpretations Committee (PIC) approved PIC Q&A No. 2019-02 discussing Accounting for Cryptographic Assets in February 2019. The four (4) possible subsets of crypto-assets were then enumerated, to wit: 1) cryptocurrency, 2) utility token, 3) security token and 4) asset-backed token – with the possibility of being a hybrid. The suggested accounting treatments were discussed accordingly.

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For details, refer to our article on Accounting for crypto-assets: Philippine perspective.

IFRS Interpretations Committee (Committee) Meeting in London, June 2019
The Committee met in London on June 11-12, 2019 and discussed ‘Holdings of Cryptocurrencies’ but decided not to add them to its standard-setting agenda.

The Committee noted that a range of crypto-assets exist but define such as:
a. a digital or virtual currency recorded on a distributed ledger that uses cryptography for security;
b. not issued by a jurisdictional authority or other party;
c. does not give rise to a contract between the holder and another party.

The Committee concluded that IAS 2, Inventories, applies to cryptocurrencies when they are held for sale in the ordinary course of business. If IAS 2 is not applicable, an entity applies IAS 38, Intangible Assets, to holdings of cryptocurrencies. The Committee also observed that an entity may act as a broker-trader of cryptocurrencies. In that circumstance, the entity considers the requirements in paragraph 3(b) of IAS 2 for commodity broker-traders who measure their inventories at fair value less costs to sell. Paragraph 5 of IAS 2 states that broker-traders are those who buy or sell commodities for others or on their own account. The inventories referred to in paragraph 3(b) are principally acquired with the purpose of selling in the near future and generating a profit from fluctuations in price or broker-traders’ margin.

The Committee concluded that a holding of cryptocurrency is not a financial asset. This is because a cryptocurrency is not cash, nor is it an equity instrument of another entity. It does not give rise to a contractual right for the holder and it is not a contract that will or may be settled in the holder’s own equity instruments.

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(Read full text here: https://www.ifrs.org/news-and-events/updates/ifric-updates/june-2019/#8)

(I)PFRS 13
In the first part of our crypto-saga entitled ‘CRYPTO: Accounting for non-monetary asset?’, we have established that Philippine Financial Reporting Standards (PFRSs) are currently fully converged with International Financial Reporting Standards (IFRSs).

(I)PFRS 13, Fair Value Measurement, defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”, and it sets out a framework for determining fair values under (I)PFRS.

Special acquisition cases
An entity may gain the opportunity to access new crypto-assets without its knowledge or permission, i.e., via hard fork (giveaway from a relative ‘spin-off’) and airdrop (‘promotional’ distribution).

Mining relates to network nodes operation to solve the cryptographic algorithm (a.k.a. ‘hash’) that is required to securely add a new block to the chain – i.e., through a proof of work. Winning (successful) ‘miners’ are entitled to transaction fees and block rewards (usually in the form of crypto).

The aforementioned cases are outside the scope of this article as we cover the underlying principles and consideration for crypto valuation under (I)PFRS 13.

FAIR VALUE….what value is fair?

Digital evolution has led to efficiency in obtaining information but, to some extent, added to the already complex valuation models for most of the asset classes.

Instances where fair value under (I)PFRS 13 is needed
Crypto’s fair value, in the context of (I)PFRS 13, may be needed in one or in combination of the following instances:

  • Initial measurement of crypto acquired in a business combination for preparers of IFRS-compliant accounts;
  • Subsequent measurement for an inventory held by a broker-trader (i.e., carried at fair value less cost to sell), or crypto classified as intangible asset where revaluation model is being used;
  • Measurement and disclosure requirement for investment funds holding crypto-assets (or parties holding crypto-assets on behalf of others who are required to disclosure the fair value); and/or
  • Expense settlement via crypto such as payment for employee or third-party services.

(N.B. – It is to be noted that at the moment, the author is not aware of any published methodology for valuing crypto for ‘tax’ purposes. In this regard, it is assumed that the tax base follows that of accounting’s and hence already included in the above instances.)

How and where to start?
How an entity measures the fair value of a crypto will depend on whether the principal market is active and whether the entity can access the principal market on the measurement date. While the most common crypto (e.g., Bitcoin, Ether) are currently considered to be actively traded on exchanges or over-the-counter markets, the other crypto may not be.

(I)PFRS 13 requires an entity to identify its principal market or in the absence of which, the most advantageous market. The market with the greatest volume and level of activity that an entity has access to for the crypto generally will be the principal market.

An entity, however, should evaluate if there are indicators of manipulation and whether that market provides relevant and reliable price and volume information.

Fair values are divided into a three-level fair value hierarchy, based on the lowest level of significant inputs used in valuation models, as follows:

– Level 1: quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date;

– Level 2: observable inputs other than level 1 inputs; and

– Level 3: unobservable inputs.

Theoretical application: Non-zero-sum game

Application of (I)PFRS 13 in practice has not been the easiest, more so for crypto-assets.

Level 1
Use quoted price for the identical asset in an active market.

Binance, Coinbase, Bitstamp, OkEx, Huobi, Bitfinex, and the recently launched Blockchain.com’s The PIT, among other active crypto exchanges (markets) in the world, provide quoted prices for prominent (alt)coins and tokens.

Level 2 or 3
If the entity’s principal market for crypto is not active, the measurement would be classified in level 2 or 3 of the fair value hierarchy, depending on the nature of the adjustments made to the quoted price in the inactive market – and may need to be valued using a valuation technique. The most appropriate valuation technique considers how market participants would determine the fair value of the crypto being measured. The use of the cost and income approach is expected to be rare in practice as compared to market approach. Whilst the valuation model should be consistently applied, the crypto market is evolving rapidly, and hence, valuation techniques used by the market participants may change. Irrespective of the approach to be taken, the goal is to estimate the exit price at the valuation date.

In EY’s The Valuation of Crypto-assets, it states that the valuation of crypto fundamentally depends on its nature, the key distinction being whether the subject asset grants its holder the right to a stream of future cash flows or now. Below summarize the suggested approaches for each of the crypto subsets:

SubsetInherent ValueValuation Technique*
Cryptocurrency*None – derives its value based on supply and demand.Market – Comparable tokens
Utility token*Value is derived from the demand for the issuer’s service or product.Market – Comparable tokens
Security tokenValue is derived from the success of the entity, since the holder of the token shares in future profits or receives cash or another financial asset.Income – Forecasts; or Market – Comparable tokens (depending on token’s liquidity and stage of development)  
Asset-backed tokenDerives its value based on the underlying asset.Market – Derivative of the value of the underlying asset; or Income – Forecasts

*EY believes that a fourth approach derived from the Quantity Theory of Money (QTM) is potentially applicable for crypto that functions as a medium of exchange. QTM posits that M x V = P x Y; where M is money supply, V is velocity, P is price level and Y is the volume of goods and services transacted in the economy, or the real GDP.

The entity should also be aware that it may need to change the hierarchy level for a crypto if market conditions change.

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