What are Cryptocurrencies?
The first step is to define what cryptocurrency truly is? The most common answer we hear being – ‘it’s a digital currency like bitcoin’. Technically, that’s true - however, with our accountant’s hat on - when you dig deeper there are a whole range of different digital assets, all bringing a different set of accounting, reporting and tax implications.
As specialist cryptocurrency accountants, in this brief article we shall start by seeking to clarify what cryptocurrency is and how new cryptocurrencies enter the market.
Frequently used terminology
Let’s first clear up a few common misconceptions in the world of cryptocurrency, bitcoin and blockchain – many terms are interchanged, incorrectly, with each other.
Firstly, cryptocurrency. Cryptocurrency is the general term given to all digital assets that have some form of value – mostly appraised by a corresponding value in USD. As at the date of writing this article, there are over 2000 cryptocurrencies in existence.
Secondly, Bitcoin. Bitcoin is a one of many cryptocurrencies available. Sure, Bitcoin is arguably the most famous cryptocurrency, but as mentioned above, there are a lot more. Bitcoin led the way in digital currencies, and even today usually commands 60%+ of daily trading volume in the cryptocurrency markets. When you hear of Bitcoin Accountants, these firms are seldom going to only focus on Bitcoin.
Lastly, Blockchain. As recently as 2016 some tax government departments internationally were using Bitcoin and Blockchain intermittently. Blockchain is not Bitcoin, Blockchain is not a cryptocurrency. Blockchain is a decentralised technology that underpins cryptocurrencies, but many blockchain companies exist to power non-crypto activities also.
It’s worth mentioning another frequent term used in the crypto-world – fiat. Fiat is the word used to describe government backed currencies, such as GBP, EUR and USD.
Types of cryptocurrency
When we consider the type of crypto, we don’t mean Bitcoin, Ethereum, Litecoin or Dogecoin – the latter created as a ‘joke’ in 2013 and now has a market cap of £200m even with the 2018 Q4 general market slump.
From an accounting perspective the name given to the cryptocurrency is, of course, irreverent – what is important is the construct of the digital asset itself.
Once listed on a cryptocurrency exchange, there is an argument to be made that the coin is established, and the accounting treatment will follow. The way to class the asset is far more complicated - there is a detailed assessment of how to account for cryptocurrencies, which we shall pick up on in our upcoming articles.
For the purpose of this article, a unique aspect, which we do not usually find with fiat currencies, is the entry of new cryptocurrencies – how can this happen?
It’s an emerging market.. within an emerging market.
We will seek to clarify a few points of entry here.
2017 was the year of ICO’s – but what actually is an ICO?
An Initial Coin Offering was a new means to fund raise for a business – in the vast majority of cases, a brand-new business idea. Once the business was built, the tokens (coins) sold, the ICO would list its token on a crypto-exchange and a new cryptocurrency would be born.
Aside from the frequent debate over the legality of ICO’s – ‘unregulated’ is rarely a good starting point, the market for ICO’s boomed in 2017. Many people hoped to get rich (or richer) on the back of the cryptocurrency boom, which saw previously unknown coins such as Ripple gain 38,000% prices rises. And no that’s not a typo.
Roll forward to today (2018 Q4) and the market has calmed down significantly – ‘easy money’ is no more – but the market is still active, and new cryptocurrencies are released frequently.
In the case of an ICO, it is possible to buy and even sell tokens that are not listed on exchanges – this is probably the most testing way to value an asset from an accounting perspective, as there is no active public market. However, purchasing cryptocurrencies pre-exchange listing is big business – this is achieved by buying in an ICO in ‘private sale’.
Replacing hacked coins
Most of us will have read in the press, at some point, about ‘hacked cryptocurrencies’.
It’s worth noting that in most cases the cryptocurrency itself was not hacked – a ‘Bitcoin hack’ is not a hack on Bitcoin itself or the Blockchain behind it - but usually the cryptocurrency exchange where people were trading. Other forms of hack are compromised wallets (a wallet in crypto being an online digital wallet).
Now, in the case of the exchanges, there have been some high-profile hacks in which people lost a lot of crypto-assets. The exchange is unable to return the hacked cryptocurrency to the users – the very nature of decentralised cryptocurrencies prevents this – nobody knows who physically hold the crypto post-hack.
In this case, sometimes the exchanges will issue their own, newly created coin to compensate users.
The effect of the compensation is debatable, but a new cryptocurrency is born.
A somewhat rare event in cryptocurrency, though becoming more usual, is ‘forking’ whereby a cryptocurrency splits in two.
This can be driven by accidental duplication in the blockchain – whereby the tracking of transactions moves away in two separate routes. This is akin to say two people both saving versions of the same excel file, at the same time, there will be conflicted copies (to put it simply). Or, at the request of the developers who choose to what’s known as ‘hard fork’ the currency, again creating an additional cryptocurrency.
Forks can cause a huge amount of volatility in the market, with accounting needing to reflect a potentially far different value into the client’s portfolio – in some cases, the client is left with a split in asset.
From an accounting perspective the cause of the fork is less an issue - we would need to insure the accounting and tax treatment aligns correct with the inclusion of a new crypto-asset, and that the ‘old’ asset is not being incorrectly valued or the coin has been compromised.
In summary, some of the ways new cryptocurrencies enter the market are 1) via token offerings, 2) as compensation on the result of a hack, or 3) forking.
As accountants, we need to understand the different approaches in order apply the relevant accounting treatment.
For more information please contact your Ecovis partner, or Harvex at email@example.com
About the Author: David Hodkinson, CEO & Co-Founder of Harvex.io – specialist cryptocurrency accountants and advisors. David can be contacted at firstname.lastname@example.org