What is Fair Value Accounting?
Fair value accounting is becoming increasingly important as companies look to accumulate bitcoin and other cryptocurrencies without compromising their balance sheet optics.
Fair value accounting is necessary for companies to accurately record the total value of their crypto holdings and mirror this in their financial reports from which a company’s financial health and value is deduced.
Under the existing methodology, historical cost accounting, crypto holdings are long-lived intangible assets; recorded in financial reports at the cost at which they were acquired, rather than the market price, their accurate value is not reflected on company balance sheets as things stand.
Current Accounting Practise Issues
The incumbent historical cost accounting practices appear to penalise and reward companies unequally, in favour of the former, for holding cryptocurrency on their balance sheets.
This is a factor of the classification of cryptocurrencies, such as Bitcoin, as long-lived intangible assets. Recognised as such, their values aren’t portrayed according to their prevailing market value, but their purchase price. This is in contrast to most securities and associated assets classes, which are accounted for under fair value, at their market price.
The example below demonstrates the pitfalls of the current accounting rules and why it discourages companies from buying digital assets:
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Brown LTD buys $1M of Bitcoin and lists the holding as a Digital Asset on its balance sheet, worth $1M
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Then the Bitcoin price rises 20%. In its financials, the company cannot recognize this increase and must maintain Bitcoin at $1M (due to the long-lived intangible asset rules)
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Following, Bitcoin falls 50%, and is now worth 60% of what the company paid for it. In its financials, the company must recognise this decrease as an impairment in value and list its Bitcoin holdings at $600K, with a $400K loss.
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Bitcoin trades back up. However, Bitcoin holdings at $600K would remain the carrying value on the company’s balance sheet going forward (and the valuation could be impaired further, or see an increase only after a sale)
Benefits of Fair Value Accounting
There are a number of benefits to using fair value accounting for crypto assets. These benefits include:
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Improved accuracy of financial reporting: provision of more accurate and timely valuation of crypto assets than the historical cost accounting standards. This is because fair value accounting takes into account the current market value of crypto assets, which can be significantly different from their historical cost.
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Enhanced transparency and comparability: It’s easier for investors and other stakeholders to understand the financial performance and risk exposure of companies that hold crypto assets.
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Improved risk management: Companies can better manage their exposure to the risks associated with crypto assets. For example, by monitoring the fair value of their crypto assets, companies can identify potential losses and take steps to mitigate them.
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Facilitated adoption of crypto assets by businesses: An uptick in the adoption of crypto assets by businesses may materialise. This is because it provides businesses with a clear and consistent framework for accounting for crypto assets.
When Will we see Fair Value Rules Enforced?
In 2023, the Financial Accounting Standards Board (FASB) – a US standard-setting accounting body – voted in favour of requiring companies to use fair value accounting for Bitcoin and other crypto assets. This is a significant development as it will provide investors and other stakeholders with more accurate and timely information about the financial performance and risk exposure of companies, such as MicroStrategy Inc and others, that hold Bitcoin and other digital assets.
The new standards will apply in 2025, however the FASB will permit companies to apply them earlier.
What does it mean for Bitcoin?
The outgoing historical cost accounting standard that labels Bitcoin as a long-lived intangible asset has put many corporations off acquiring crypto assets as depreciation and appreciation are recorded disproportionately on balance sheets, resulting in higher risk and lower reward proposition for companies, independent of the investment’s return potential, due to ill-fitting accounting formalities.
The incoming fair value accounting rules should address the barrier to entry for companies, which may change tact and start to accumulate Bitcoin. If this comes to pass, institutional adoption of BTC will grow, which in turn could well see it go mainstream in society. Such a trend would drive up the demand for Bitcoin, its price, and perhaps other crypto assets along with it.
As it stands, over 1% of circulating Bitcoin supply (240k) is already held by publicly listed companies.
Recommended reading: Why is Bitcoin Valuable?
Fair value accounting provides a more accurate valuation of crypto assets, enhances transparency and comparability, improves risk management, and facilitates the adoption of crypto assets by businesses. The FASB's decision to require companies to use fair value accounting for Bitcoin, are positive for the crypto asset industry as it makes it easier for companies to hold digital assets.
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