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Crypto-Assets: An Overview

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 Crypto-Assets: An Overview
Hassan Sarhan1

June 2020

1
Hassan Sarhan is an MSc student at the University of Northampton and is a Chartered Financial Analyst (CFA) and
a chartered accountant (ACCA). Email: Hassan.m.sarhan@gmail.com
Contents
Contents ........................................................................................................................................................ 2
List of figures ................................................................................................................................................. 3
Abstract ......................................................................................................................................................... 4
Introduction .................................................................................................................................................. 5
Section One: Blockchain and the Distributed Ledger Technologies ............................................................. 6
Section Two: Crypto-Currencies and the Bitcoin .......................................................................................... 9
Section Three: STO and ICO ........................................................................................................................ 12
Section Four: Regulatory Perspective ......................................................................................................... 17
Section Five: IFRS Analysis .......................................................................................................................... 20
Section Six: Audit Perspective ..................................................................................................................... 23
Section Seven: Conclusion and Recommendation...................................................................................... 25
References: ................................................................................................................................................. 26

2
List of figures

Figure (1) New block creation process

Figure (2) DLT system layers
Figure (3) DLT network
Figure (4) Money transfer procedure
Figure (5) Crypto-currency transaction procedure
Figure (6) Biggest five crypto-currency exchanges in market capitalization
Figure (7) Benefits of ICO
Figure (8) ICO and STO development
Figure (9) Geographical distribution of STO/ICO major transactions since 2016
Figure (10) Limitations of the ICO
Figure (11) Regulatory map

3
 Abstract

Technology is changing every aspect in our life. Everything is being digitalized which creates both
risks and opportunities. Ignorance of the recent development on the technological fronts may have
sever effects on us including the cost of losing a career or a financial wealth. On the other hand,
such technological developments open the door for inclusion of the unbanked population as well
as allowing small and medium enterprises to secure the financing needed for survival. This article
discusses the concepts of the blockchain technology and the crypto-assets including the crypto-
currencies and securities token. More specifically, the article discusses the underlying
infrastructure of the blockchain technology, the security token offering and initial coin offering as
controversial means of finance, the regulatory environments surrounding the blockchain financial
products, the International Financial Reporting Standards “IFRS” point of view on accounting and
reporting of the crypto-assets and finally the external auditor challenges in auditing such type of
assets. The article adopts the descriptive method and concludes that: First, investors should be
aware of the basics of the blockchain-based financial products and the underlying benefits and risk
involved. Otherwise, they should consult with the relevant expert to avoid uncalculated legal or
financial risks. Second, preparers of financial statements should understand the relevant
circumstances of each blockchain product and analyze them in the context of the relevant IFRS in
order to conclude on the proper treatment in the financial statements. Third, external auditors,
similar to the investors and preparers of the financial statements, should understand the basics of
the blockchain technology and the related products in order to be able to design proper audit
procedures. In addition, it is necessary that the auditors consider involving a subject matter expert
properly in advance.

Keywords: Blockchain, Distributed Ledger, Crypto-asset, Crypto-currency, IFRS, Audit,

Regulatory, STO, ICO.

4
Introduction

First Industrial Revolution cultivated mechanization and changed the way we produce goods. The
Second Revolution used electric power to create mass production. Third revolution leveraged
electronics and information technology to automate production. Building on the Third, the Fourth
Industrial Revolution (4IR) brings the cyber-physical systems and digitization of everything
(Seow, 2018). Blockchain is one area that is extensively being explored for digitization of
everything. Satoshi Nakamoto developed the revolutionary idea of the Bitcoin in 2008 which is
based on blockchain technology (BCT). The core idea of BCT is the decentralization of the
database among network users and the consensus of the nodes on the network to approve adding
any new block. Supporters of the BCT list inherent limitation in the current centralized financial
system including: possibility of hacking personal data stored with financial institutions, billions of
unbanked populations are excluded from the global economy and remittance fees to transfer cross-
countries reach to 10-20% (Seow, 2018). The use of BCT has evolved since Nakamoto in terms
of use-cases including: the use of BCT in creating financial securities such as the Security Token
Offering (STO) and the Initial Coin Offering (ICO), the utilization of the blockchain technology
to build business models competing with well-known online e-commerce bussies such as
ArcadeCity (versus Ober) and OpenBazaar (versus Amazon), the role of the BCT in the
development of the Web 3.0, insurance claim processing, Internet-of -Things (IoT), Blockchain
governments (see Rosic (2018) and Hileman and Rauchs, (2017) for other use-cases). Therefore,
it is of paramount to understand this technology and its use-cases as it is affecting many aspects in
our life.

This article is intended to highlight two use-cases in the blockchain technology that are of interest
to the finance community. Namely the Security Token offering (STO) and the Initial Coin offering
(ICO). After introducing the blockchain and the distributed ledger technologies in Section One,
and briefly describing the crypto-currency in Section Two, this article will introduce the concepts
of the STO and ICO in Section Three, discusses legal perspectives of these two digital securities
in Section Four. In addition, in Section Five, this article will identify the International Financial
Reporting Standards point of view with regards on how to account for such digital assets. Section
Six discusses the auditor challenges with crypto-assets. Finally, Section seven concludes the article
and provides recommendation for further research.

5
Section One: Blockchain and the Distributed Ledger Technologies

Blockchain is simply a chain of blocks, each block contains three things, the data, the hash of the
current block and the hash of the previous block. The data in the block depends on the type of the
blockchain. For instance, a Bitcoin block contains the sender and the receiver encrypted identifiers.
The hash on the other hand is a value generated from a string of text using mathematical function.
Changing something inside the block, changes the hash. Adding a new block to the chain requires
consensus of the participating nodes (users) which is achieved either by the proof-of-work or the
proof-of-stake (discussed later in this section). Each participating node has a copy of all the blocks.
That is why it is called distributed ledger versus the centralized ledger maintained by a bank for
example for the customer accounts (Tania, 2018). According to a joint research between the
internal audit foundation and Crowe, blockchain technology (BCT) is defined as “a shared
database that creates a permanent record of transactions. The database is shared across a network
of multiple connected devices, which are known as “nodes.” Whenever a new transaction is added
to the ledger, the update is immediately viewable by all the other nodes on the network. In addition,
the transactions – or blocks – are structured in a way that is designed to make it impossible to go
back and change a previous entry” (Kloch and Little, 2019: p.4). Muneeza et al. (2018) indicate
that blockchain is a decentralized and distributed ledger technology that ensures data security,
transparency and integrity and therefore of great importance to the finance industry. Therefore, the
main feature of the blockchain is that is builds on the Distributed Ledger Technology (DLT).
Understanding of the DLT is fundamental to understanding the mechanism of how BCT works
and then understand the sense of decentralized control of crypto-assets such as the Bitcoin.

DLT is simply a ledger of all transactions that take place on the network and which is not
maintained on any data center of any organization or government. The DLT is featured of being
“immutability, resistance to censorship, decentralized maintenance, and elimination of the need
for a centralized trusted third party, In other words, there is no need for an entity to be in charge
of conflict resolution and upkeep of a global truth that is trusted by all stakeholders which do not
trust each other. Distributed ledger is suitable for tracking the ownership of digital assets, and
hence it’s most prominent application is the Bitcoin network” (Bencic and Zarko, 2018: p. 1569).

6
Based on the preceding discussion, one would ask the following questions: If the DLT and the
related BCT are operated in a desterilized fashion without the need for central maintenance and
monitoring by an organization or a government, then how does it function, who maintains the
ledger information, how it is secured, how the ledger transactions are created and maintained, how
it is updated to be viewable to all users on the network and in equal importance, who benefits
financially out of all these transactions that take place on the network?

GSMA (2018) argues that the DLT underlying assumption is that all nodes on the network are not
implicitly trusted and they need a mechanism by which all users on the network can reach to
consensus on what the status of the ledger is; it further argues that BCT is a linear form of a
distributed ledger composed of immutable blocks of data, each block containing a list of
transactions and a unique reference to its predecessor block. Strong cryptographic techniques are
employed to maintain integrity between each block and its predecessor. This allows blockchains
to be shared and corroborated by anyone with the appropriate permissions. This effectively means
that one needs to understand the consensus process to understand how the ledger is updated in a
secure manner by those who are permissioned. According to the discussion above, the transactions
between the peers on the network are encrypted and each transaction is included in a block. Those
blocks are linked to each other in a chain and only those blocks that gets the consensus of all the
nodes are added to the chain. Consensus is achieved by either the proof-of work or the proof-of
stake. Proof-of work mechanism means that “the nodes all try to solve the mathematical problem,
but it is the first node to solve the problem that gets compensated, (and other users use the solution
provided by the first node to verify the problem has been correctly solved), while in the proof-of
stake, the user with the largest stake is nominated to confirm the transaction” (GSMA, 2018: p. 5).
Those nodes that try to solve the mathematical problem are called the miners who are those with
proper computing power and try to solve a cryptographic puzzle to create a new block on the
blockchain (Grant Thornton, 2018). This mechanism is difficult to fraud, because one with the
intent to perpetrate fraud through, adding new block, adjusting existing block or changing the data
in the blocks will have to hack the computer of every blockchain participant and slip in the invalid
block. However, even if this is possible, none of the nudes would verify the block. (Tania, 2018).

7
Consensus process is also affected by the type of the network. According to Elasrag (2019), BCT
has three types: The public type, the private type and the hybrid. The public type is when the
network is open to all users and anybody on the network can download the code and participate in
the consensus process and everybody on the network can see and audit a transaction on the public
block. No central entities are involved and the identity of the users are anonymous (This is the type
used in the Bitcoin currency). The private type (called permissioned) is when a central organization
controls the consensus process and the number of nodes participating in the network. The last type
is the Hybrid (Federated), It operates under the control of a specific group of organizations which
are allowed to perform the role of full nodes. As opposed to public blockchain, the structure does
not give access to all persons to participate in the process of verifying transactions. The consensus
process is controlled by a preselected set of nodes in which the protocol defines the minimum
number required to sign every block in order for the block to be valid.

Figure (1) below illustrate the creation of a new block under the BCT.

Figure (1): New block creation process

Source: The Future is Decentralized (cited in Seow, 2018)

The DLT system layers can be explained by the figure (2). Based on the discussion in (Hileman
and Rauchs, 2017), the underlying protocol is the core software that constitutes the backbone of
the distributed ledger. The protocol alone is of now add value without the network. The network
layer is the P2P layer that connects the participants and brings the distributed ledger into life. The

8
network can be industry-specific, enterprise-specific, or case-specific. Finally, the application
layer is the primary user interface built on the network and provides the user with the services.

Figure (2) DLT system layers.

Source: Hileman and Rauchs (2017)
The DLT network is illustrated in figure (3)

Figure (3) DLT network

Source: Hileman and Rauchs (2017).

Section Two below builds on the basic understanding obtained in this section with regards to the
BCT, DLT and the consensus process to discuss the difference between the fiat money and crypto-
currencies including the Bitcoin.

Section Two: Crypto-Currencies and the Bitcoin

The idea of the Bitcoin was coined by Satoshi Nakamoto (2008) who introduced how a peer-to-
peer electronic cash system can work without the need to go through a financial institution. Bitcoin

9
is a digital currency (called Crypto-currency because it is built on the blockchain technology and
cryptography). Fiat money is the currency units that we deal with everyday such as the U.S. dollars,
the Japanese Yen, or the United Arab Emirates dirham. These currencies have physical substance,
deposited in banks and transferred between banking accounts. The supply of these currencies is
controlled by central banks (the Fed in the case of the U.S. dollars). The transfer of funds is
monitored and the identities of the transferrer and the beneficiary are maintained within the
banking system. The central bank in each country runs the monetary policy wherein the supply of
funds into the monetary system is controlled in order to control the macroeconomic variables such
as the inflation. The fiat currencies are also guaranteed by the issuing governments. However,
crypto-currencies do not share the same features of having central control and being backed-up by
governments. Crypto-currency is defined by (Nashirah et al., 2017: p. 20) as “a digital currency in
which encryption techniques are used to regulate the generation of units of currency and verify the
transfer of funds, operating independently of a central bank ……work as a medium of exchange
using cryptography to secure the transactions and to control the creation of additional units of the
currency”.

A comparison of the mechanism of money transfer between users is shown in figures (4 and 5)
below:

Figure (4): Money transfer procedure

10
 Figure (5): Crypto-currency transaction procedure
Source: Nashirah et al. (2017)

Although Bitcoin is the most popular crypto-currency, there exists many other digital currencies
including as an example, Ripple (XRP), Litecoin and Ether. The latter is based on the Ethereum
that is a blockchain permission-less network similar to Bitcoin and is a decentralized platform
similar to the one on the smartphones. One can build applications on this platform to perform
various tasks. This platform runs smart contracts which are protocols that enforce or negotiate
contracts through code. Ethereum is different from Bitcoin as the latter design is limited to specific
logic (peer-to-peer electronic cash system) (Ernst and Young, 2018). Crypto-currencies are traded
on crypto-currency exchanges. There are 314 exchanges worldwide including among others in
terms of the highest market capitalization: Binance, Huobi Global and Coinbase Pro (see figure
(6))

Figure (6): Biggest five crypto-currency exchanges in market capitalization

Source: https://coinmarketcap.com/rankings/exchanges/, [accessed on 16/6/2020].

11
The discussion of the blockchain technology and the crypto-currency thus far, has clarified that
fiat money is the money that is supported by central banks and the identity of the users are known
to the financial institutions, while on the other hand with crypto-currencies, the identity of the users
is anonymous (in the case of public blockchain supporting Bitcoin for instance) and the digital
money is not supported by central banks, rather it is supported by the consensus of all the users on
the network who are participating in the crypto-currency transactions and by the strength of the
chain link between the blocks of the transactions that is protected by the cryptographic technology.

The following paragraph introduces the Security Token and the Initial Coin Offerings (STO and
ICO)

Section Three: STO and ICO

As a start to the discussion about the STOs and ICOs, one needs to recognize that both terms are
used interchangeably since there is no universal generally-accepted definition on what constitutes
an STO and an ICO. This section adopts a clarification of the BCT based offerings through
contrasting the characteristics of the traditional and the blockchain based offerings. More
specifically, the traditional IPO on one hand and the ICO and STO on the other hand. IPO (initial
public offering) is the way by which organization offer debt or equity securities to the public under
the rules of the local or foreign security exchange markets. This type of offering is served by
intermediaries such as the investment bankers and brokers and is approved by the exchange
authorities before publication. The price is determined based on the fundamentals of the issuers
and the underlying asset. Some issues might not be eligible for all investors, only those with
minimum wealth are allowed in order to protect light capital investors. The prospectus is the
document that is used by the issuers to convey to the public the details of the offer and what type
of ownership as well as the price and return and risks involved. Once sold to the public, the
securities (stocks or bonds for instance) are then publicly traded on the exchange markets and the
records of those transactions including the price, the volume and seller and buyer are stored and
controlled by the markets.

In the case of the STO and ICO, the offering is digitalized and the technology used to facilitate the
offering is the BCT. In general, the issuer prepares a business-case published through a white-

12
paper (similar to the prospectus) which identifies the use case, the capital needed and defines the
selling price (BDO, 2019). The amounts are settled in crypto-currency or fiat money. The security
given to the investors are digital and are used by the investor to either utilize the services offered
by the business (ICO) or to evidence a share of ownership in the underlying business or asset
(STO).

Deloitte (2019) and Ante and Fiedler (2019) divides the crypto-assets into three archetypes, the
payment or exchange token, the security token and the utility token. All of the tokens share the
same feature of being crypto-assets based on the BCT. The payment token is similar to the crypto-
currency discussed earlier and used for payment, while the security token is a sort-of investment
token that provides the holder, among others, with a share of the underlying asset, right to
dividends or right to vote. Utility token on the other hand provides the holder with access to
functions provided directly by the token issuer. Similarly, PwC (2019: p.3) explains the issuance
of utility token (ICO) as “the issuer receives consideration in the form of cash or another
cryptographic asset (most commonly, a cryptocurrency such as Bitcoin or Ether). In exchange, the
developer might issue (or promise to issue) a digital token to the parties that provided contributions
for the development of the digital token”. This effectively means that the difference between the
STO and the ICO is that the former is an investment vehicle that gives rights to assets or cash flows
while the ICO is a utility vehicle whereby the holder is eligible to receive benefits by utilizing the
issuer services. Exchange markets for the token exist, as an example Global Blockchain Exchange
(GBX) is a company registered under Gibraltar laws that list token issued by companies
specialized in the blockchain based security token investments.

ICO offering provides an opportunity for business of small and medium size to obtain financing
that is not available to them through traditional IPO. This is due to the fact that ICO does not
undergo the same regulatory procedures and does not have the same rules imposed by security
exchange markets during the IPO process (for further discussion, see OECD (2019). However, the
ICO is not suitable for all businesses because these blockchain-based tokens do not grant any right
of ownership or dividends. On the other hand, STO are blockchain tokens that grant these rights
to the investor (Ante and Fiedler, 2019). Ante and Fiedler (2019) argue that the benefit of the STO
over the IPO is the speed of execution as the register of the ownership is updated instantly, the
settlement of transactions is final, transactions are broadcasted transparently to the network, so

13
that the ownership of the token is known at all times, the securities can be traded 24/7 and investors
can hold their assets without the need to brokers and custodian.

The benefit of ICO can be illustrated in figure (7) as compared to other means of finance such as
crowd funding and venture capital. Among others, the ICO allows access to a larger pool of
investors, requires shorter time to implement, and is more efficient as it uses automation.

Figure (7): Benefits of ICO

Source: OECD (2019)
The volume of STO/ICO activities is shown in figure (8). There is an increasing number of
transactions year-over-year since the year 2013. The total volume and the total U.S. dollar value
have increased as well especially in the year 2018 from 7 billion in 2017 to c.20 billion in 2018.
In 2019, there was a decline in the volume of token offering to 4 billion in year-to-date till October
2019.

Figure (8) ICO and STO development

(3) until October 2019
Source: 6th ICO/STO Report (A Strategic Perspective,) by PwC and Crypto Valley (2020)

14
The geographical distribution of major transactions is depicted in figure (9)

Figure (9): Geographical distribution of STO/ICO major transactions since 2016

Source: 6th ICO/STO Report (A Strategic Perspective,) by PwC and Crypto Valley (2020)

Challenges to the ICO are illustrated in Figure (10). among others, ICO issues have legal and
regulatory risk due to unclear regulations, risk of fraud, risk of hacking (refer to the DAO case in
the regulatory perspective section), volatility of token prices due to speculation, inadequate Ant—
Money laundering and know your customer procedures, data privacy issues and operational risk
related for instance to solving coding errors.

15
16
 Figure (10) Limitations of the ICO
Source: OECD (2019)

Although ICO/STO are efficient tools to raise finance for enterprises that would otherwise find it
difficult to raise such funding, the investment in these securities is not risk-free. Entities as well as
individuals would need to understand the pros and cons of the investment in order to avoid taking
uncalculated risk.

The following paragraph discusses the regulatory perspective regarding the STO and ICOs.

Section Four: Regulatory Perspective

Figure (11) shows regulatory map that highlights the countries’ regulatory perspectives towards
the legalization of the crypto-assets including the STO and ICO. From this map, one can deduce
that there are certain countries that ban the ICO/STO securities such as China, India and Pakistan.
Other countries have existing regulations or still in the process of development of new ones
including among others, the USA, Thailand, Bahrain and Luxemburg. On the other hand, there are
certain countries that have favorite regulatory environment such as Uzbekistan, Taiwan, Japan,
Lithuania, Estonia, Slovakia and Switzerland. More specifically, in Switzerland for example, the
Financial Market Supervisory Authority issued guidelines concerning the regulation of the ICO

17
issuance as utility, asset and payment tokens. The authority assesses the issues case-by-case against
the securities law for any breach.

Figure (11) Regulatory map

Source: PwC ICO web site: https://www.pwc.ch/en/industry-sectors/financial-services/fs-regulations/ico.html

In the U.S.A, the definition of the securities is very wide, however, the U.S. regulator applied the
U.S. securities law to the DAO case (A case of a German origin decentralized entity which sold
tokens to individuals in exchange for Ether and then due to hacking of the Ether by an outsider, a
hard fork was necessary (refer to IFRS section for more discussion about hard fork). The
conclusion of U.S. Security and Exchange Commission investigation report with regard to the
DAO stated that “Whether or not a particular transaction involves the offer and sale of a security—
regardless of the terminology used—will depend on the facts and circumstances, including the
economic realities of the transaction. Those who offer and sell securities in the United States must
comply with the federal securities laws, including the requirement to register with the Commission
or to qualify for an exemption from the registration requirements of the federal securities laws.
The registration requirements are designed to provide investors with procedural protections and
material information necessary to make informed investment decisions. These requirements apply
to those who offer and sell securities in the United States, regardless whether the issuing entity is
a traditional company or a decentralized autonomous organization, regardless whether those

18
securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are
distributed in certificated form or through distributed ledger technology. In addition, any entity or
person engaging in the activities of an exchange, such as bringing together the orders for securities
of multiple buyers and sellers using established non-discretionary methods under which such
orders interact with each other and buyers and sellers entering such orders agree upon the terms of
the trade, must register as a national securities exchange or operate pursuant to an exemption from
such registration”. This report clarify the importance placed on compliance with securities laws
for those interested in offering of securities to the public, it is clear that according to the regulator
in the U.S, any issuer of securities in the U.S. whether electronic or not should register with the
commission and comply with the security law or file for exemption therefrom.

The STO and ICO are a source of financing that is competing with the venture capital funding for
small and medium sized entities (OECD, 2019). This type of funding has reported 20 billion U.S.
Dollars of transactions in 2018 as discussed earlier. Therefore, the difference in the regulatory
environment worldwide shows that these types of securities is still not clearly regulated and that
investors should be cognizant of this fact before investing their funds in ICO and STO unless they
have full legal knowledge of their rights and obligations regarding the securities issued. One should
check if the security being offered is considered as a financial security and is protected under the
securities’ law in the relevant jurisdiction. So, for example if a promoter is raising fund through
an STO in Singapore, one would first need to understand what is the underlying assets being
tokenized e.g. company shares, company assets, cash flows, painting, land or the benefit of using
the issuer cloud storage facility. Second, if the security being offered have protected rights that are
regulated under the Singaporean securities law. Finally, one would need to understand what are
the rights attached to the security and if they are different from the rights usually associated with
the traditional securities. For instance, shares offer the holder the right in the net assets of the
company, the dividends declared and the voting right, while and STO may offer only right to cash
flows through dividends if declared and no rights to the ownership or voting rights.

Giving the legal complexity inherent in the investment in crypto-financial securities, investment
decision in STO and ICO should not be taken light by investors before ensuring that all their rights
are properly protected by laws of the relevant jurisdiction.

The following section discusses how the IFRS is addressing the accounting for crypto-assets.

19
Section Five: IFRS Analysis

There is no one IFRS that is concerned with accounting and disclosure of the crypto-assets.
Accounting firms have developed analysis of the possible accounting treatment under IFRS for
different crypto-assets related transactions. For instance, Grant Thornton (2018) analyses the
accounting treatment of the transaction fees that the miners and validators earn while solving the
computational problem (see Blockchain and Distributed ledger technologies paragraph). The study
suggests three things for minors. First, miners who are eligible for a share of the new block to
record a revenue equal to the transaction fee based on the fact that there exists a customer contract
with clear performance obligation and price as per IFRS 15. Second, miners with block reward i.e.
are rewarded a new block not a share of, to recognize other income because a contract with the
whole community of miners does not exist. Therefore, revenue cannot be recognized as per IFRS
15. Third, for pool of minors, the contract is either among the miners as a joint arrangement or
between the miners and the pool operator. The transaction price in the latter is variable because
the share of computing power contributed by the minor to the pool is not known until the block
computational problem is solved. Therefore, the variable fee determination steps in IFRS 15 are
to be followed. Moreover, the study discusses the internally generated intangible assets under IAS
38 and concludes that the generated crypto-asset is not recognized until sold and that the cost is to
be expensed as incurred because it cannot be measured reliably. Ernst and Young (2018) discussed
the activities of the standard setters with regards to the crypto-assets. The AASB (The Australian
Accounting Standards Board) paper (Digital Currency- A case for standard setting activity)
discusses the possible accounting treatment of crypto-currencies and concludes that it should be
accounted for at fair value through profit or loss. The conclusion was based on analysis of whether
the crypto-currencies are considered cash under IAS 7, Investments under IAS 32, Intangible assets
under IAS 38 or inventory under IAS2. The paper argues that a crypto-currency is not cash as it is
not publicly accepted as a mean of exchange issued by central banks, is not an investment because
it does not represent legal right of one party and obligation of another party and is an intangible
asset because it is not a monetary asset with no physical existence. This asset is considered as an
inventory held for sale then should be accounted for at the lower of cost-or-net realizable value.
However, there is no certainty that the holder of the crypt-currency is holding them for resale
except in the case of the broker-dealer situation where in such a case the inventory is held at fair
less cost to see and changes in fair value through profit or loss. Similar argument is found in PwC

20
(2019). Ernst and Young (2018) further discuss that the FASB as of 30 September 2017 has yet to
discuss the extensive research conducted by the staff in July 2017. The paper further discusses that
the Accounting Standards board of Japan issued an exposure draft in December 2017 for public
comment (Practical Solution on the Accounting for Virtual Currencies under the Payment Services
Act). This draft identified two cases. First, if the crypto-currency is held by an entity for its own
behalf, then the value is determined at the balance sheet date at the market price if an active market
exists. Otherwise, the value is determined on the lower of the cost and the estimated disposal value
with the difference reported to profit or loss and not reversable. Second, the dealer who holds the
virtual currency on behalf of a customer, in the case of having a contract with the customer to hold
the currencies, will recognize initially an asset and a corresponding liability at the fair value of the
currency at the date of deposit. Subsequently, the asset and liability are measured similar to the
first case discussed in the draft. Therefore, the net result is no gain or loss are reported in the profit
or loss account. By the same token, PwC (2019) argues that if the entity holding the crypto-asset
on behalf of others have the right to borrow the asset and use it for its own benefit, then the crypto-
asset can be regarded as asset, and if the customer for which the asset is being held has the right to
recover the asset (unsecured creditor), then an asset and a liability are to be recognized. Therefore,
the treatment is dependent on the circumstances. Ernst and Young (2018) further mentions that
The IASB discussed in January 2018 number of issues regarding digital currencies, and will
discuss in the future whether to add a research project on some or all of these transactions. The
paper also discusses the special case of hard and soft fork and concluded that the hard fork results
in new asset granted to the owner besides the previous asset and that this new asset should be
accounted for with corresponding income statement effect, but the study did not identify what type
of income. The hard fork is when the blockchain protocol software is changed and a new crypto-
currency is added besides the original one, while the soft work is when the protocol software is
only updated. In the case of short-selling position of crypto-currency while the hard fork is taking
place. This is discussed in the paper to resample the case of an equity short-seller who receives
dividends and eventually owes these dividends to the owner. Finally, Ernst and Young (2018)
clarifies that a pre-sale of the ICO token is considered as a forward contract under the US securities
law wherein one party agree to buy token from another party in the future and that financial
reporting should follow this lead. The IFRIC met in London in June 2019 (IFRIC, 2019) and
concluded on how to account and disclose the holding of crypto-currencies. The decision was that

21
the holding of crypto-currencies is accounted for as intangible assets under IAS 38, unless the
currency is held for resale, then it is accounted for under IAS 2 as inventory at the lower of cost or
net realizable value. In addition the IFRIC decision imposed certain disclosure about the crypto-
currencies including the disclosures needed as per the relevant standard IAS 38 and IAS2 based
on the case, the IFRS13 fair value disclosures, the judgment used by management, and subsequent
even disclosure if those events are significant to the users of the financial statements.

PwC (2019) discusses the accounting treatment of the holder and issuer of the crypto-assets. More
specifically, the accounting treatment of the holder and issuer of the STOs and ICOs. The main
idea is that, one should inspect the facts and circumstances related to the issue to identify the proper
treatment. First, as far as the issuer is concerned, if the token provides the contractual right to the
holder to recover the money invested at some point in time, such token would be accounted for
under IFRS 9. If the token provides for a share in residual interest in the issuing entity, then the
token is an equity instrument under IAS 32. PwC (2019) argues that these two cases are not likely.
On the other hand, if the token issued is in exchange for future services at discounted price as is
the case of the utility token, IFRS 15 can be applied as if the amount received was a prepayment
from a customer for unearned revenue. Second, with regards to the holder of the token, if the token
provides right to the underlying asset wherein the holder can trade the asset at a minimal cost
without physically holding it (assed-backed token), the relevant standard related to the accounting
of the underlying asset can be used. If the token provides the right to the holder to utilize future
services when available at discounted prices, the token can be treated as a prepayment unless it
meets the definition of an intangible asset and If the token provides the right to the net asset of the
issuer, a financial asset is considered under IFRS 9.

There is no IFRS that governs the accounting and disclosure of all types of crypto-assets. As
discussed in this Section, IFRIC committee decision in 2019 concerned only the crypto-currencies
and did not cover the STO and ICOs for example. Therefore, interested users and preparers of
financial statements according to IFRS would need to follow relevant IFRS guidance and make
sure to be consistent in the logic used until the IASB finally issues a related IFRS standard.

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The following section adds on the financial reporting issues by discussing auditor challenges and
suggested procedures to address the crypto-asset financial audits.

Section Six: Audit Perspective

The topic of auditing blockchain based transactions and assets is an important topic as it is new to
the audit profession and requires that the auditor to possess the necessary understanding of the
blockchain ecosystem and mechanism to be able to address different risk of material statements
with proper audit procedures. Canadian Public Accountancy Board (CPAB) published an article
regarding auditing in crypto-asset sector. The discussion to follow is derived from that paper unless
otherwise stated.

As far as the crypto-assets audit is concerned, the auditors’ areas of interest are the existence,
ownership and rights of the crypto-assets, the occurrence of crypto transactions, revenue from
mining activities, impairment of mining assets, related party transactions, valuation of crypto-
assets and subsequent events.

 Existence of the crypto-assets and occurrence of the crypto transactions

Generally, auditors are required to obtain an understanding of the underlying blockchain
technology supporting the crypto transactions and should involve experts to check the
reliability of the protocols and cryptography associated with the blockchain transactions
before relying on the blockchain ledgers. Further, the auditor should identify the controls
relevant to completeness, occurrence and subsequent modification of transactions on the
blockchain ledger by looking into mitigating controls including validation algorithms and
consensus mechanism and test whether these controls are operating as intended. In
addition, auditors are expected to use block explorer tools to review information recorded
on the block ledgers. As far as the rights to the crypto-asset is concerned, a risk of fraud
exists in the sense that the entity claims a right to the asset through the control of the private
key, while others also have the same private key and control the same asset. Suggested
audit procedures in this area include: First requesting the entity to use its private key to
transfer part of the asset between different wallets controlled by the entity. Second, the
auditor will need to test the controls specifically designed to mitigate the fraud risk by
looking for instance whether the key generation is done through a cryptographically

23
 controlled manner, whether multi-signature protocol is performed before a transaction is
executed and whether effective ITGC are designed over digital wallets. Finally, when a
client keeps the private key custody with the crypto exchanges which might not have
service auditor report on internal controls at the service organization, the auditor will need
to test the controls at the service organization directly.
 Revenue from mining activities
In the case of mining pool discussed earlier under IFRS perspective section, the auditor
will need to understand the pooling agreement and the fee allocation mechanism to the
pool participant. Thereafter, the auditor should design audit procedures that address the
risks associated with revenue recognition of the transaction fees including risk related to
occurrence, completeness and accuracy. Vouching of cash receipts is not enough.
 Impairment of mining assets
In the price-declining environment of the crypto-assets, mining companies should be
skeptical of the value of their mining assets. Auditors should be skeptical too by verifying
if an impairment is required.
 Related party transactions
Public address in the blockchain consists of alphanumeric strings and cannot be associated
with specific identities which makes it difficult for auditors to check related party
transactions in the crypt assets. Therefore, auditor should assess this area as significant risk
and design procedures to assess the business purpose of the transactions and if these
transactions are held in the arm’s length.
 Valuation of crypto-assets
Valuation of crypto-assets is significant risk to auditors. If the asset is traded in multiple
active market, the auditor should identify the principle market. If no active market exists,
the auditor will require the help of a valuation specialist.
 Subsequent events
Due to significant risk inherent in existence and ownership of the crypto-assets, the auditor
should perform subsequent event test to ensure that the asset still exist and owned by the
entity after reporting date and before audit report date.

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Section Seven: Conclusion and Recommendation

Blockchain technology has brought a lot of challenges to the investment and finance professionals
as well as to regulators. These challenges stem from the fast advances in the technology that do
not have a corresponding reaction from financial and audit standard setters as well as the
regulators. At the same time, this technology provided an investment opportunity to retail investors
and an efficient and timely funding opportunities for small and medium size enterprises. In this
continually developing environment, one would need to obtain proper education with regards to
the basics of the blockchain and distributed ledger and prepare for the vast expansion of the use-
cases of the technology as discussed in the introduction paragraph. This article shed the light on
the technology basics, the use-cases including the digital currencies, the STO and ICO. In addition,
the article discussed the regulatory environment surrounding the STO and ICO and discussed the
recent announcements in the IFRS and in the audit with regards to the crypto-assets. It is
recommended that further research is conducted to explore in more depth each area of the BCT
including those topics discussed in this article in order to enrich the literature for those interested
in investing and researching in the crypto-asset domain. Moreover, it is important to note that this
article is not intended to draw conclusions on the suitability of the STO or the ICO to any investor
as an investment vehicle; such decisions should be taken in consultation with experienced financial
and legal advisors.

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