Digital Assets: Accounting for ERC Tokens

Can we classify crypto tokens as a financial instrument?, no, it can be used as cash therefore it should be classified as Cash and cash Equivalents, not at all, without doubt, it is an intangible asset, and as a result, an intangible asset classification will suffice. These are the dilemmas that confront many accountants and finance professionals as well as regulators in trying to understand ERC Tokens. You are not alone.
A token is a digital assets that exist on the blockchain, however, they are not native to their blockchain compared to the likes of bitcoin or Ethereum, these tokens are built on top of other blockchain networks. Most digital tokens are built on top of the Ethereum blockchain.

This gives ERC tokens most characteristics of their native currencies and other programmable states. The most common standard used for building tokens is the ERC-20, this allows tokens to be interoperable and ability to participate in DeFi applications (Dapps).

What are ERC-20 Tokens

ERC20 standard defines a set of functions to be implemented by all ERC20 tokens so as to allow integration with other contracts, wallets, or platforms. All ERC20 tokens share basic functionalities. ERC20 tokens can not be mined since they do not have their own blockchain.

Accounting for ERC tokens

The boom of cryptocurrencies has brought challenges for regulators and accountants in the application and classification of cryptocurrency transactions. Accounting standards setting bodies like FASB and the IASB do not currently have standards solely focused on cryptocurrencies or issued authoritative guidelines.
Before delving into how to account for Tokens, it is necessary to take note of the following as stipulated by IFRS and other standards.

In accordance with IFRIC decision, cryptocurrency meets the definition of intangible asset in line with the standard IAS 38 Intangible Assets.
Since tokens are share the same attributes of cryptocurrencies, It is my honest view that tokens are also intangible assets and therefore should be accounted for in a similar manner.
IAS 32,financial instrument is a contract that gives rise to a financial asset of one entity (holder), and a financial liability or equity instrument of another entity (issuer). Also, according to the standard, an equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities
IAS 38, describes an Intangible asset as an identifiable non-monetary asset without physical substance. An asset is a resource that is controlled by the entity as a result of past events (for example, purchase or self-creation) and from which future economic benefits (inflows of cash or other assets) are expected.
IAS 7, describes Cash equivalents as held for the purpose of meeting short-term cash commitments other than for investment or other purposes. It further goes on to say that if an investment is going to be available to meet those short-term needs, then it should be readily convertible into a known amount of cash, and subject to only an insignificant risk of value change.

As noted from the statement above, cryptocurrencies meets the definition of intangible assets, however, the treatment of a token may depend on the peculiarities of the token as defined by a whitepaper. In most instances, tokens may be classified as intangible assets, in other instances a financial instrument (debt or equity).

Types of Tokens

Generally, tokens may fall under three categories namely: security tokens, asset backed tokens and utility tokens.

Security Tokens: Security token is a token, issued on a blockchain, that represents a stake in some external enterprise or asset. These can be issued by entities like businesses or governments and serve the same purpose as stocks or bonds.
Security tokens issued during an STO, could be considered as assets that promise rights of ownership, payment of dividends or entitlement to share of future profits. As such, security tokens will create a contractual obligation for the issuing company to deliver cash back to the token holders (investors). Therefore, it can be strongly argued that security tokens can be classified as financial instruments.

In order to properly classify and record the security token in the accounting books, the promises made by the issuer to the holders must be taken into account.

Asset Backed Tokens: Asset-backed tokens may give the holder a right to an underlying asset. Asset backed token may be fiat-backed, crypto-backed, commodity-backed, gold backed, oil backed. These tokens may be used to transfer the ownership of underlying assets without physically moving them.

Asset backed token gives holders right to a tangible assets and also derive its value from the asset. In this light, asset backed tokens other than fiat can be argued to be considered as a non current asset.

With regards to fiat-backed tokens or stable coins, they give their holders right to the underlying asset. They may or may not be legal tenders in some jurisdictions. However, an argument can be made to classify stable coins as cash equivalents (not cash) since they can be converted to cash with insignificant loss of value.

Utility Tokens: Utility tokens grant their owners to access a specific product or service. We could analogize the tokens’ role to loyalty points. They can be used to purchase goods (or can be sold), but they offer no stake in the business distributing them.

As a result, their values are often driven by speculation. Many investors will purchase tokens in the hopes that they will appreciate in price as the ecosystem develops. Should the project fail, there is little by way of protection for the holders. Utility tokens don't give ownership rights to the holders. Their value is derived from the demand and supply. Utility tokens can be compared to gift cards or vouchers. And it may be expected but not assured that future discounts or freebies may be enjoyed.

From the peculiarities of utility tokens, they meet the definition of intangible assets perfectly and should be classified as such with no ambiguities unless they are held for trading.

Where the tokens are held in the ordinary course of business for trading purposes, you might need to apply IAS 2- Inventories. Brokers and traders of cryptocurrencies should apply IAS 2 and measure their inventories at fair value less cost to sell.

Conclusion

The accounting treatment may vary from national legislation. where there is a conflict of interest as to how to apply an accounting principle, the national legislation is paramount. IFRS however does not provide detailed guidance on the treatment of cryptocurrencies and tokens, so it is expected that based on the peculiarities another treatment may be applied.

As the blockchain and cryptocurrency space mature, it is expected that detailed guidance will be developed.

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