1.0 Audit Verification of Cryptocurrency
Due to the unusual nature and specific risks of Cryptocurrency investments these additional audit procedures will apply:
i) Our audit will make sure an investment in this risk category is permitted by the Fund Trust Deed.
ii) Our audit will review the Fund Investment Strategy to ensure the investment is in accordance with the Strategy.
iii) Our audit will ensure the investment is recorded in the title of the Fund.
iv) We will ensure, by enquiry, no commissions or fee rebates are being paid or directed to members.
v) We will ensure transactions and closing unit balances are verified to on-line statements.
vi) Year-end valuations will be substantiated with a reputable trading platform, a screen dump to support substantiation.
2.0 Professionally auditing crypto assets has proven challenging, even with calls for greater industry transparency following scandals including missing tokens and regulatory probes. Accountants have struggled to verify the ownership of crypto tokens, and in an industry dominated by start-ups many firms lacked the risk-management and process controls expected by a seasoned auditing firm.
2.1 Cryptocurrency is a type of digital asset that is an intangible, digital currency that uses a highly sophisticated type of encryption called cryptography[1] to secure and verify transactions as well as to control the creation of new units of currency. It is designed to work as a decentralized medium of exchange, independent of a financial institution or any other central authority. While Bitcoin is the most well-known cryptocurrency, it is not the only one. Other major types of cryptocurrencies include Ethereum, Ripple, Bitcoin Cash and LiteCoin. There are also other digital assets (or “cryptoassets”).
2.2 These are commonly referred to as digital tokens. For example, a company can initiate a “token sale” or a “token launch” which is otherwise frequently referred to as an initial coin offering (ICO). In an ICO, a company is creating a new product and wants to build a user base who will benefit from purchasing the product early. The ICO also enables the company to raise proceeds to develop the product. It is attractive to companies because they can bypass the rigorous and regulated capital-raising process required by venture capitalists or banks. While this FTB does not further explore ICOs or tokens, entities are encouraged to consult with their legal, accounting and tax advisors given the complexities and significant debate by regulators around such digital assets.
What is Bitcoin?
3.0 While there have been several attempts to create cryptocurrencies since the 1990’s tech boom, Bitcoin is the first to gain widespread public notoriety. Leveraging opensource peer-to-peer technology, the transaction and issuance of Bitcoin is collectively managed by the network, effectively cutting out the middleman.
3.1 Introduced by an anonymous programmer or group of programmers under the alias “Satoshi Nakamoto,” Bitcoin has consistently dominated the crypto market since it became available to the public in 2009. It has remained relatively unchallenged until the introduction of the Ethereum platform in 2016. Cryptocurrencies, including Bitcoin and Ethereum, are more volatile than traditional fiat currencies. Fiat currencies are declared to be legal tender by a government and are not backed by physical commodities.
What is blockchain and how is it connected to cryptocurrency?
4.0 Blockchain technology is a type of distributed ledger technology (DLT) that facilitates peer-to-peer transactions in a secure and verifiable way without a centralized party. It is a single, incorruptible database that continuously records and timestamps transactions (or “blocks”) chronologically. Every transaction must be verified through a process known as “consensus,” requiring multiple-system participants to independently verify authenticity of the output of the algorithm creating the “block.” Once a new entry has been agreed to (verified) and made in the blockchain, it is “locked”, meaning it cannot be modified; it can only be updated by adding a new entry as an addendum.
4.1 The best-known use of blockchain to date is to support the transaction of cryptocurrencies such as Bitcoin and, while the two are often conjoined—and confused—Bitcoin is just one of many potential blockchain applications. Bitcoin is, in essence, a form of currency; blockchain is the database that enables its unique, secure transaction.
How are cryptocurrencies created?
5.0 The process of creating a new type of cryptocurrency coins requires either building a new blockchain or modifying an existing process to create a new variant, or “fork.” The majority of these so-called “altcoins” are forks of the Bitcoin protocol.
5.1 The only way more coins of an existing crypto coin can be created is through a process called “mining” in which the miner is awarded a transaction fee (a new coin) in exchange for contributing to the underlying blockchain algorithm by being the first to solve a cryptographic puzzle. Mining is extremely competitive and requires significant computing power.
5.2 Some cryptocurrencies, like Bitcoin, are finite in supply, meaning that there is a maximum number of coins that will ever be in circulation. Others do not have a maximum cap, but limit the number of new coins that can be generated each year.
Does U.S. GAAP address the accounting for cryptocurrencies?
6.0 Currently, U.S. GAAP does not specifically address the accounting for cryptocurrencies. However, given the increase in cryptocurrency transactions, questions are now being raised about how cryptocurrencies should be accounted for.
Can cryptocurrencies be used for purchasing and investing just like traditional physical money?
7.0 Cryptocurrencies can be used to pay for goods and services, as well as for investing in some areas around the world. In this respect, they are similar to physical currencies. However, unlike fiat money, cryptocurrencies have no physical form, they have not been declared to be legal tender in the United States, and the vast majority are not backed by a government or legal entity. In other words, the supply of a cryptocurrency is not determined by any central bank. Therefore, users participate in transactions directly without the involvement of any intermediary, which for fiat money, would typically be a bank. It should be noted that while cryptocurrencies may be used legally in many countries, there are others that hold transacting in cryptocurrencies to be restricted and still others to be illegal and may result in jail sentences for those doing so. These countries include (restricted): China, Saudi Arabia, Egypt, Zambia, and Mexico; (illegal): Bangladesh (jail), Vietnam, Morocco, Algeria, Bolivia (jail), Ecuador, and Nepal (jail).
Does cryptocurrency represent cash, a cash equivalent or a foreign currency?
8.0 Cryptocurrencies are not cash because they are not legal tender and are not backed by a government or other legal entity. For similar reasons, they are also not cash equivalents or foreign currencies under U.S. GAAP.
Does cryptocurrency represent inventory?
9.0 Entities use cryptocurrencies as a medium of exchange or for speculative purposes. In these instances, cryptocurrencies are clearly not inventory. In other situations, entities purchase or mine cryptocurrencies with the intent to sell them in the ordinary course of business and therefore, might be considered inventory. However, cryptocurrencies do not represent “tangible personal property” and therefore do not meet the definition of inventory under U.S. GAAP.
Is a cryptocurrency a financial instrument?
10.0 Cryptocurrencies are not financial instruments under U.S. GAAP because they do not represent cash or a contract establishing a right or obligation to deliver or receive cash or another financial instrument.
Is a cryptocurrency an intangible asset?
11.0 In our experience, cryptocurrencies are generally accounted for as indefinite-lived intangible assets, except in a few specific situations whereby they are held as an investment by investment companies – in which case fair value accounting is applied.
11.1 Intangible assets under U.S. GAAP are “assets (not including financial assets) that lack physical substance.” Further, financial assets are cash, evidence of an ownership interest in an entity, or a contract that conveys to one entity a right to receive cash or another financial instrument, or a right to exchange other financial instruments on potentially favorable terms.
11.2 Cryptocurrencies are not financial assets. They also lack physical substance. Therefore, they meet the definition of an intangible asset and would be recorded at acquisition cost (i.e. price paid or consideration given). Intangible assets are subject to an impairment test. Any recognized impairment losses cannot be subsequently reversed. Some believe the intangible model does not properly reflect the economics of cryptocurrencies because they can potentially be written down for impairment but never written up when they appreciate in value. This outcome could be less than helpful for financial statement users when significant volatility exists.
11.3 Unlike a direct purchase, additional complexity arises if cryptocurrencies are obtained through mining activities, as described above. In such instances, questions arise as to whether the transaction fees should be recognized as revenue or some other form of income. Additionally, miners incur costs for computer equipment, electricity and overhead. They must determine whether such costs can be capitalized based on existing U.S. GAAP, such as the guidance for internally developed intangible assets or other areas of U.S. GAAP.
How is cryptocurrency taxed?
12.0 The Internal Revenue Service has released very little guidance on the taxation of cryptocurrency. However, it did issue a 2014 notice in which they stated that cryptocurrency will be treated as property for federal income tax purposes. Depending on how the cryptocurrency is held, it could be classified as business property, investment property or personal property. 12.1 In addition to the character of the gain, it is critical that owners of cryptocurrency track their basis. Every time cryptocurrency is used for the exchange of goods or services, a taxable transaction occurs. For example, events that are considered taxable events include a coin to fiat sale, a coin to coin swap, purchases made by the cryptocurrency and the receipt of cryptocurrency for services. Other complexities around taxation of cryptocurrency exist and it is very important that individuals and businesses continue to monitor future guidance.
13.1 In 2014, the ATO issued two taxation determinations (TD 2014/25 and TD 2014/26) clarifying that bitcoin and cryptocurrencies like bitcoin are not money but are capital gains tax (CGT) assets.
13.2 If an SMSF transacts in cryptocurrencies, SMSF trustees and members need to be aware of the tax consequences; in each case these will depend on the nature of the SMSF’s circumstances. SMSFs involved in acquiring or disposing of cryptocurrency must keep records in relation to their cryptocurrency transactions. There are also super regulatory considerations for SMSF trustees, members and SMSF auditors.
13.3 An SMSF’s investment strategy outlines its investment objectives and specifies the types of investments it can make. Before investing in cryptocurrency, SMSF trustees and members should consider the level of risk of the investment. Trustees and members may then review and if necessary, update their fund’s investment strategy to ensure the investment being considered is permitted.
13.4 Trustees and members also need to ensure that investments in cryptocurrency are allowed under the SMSF’s deed.
Ownership and separation of assets
14.0 The super laws require trustees and members to ensure their fund’s assets are held separately from personal assets. An SMSF’s cryptocurrency investments must be held and managed separately from the personal or business investments of trustees and members. This includes ensuring the SMSF has clear ownership of the cryptocurrency. This means the fund must maintain and be able to provide evidence of a separate cryptocurrency wallet for the SMSF from that used by trustees and members personally.
Valuation
15.0 SMSFs must ensure their investments in cryptocurrency are valued in accordance with ATO valuation guidelines. The value in Australian dollars will be the fair market value which can be obtained from a reputable digital currency exchange or website that publishes its rates publicly.
The value of cryptocurrency can change constantly. For the purpose of calculating member balances at 30 June, the ATO will accept the 30 June closing value published on the website of a cryptocurrency exchange that reports on historical cryptocurrency values.
Related-party transactions
16.0 With certain exceptions, SMSFs are prohibited from intentionally acquiring assets from related parties. The exceptions include listed securities and business real property, when acquired at market value. Cryptocurrencies such as bitcoin are not ‘listed securities' so do not fall within the exceptions. They therefore cannot be acquired from a related party.
16.1 It follows that SMSF trustees and members – being related parties of the fund – cannot make in specie contributions or other transfers of cryptocurrency to the fund.
Sole Purpose Test
17.0 An SMSF must be maintained for the sole purpose of providing retirement benefits to trustees and members, or to their dependants if a member or trustee dies before retirement.
17.1 It is unlikely that an SMSF will meet the sole-purpose test if trustees or members, directly or indirectly, obtain a financial benefit when making investment decisions and arrangements. For example, it may be a breach of the sole-purpose test where affiliate fees or commissions associated with the fund’s cryptocurrency investment are paid to a trustee or member personally.
Pension or benefit payments
18.1 Where a trustee or member satisfies a condition of release, the SMSF can make an in specie lump sum payment by way of transfer of cryptocurrency. However, pension payments must be made in cash.
18.2 Trustees and members will need to consider the fund’s trust deed and any CGT implications associated with the transfer of assets such as cryptocurrency.
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