Fair value of Cryptographic assets
The fair value of a cryptographic asset (‘CA’) might be accounted for or disclosed in financial statements. Fair value might be needed in a variety of situations, including:
Inventory of cryptographic assets held by a broker-trader applying fair value less costs to sell accounting
Expense for third party services paid for in cryptographic assets
Cryptographic assets classified as intangible assets in cases where the revaluation model is used
Expense for employee services paid for in cryptographic assets
Revenue from the perspective of an ICO issuer
Cryptographic assets acquired in a business combination
Disclosure of the fair value for cryptographic assets held on behalf of others
Cryptographic assets held by an investment fund (either measured at fair value or for which fair value is disclosed)
IFRS 13, ‘Fair Value Measurement’, defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”, and it sets out a framework for determining fair values under IFRS.
1. The fair value hierarchy of IFRS 13
- Level 1: quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date;
- Level 2: observable inputs other than level 1 inputs; and
- Level 3: unobservable inputs.
Generally, IFRS 13 gives precedence to observable inputs over unobservable inputs. If a valuation is not based on level 1 inputs at the reporting date (for example, because there is not an active market at the date or time of reporting), the value will need to be determined using a valuation model. The objective in such valuations should be to estimate what the exit price of the entity’s position at the valuation date would be. [IFRS 13.B35-B36]
It should be noted that the hierarchy level of a cryptographic asset might evolve over time. For example, it is possible that a cryptographic asset that was previously valued using level 3 inputs might become traded in an active market, or vice versa.
IFRS 13 contains a number of disclosure requirements, depending on the level of the measurement hierarchy that a fair value measurement falls into, as well as the measurement basis used in the financial statements.
Given that markets for cryptographic assets are rapidly evolving, determining the fair value of cryptographic assets can be complex. IFRS 13 notes that, in making disclosures about fair value, the following factors should be considered:
- the level of detail necessary to satisfy the disclosure requirements;
- how much emphasis to place on each of the various requirements;
- how much aggregation or disaggregation to undertake; and
- whether users of financial statements need additional information to evaluate the quantitative information disclosed.
If the specific disclosures required by the standard are insufficient to meet the objective of helping users to assess the fair values, IFRS 13 requires additional information to be disclosed to meet that objective.
Many cryptographic assets show a high volatility of prices, and markets remain open 24/7. So the time at which a reporting entity values the cryptographic asset might be important. For example, is the valuation time 11:59 PM at the end of the reporting period, or the close of business on that day? How is the valuation time determined in groups with subsidiaries in different time zones? This might represent a significant accounting policy, in which case it would also have to be disclosed in the notes to the financial statements.
2. Determine the valuation of a cryptographic asset
3. Determining an active market
The first step in considering the fair value of a cryptographic asset is to determine if an active market exists for that cryptographic asset at the measurement date (in other words, whether a level 1 valuation can be performed).
IFRS 13 defines an active market as one “in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis”.
A benchmark for evaluating the depth of a market could include active trading days within a given time period. The average daily turnover ratio, which is calculated by dividing the average daily trading volume by the total amount of cryptographic assets outstanding, is a metric for volume that could also be considered.
IFRS 13 does not define specific thresholds that need to be exceeded with regard to frequency (such as active trading days) and volume (such as turnover ratio) to determine if an active market exists. This means that the conclusion requires professional judgement.
Many large traditional shares have a turnover rate of less than 1% every day. Those shares would likely still be considered to be traded in an active market if there are sufficient active trading days within a given period.
Data available from CoinMarketCap1 (‘CMC’) for December 2018, for the five cryptographic assets with the highest market capitalisation, suggested average daily turnover ratios between 4% and 41%, with active trading every day. Looking purely at that quantitative information, it would likely be possible to conclude that active markets exist for these cryptographic assets.
However, further analysis of the underlying data suggests that some other qualitative factors might need to be considered:
In some cases, there might be several markets for a particular cryptographic asset that meet the definition of an active market, and each of those markets might have different prices at the measurement date. In these situations, IFRS 13 requires the entity to determine the principal market for the asset.
The principal market will be the market with the greatest volume and level of activity for the relevant cryptographic asset which the entity holding the cryptographic asset can access. While CMC includes data from numerous exchanges, many exchanges serve regional markets and might not be an option for a principal market for a specific entity. IFRS 13 also contains a tiebreaker, if there is not a clear principal market (that is, because there are several markets with approximately the same level of activity). In the case of a tie, IFRS 13 defaults to the most advantageous market within the group of active markets to which the entity has access with the highest activity levels.
Paragraph 17 of IFRS 13 states that “an entity need not undertake an exhaustive search of all possible markets to identify the principal market […], but it shall take into account all information that is reasonably available. In the absence of evidence to the contrary, the market in which the entity would normally enter into a transaction to sell the asset […] is presumed to be the principal market […]”.
Once a principal market is identified, it is still necessary to investigate the pricing mechanisms used by the market to ensure that the pricing is based on orderly transactions in accordance with IFRS 13.15 and IFRS 13.B37–B44.
An entity might purchase cryptographic assets outside an exchange, in a private placement (for example, purchase from a liquidity provider). In that case, the purchase price is an entry price, and so it is not the relevant valuation basis for measurement of the cryptographic assets. The fair value of assets held is based on an exit price in accordance with IFRS 13.9 and IFRS 13.B2.
4 Reliability of data
In a presentation from a market participant to the SEC, trading data from one of the principal market sources was analysed, and it was suggested that, after comparing trading data from a prominent provider among the different crypto- and ‘traditional’ exchanges and performing other analysis over available data, there were indicators of various exchanges reporting inflated trading data.
However, the report did highlight that, when obtaining trading data used for an assessment of frequency and volume, it is crucial to consider the source of the data. Data from regulated exchanges is generally considered more reliable than from an unregulated exchange, but it is necessary to consider the regulation criteria and if there is any surveillance over the trading data.
5 Trading pairs
A level 1 fair value input is defined in Appendix A to IFRS 13 as “Quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date”. A cryptographic asset is often exchanged for another cryptographic asset (‘crypto to crypto’), instead of being exchanged into a traditional currency (‘fiat’) (‘crypto to fiat’). These crypto to crypto exchanges are usually included in the trading prices and volumes of a given cryptographic asset published by data provider websites. The trading prices used in these instances seem to be results from an implicit conversion of the cryptographic asset into fiat, at a rate under discretion of the respective exchange or the publisher of the data.
In general, an active market for a certain cryptographic asset exists only when crypto to fiat exchanges published by reliable sources exist. Crypto to crypto exchanges should not be considered when determining if there is an active market.
In practice, there are exchanges that do not offer the possibility for crypto to fiat trades at all. In this instance, an entity might exchange a cryptographic asset for another cryptographic asset, and then exchange the second cryptographic asset into fiat at another exchange. This means that it is possible for a market to exist for a cryptographic asset in which there is frequency and volume of trades, but that this market is not an active market under IFRS 13.
While generally, under IFRS 13, the market predominantly used by the entity to sell a cryptographic asset should be considered the principal market, a market that does not exchange crypto to fiat cannot be the principal market, because it is not an active market under IFRS 13.
For example, if an entity would like to determine if active markets exist for Bitcoin, it would consider all exit trades (Bitcoin/fiat) from exchanges to which it has access. The entity could then consider the active trading days and average turnover ratio, and conclude on the sufficiency of frequency and volume in accordance with IFRS 13, to determine whether the exchange was the principal market.
A Case – Active market?
Assume that two cryptographic assets, asset A and asset B, exist. Assets A and B are frequently converted into each other, based on a market where there are observable exchange ratios. Assets A and B are not considered foreign currencies within the scope of IAS 21.
Asset A is readily convertible to cash in an active market, but there is no active market where asset B can be converted to cash. In valuing asset B, would the transactions converting asset B to asset A on the active market be observable transactions that qualify for level 1 fair value measurements?
There is not an active market, and hence not a level 1 fair value in the entity’s functional currency (fiat), for asset B. This is because there is no active market where asset B can be directly converted to cash. Moreover, converting asset B to cash, via conversion to asset A, will generally incur costs or a spread that will be a non-level 1 input, and it will take time, during which the fair values of the assets might change. Since measurement in the fair value hierarchy requires the lowest level of significant inputs to the ‘entire measurement’ [IFRS 13.73], the ‘entire measurement’ in this case cannot be a level 1 fair value measurement.
Although the definition of an active market does not refer to fiat currency, the presumption is that, in order to qualify as a level 1 fair value measurement, the transaction should be measured in a fiat currency. Such fiat currency might be a foreign currency translated under IAS 21 to the reporting entity’s functional currency. However, for financial reporting purposes, the valuation needs to be established in some unit that qualifies as a foreign or functional currency under IAS 21.
Any cryptographic assets that are not directly convertible into fiat at an active market do not fulfil the criteria of a fair value level 1 asset, as defined by IFRS 13.76–78, because there will always be some additional implied fee or spread to exchange into fiat.
Where this implied fee or spread is observable (for example, because the cryptographic asset held is convertible into fiat through another cryptographic asset, which trades into fiat in an active market), the fair value of the cryptographic asset held will likely qualify as a level 2 asset in the fair value hierarchy.
Cryptographic assets that cannot be readily converted to fiat will likely qualify as a level 3 asset.
Two other issues that arise in determining if there is an active market are:
- In some cases, there might be significant price fluctuations between markets. These could result in a difference between the price in the principal (or most advantageous) market and the actual price received, and hence in day one gains or losses, when using a fair value model. The existence of such price differences would not, of itself, be an indicator that there is no active market.
- Some cryptographic assets aim to be backed by a fiat currency – for example, for one cryptographic token to represent the value of US$1. However, because these cryptographic assets are not considered a foreign or functional currency in the definition of IAS 21, they are treated no different to other cryptographic assets with regard to determining if an active market exists.
6. Valuation in the absence of an active market
6.1. Valuation techniques and inputs
Many cryptographic assets will not have an active market as described by IFRS 13, and so they will need to be valued using a valuation technique.
An appropriate valuation technique is one that estimates an orderly transaction price to sell the asset or to transfer a liability at the measurement date under current market conditions.
In some cases, multiple valuation approaches should be used. The appropriate valuation technique should consider how a market participant would determine the fair value of the cryptographic asset being measured.
In many cases, the market approach (IFRS 13.B5) will be the most appropriate technique for a cryptographic asset, because this would be used by a market participant. However, there might be particular facts and circumstances where an entity could demonstrate that a market participant would use a different approach. The cost approach (IFRS 13.B8) or the income approach (IFRS 13.B10) is likely to be rare in practice.
In determining an appropriate valuation technique, IFRS 13 indicates that the technique should be appropriate in the circumstances, and it should maximise the use of relevant observable inputs and minimise the use of unobservable inputs.
For a cryptographic asset, observable inputs might include information obtained on bilateral transactions outside an active market, certain quotes from brokers, and other information, given that many markets are still unregulated.
Where broker quotes are used, these should be carefully evaluated. Broker quotes can be derived from models rather than being based on observable market transactions.
In general, a valuation model should be applied consistently from period to period. The market for cryptographic assets is evolving rapidly, and so valuation techniques used by market participants are also likely to evolve. IFRS 13 permits an entity to change valuation techniques (or change weightings amongst multiple valuation techniques) where the change results in a measurement that is equally, or more, representative of fair value, in the circumstances. Factors such as the following might result in changing valuation techniques:
- new markets develop;
- new information becomes available;
- information previously used is no longer available;
- valuation techniques improve; or
- market conditions change.
6.2. Calibration of valuation techniques
IFRS 13 contains certain restrictions on determining fair values at initial recognition where this results from an arm’s length transaction. This is because the acquisition transaction represents an observable transaction for the cryptographic assets.
A Case – Calibration
A cryptographic asset not traded in an active market is purchased in an arm’s length transaction, without other elements, for CU100 at the beginning of the day on 1 June.
At the end of 1 June, the entity uses a valuation technique and determines that the value is CU104. Prior to considering the CU4 increase in fair value, the entity would firstly re-evaluate the appropriateness of the valuation technique/model used. Secondly, the entity would be required to determine whether the model was calibrated to the transaction price of CU100 paid at the beginning of 1 June, as set out in IFRS 13.64. That is, the valuation model would need to be run at the acquisition time, to determine whether the transaction price differed from CU100.
Now assume that the output of the valuation model (using unobservable inputs) is CU102 at the acquisition time, even though only CU100 was paid. In this case, the entity would likely consider that the difference between the valuation technique and the fair value at the beginning of the day amounted to CU102 – CU100 = CU2.
Therefore, at the measurement time (the end of the day, in this example) the output of the valuation technique would be adjusted for that difference, to arrive at a fair value of CU104 – CU2 = CU102.
The more time that passes between the initial transaction date and the measurement date, the less relevant the initial transaction price might become. However, in measuring the cryptographic asset, entities should ensure that their valuation method provides a sensible result in the light of IFRS 13’s calibration requirement.
It is important to note that not all appraisal reports obtained from third party valuation experts take into account these calibration requirements. When relying on a third-party appraisal, an entity would need to ensure that the methodology used by the appraiser is consistent with all aspects of IFRS 13, including its calibration requirements.
The transaction price paid by the entity might also be relevant to the valuation of other units of the same cryptographic asset held at the measurement date.
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