Of all the challenges that crypto businesses have to tackle, accounting and bookkeeping probably aren’t the most interesting. This results in most businesses not prioritizing these tasks, but then ultimately having to throw a lot of money and time at it later to sort it out. When the tax season arrives, these crypto businesses scramble to clean their books and comply with all the regulations.
For most of them, it is a nightmare just to meet basic regulatory needs like finding an accountant, managing and tracking all their cryptos, opening a bank account, getting audited and meeting compliance requirements. The main challenge lies in the fact that most accounting practices and financial reporting guidelines are formulated for traditional FIAT currency based businesses. The lack of global standards for crypto accounting and the constantly changing regulatory environment make this mess a lot more complex. Hence, setting up an efficient accounting process that automatically does regular bookkeeping tasks will save cryptocurrency companies and blockchain businesses a ton of money, time and sleepless nights
This guide will give you the ultimate primer that your crypto -related business will need to implement a good accounting system.
It is advisable to hire a professional accounting service or CPA to keep your books clean. However, it is always good to know the key basics and fundamentals to set the right accounting practices within your business from the start. Having an efficient tracking and monitoring of your expenses and transactions isn’t just a ‘tax obligation’, but they also help stay on top of your business, identify financial loopholes early on, control your burn rate and grow the financial health of your business. If you have investors or are looking for investors, you will require regular financial reports to prove that you are on the right track. In fact, according to a study by CB insights, ‘cash flow management’ was the 2nd highest reason why startups failed.
The accounting basics
What is Accounting?
Accounting is the process of systematically recording, analyzing, summarizing and interpreting your business’s financial information. A proper record of all your cryptocurrency and FIAT transactions will help you keep track of operational costs, easily meet legal and tax obligations, and make better business decisions. It will also help you measure your revenue, your expenses, how much money you made and plan ahead on what changes need to be made. As Peter Drucker puts it, ‘If You Can’t Measure It, You Can’t Improve It’. Having a great accounting and bookkeeping system for your business will help measure the financials of your firm, which will in turn empower you to improve your operations, make strategic decisions and grow your company’s valuation.
Basic Accounting Terminologies
Let’s start with some basic accounting terminologies. If you are already well versed with them, feel free to skip ahead. Though a little brushing up of the basics never hurts.
- Assets – This one is easy. Assets are resources that you own that have future economic value. Some examples of assets include cash (or cryptos), land, building, equipment, inventory, patents etc.
- Liabilities – Liabilities are legal financial debts or obligations that your company owes in the long or short term. Some examples include taxes or salaries payable in the future.
- Equity – As founders, you would know about equity all too well! It represents the shareholders’ stake in the company. A technical definition is that equity represents the amount of money that would be returned to a company’s shareholders if all of the assets were liquidated and all of the company’s debt was paid off.
- Balance Sheet – The balance sheet is the summary or snapshot of your startup’s finances. The balance sheet is constructed through the fundamental equation: Assets = Liabilities + Equity.
- Accounts Receivable – Accounts receivable is the money that your customers owe you for your goods or services, and is not yet paid for by them. It’s considered an asset on your balance sheet.
- Accounts Payable – Accounts payable is the money that you owe people and you haven’t paid yet. It is considered a liability on your balance sheet
- Expenses – Also known as ‘cost of doing business’, these are expenses you incur while running your business. These include salaries, utilities, rent for your office, cost of running your website and severs etc.
- Profit & Loss statement – The profit and loss (P&L) statement, as the name suggests, summarizes the profits/losses, revenues, costs and expenses incurred during a specified period. It is also called income statement.
- Cash flow statement – A cash flow statement is a financial statement that summarizes how well the company generates cash ( and cash equivalents) and how it spends this cash during a given time period.
The main difference between P&L statement and cash flow is that the P&L statement also includes revenues that may actually not have yet been collected (Account receivables) and expenses that may not have yet been paid (Account payables) whereas the cash flow only includes cash that has actually been received or paid.
Bookkeeping methods: Cash vs Accrual
Before filing your first tax return, you will need to choose an accounting method. There are two main methods to recognize or classify your revenue and expenses.
Cash Method: The Cash method recognizes revenue and expenses on the day they’re actually received or paid. This means there is no need to track account payables or receivables, and hence is simpler and more suited for smaller businesses.
Accrual Method: The accrual method recognizes revenue and expenses on the day the transaction takes place, regardless of whether or not it’s been received or paid.
The cash method is a better reflection of how much money, or cryptocurrencies, you actually have at a given time. Whereas the accrual method is a better depiction of how your business is actually performing and gives a better long term picture. The accrual method is much more commonly used, specially if your business gains substantial action. As you will need to necessarily adopt the accrual if you become a decently sized business (which I really hope you do!), it may make sense to set accrual as the bookkeeping practice from the start. However, we would still recommend chatting with a CPA about it.
Valuing your inventory: FIFO vs LIFO vs average cost
You need to value your inventory for adding that value to your financial statements. But the challenge arises when the price of buying and selling this inventory fluctuates. For example, if you bought 10 items at 10$, then 15 more at 8$, and sold 20 of them in this period, how would you value the remaining 5 items in your inventory? There are three main ways to do it:
- FIFO (first in first out): Under the FIFO method, the oldest cost (first in) of an item in the inventory is recorded first (first out) when an item is sold. In case of the same example as above, the first 10 items sold will be valued at 10$ and then rest 10 sold will be valued at 8$. Hence, the remaining inventory will be valued at 8$ each, which is 8$ x 5 = 40$.
- LIFO (last in first out): Under the LIFO method, the most recent cost (last in) of an item in the inventory is recorded first (first out) when an item is sold. In case of the same example as above, the first 15 items sold will be valued at 8$ and the rest 5 sold will be valued at 10$. Hence, the remaining inventory will be valued at 10$ each, which is 10$ x 5 = 50$.
- Average cost: Under the average cost method, the cost of all the items is averaged and assigned to each of them. In case of the same example as above, the cost of each item will be valued at 8.8$. Hence, the remaining inventory will be valued at 8.8$ each, which is 8.8$ x 5 = 44$.
Which method should your business use?
- The FIFO method has the advantage that your inventory value will be closer to the current market prices. If you are expecting rising costs of the items, it will allow you to record lower prices for the remaining inventory thus resulting in higher reported income, reported profits and reported assets.
- The LIFO method has the advantage that during rising costs of items, it will allow you to record higher prices for the remaining inventory thus allowing you to pay lower taxes by deducting a larger cost from your taxable income.
- The average cost has the advantage that it smoothes out the price fluctuations.
Whatever method you choose, you have to stick to it and cannot switch between them every year just because a method allows you to pay less taxes or show higher profits. But it is generally permissible to use different methods on your tax returns and financial statements depending on what your objective is.
It is also important to note that LIFO is disallowed in non-US counties (which is basically the rest of the world).
Cryptio tip: For internal management decisions, it makes sense to analyse your business under both FIFO and LIFO to see if your operations are sustainable for both optimistic and pessimistic outlooks.
Accounting crypto assets
Recording cryptocurrencies on your financial statements
The rising popularity of cryptocurrencies in recent years has opened the pandora’s box for regulatory authorities around the world. There is still no single, generally accepted crypto accounting and bookkeeping framework in the IFRS (International Financial Reporting Standards) for the various digital assets. IFRS is a set of accounting standards developed by an independent, not-for-profit organization called the International Accounting Standards Board (IASB) to provide common global financial reporting standards. Hence, businesses are advised to adopt a principles-based approach derived from the existing IFRS. There is no ‘one size fit all’ answer and different businesses will have different standards for recording cryptocurrencies depending on their business model and use case. Hence, we would strongly advise consulting an expert to figure out the accounting practice for your particular business. However, there are some broad classifications that we discuss below.
On the basis of the existing guidelines in the IFRS, the standards that may be applicable to cryptocurrencies are:
- Cash or a currency
- Cash equivalents
- Financial asset
- Property, plant and equipment
- Intangible asset
Due to various interpretations discussed in this report by PwC, the most appropriate classification for a majority of cryptocurrencies of token businesses is as an ‘intangible asset’ as per IAS 38. Unless your business model is one of the exceptions discussed below, this classification will likely apply to you and your use cases.
IAS 38 allows intangible assets to be measured through one of two applicable standards – cost model or revaluation model.
Reevaluation model: The most appropriate model is the reevaluation model, but it requires the existence of an active market to measure the ‘fair value’. That is, the cryptocurrency is measured at cost on initial recognition and are subsequently measured at the market price of the cryptocurrency on the trading exchanges. This fair value is recognized in the profit and loss, or ‘other comprehensive income’ in case of reevaluation cost being higher than initial cost, and accumulated in equity.
Cost model: If your crypto business has digital assets that do not have an active market, then the cost model is applied. Under the cost model, the cryptocurrency is measured at cost on initial recognition and are subsequently measured at cost less accumulated amortization and impairment losses. In most cases, amortization is not expected for cryptocurrencies. This fair value is recognized in the profit and loss and accumulated in equity.
On June 2019, the International Financial Reporting Interpretations Committee (IFRIC), which sets the well-known IFRS, concluded that that holdings of cryptocurrency meet the definition of an intangible asset, based on the fact that “(a) it is capable of being separated from the holder and sold or transferred individually; and (b) it does not give the holder a right to receive a fixed or determinable number of units of currency”.
There are, however, exceptions to this classification depending on your business model.
- If your business ‘holds cryptocurrencies for sale in the ordinary course of business’, then the appropriate classification will be as ‘inventory’. This is true if your business model is to actively trade cryptocurrencies with the purpose of generating a profit in the near future from fluctuations in price. In this case the guidance in IAS 2 for commodity broker-traders may be applied. Under this, the cryptocurrencies will be measured at ‘fair value less cost to sell’ with changes in fair value recognized in profit or loss.
- If your business involves asset-backed tokens, the relevant accounting standard applicable to the underlying asset (gold, real estate, artwork, license) will be used.
- If your business holds cryptographic assets on behalf of your customers and other third parties, the assessment whether the assets should be on or off the balance sheet depend on various factors and will need a case by case solution. On a broad level, if your customer’s assets are segregated from your own assets (through a dedicated blockchain address, or a hot/cold wallet etc) then the assets held on behalf of third party will be off the balance sheet. This means that these are effectively your assets or liabilities but do not appear on your balance sheet. Conversely, If your assets and your customer’s assets are not segregated, then the cryptographic assets and the corresponding liability should be recognized on the balance sheet. We would advise to consult an expert to make this judgement.
- If the digital assets are permanently used for business operations, they would need to be allocated to fixed assets. In this case, they must be valued at their acquisition cost (production costs if they were mined). However, if they are intended for short-term sale, consumption, processing or repayment, they will be allocated to current assets. In the case of current assets, the digital assets will be valued at the market price on the balance sheet date and depreciation or appreciation will have to be applied.
Crypto Accounting for token sales
ICO (initial coin offering)/IEO (initial exchange offering)/STO (security token offerings) has been the new ‘cool’ way of raising funds by issuing crypto tokens on a blockchain, most commonly Ethereum, and selling them to investors or contributors. The capital received by the company through the sales will be recorded as the debit side. However the main question arises if the newly created tokens should be added as liability or as equity in the credit side. These tokens can broadly be classified as ‘financial instruments’. However, to figure out how to classify them we need to look at what functions these tokens perform. The common types of ICO coins are equity tokens and utility tokens.
Utility Tokens: Utility tokens are simply ‘tokens’ to enable future access to the products or services offered by a company. They are not designed as investments, though people contribute to utility token ICOs with the hope that the value of the tokens will increase as demand for the company’s product or service increases. An example of a utility token will be BAT token or RLC token. For crypto businesses that have utility tokens, these would normally be classified as a financial liability.
Equity Tokens: Equity tokens are tokens that entitle the holder to ownership, voting rights or to the variable returns (such as dividends to company’s performance). They are a subcategory of security tokens, and are similar to the traditional initial public offering (IPO). For crypto businesses that have equity tokens, these would normally be classified as a financial equity.
Hybrid: For certain business models, the token type may not be clear due to tokens having characteristic of both equity and liability. Hence, these companies may require to present proceeds raised through ICO as hybrid instruments with both equity and liability components.
Cryptio Tip: If you allocate some tokens for the purpose of your own use, such as platform development or employee remuneration, this would not be considered for accounting purposes. However, when these tokens are paid to third parties in exchange for work, then this exchange will have to be recorded in the books.
Hence, how a crypto business accounts for an ICO depends on the rights and obligations attached to the tokens, which vary from one transaction to another. You can refer to this discussions of the IFRS (International Financial Reporting Standards) Interpretations Committee to dig deeper into this.
Crypto Accounting best practicess
Track your expenses
The biggest key to good accounting and bookkeeping is to track all your expenses and transactions. In the olden days businesses would have to keep 1000s of bills and receipts to record everything. Now you have tons of online tools to do it automatically for you. Tracking your expenses will make it easy for your when it comes to doing taxes. It also helps to calculate your cash flow statements and analyse your profit-loss, which is a good way to always have an idea of how your business is performing.
You also need to document the invoices through a proper invoice management tool that integrates with your accounting software. Other documentations that you should track, digitise and record, apart from invoices, include bills, receipts, bank and credit card statements, previous tax returns. You would also need to categorise all these transactions to have more detailed and extensive reporting. This will help you save money that you would have spent on taxes by showing tax deductibles. Moreover, it helps give an overall picture of how and where your business’s money is being spent.
For blockchain businesses that have dealings in cryptos as well as FIATs, you will have to track them both and create consolidated financial reports. It is a lot more complex for token companies. You will most likely have multiple wallets across multiple exchanges, each with its own format for historical crypto transactions, different base rates, and non-consistent price data. And then you will need to consolidate all these transactions on Excel, converting them to FIAT with multiple conversion rates to finally start doing proper accounting. As Bertrand Ducros, CPA at iExec, rightly explains this can become a nightmare:
“Accounting management involving crypto digital assets is essential but so painful today. What can I do if I can’t get easy access to all my transactions? How can I manage my cash flow if I don’t have a clear vision on my future taxes, my stocks, my invoices … ?”
Bertrand Ducros, CPA at iExec
Thankfully, there are a few crypto focussed accounting & cryptocurrency tracking tools coming up in the market. We too, at Cryptio, provide such an automated crypto accounting & bookkeeping tool to track your expenses, and manage all your cryptos and FIAT transactions across all your wallets.
Stay up to date with crypto tax regulations
Benjamin Franklin said there are only two things certain in life: death and taxes. And YES, even if you are a crypto or blockchain business you must pay your taxes. However, having an efficient accounting system to tag and classify all your expenses, and being on top of the tax regulations in your jurisdiction will help you find LEGAL tax break opportunities. Expenses such as marketing, advertising, business travel etc. can possibly be tax deductible. However it is important to do proper invoicing for these and document them regularly.
It is important to stay up to date with tax regulations regarding cryptocurrencies and blockchain businesses in your jurisdiction. Governments and regulatory authorities across the world have been in extensive discussions lately on how they can manage corporate taxation on crypto businesses. But it is a constantly evolving space with new rules and recommendations almost very week or so. We would suggest keeping an eye on this space for your jurisdiction, investing some time to understand the dynamics, and consulting your CPA or expert fairly regularly and not one week before you file your taxes.
On a broader lever, crypto business will be taxed on the net profits they declare, just like a traditional non-blockchain business. The net profits are calculated using the business’s transactions, and every crypto transaction will be classified as a ‘taxable event’. Hence, it is important to accurately track all your transactions. These profits will have to be recorded in the local FIAT currency such as USD. In many jurisdictions crypto tax gains are categorized under ‘capital gains and losses’. Investopedia defines it as ‘Capital gain is a rise in the value of a capital asset (investment or real estate) that gives it a higher worth than the purchase price’. However, this gain is not realized until the asset is sold. Hence, it may be beneficial to HODL.
You need to keep in mind the due dates for filing taxes, and start the necessary preparation well in advance. The regulatory atmosphere surrounding cryptocurrencies is really uncertain and constantly changing, so you need to work with crypto accounting experts. A professional advisor will save your hours of frantic work trying to figure it out. But if you have stuck to your accounting practices all through the year and have everything tracked, classified and reported through your accounting tool, you will make life much easier for the expert as well yourself.
Cryptio tip: You can save on your crypto taxes legally by taking certain steps such as tax loss harvesting, offsetting crypto gains with other capital losses, tracking tax deductible expenses and avoiding triggering capital gains by HODLing.
Here are some resources to dig deeper on taxation in your jurisdiction:
- How to do crypto taxes in France
- How to do crypto taxes in Germany
- How to do crypto taxes in USA
- How to do crypto taxes in UK
Leverage crypto accounting & bookkeeping tools
With the boom in SaaS businesses and tools in the past few years, there are tons of online tools available in the market to simplify the accounting process. You can do all the reporting, categorising and tracking of your transactions yourself through excel sheets and inputting a lot of data manually. And you will need to do this regularly every few weeks so that you don’t miss anything. Probably if you are bootstrapping you have no other choice. But this is going to get exponentially complex very fast and take up a lot of your time trying to navigate through the mess. And if you own cryptocurrencies on multiple wallets across multiple exchanges, having to record all of them manually and then convert all transactions into FIAT is going to push you to a hair puling frustration.
Hence, it really is a wise investment to have tools do it for you automatically so you can focus on your business’s core competencies. And start using them when you are still decently small so that the records are clean from the start. Even if you are the chief financial officer and your business is doing well, using sheets and hacks to update your bookkeeping is not a good investment of your time. Yes, we have built such a tool (and i am glad you remember!) but this is not a sales pitch. You can integrate one of our competitors if you want, but leveraging an online tool to track, report and do all the bookkeeping automatically for all your cryptocurrencies across all wallets and exchanges will save you a lot of time (and sleepless nights). 100% recommended.
Bookkeeping Tasks to be done regularly
To summarize how to create an efficient crypto accounting and bookkeeping process for your cryptocurrencies and tokens, here are the tasks a blockchain business must do:
- Record and track all your expenses, costs and transactions
- Consolidate all cryptos across wallets and exchanges, as well as FIAT currencies
- Convert all crypto transactions into your choice of FIAT currency
- Monitor and analyze your daily activity, asset performance and cryptocurrency balances
- Categorize transactions into expenses, revenue, operational costs etc.
- Reconcile your bank accounts and wallet balances regularly
- Send invoices, pay your bills, review account payables and account receivables
- Create and update financial reports such as balance sheet, P&L statement and cash flow statement
- Check the reports comply with the regulatory needs of your jurisdiction
- Analyze your financial reports to grow your business and make strategic decisions
Running a successful business in the crypto ecosystem is a challenge. From scalability issues to driving user adoption, there is no dearth of critical issues that will require your focus. Hence, it is very easy to skip thinking about accounting and bookkeeping. However, having an efficient crypto accounting, tracking and management process in place will be a worthy investment to make your life easy. Hopefully this guide helped you get a better idea about cryptocurrency accounting for your business. In case you wish to learn more, sign up for our newsletter below!