Borrowed cryptoassets
Should the lenders of crypto assets derecognize assets transferred to a borrower?
Accounting for borrowings of crypto assets poses a number of difficult questions for accountants. Because digital assets are non-financial assets, we cannot apply existing guidance on fiat borrowings directly (although why not apply it by analogy?) and have to evaluate the transaction from the perspective of assets being transferred. The transfer of financial assets, or to be more precise, the transfer of control over financial assets is based on the assumption that such assets are fungible. This means that the economics of the transaction will not change if one unit of financial asset is replaced with another unit of the same financial asset. However, the value of non-financial assets depends on their individual characteristics (such as quality, weight, color, etc.) and may not always be fully replaced by the same number of different units of the same asset. For example, a bag of potatoes may usually be replaced by another bag of potatoes, but what if the buyer believes that the replacement doesn't look as nice as the potatoes in the original bag? At the same time, any 50 of the $20 bills will have a financial value regardless of the quality and age of the dollar bills. It is a feasible assumption that the value of any non-financial good is heterogeneous. Therefore, the evaluation of the economics of the transaction with non-financial assets now will depend on whether the subject asset is being transformed, modified, replaced, or remains substantially unchanged.
Fungibility is the key differentiating criterion that drives our conclusion about whether borrowed assets are controlled by the borrower, lender, or both.
However, until the end of 2022, the predominant view in the accounting community was that the borrowed crypto assets are controlled by both lender and borrower. This was due to the fact that based on requirements of ASC 606 and ASC 610, the lender would not be able to derecognize non-financial assets transferred to the borrower, because the guidance about the right of return would not allow that to happen. This position is well discussed, and details can be found in the PwC Crypto assets accounting guide.
SEC view
During the AICPA Conference 2022 we, however, encountered the opposite view expressed by SEC staff who believed that:
"Because of the difference in fact pattern, the right/obligation to return the loaned crypto assets is different from a call option or forward under Topic 606"
["Lenders Accounting for crypto intangible asset loans" by KPMG]
As we often can observe in SEC staff interpretations, the conclusions they derive are based on the underlying intention of the standards and what the commissioners believe will better serve the interests of the investors. Sometimes, this may be different than what actually is required by the standard. Although we support the view stated by the SEC representative, we do not believe this is fully compliant with the current requirements of the FASB guidance.
Illustrative Journal entries - SEC Approach
LENDER ACCOUNTING
Origination
Debit Crypto Loans Receivable
Credit Crypto AssetsMonthly Recurring Accrued Interests
Debit Crypto Loans Interests Receivable
Credit Interest Income on Crypto LoansMonthly Recurring Remeasurement
Debit Crypto Loans Receivable - Embedded Derivative
Debit Crypto Loans Interests Receivable - Embedded Derivative
Credit Other Income/(Expense) - Unrealized Gain/(Loss) on Embedded DerivativesMonthly Recurring Paid Interests
Debit Crypto Assets
Credit Crypto Loans Interests Receivable
Debit Crypto Loans Interests Receivable - Embedded Derivative
Credit Settlement Gain
Debit Other Income/(Expense) - Realized Gain/(Loss) on Embedded Derivatives
Credit Other Income/(Expense) - Realized Gain/(Loss) on Embedded DerivativesSettlement
Debit Crypto Assets
Credit Crypto Loans Receivable
Credit Settlement GainBORROWER ACCOUNTING
Origination
Debit Crypto Assets
Credit Crypto LoansMonthly Recurring Accrued Interests
Debit Crypto Loans Interests Payable
Credit Interest Expense on Crypto LoansMonthly Recurring Remeasurement
Debit Other Income/(Expense) - Unrealized Gain/(Loss) on Embedded Derivatives
Credit Crypto Loans - Embedded Derivative
Credit Crypto Loans Interests - Embedded DerivativeMonthly Recurring Fair Value Hedge
Debit Other Income/(Expense) - Unrealized Gain/(Loss) on Embedded Derivatives
Credit Crypto Assets - MTMMonthly Recurring Paid Interests
Debit Crypto Loans Interests Payable
Debit Crypto Loans Interests Payable - Embedded Derivative
Credit Crypto Assets
Credit Settlement Gain
Debit Other Income/(Expense) - Realized Gain/(Loss) on Embedded Derivatives
Credit Other Income/(Expense) - Realized Gain/(Loss) on Embedded DerivativesSettlement
Debit Crypto Loans
Debit Crypto Loans - Embedded Derivative
Credit Crypto Assets
Credit Crypto Assets - MTM
Credit Settlement GainOvercollaterized Crypto Loans
Now one more question is how we should account for overcollaterized crypto loans (i.e., tokens issued to owners of vaulted ETH and BTC collateral from Maker DAO or Aave). In our view, when depositing assets in vaults owners may retain control over these assets as long as they follow the contractual terms of the arrangement and maintain the collateral level above liquidation thresholds. Based on the nature of an individual smart contract and other facts and circumstances, the Company may conclude that the vaulted assets should not be derecognized (hence, accounted for at cost basis on the company's balance sheet); or, alternatively, they may conclude that control of vaulted assets passed to the smart contract issuer (hence, the crypto assets should be derecognized and crypto receivables should be recorded at the fair value of assets on the date of transfer with the difference between cost basis and fair value recognized as unrealized gain/loss). However, regardless of the conclusion, cryptos assets (i.e., DAI) borrowings will be recorded at their fair value on the date of receipt in correspondence with the short-term borrowings account (as DAI loans typically do not have a stated term but the settlement may be enforced at any time if the fiat value of the collateral falls below the threshold set in the smart contract).