Legal and Technological Restrictions on the Sale and Transfer of Tokens: Impact on Fair Value
The post studies the effects of restrictions on the sale and transfer on the evaluation of the fair value of tokens subject to these restrictions.
Restrictions on the sale and transfer of tokens are a frequent and critical consideration when evaluating the fair value of digital assets. This issue affects financial reporting under US GAAP, particularly for entities holding or issuing crypto assets, token-based compensation, or tokens receivable and payable.
This article explains how contractual and inherent to an instrument restrictions affect fair value measurement, disclosure requirements, and the assessment of whether crypto assets are readily convertible to cash.
Relevant Considrerations
Fair Value
Up until last year, entities reporting under US GAAP were not prohibited from applying a discount to the price of securities subject to a contractual sale restriction. Some preparers adjusted the fair value of securities subject to restrictions to reflect such discounts. In contrast, others considered such a discount inappropriate. ASU 2022-03 has now unified practice by requiring that the fair value of an equity security be adjusted only for transfer restrictions inherent to the asset’s unit of account (and that apply to any holder), while no adjustment is needed for restrictions that are specific to the reporting entity [FASB ASC 820-10-55-52, -55-52A]. Contractual restrictions on sale are not part of the unit of account and, therefore, are not considered in measuring the fair value of the instrument. Although ASU 2022-03 specifically discusses equity securities, it is generally considered appropriate to apply this guidance by analogy, including to crypto assets subject to restrictions.
Even though ASU 2022-03 limits the scope of disclosure requirements to equity securities subject to contractual sale restrictions, the same disclosures are required for crypto assets subject to contractual sale restrictions [FASB ASC 350-60-50-6], including:
The fair value of equity securities subject to contractual sale restrictions is reflected in the balance sheet.
The nature and remaining duration of the restriction(s)
The circumstances that could cause a lapse in the restriction(s)
Further, entities should provide similar disclosures for any material balance of other digital assets subject to contractual sale restrictions, even if those assets are neither equity securities nor crypto assets within ASC 350-60.
Readily Convertible to Cash
Contractual sale restrictions are also relevant to whether assets are “readily convertible to cash”. Under this guidance:
”Shares of stock in a publicly traded entity to be received upon the exercise of a stock purchase warrant do not meet the characteristic of being readily convertible to cash if both of the following conditions exist:
The stock purchase warrant is issued by an entity for only its own stock (or stock of its consolidated subsidiaries).
The sale or transfer of the issued shares is restricted (other than in connection with being pledged as collateral) for a period of 32 days or more from the date the stock purchase warrant is exercised.”
[FASB ASC 815-10-15-131]
However, ASC 815-10-15-132 explicitly prohibits applying this guidance by analogy. Thus, contractual sale restrictions do not disqualify crypto assets from being considered readily convertible to cash.
Accordingly, embedded derivatives referencing crypto assets are not affected by such restrictions, although their initial and subsequent measurement will follow fair value guidance, which incorporates inherent restrictions.
Thus, the identification and recognition of embedded derivatives for tokens receivable/payable are not affected by restrictions on the transfer of tokens. But the fair value measurement (initial and subsequent) might require an adjustment to account for the effects of restrictions inherent to the underlying tokens.
Practical Implications for Token Fair Value Measurement
When measuring the fair value of token compensation liabilities or tokens receivable, entities should consider restrictions on sale or transfer and adjust the fair value when the restrictions are inherent to the asset. This occurs when:
The lockup feature is embedded directly in the token’s smart contract or code base
The restriction exists because the token has not yet been created, issued, or generated
These restrictions are considered inherent to the asset based on its unit of account.
However, when tokens are locked up in a separate smart contract (that is, when an authorized account or program deposits tokens into a smart contract that is not part of the token’s own code base), such restrictions are not inherent to tokens and should be viewed as entity-specific contractual restrictions. Hence, entities need NOT account for such restrictions when measuring the fair value of tokens receivable or payable.
Further, when measuring the fair value of token compensation liabilities, entities should not make adjustments for vesting or lockup provisions specific to an individual award.
Conclusion
A clear distinction must be made between restrictions that are inherent to the digital assets themselves (that is, technological restrictions) and contractual restrictions that apply only to an individual entity (that is, legal restrictions). Only restrictions inherent to the asset’s unit of account affect its fair value. Contractual restrictions do not affect fair value, nor do they prevent crypto assets from being considered readily convertible to cash.