DeFi Accounting. Part 1. Swaps
Diving into accounting for DeFi arrangements, starting from the first primitive that every crypto accounting professional needs to understand - swaps.
Introduction
Swap is the first DeFi primitive that we will cover in the series devoted to DeFi accounting under US GAAP. Accounting guidance relevant to this topic consists of the following:
ASC 610-20, Gains and Losses from the Derecognition of Nonfinancial Assets
ASC 860-20, Sales of Financial Assets
ASC 350-60, Crypto assets
ASC 350-30, Intangibles other than goodwill
ASC 805-50-30, Business Combinations - Related Issues - Initial Measurement.
However, the overall logic behind the complex rules we will cover below are based on whether the reporting entity acts primarily as:
Purchaser of a nonmonetary asset for cash, monetary, or financial assets,
Seller of nonmonetary asset that is being realized in exchange for cash or non-cash consideration,
Neither seller nor purchaser when assets surrendered and received are essentially the same assets.
The general rule is that the role of the reporting entity determines the measurement of assets acquired as follows:
Purchaser measures assets acquired at the fair value of assets surrendered.
Seller measures assets acquired at the fair value of assets received and recognized gain/(loss) realized on the disposition of assets surrendered.
Neither seller nor purchaser measures assets received at the cost basis of assets surrendered (i.e. with no recognition of gains or losses).
The first step in accounting for swaps is determining the appropriate guidance (scope). In the context of blockchain token swap transactions, we are most concerned with the scoping questions discussed below.
I. Guidance
This guidance has also been implemented in this Notion form you can use.
1. Transfer of control
Is the control over the token being transferred as a result of the swap?
If no, continue to account for the token on the balance sheet even after the swap happened but you may need to track the original asset separately. For example, the reporting entity may send an asset into a vault and use it as collateral for borrowing. Here when a token is transferred to a vault, the user may receive another non-liquid token that represents its ownership claim on the assets in the vault. This transaction will appear as a swap. Assuming that the token received is not actively traded, and the reporting entity remains in control of tokens stored in the vault, the original token should remain on the entity’s books. However, the reporting entity should be able to separately track all collateralized tokens for disclosure purposes. As such, this swap may be recorded by debiting the account for collateralized assets and crediting the account used to track the original asset at book value.
2. Specialized Guidance
Is the token swap a part of a transaction where transferred assets constitute a business? If yes, the swap falls in the scope of the business combination guidance.
Does the swap constitute a sale of a financial asset within the scope of ASC 860-20, Sales of Financial Assets? ASC 805 requires measuring assets acquired in exchange for monetary assets as the amount of cash given plus the amounts paid as transaction costs.
3. Nonmonetary Transactions
ASC 845 applies to all transactions that fall under one of the three exceptions that require the application of the modified approach to recognition based on the book value of assets surrendered. The modified principle of recognition under ASC 845, Nonmonetary Transactions will apply if you answer “yes” to any of the following three questions:
Does the swap constitute a non-monetary exchange with no commercial substance?
Does the swap constitute a non-monetary exchange in the ordinary course of business for a token to be sold in the same line of business to facilitate sales to customers other than the parties to the exchange? For example, the swap of bitcoin held in the US exchange for the same amount of bitcoin held in the South Korean crypto exchange.
Can the fair value (within reasonable limits) of both received and surrendered assets not be determined? If neither token has a known fair value, no gains or losses are recorded and the cost of tokens received equals to cost of tokens surrendered. Otherwise, if at least one token has a known fair value, we should account for gain and associated costs under the respective accounting guidance.
4. Revenue vs. Other income
Does the token being sold represent an output of the reporting entity’s ordinary** business activities? If yes, apply the guidance of ASC 606, Revenue from Contracts with Customers. ASC 606 applies to the measurement of both income and assets received when assets surrendered are the output of ordinary business activities of the reporting entity and ASC 610 applies when assets surrendered are non-financial or in substance non-financial assets that are not the output of ordinary business activities of the reporting entity. Under both standards, income from disposition is recognized in the amount equal to the fair value of assets received if this value is known [ASC 606-10-32-21]. If the fair value of tokens received is unknown (e.g. when tokens are acquired prior to the token generation event and with no valuation report available), then the assets acquired are measured using the standalone selling price of assets surrendered [ASC 606-10-32-22].
The initial value of digital assets accounted for as intangibles that were acquired in the swap would be equal to the amount of income recognized. But the initial value of cryptoassets within the scope of ASC 350-60 or the initial value of financial assets (e.g. certain stablecoins) should be equal to the fair value of the respective assets consistent with the requirements of ASC 805-50-30. The difference between the income amount recognized and the cost basis of assets acquired results in an unrealized gain/(loss).
The current cost basis of tokens surrendered is calculated using the disposition method selected by the entity as its accounting policy. We then remeasure this cost basis to the fair value of disposed tokens through the Realized Gain/(Loss) and charge the fair value of disposed tokens as costs of swaps in the income statement. At this point, we should also reclassify any previously recorded unrealized gain/(losses) associated with the disposed of tokens to the Realized Gain/(Loss) account.
Does an arrangement meet all criteria for contract existence* but the party does not meet the definition of a customer? If yes, the transfer in the scope of ASC 610-20, Gains and Losses from Derecognition of Nonfinancial Assets and consideration received is measured at its fair value (if known), or at standalone selling value of tokens given (if the fair value of tokens received is not known).
* Existence criteria are defined in ASC 606, Revenue from Contracts with Customers
** Be careful when answering the question about whether tokens are the output of ordinary business activities for tokens received as an allocation from the issuing foundation.
5. Multiple Assets
When multiple assets received including cryptoassets or financial assets, the cost basis of assets received should be the fair value of assets surrendered. The total fair value of the acquired assets is first reduced by the fair value of any financial assets acquired. Any remaining amount is then reduced by the fair value of cryptoassets acquired (as per ASC 350-60 cryptoassets acquired should be initially measured at the fair value). Only after that any remaining amount of the total fair value of acquired assets is allocated between tokens accounted for as intangibles pro rata to individual fair values of tokens acquired. However, the amount of income recorded on this transaction will be the fair value of the tokens received.
6. Asset Acquisitions
When no other guidance applies to the transaction, ASC 805 requires measuring assets acquired in exchange for nonmonetary assets using the fair value of assets surrendered or received whichever is more clearly evident.
When the fair value of assets received is more evident, record all assets received at their respective individual fair values and the difference compared to the cost basis of assets given is recorded as realized gain/(loss).
If the fair value of assets received to be recorded at fair value exceeds the fair value of assets surrendered, the fair value of assets received is usually more evident.
If the fair value of assets surrendered is believed to be more clearly evident and it is less than the net fair value of crypto assets, financial assets, and financial liabilities, no cost should be allocated to any received assets. Rather all assets received are recorded at fair values and a realized gain is recorded for the excess over the cost of assets surrendered.
When the fair value of assets surrendered is more evident and the fair value of assets received and to be recorded at fair value is less than the fair value of assets surrendered, we record financial items and in-scope crypto assets at their fair values. We allocate the remaining fair value of consideration given (if any) between other tokens received at their fair value (if no other tokens are received, we record a realized loss).
II. Practical scenarios
Now let’s discuss various scenarios for applying this guidance in more detail.
Question 1: How should the company account for swaps that have no commercial substance?
Answer: Under FASB ASC 845-10-30-3, the exchanges of non-monetary assets that lack commercial substance are accounted for using the recorded basis of assets transferred. In other words, the transaction should not affect the value of assets recorded on the balance sheet immediately prior to the exchange.
Sample journal entries are presented below:
DEBIT Token A at Cost of Token B
CREDIT Token B at Cost of Token B
The entity that determines that swaps have no commercial substance would account for tokens received at the book value of assets transferred, with no gain/loss recognized.
Question 2: How should a company account for simple swaps when Token A is exchanged for a crypto asset within the scope of ASC 350-60 or for stablecoins accounted for as financial assets (swap fees paid in Token A)?
Answer: The entity should record the tokens received at their fair value and derecognize the book value of assets surrendered with any difference recorded as realized gain/loss.
DEBIT Crypto / Financial assets at Fair Value
CREDIT Surrendered Assets at Cost
CREDIT Gas Token at Cost
DEBIT/CREDIT Realized gain/(loss) on assets surrendered / received
Question: How should the entity account for the swap of stablecoins accounted as financial assets for digital assets accounted for under FASB ASC 350-30, Intangibles other than goodwill?
Answer: The entity that swaps financial assets (e.g. USDC and some other stablecoins) for non-financial assets (digital assets accounted for as other intangibles), should record the non-financial assets at the fair value of financial assets surrendered, because the fair value of these assets is more clearly evident than the fair value of tokens received. As such no gain or loss is recognized.
DEBIT Token A at Fair Value of USDC and Gas Fees
CREDIT USDC at Cost
CREDIT Gas Token at Cost
DEBIT/CREDIT Realized gain/(loss) on assets surrendered
Question: How should the entity account for a swap of two tokens accounted for under FASB ASC 350-30, Intangibles other than goodwill?
Answer: The entity that swaps crypto assets or other intangibles in exchange for other intangibles should, first, determine whether the control over the token surrendered transfers to the other party. In our scenario, the control of the first token is assumed to pass to the recipient.
The next step is to determine whether the modified approach to recognition based on the book value of assets surrendered under ASC 845 applies:
Do neither of assets have a known fair value?
Does the swap lack commercial substance?
Are tokens received and surrendered exchanged with another company in the same line of business to facilitate sales to customers other than the parties to the exchange?
We assume for this scenario that neither of these scenarios applies. We then evaluate whether the token surrendered is a result of the reporting entity’s primary business activities and whether the swap is entered into with a customer. If yes, assets received should be recorded as noncash consideration component of revenue from contracts with customers. Otherwise, we will recognize only the net gain/(loss) from the swap as other income/(expense). Assuming that the fair value of Token A is $6.00 and the cost of Token B is $5.00, we will record $1.00 of net other income.
DEBIT Token A at Fair Value of Token A
CREDIT Other Income (ASC 610)/Revenue (ASC 606)
DEBIT Other Expenses (ASC 610)/COS (ASC 606)
CREDIT Token B at Cost of Token B
Conclusion
Remember that when accounting for swaps, we need to determine answers on the following six questions:
How do we measure an expense recognized in a swap?
How should we measure the expensed value of tokens surrendered in the swap?
How do we account for the difference between the basis of tokens surrendered and expenses recognized (if any)?
How do we measure the income recognized in a swap?
How should we measure the initial value of tokens received in the swap?
How do we account for the difference between income recognized in a swap and the basis of tokens received (if any)?
Answers are surprisingly inconsistent, so the clearly documented accounting policy is critical to ensure the appropriate accounting for swaps.
Due to the number and complexity of accounting considerations, this post is lengthy and heavy for digestion. But now having gone through these complexities, we can move on to more interesting questions around accounting for DeFi activities.
References
“In general, the accounting for nonmonetary transactions should be based on the fair values of the assets (or services) involved, which is the same basis as that used in monetary transactions. Thus, the cost of a nonmonetary asset acquired in exchange for another nonmonetary asset is the fair value of the asset surrendered to obtain it, and a gain or loss shall be recognized on the exchange. The fair value of the asset received shall be used to measure the cost if it is more clearly evident than the fair value of the asset surrendered.”
[845-10-30-1]
“An entity shall measure crypto assets at fair value in the statement of financial position. Gains and losses from the remeasurement of crypto assets shall be included in net income.”
[350-60-35-1]
“An intangible asset that is acquired either individually or with a group of other assets (but not those acquired in a business combination) shall be initially measured based on the guidance included in paragraphs 805-50-15-3 and 805-50-30-1 through 30-4”
[350-30-30-1]
“Paragraph 805-50-25-1 discusses exchange transactions that trigger the initial recognition of assets acquired and liabilities assumed. Assets are recognized based on their cost to the acquiring entity, which generally includes the transaction costs of the asset acquisition, and no gain or loss is recognized unless the fair value of noncash assets given as consideration differs from the assets' carrying amounts on the acquiring entity's books. For transactions involving nonmonetary consideration within the scope of Topic 845, an acquirer must first determine if any of the conditions in paragraph 845-10-30-3 apply. If the consideration given is nonfinancial assets or in substance nonfinancial assets within the scope of Subtopic 610-20 on gains and losses from the derecognition of nonfinancial assets, the assets acquired shall be treated as noncash consideration and any gain or loss shall be recognized in accordance with Subtopic 610-20.”
[805-50-30-1]
“Asset acquisitions in which the consideration given is cash are measured by the amount of cash paid, which generally includes the transaction costs of the asset acquisition. However, if the consideration given is not in the form of cash (that is, in the form of noncash assets, liabilities incurred, or equity interests issued) and no other generally accepted accounting principles (GAAP) apply (for example, Topic 845 on nonmonetary transactions or Subtopic 610-20), measurement is based on either the cost which shall be measured based on the fair value of the consideration given or the fair value of the assets (or net assets) acquired, whichever is more clearly evident and, thus, more reliably measurable. For transactions involving nonmonetary consideration within the scope of Topic 845, an acquirer must first determine if any of the conditions in paragraph 845-10-30-3 apply. If the consideration given is nonfinancial assets or in substance nonfinancial assets within the scope of Subtopic 610-20, the assets acquired shall be treated as noncash consideration and any gain or loss shall be recognized in accordance with Subtopic 610-20.”
[805-50-30-2]
“A nonmonetary exchange shall be measured based on the recorded amount (after reduction, if appropriate, for an indicated impairment of value as discussed in paragraph 360-10-40-4) of the nonmonetary asset(s) relinquished, and not on the fair values of the exchanged assets, if any of the following conditions apply:
a. The fair value of neither the asset(s) received nor the asset(s) relinquished is determinable within reasonable limits.
b. The transaction is an exchange of a product or property held for sale in the ordinary course of business for a product or property to be sold in the same line of business to facilitate sales to customers other than the parties to the exchange.
c. The transaction lacks commercial substance (see the following paragraph).”
[845-10-30-3]