Crypto Assets Fair Market Value

The crypto assets landscape presents unique treatment for financial reporting. Guidance from ASU 2023-08 requires qualifying crypto assets to be measured and disclosed at fair value, making it critical for preparers of financial statements to accurately assess fair value. This article explores the intricacies of fair value measurement specific to crypto assets, including hierarchical levels of valuation and practical considerations in methodology selection. By providing insights into the complexities of fair value measurement within the crypto asset space, this article aims to equip preparers with the knowledge needed to navigate financial reporting for crypto assets.

Fair Value Overview

In adherence to US GAAP ASC 350-60-15-1, crypto assets meeting specified criteria as intangible assets must be reported at fair value, as outlined in ASC 820. Fair value, defined in ASC 820-10-20, represents the price expected to be received for selling an asset or transferring a liability in an orderly transaction among market participants at the measurement date. This measurement process involves utilizing various inputs that provide data and information regarding the crypto asset’s value. These inputs can vary in terms of their observability and reliability. For instance, using a crypto asset’s quoted price in an active market for measurement purposes is considered more reliable than using general market information to derive the crypto asset’s value.

Depending on the observability and reliability of these inputs, fair value measurement of a crypto asset is performed at one of the following levels:

Level 1	inputs are quoted prices in active markets for identical assets or liabilities.
Level 2	involves inputs other than quoted prices that are observable for the asset or liability, either directly or indirectly. These inputs may be quoted prices ofr identical assets/liabitlites in markets that are inactive, quoted prices for similar assets/liabilities, private investments in public companies, or observablew market inputs like yield curves or interest rates.
Level 3	comprises unobservable inputs and relies more on professional judgment.

This article explains how this measurement framework pertains specifically to accounting for crypto assets.

LEVEL 1

Level 1 measurement applies to inputs sourced from quoted prices in active markets for identical assets or liabilities. According to ASC 820-10-20, an active market is characterized by transactions for the asset or liability occurring with sufficient frequency and volume to provide pricing information on an ongoing basis. The exact determination of what constitutes sufficient frequency and volume is left to professional judgment. Examples of active crypto markets meeting this definition include Binance, Coinbase, Kraken, and Uniswap. Therefore, if a crypto asset is actively traded in such a market, it falls under Level 1 measurement.

Which Exchange/Market Should be Used?

Often a level one crypto asset can be found across multiple active markets at varying prices. In such scenarios, companies are required to use inputs from the principal market, which is defined as the market exhibiting the highest volume and activity for the asset or liability. To appropriately determine the principal market for each asset, the following two questions must be answered:

Which of the active markets do you have access to trade in?
Of the markets you have access to, which has the greatest trading volume for the asset?

The accessible market with the greatest trading volume for the specific asset will be the principal market used for fair value measurement. This means that even if your company regularly/exclusively trades the asset on a different exchange, you must still use the market with the highest trading volume for valuation purposes.

If a principal market is unavailable or indeterminable, entities should resort to the most advantageous market - the market where selling the asset would yield the highest amount.

It's crucial to emphasize that a level 1 measurement necessitates inputs from a single market; averaging inputs across multiple markets is not permissible. Therefore, using a volume-weighted average price (VWAP) or other types of aggregated pricing when measuring the fair value of crypto assets traded in active markets is inappropriate. According to the AICPA, this approach would not be consistent with the general principles of ASC 820, which gives the highest priority to quoted prices in active markets and the lowest priority to unobservable inputs.

Additionally, level 1 assets trading in active markets with observable transactions must rely on executed prices rather than selected markets or indexes to determine fair value.

When should the Measurement be Taken in Markets that Never Close?

Many crypto asset exchanges and markets operate 24/7. This uninterrupted trading presents challenges in pinpointing a specific moment for fair value measurement, as prices can fluctuate significantly based on the time of day and trading volume. Best practice recommends selecting a specific day and time for conducting fair value measurements. Once this decision is made, it's essential for firms to adhere to the chosen date and time consistently over the years to ensure comparability in reporting.

How do Restrictions Become a Factor?

The impact of restrictions on sale, transferability, or use on the fair value of a crypto asset hinges on whether the restriction is inherent to the asset or specific to the holder. If the restriction is unique to the holder and doesn't carry over in a hypothetical sale, it will not factor into the fair value measurement. However, if the restriction is inherent to the asset and transfers in a sale, it will be considered when determining the fair value of the crypto asset.

LEVEL 2

Level 2 measurement encompasses observable inputs other than quoted prices. These other inputs may be quoted prices for identical assets/liabilities in inactive markets, quoted prices for similar assets/liabilities, or private investments in public companies. These inputs are often used in conjunction with valuation models that use market corroborated inputs like yield curves or interest rates to determine a crypto asset’s fair value. If this approach is used, the aim of the valuation model should be to determine the exit price of the entity’s position at the measurement date.

For Level 2 measurements, the valuation model used must be widely accepted and the data used as inputs must be observable. Any significant judgment or adjustments to the model or data will likely result in a Level 3 designation. In addition, measurements derived from quotes obtained in brokered markets must signify a genuine commitment to engage in an arm’s length market transaction.

Crypto assets that may fall in the scope of level 2 measurement include the following:

Crypto safeguarding liabilities and corresponding assets: These assets typically refer to situations where an entity holds cryptocurrency on behalf of others. Safeguarding liabilities encompass the obligations an entity undertakes when it holds cryptocurrency, including ensuring security, maintaining accurate records, and facilitating transactions for the rightful owners. Corresponding assets, on the other hand, represent the cryptocurrency holdings themselves, held in custody by the entity for its clients or customers. While there may be quoted prices in active markets for the underlying crypto assets (the corresponding assets), determining the fair value of safeguarding liabilities, which are separate from the underlying crypto assets, may be more complex. This is because there may not be readily available market prices for these liabilities. As a result, fair value measurement for safeguarding liabilities may require the use of Level 2 or Level 3 inputs, depending on the circumstances.
Utility Tokens with Limited Exchange Listings: Utility tokens that serve a specific purpose within a blockchain network but have limited exchange listings or trading volume may lack observable market prices. Valuing these tokens may involve Level 2 inputs, such as referencing prices from less liquid markets where the tokens are traded, or similar tokens with more established market prices. Alternatively, Level 3 inputs, such as discounted cash flow models may be employed.
Tokens with Restricted Trading: Tokens subject to trading restrictions, lock-up periods, or regulatory limitations may not have active markets where prices are readily observable. In such cases, fair value measurement may require Level 2 inputs from restricted markets or Level 3 inputs based on discounted cash flow models or similar valuation techniques.

LEVEL 3

Level 3 digital assets lack a public market and observable inputs. These unobservable inputs may include an entity’s own assumptions about cash flows. These assets often comprise complex financial instruments or digital securities that lack readily available market prices or observable data points. Examples of crypto assets falling into the Level 3 category include Initial Coin Offerings (ICOs), Simple Agreements for Future Tokens (SAFTs), Simple Agreements for Future Equity (SAFEs), and other forms of digitized equity ownership interests may also be classified at Level 3. Due to the limited availability of observable market data, valuing Level 3 digital assets typically requires significant judgment and estimation by entities.

Many funds that invest in the above positions traditionally record the fair value of those investments at their initial transaction cost and make subsequent adjustments when there is a new round of financing.

In a comment letter to Wave Sync Corp., the SEC questions the rationale behind valuing stock that was issued in a November 2021 transaction at a significantly different amount from the cash received in a July 2021 third-party stock sale. The letter points out Wave Sync Corp.’s absence of substantive operations before November 2021 and the lack of observable factors supporting the notable increase in stock value during that period. Specifically, the SEC states, “we note that the Registrant had no substantive operations prior to the November 2021 transaction and that there were no observable factors that could reasonably support your conclusion that the stock value increased from $.50/share to $4/share during that period.” Additionally, the SEC references the commencement of negotiations in April 2021 and emphasizes the need to adhere to ASC 820-10-05-1c, which requires maximizing the use of relevant observable inputs for fair value estimation. They request a revision to fully comply with ASC guidance.

The response from Wave Sync Corp. asserts that since new management took over and the company began generating revenue in 2021, the value of the company and its common stock has increased from less than $1 per share to over $1 per share. In this response, Wave Sync Corp. backed up this assertion with an estimation that management conducted using level 3 inputs.

Level 3 Measurement

Wave Sync Cor. outlined its transition into the digital mining industry and shared that its five-year projection would include total profits of $81.5 million ($16.3 million per year on average). It also shared its earnings per share (EPS) prediction over the five-year period of $2.58 ($0.52 each year). Using this information and the given market price-to-equity ratio (P/E ratio) of 1.6, Wave Sync Corp. calculated its projected share price as $0.83 per share before its stock reverse split. Following the 1-for-5 reverse split, it calculated a share price of $4.14 per share.

Finally, Wave Sync Corp. argued that its stock price of $0.50 may not effectively reflect the company’s value in an inactive market. Wave Sync Corp. defended its valuation, based on Level 3 unobservable inputs derived from market data at the time, as representing the company's worth accurately.

Based on its analysis and negotiation process, Wave Sync Corp. concludes that $4 per share is a reasonable price for the November 2021 purchase transaction, which was agreed upon unanimously by both parties involved.

Wave Sync Corp.'s response justifies the notable rise in the valuation of its stock from $0.50 per share to $4 per share, relying on Level 3 inputs for fair value measurement. Using fair value methodology ensures that financial measurements accurately depict the economic reality of a company, providing stakeholders with reliable information for decision-making. This approach is particularly crucial in volatile markets like cryptocurrencies, where precise valuation is essential for transparency and credibility.

Conclusion

It should be noted that the hierarchy level of a crypto asset might evolve over time. For instance, a crypto asset once valued using Level 3 inputs may later become actively traded in an active market and become eligible for Level 1 measurement. When such changes occur, it's important to adjust the fair value level and methodology accordingly to ensure accurate valuation that reflects current market conditions. Disclosure of the fair value hierarchy level and information on valuation techniques and inputs used is mandatory. This disclosure aids users in comprehending how fair values are determined and allows them to assess the reliability of these measurements across various entities and industries. In essence, transparent disclosure and adaptive valuation practices are essential for maintaining trust and comparability in financial reporting of crypto assets.

This article has examined fair value measurement for crypto assets in financial reporting. Adhering to guidance and maintaining transparency in reporting practices are essential for addressing crypto assets in financial reporting. By analyzing hierarchical valuation levels and practical methodology considerations, stakeholders gain insights to navigate crypto asset fair value measurement.

Resources:

https://lukka.tech/new-sec-valuation-guidance-for-cryptocurrencies/

https://richeymay.com/resource/whitepapers/guide-cryptocurrency-fair-value-best-practices-under-asc-820/

https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/crypto-assets-guide/assets/pwccryptoassetsguide1223.pdf

https://www.request.finance/post/a-comprehensive-guide-to-crypto-asset-accounting

https://www.sec.gov/Archives/edgar/data/860131/000121390022062846/filename1.htm

https://www.aicpa-cima.com/resources/download/accounting-for-and-auditing-of-digital-assets-practice-aid-pdf

https://taxbit.com/blog/fair-market-value-measurements-for-digital-assets/#identifying-an-active-market