When auditors find digital assets in a company’s financial statements, how should they audit them? As cash? Financial instruments? Or something else entirely?
The digital asset boom, bust and uncertain aftermath is widely documented. As digital currencies such as Bitcoin and Ether soared in value, investors took notice, eager to realize the rewards of this revolutionary new asset class that appeared to usher in a major leap forward in the digital age.
The boom soon led to bust. Now a new generation of digital assets are emerging, promising greater stability, and these are being increasingly adopted by companies. Stablecoin assets, for instance, are often backed by traditional hard currencies, or a blend of currencies and assets. This potentially stabilizes the value of the assets, which would link via the blockchain to other, measurable asset values, and also creates a huge increase in the number of possible uses.
The question for auditors, is how to audit these assets as they become more prevalent in financial statements.
To start, it is important to understand management’s responsibilities: how they should classify and account for digital assets within their financial statements. Once that is established, we can see more clearly how the auditor should undertake providing assurance on their fair presentation.
Digital assets have diverse terms and conditions and may be held for different purposes even within the same organization. Therefore, there are four possible selections for their accounting treatment:
- Cash – it may be tempting to group these assets with cash, as they serve as a form of digital currency. But for this approach to be valid, the digital asset would need to be considered as a generally accepted medium of exchange, supported by government and recognized as legal tender.
- Financial assets – again, this approach may be valid if the digital asset entitles holders to cash or another financial instrument, the right to trade in financial instruments under favourable terms, or electronic share certificates that entitle holders to the net assets.
- Derivatives – this might be considered if the contract can be settled net, or can be readily convertible to cash. However, there would be more specific criteria that would need to be adhered to.
- Intangibles – since digital assets are not tangible (they have no physical substance), they might widely meet the definition of an intangible asset, unless their nature is more suited to be in scope for another accounting standard. For example, if they are being held for sale in the ordinary course of business, they would be treated as inventory.
Very generally speaking, then, the organization should follow intangible asset accounting, subject to impairment or a revaluation model, which continuously compares the value of the digital asset against the market.
The auditor’s responsibilities
These four very different accounting approaches may pose a challenge for auditors, so efforts are under way to establish consistency across global auditing practices. Accountancy bodies (such as the American Institute of Certified Public Accountants, the Public Company Accounting Oversight Board and the Center for Audit Quality) have launched working groups focused specifically on handling emerging technologies, including digital assets. While there are still obstacles to overcome before procedures and approaches are fully aligned, these are promising steps forward and, over time, we can hope to see gradual convergence.
The auditor’s first responsibility is to evaluate the actual blockchain protocol that is used. At EY, for instance, the blockchain assurance team works to understand the nature of the digital assets and their underlying protocols, since this is critical to the auditor in assessing evidence from the blockchain.
To add further complexity, the definition and assessment of risks can vary depending on the specific cryptocurrency in question, or the way in which they transact. This means there can be a wide range of influences on the risk spectrum.
For instance, more mature digital assets tend to have a better blockchain architecture and higher numbers of interested parties (e.g., holders, developers, miners), which reduces the likelihood of material misstatement. Similarly, digital assets that are pegged to other economic claims (e.g., gold-backed cryptocurrency or the stablecoin propositions mentioned earlier) might present different risks than those without such intrinsic value such as utility tokens and native cryptocurrencies. Asset-backed tokens may even present additional complexity, since their smart contract functionality would have to be considered as well. The position of any particular cryptocurrency on the risk spectrum depends on a number of factors. Is the blockchain widely used? Is it open source? How many developers use it?
Auditors also must consider whether transactions are manually initiated or executed automatically via a smart contract. If automatic, there may be higher risks of unauthorized or incorrect transactions occurring, as smart contracts introduce additional risks from software flaws, hacking and reliance on potentially inaccurate information provided to the blockchain by third-party data feed services (known as oracles).
These challenges are further complicated by the fact that it is more difficult for the auditor to verify the existence of digital assets than it is for traditional assets. While custody solutions for digital assets are increasingly being developed, in some cases auditors are still forced to adopt a more direct approach, such as confirming the address of the wallet where the assets are held.
EY teams remain at the forefront of developing solutions to audit digital assets. One innovative tool is the EY Blockchain Analyzer, built to aid audit teams in gathering automated audit evidence over the completeness and accuracy, existence, and rights and obligations of digital assets. This audit tool also assists in understanding the business through analytical reviews, as well as addressing the risks associated with “Information Produced by Entity” (IPE). And to keep pace with the market evolution, the next generation of EY blockchain solutions will include capabilities for the valuation of digital assets, as well as for testing smart contracts. With stablecoin propositions, for instance, the ability to provide regular valuations of the underlying assets against the trading values of the tokens offers a vast array of new potential uses.
Regulators and standard setters
Most governments recognize that introducing regulations to help monitor digital assets will offer greater protection to investors and businesses, but consistent regulation across jurisdictions does not yet exist. Two examples illustrate how polarised approaches can be: Luxembourg has gone to lengths to encourage the use of digital assets by introducing the first nationally-licensed bitcoin exchange; and China, on the other hand, has banned mainland residents from trading digital assets on exchanges and has made it illegal for companies to engage in Initial Coin Offerings (ICOs) to raise cash. In India and inter-ministerial committee is proposing to criminalize dealing in private cryptocurrencies.
Similarly, whilst the International Accounting Standards Board has not put digital assets on its standard-setting agenda at this stage, it is, along with other standard setters, continuing to monitor the development of digital assets and their significance for the International Financial Reporting Standards.
This much is certain
Ultimately, the fundamental considerations to audit digital assets remain the same: auditors are responsible for gathering evidence relevant to management’s assertions regarding the fair presentation of the financial statements.
However, the way digital assets are audited is dramatically different, due to the complex nature of the environment.
As auditors, we must apply our expertise and work with all stakeholders to develop a comprehensive approach to accepting, designing and executing audits of digital assets.
We play an essential role in maintaining confidence and trust in the capital markets. New digital assets and their pace of change mean we must actively engage in helping new develop methodologies and tools, as we continue to apply the best analytical thinking and enhance effective and systematic examination.