Thursday, January 12, 2023
The recent implosion of crypto firm FTX and its affiliates provides a case study for potential crypto exposure under traditional insurance policies in this series of four articles: Silent Crypto for D&O and Corporate Liability Insurance (Part I), Silent Crypto Exposure for Accountants (Part II), Silent Crypto Exposure for Lawyers (Part III), and Crime and Custody Coverage for Crypto Assets (Part IV).
Silent Crypto Exposure for Accountants
Given the collapse of FTX and other crypto firms, it is imperative that accountants and tax professionals familiarize themselves with the existing regulations and official positions the SEC and IRS have taken with respect to cryptocurrency and digital assets. Digital currency continues to be an increasingly popular asset and is changing the norm of traditional accounting practices. The varying treatments of cryptocurrency require accountants of corporate taxpayers in particular to pay closer attention to the best practices of how to treat cryptocurrency and how to calculate capital gains and losses based on that treatment.
FTX’s (Unreliable) Audited Financial Statements
The fourth largest crypto exchange, FTX, has faced a public and sudden decline, creating major implications in the cryptocurrency world. Surprisingly, prior to its collapse, FTX received a clean bill of health from two accounting firms that reportedly conducted comprehensive audits under Generally Accepted Accounting Principles (GAAP). One of these firms markets itself as one of the first-ever CPA firms to operate in the Metaverse.
That aside, in recent FTX bankruptcy filings, the company’s new CEO has cautioned stakeholders not to depend on FTX’s audited financial statements as a reliable indication of the company’s financial condition. The bankruptcy filings further note that FTX did not keep appropriate books and records or security controls with respect to digital assets. Accordingly, the FTX debtors have engaged forensics analysts to identify potential FTX assets on the blockchain. Nonetheless, FTX’s accountants reportedly stand by their audit opinions and have suggested that the events leading up to the company’s demise post-dated the audits. Critics observe that one of the weaknesses in the audits was the fact that they did not address the effectiveness of FTX’s internal financial controls, which might have contributed to its failure.
FTX was one of the few crypto firms that actually conducted GAAP audits, most do not. Unlike publicly traded companies, private companies are not required to publish or audit their financial statements. Some crypto firms try to reassure investors by conducting proof-of-reserve checks, which provide limited information to verify that assets are held in customer accounts.
The Murky World of Proof of Reserves for Crypto Firms
In an effort to alleviate customer and investor fears following the collapse of FTX, other crypto firms and exchanges such as Binance are hiring accounting firms to provide partial audits of cryptocurrencies and digital assets held by these firms. Notably, many of these entities are not publicly traded U.S. companies, and therefore are not legally required to file full audited financial and accounting statements in compliance with GAAP. To take advantage of this, crypto firms such as Binance are increasingly requesting independent accounting firms to provide non-GAAP “proof of reserves” reports, which are intended to verify the value of customer funds and digital assets held in custody.
To be clear, these limited proof-of-reserve reports are a far cry from audited financial statements and routinely fail to address the effectiveness of a company’s financial reporting controls. This is a significant omission when recalling the fact that the Sarbanes-Oxley Act of 2002 (SOX) was enacted by Congress in the wake of high-profile corporate accounting scandals involving companies the likes of Enron, WorldCom, Adelphia and Tyco. In particular, section 404 of SOX requires management and the external auditor to report on the adequacy of the company’s controls over financial reporting. Moreover, section 302 of SOX requires senior officers to personally certify in writing that the company’s financial statements fairly present in all material respects the company’s financial condition and operations. Corporate officers may be subject to harsh criminal penalties and jail time for knowingly providing false and misleading certifications.
Documenting and testing a company’s internal controls for financial reporting can be exceedingly costly and time-consuming. As a result, many companies do not voluntarily undertake this task unless legally required to do so. In the case of Binance, some critics observe that the company’s proof-of-reserve report is meaningless without information about Binance’s internal controls for financial reporting.1
Tax Treatment of Cryptocurrency
Notably, the IRS treats cryptocurrency and other digital assets as property for tax purposes. In particular, the IRS notes that digital assets may include but are not limited to convertible virtual currency and cryptocurrency, stablecoins and non-fungible tokens (NFTs). Transactions involving digital assets have to be reported for tax purposes.
The IRS has indicated that taxable gains or losses may result from the following types of transactions involving digital assets:
Sale of a digital asset for fiat currency
Exchange of a digital asset for property, goods or services
Exchange or trade of one digital asset for another
Receipt of a digital asset as a payment for goods or services
Receipt of a new digital asset as a result of mining or staking activities.2
Many crypto exchanges supply user records to the IRS for its review. These records typically include names, addresses and social security numbers, and now often include biometric identification and various identification card copies. While usually not included in the Know-Your-Customer (KYC) records sent to the IRS, the exchanges typically maintain banking information, phone numbers and various other identification information. Since many exchanges send 1099-B or 1099-K forms, individuals and corporations are likely to be audited if it is determined that the taxpayer has unreported income. As such, obtaining and submitting these forms is imperative to completing taxes.
The following steps include the basics of completing crypto taxes:
Collect all transaction data
Sort all transaction data into one place and determine holdings
Compare cryptocurrency and digital asset holdings and determine if they match the final results from collecting the data
Complete a capital loss/gains analysis
Fill out form 1040 Schedule D. Most large exchanges provide forms that can be downloaded with all of the transaction data that exists on that exchange.
Steps 1 and 2 may need to be repeated after a review of current holdings if the total holdings discovered in the collection of data and the taxpayer’s actual holdings do not match. The IRS requires taxpayers to keep records that are sufficient to establish positions taken on tax returns.
As stated by SEC Chair Gary Gensler, cryptocurrency is a security governed by U.S. securities laws. Considering the seismic impact of recent major crypto events, such as FTX’s bankruptcy, the SEC has increased its regulatory oversight of crypto exchanges. While many cryptocurrency owners and users do not actually realize regular currency value until they sell for USD or some other currency, each transaction or payment of digital currency is income. As such, the SEC expects individuals to follow the same regulations, such as reporting receipt of cryptocurrency.
Accountants’ Professional Liability Insurance
Many accountants have errors and omissions coverage in the form of dedicated Accountants Professional Liability Insurance policies, which typically afford coverage for third-party claims, suits or demands made against the accounting firm during a 12-month policy period. Coverage is generally limited to professional services rendered by the insured as an accountant or CPA to clients for a fee. These policies were designed to cover traditional accounting functions. However, given the complexities and uncertainties regarding accounting and tax reporting for cryptocurrencies and digital assets, insurers may be on the hook for unintended exposures related to the nebulous world of crypto finance and accounting.
The Future of Cryptocurrency Accounting
Digital currency is here to stay and the implications for the economy and methods of accounting are significant. The IRS and SEC already have begun fortifying their departments to prepare for the future onslaught of investigations and audits. The SEC has investigated and fined celebrities such as Kim Kardashian for failure to disclose payment in the form of cryptocurrency for an Instagram post.
Earlier this year, the IRS issued a “John Doe” summons requiring M.Y. Safra Bank to produce information on taxpayers who are customers of sFOX, a full-service crypto prime dealer. M.Y. Safra Bank offered banking services in relation to applicable crypto transactions. With more than $12 billion in crypto transactions undertaken since 2015 by sFOX users, the IRS is using this summons to launch a full-scale and vigorous investigation into discovering tax cheats and noncompliance with tax reporting regulations.
Cryptocurrency was meant to be an unregulated currency – unaffected by inflation or market downturns and government oversight. Today, it is becoming clear that government entities will not overlook the high-value return cryptocurrency offers taxpayers, albeit in a high-risk asset. This higher risk creates concerns for the overall economic market and financial health of individuals. The high return makes cryptocurrency an ideal asset to tax and regulate. With this in mind, cryptocurrency users, exchanges and accountants that provide tax advice with respect to taxpayers’ cryptocurrency holdings need to pay attention to the changing landscape of regulations in the digital currency world.
1 Wall Street Journal, “Binance Seeks to Calm, but Finances Still Unclear” (December 12, 2022).
2 IRS – Digital Assets at https://www.irs.gov/businesses/small-businesses-self-employed/digital-assets#.