Lightning Strikes
Emerging Accounting Challenges Presented by the Bitcoin Lightning Network
The Bitcoin network, now a decade in existence, is ever-evolving. The most recent evolution of the protocol will create significant impacts for ecosystem participants. Exchanges, wallets, custodians, merchants and end users (let’s call them tax payers?) that embrace the Lightning network will also have to navigate changes in accounting, audit, security, tax, legal and compliance domains.
The Bitcoin network’s on-chain transaction capacity is approximately 7 transactions per second. The average throughput of the Visa payment network is greater than 1,500 transactions per second. This represents a staggering 200x gap.
The blockchain paradigm has been that speed and security are inversely related. As speed and volume of throughput increase, necessarily security must decrease. The Bitcoin community’s move to Segregated Witness (BIP 144) was a move to remove unnecessary data that cluttered as much as 65% of Bitcoin’s 1MB transaction blocks. Thus, more transactions per block, more throughput, but security preserved. However, without increasing block size, throughput remains limited.
Thus, members of the Bitcoin community have sought to upend the paradigm and decouple throughput from security. Many in the Bitcoin community believe this is the answer which will enable Bitcoin to achieve worldwide adoption as a global peer-to-peer payment network and overcome the s so-called scalability problem. Ideally, this solution would also adhere to the community’s ethos of decentralization and self-sovereignty.
Since the early days of Bitcoin, brilliant minds have pondered a solution. In early 2016, a promising proposed solution that would enable Bitcoin to rival the throughput of Visa, Mastercard, and other payment processors was revealed, The Bitcoin Lightning Network.
What is the Lightning Network
The Bitcoin Lightning network proposes a solution to Bitcoin’s networking capacity problems. Rather than trying to increase the throughout of the blockchain itself, The Lightning Network proposes a system of second-layer payment channels, with payments between parties only settled on the base-layer (the blockchain) when opening and closing a channel. The transactions in-between the opening of the channel and the closing settlement transaction act as “netted” IOUs between parties until one (or both) parties wishes to close the channel. The Lightning “network” itself refers to how parties communicate using a specific set of rules (protocol). As long as users follow the rules of the network, the Lightning Network should act as intended, enabling instant and secure transferability of Bitcoin with very low (if any fees).
New Solutions, New Challenges
While the Bitcoin Lightning Network seems to be proving valuable solution (a 3x YoY increase in total number of channels), new challenges have emerged with the implementation of this new technology. Just when Accountants, Auditors, and Tax Professionals (albeit not all of them) seemed to have obtained an understanding of the base layers of the Bitcoin network, the implementation of the Lightning Network spawns a new batch of accounting, audit, and tax issues.
Below are some initial thoughts on the audit, tax, and accounting issues. We are looking forward to writing more, and updating the community with our work in the field as our exchange, wallet, custody, fund and trading clients see material transactions on Lightning.
1) Audit Implications
Auditors used to look to at the appropriate blockchain (typically using an explorer) to prove the existence of a Bitcoin transaction. However, that changes on the Lightning Network. Since all transactions besides the opening and closing transaction occur “off-chain,” auditors will need to understand and employ new strategies to confirm balances represented by a client within a payment channel.
The challenge compounds for auditors. The “IOU” swapped within a Lightning Channel is only known by those channel participants. When transactions occur within a channel, the IOU is updated for the new balances owned by each participant. This is known as the new channel “state.” However, the auditor may have challenges confirming the client is not representing a previous state, perhaps where they owned more Bitcoin.
2) Tax Implications
While many tax issues still remain due to the lack of guidance presented by the IRS, the Lightning Network will create more unresolved challenges. In particular, when does a transaction actually occur? Does the updating of an “IOU” between parties within a payment channel constitute a taxable event? Or would the “taxable event” wait until the channel closes and the transfer of funds is represented on-chain? These are difficult questions, especially when you consider a payment channel can be opened with any amount of Bitcoin, and for a prolonged amount of time (theoretically forever).
Going out on a limb, if the IRS follows the AICPA’s recommendation of implementing a de minimus amount for transactions (whereby user’s wouldn’t have to worry about the tax implications for small purchases), the Lightning Network would enable feeless, instant, and repeatable transfers of funds right under the de minimus amount to avoid the tax liability. This could be advantageous for Bitcoin, but could also be taken advantage of, prompting a secondary response from the IRS.
3) Accounting Implications
When users enter into a payment channel with another party, on a technical level, the funds enter a 2-of-2 multi-signature wallet. Each channel participant owns ½ of the keys used to govern the channel. On an operational level, the Lightning Network ensures transactions within the channel are adhered (using Hash-Time Locked Contracts, Breach Remedy Contracts, & Revocable Sequence Maturity Contracts). However, how should these be accounted for a Company’s books? Should the funds in a Payment Channel be treated like Escrowed Funds in a “Restricted Cash” account? Should the Bitcoin asset in a payment channel be complimented with a liability because the funds could be seen as “encumbered” by the 2-of-2 multi-sig? These questions remain and are bound to exacerbate in the coming years.
Solutions through Technology
As the complexities with cryptocurrency transactions amplify in the coming years, accounting professional and companies alike will have to place a heavier reliance and automated technologies. Crypto-Accounting Technology platforms could be expanded to exclude payments under the potential de minimus amount for tax purposes and track this exclusion automatically. Additionally, accounting firms and/or crypto accounting software may the ideal players to act as a “Watchtowers” within the Lightning Network. Traditionally, these Watchtowers have been employed to ensure payment channel rules are adhered to, but this function could be expanded to providing the current state to accountants and auditors alike.
Solutions through Creativity
As Watchtowers are still a new development, when confirming the current balances of channel participants, an auditor could confirm the most recent “state” with the counterparty, much like a traditional bank confirmation. From a tax-perspective, a tax professional may think about recognizing the tax effects when the encumbrance is removed, or in essence, the channel is closed and confirmed “on-chain.” If one treats the funds within the channel as encumbered, for financial reporting purposes, the accountant may think about booking a liability to represent locked or funds or treat the funds as restricted cash. While these solutions are not bullet-proof, they offer a starting point for accounting professionals to further refine and think about these new challenges. Needless to say, the future of crypto-accounting is unique and full of opportunities.
