Insights from the Balanc3 Beta
Get up to speed on industry standards and best practices for transparency in accounting for digital assets and tokens.
The Balanc3 accounting software for digital assets has been in beta for several months. During that time, we have on-boarded and guided 30+ Token Companies onto the platform. On-boarding these Token Companies consisted of assisting in the training and accounting guidance needed to successfully create accounting books and records on the interactive Balanc3 platform.
We have also conducted informational deep dives with 50+ Token Companies to understand their current accounting processes and challenges. Additionally, we collected feedback from accounting firms that support the blockchain industry as they work to adopt best practices.
During these months of research and on-boarding, we have noticed general trends and best practices being adopted by the emerging Digital Asset Accounting industry, and how the Balanc3 platform can be utilized to achieve transparency and accountability in the token economy.
General Accounting and Custodianship Trends
From an accounting perspective, Token Companies are tackling how best to structure their wallets, determine their capital gains and losses, and label their chart of accounts and their use in classifying transfers.
Wallet Structuring
Typically, Token Companies align with accounting firms’ standard processes by organizing separate wallets into either token sale, cold storage, or hot wallets.
A designated token sale smart contract will accept funds from the participants and transfer them to a cold storage wallet. Usually, the cold storage wallet is a multisig wallet that contains the bulk of the raised funds and requires multiple signatures to move funds. To increase liquidity, the company sends funds from the cold storage wallet to a hot wallet in order to cover company expenses, including payroll, legal, and marketing.
In some cases, multiple hot wallets are used to separate and categorize payments based on the expense, i.e. a hot wallet solely for payroll expenses. Exceptions to this process include scrambling transfers from the token sale contract to increase the difficulty of discovering the cold storage wallet as well as keeping large amounts of funds on centralized exchanges such as Kraken, GDAX, and Poloniex.
Capital Gains and Losses
Many Token Companies are registered in countries that treat cryptocurrencies as assets or property, including the US, UK, Canada, Israel, Singapore, and Australia. These countries levy taxes depending on a variety of factors, including holding periods. Those Token Companies registered in these areas must take into consideration how to track their “inventory” and the resulting capital gains or losses, which could be spread across multiple cryptoassets, blockchains, and wallets. There are numerous inventory methods to calculate gains or losses on the disposition of cryptocurrencies; the most common one has been coined “FIFO by Address.” This is a similar concept as FIFO, or First-In-First-Out, in which the most recently sold cryptocurrencies use the historical price of the oldest incoming cryptocurrencies.
Two primary qualities differ FIFO from FIFO by Address. First, FIFO by Address does not coincide with a realized event when cryptocurrencies are transferred between addresses that are owned/controlled by the company. Second, with FIFO by Address, it is a choice out of which wallet to record the sale. These two qualities allow Token Companies to track the cost basis only as far back is it goes within their internal wallets and choose from which wallet to sell. As an example, a Token Company that has theoretically created thousands of wallets, each with its own unique purpose, could strategically pick the wallets with the highest cost basis when they choose to sell.
Chart of Accounts Created and Used
Crypto-assets and crypto wallets have given rise to a new taxonomy of transactions and their purposes. As a result, new names for the Chart of Accounts have emerged as Token Companies respond to accounting challenges. The most commonly used Chart of Accounts on the Ethereum network is “Gas Fee Expenses” to refer to associated fees on the blockchain. Consensus does not exist around how to approach token sales. However, Token Companies have classified funds raised through ICOs as “Sales Revenue,” “Deferred Revenue,” or “ICO Revenue,”as a sub-account of “Revenue.”
Sales Revenue accounts create income taxes against immediately-recognized funds raised upon receipt. Deferred revenue, on the other hand, can defer the recognition of taxable income for about a year while expenses accrue to offset taxable income. The classification of funds raised through ICOs have been determined on a case-by-case basis, often on accounting advice from professionals. Other Charts of Accounts commonly used in digital asset accounting classify newly-created wallets undergoing testing, which are classified to the receiving wallet as “Test Revenue” and from the sending wallet as “Testing Expense.”
The Financial Processes
The financial process currently required by Token Companies to manage their assets can be demonstrated in three steps — each of which is error-prone, untrustworthy, and manipulatable.
- The first step in an accounting process is to obtain records of all blockchain transactions for every address for every token. For tokens on Ethereum, this requires downloading all transactions one by one for each address and token from a block-explorer such as Etherscan.io. Block explorers are slow and laborious. They require the user to repeatedly return to the platform to download transactions by time period until all records are obtained. The same process must occur if the Token Company holds any other coins on blockchains, including Bitcoin or Bitcoin Cash.
- The second step of the current financial process requires manually organizing all the exported transaction data into an Excel spreadsheet for further accounting and analysis. The information needed to be recorded is extensive, including: to/from addresses, wallet ID, asset amount, asset type, historical exchange price, txn hash, realized gain/loss, unrealized gain/loss, movement across internally-owned wallets, and the classifications or chart of accounts. Each of these data columns in Excel requires continuous maintenance; historical exchange prices must be fetched and maintained and the classification of transactions must be manually monitored, as no chart of accounts standardization exists.
- Lastly, only once the data is pulled and organized, including historical prices of incoming and outgoing transfers across all addresses and split by asset, then an inventory method is chosen to calculate realized and unrealized gains can be determined. This final point is necessary for Token Companies to track tax liability and understand potential future tax liabilities from moving assets.
All in all, there are multiple pain points throughout the financial process that are time consuming, error-prone, repetitious, manipulable. The current processes are neither scalable nor maintainable for continuous business operations.
The current challenges faced by Token Companies with respect to general accounting and financial processes create an opportunity for a platform that eases the strain on companies seeking to manage their crypto-assets. We’ve spent months uncovering and understanding these challenges, and have built the solutions to these problems directly in the Balanc3 application.
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