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Accounting For Digital Assets

Accounting For Digital Assets IntroductionRecent years have seen a significant growth in the number and type of digital assets.1 This is in line with ongoing structural transformations in technology and reflects the preferences of investors and consumers. While standard setters continue to debate the best way forward, different forms of crypto‐asset classes, such as non‐fungible tokens (NFTs), continue to emerge. In November 2021, the global market value of digital assets was estimated at around US$3 trillion.2 The Bank of America estimated that 14% (21.2 million) of US adults owned digital assets in 2021, with an additional 13% (19.3 million) planning to buy that same year. The shift has also been noted by corporate America, with companies not taking the risk of ignoring digital assets and applications (Moore 2021).These figures highlight that crypto‐assets are no longer viewed as solely a hotbed for criminal activity, as alluded to in comments by the secretary of the US Department of Treasury, Janet Yellen, due to their fluctuating value and use on the dark web. Looking ahead, we are likely to see crypto‐assets define themselves as an integral medium of exchange or a store of value in the financial system. Already, some companies are accepting payment in digital currencies, such as Wikipedia, Microsoft and AT&T with Bitcoin, and Tesla with Dogecoin. For this reason, it is important that there are clearly agreed upon accounting and reporting requirements, and that auditors carefully consider how to audit these assets.Prior literature has documented the diversity in practice in the application of the current accounting standards on the holding of cryptocurrencies (Sixt and Himmer 2019) and the perceptions of stakeholders on the best way to account for crypto‐assets (Chou et al. 2022). The objective of this paper is to describe the current accounting treatment of crypto‐assets in practice, to analyse potential accounting treatments under various accounting standards, and provide policy advice as to the most appropriate accounting treatment for these types of assets. Where Chou et al. (2022) provide recommendations, they do so based mainly on the perceptions of stakeholders. Instead, our approach is to analyse current accounting standards to assess the most appropriate treatment and consider how amendments may be required to best account for the purpose and nature of crypto‐assets.While the technology behind blockchain is complex, it is important to note that blockchain is a technology and not a type of asset. However, the newness, uncertainty in usage and lack of clear tangible benefit and value can lead to complexity in accounting. Coupled with this, it is not the nature of the token, but the purpose of use that makes the accounting issues more complicated. This poses a substantial hurdle for regulators to adequately update existing accounting standards or to draft a new stand‐alone standard, as the developments in the digital assets industry is unpredictable. The results of our analysis largely support two positions. First, develop a new standard that is able to address the nuances in the nature of the different types of digital assets. Second, in the absence of a new standard, amend existing standards, particularly on financial assets as the nature and purpose of holding digital assets appear to be more consistent with these, particularly in terms of derivatives.Definition and CategoriesA digital asset is anything that is stored digitally and is uniquely identifiable that organisations can use to realise value. More formally, the European Financial Reporting Advisory Group (EFRAG) defined a crypto‐asset as ‘a digital representation of value or contractual rights created, transferred and stored on some type of distributed ledger technology (DLT) network (e.g. blockchain) and authenticated through cryptography’ (IFRS 2019).3 Similarly, EFRAG defines a crypto‐liability as being an ‘obligation that arises from the issuance of crypto‐assets resulting in a present obligation for the issuing entity to transfer or grant access to an economic resource in the digital or non‐digital form’ (IFRS 2019).While cryptocurrencies represent a significant portion of the overall crypto‐assets by market capitalisation, there are many other types. Despite not being formally differentiated, there are two categories of digital assets. ‘Coins’ are assets issued directly by the blockchain protocol on which it runs, while ‘tokens’ are built upon existing blockchains.When cryptocurrencies were first introduced it may have been accurate to use the term ‘digital currencies’ synonymously with ‘digital assets’. However, this is no longer valid because the coins and tokens have grown exponentially since then, each having unique characteristics and purposes. Hence, coins and tokens can be classified based on their intended purpose and how they derive their inherent value, as summarised in Table 1.1TableTypes and features of digital assetsType of digital assetPurpose and characteristicsBasis for valuingExamplesCryptocurrencies/digital currenciesDigital/virtual currencies that exist and are traded using DLT. Poses an alternative to fiat currency, except not being issued by a central governing authority.Entities hold them as investments and mediums of exchangeValue is derived from the market forces of supply and demandBitcoinEthereumUtility tokensTokens that are based on DLT and provide the holder with a right to attain some underlying utility in the future. While the ownership of these tokens is legitimised using blockchain, the goods/services that are accessed using these tokens are also usually based on DLTRight to access the issuer's service/product. Hence, its value is derived from the demand for the particular good/service to which the token grants rightsFunfairBasic attention tokenSecurity tokensTokens based on DLT with characteristics similar to traditional securities and financial instruments. It usually provides holders with an economic interest in assets, typically a company. Common security tokens can also vest holders with the right to: (i) receive cash, dividends, or another financial asset; (ii) the ability to vote; and (iii) a residual interest in an entityEconomic stake in the entity with rights to certain financial assets. Like traditional shares debt has contractual value and its value is dependent on the success of the issuing entitySia fundsBcapAsset‐backed tokensIn essence, digital, liquid contracts for ownership of some asset, such as a house, commodities, artwork, or equity in a company. Holders are provided with an interest in an underlying asset. Instead of trading on the underlying asset itself, the token is exchanged. Here, DLT functions to guarantee ownership of tokens, which represents part ownership of an assetThe value derives from the supply and demand for the underlying asset. It should be noted that while the token guarantees the holder's ownership of the asset, the asset's existence cannot be assuredDIAMERC‐20 tokensNon‐fungible tokens (NFTs)Tokens that are unique digital identifiers that use DLT to legitimise ownership of a specific item that can either be tangible or non‐tangible. The difference between NFTs and other asset‐backed tokens is that the underlying asset is not fungible, that is, it cannot be replaced with another identical itemNFTs are valuable because it guarantees authenticity of the underlying asset because it cannot be exchanged with another oneTwitter founder Jack Dorsey's first tweet NFTBeepleStable coinsIts transfer and ownership is based on DLT, with the distinguishing characteristic that its price is pegged. There are three main types of stable coins:Fiat‐collateralised: coin is backed by a fiat currency.Crypto‐collateralised: crypto‐currency is backed by another cypto‐currency.Non‐collateralised: not collateralised to another asset but relies on a smart contract to buy/sell the stable coin in order to manipulate the supply and keep its price constant.Stable coins aim to remedy the volatility that is a significant limitation of other cryptocurrencies being used as a medium of exchange. By pegging it to an asset and attempting to keep its price stable, merchants can denominate its prices in stable coinsDepending on the type of stable coin, it can be backed by the issuer holding a certain amount of the collateralised asset. The issuers curtail price movements and maintain the coin's peg by trading the token and collateralised assetTetherUSD CoinCurrent Accounting TreatmentAs there is no specific accounting standard addressing digital assets, there are diverse accounting treatments in practice. To collect data for this study on how public entities treat and disclose their holdings of digital assets, two methods were used. For US entities, we used directEDGAR to search Form 10‐K, 10‐Q and 8‐K over the period 2016 to 2021. Search terms ‘(digital asset* or cryptoasset* or crypto asset* or crypotgraphic asset*) w/15 (account* or record*)’ returned 121 results. From reading the search results, only 18 entities were identified as disclosing meaningful information in the notes regarding how the company treated its digital asset holdings. The majority of the remaining documents merely quoted digital assets because they were a material risk factor that ought to be disclosed, or the company's business operations involved traditional digital assets that do not concern blockchain, such as videos, photographs and music.Wallabit Media4 was used to identify entities from jurisdictions other than the US that had material holdings of digital assets. Subsequently, the financial reports of each identified entity were individually examined to extract the relevant information regarding the accounting policy that was adopted for digital assets. From the search for companies reporting digital assets, it is clear that the proportion of firms disclosing their holdings of digital holdings is low. The International Accounting Standards Board (IASB) has interpreted this as meaning that the issue of how to account for digital assets is not currently significant. However, there have been calls from practice for guidance to be provided as this is a rapidly evolving state and there is expected to be growth in the holdings of digital assets in the future. It is therefore important to consider the appropriate accounting treatment for these items, especially given limitations in the IASB's lengthy regulatory process when faced with emerging accounting issues and rapidly evolving technology (Prochazka 2018; Ramassa and Leoni 2022).In June 2019, the International Financial Reporting Standards (IFRS) Interpretation Committee (IC) issued an agenda decision clarifying the appropriate IFRS‐based accounting treatment for cryptocurrencies. They concluded that cryptocurrencies should be accounted for under IAS 38 – Intangible Assets – unless they are also held for sale in the ordinary course of business, in which case IAS 2 – Inventories – would apply (IFRS 2019). A 2016 staff paper from the Australian Accounting Standards Board (AASB) reached the same opinion (Chou et al. 2022). The characteristics of the cryptocurrencies they examined, however, were quite narrow and it is unclear whether this focus is currently appropriate.This guidance appears to have been followed in a number of jurisdictions, summarised in Table 2. Firms listed in Canada, Germany, Japan and Hong Kong classified digital assets as intangible assets; and firms in Canada and the UK classified them as inventory. The only country reporting digital assets that does not follow this guidance is Australia, with the one listed firm disaggregating their holdings across intangible assets, financial assets and inventory.2TableClassification of accounting treatment of digital assetsClassificationCountryIntangible assetsFinancial assetsInventoryTotalUS153018Australia0.330.330.331Canada1023Germany1001UK0011Japan1001Hong Kong1001Total19.333.333.3326Despite crypto‐currencies falling within the scope of the definition of an intangible asset and inventory under current standards, its substance may not fit the standards (Chou et al. 2022). The main argument against applying IAS 38 is that the standard expects production of cash flows, but does not address intangible assets being held for speculative or investment purposes, or with cash‐like features used for the payments of goods and services (Ventner 2016). Similarly, while the IAS 2 broker‐trader guidance can apply to crypto‐currencies held for sale in the ordinary course of business, concerns have been raised that the non‐value additive feature does not fit within the principle of IAS 2 (Prochazka 2018).Under US GAAP, holdings of digital assets appear to be most consistent with indefinite‐lived intangible assets in accordance with Accounting Standard Codification 350 (ASC350). The majority of US firms reporting digital assets used this method. This classification, however, has not been universally accepted, with Deloitte US (2021) summarising the sentiment:When companies use digital assets that are accounted as intangibles for business transactions, such as paying vendors, these transactions will require a different accounting treatment, which is more complex. That is a consequence of the intangible asset now being used as a tangible one – i.e. a financial versus nonfinancial asset. The resulting financial reporting oftentimes does not align or make sense. Many have expressed concerns that the financial reporting may be misleading, rather than useful, to investors.An alternate treatment has been recognition as a financial asset, which four US firms apply. In their 2020 10‐K, CleanSpark 2020 stated that ‘by analogy we intend to record digital assets similar to financial instruments under ASC825 – Financial Instruments – because the economic nature of these digital assets is most closely related to a financial instrument such as an investment in a foreign currency’. They subsequently considered guidance issued by the IRS, requirements of the Foreign Account Tax Compliance Act (FATCA), legal precedent and sections of the Inland Revenue Code, but did not clearly justify their decision further. Within Australia, Digital X in their 2020 Annual Report did not provide the basis that explains the recognition of their digital asset portfolio as financial assets.General IssuesThe issues surrounding current practices in accounting for digital assets are largely centred around the qualitative characteristics of understandability and comparability. The newness, uncertainty in usage and lack of clear tangible benefit can lead to complexity in accounting, resulting in the nature of the various types of digital assets being highly sophisticated.Recall that there are many different types of digital assets, with different nature and purpose. Other than a few firms that provided a breakdown of their holdings,5 most entities failed to clearly disclose the constituent parts of their investments in digital assets. As it is expected that investments in digital assets will grow, the lack of adequacy in accounting policies in relation to digital assets is unable to be properly evaluated, impairing users from acquiring a complete understanding of the company.Further, due to the lack of authoritative guidance and accounting standards addressing digital assets, entities are required to exercise significant judgement and rely on concept statements, principle‐based accounting and non‐authoritative information (Vincent and Wilkins 2020). Consequently, great diversity exists across entities. This is particularly an issue when entities are recognising digital assets as financial assets, with none of the entities identified as adequately explaining their position in the notes to the accounts. This lack of consistency, coupled with diverse terms used to describe digital assets,6 inhibits the comparability of financial reports across firms and over time.In recent years, digital assets on the subject of cryptocurrencies were discussed by the IFRS IC. The IC defined cryptocurrencies as exhibiting the following characteristics:A digital or virtual currency recorded on a distributed ledger that uses cryptography for security.Not issued by a jurisdictional authority or party.Does not give rise to a contract between the holder and another party.This guidance, therefore, does not apply to any other type of digital asset. The IFRS IC concluded that cryptocurrencies, depending on their purpose of holding, should be treated as an intangible asset or inventory.Potential Accounting TreatmentsCashAlthough there is no substantive definition of cash provided by IFRS Accounting Standards the IC did consider whether cryptocurrencies could be classified as cash. They concluded cryptocurrencies are not cash by drawing analogies with IAS 32 – Financial Instruments: Presentation. While digital assets have been observed to be used in exchange for goods and services, they are not being ‘used as medium of exchange and as the monetary unit in pricing goods or services to such an extent that it would be the basis on which all transactions are measured and recognised in financial statements’ (IFRS 2019). PWC (2019) further argued cryptocurrencies do not share the common characteristics of what is traditionally considered as cash, such as ‘not being legal tender’ and ‘mostly not backed by any government or state, and currently not capable of setting prices for goods and services directly’. KPMG (2019) noted that cryptocurrencies are a ‘poor store of value because their value is based on demand and supply‘, which has proven to be highly volatile over the past decade. ACCA (2021) also concurred that cryptocurrencies are not cash because they are not readily exchangeable for goods and services and their use as a medium of exchange is not sufficiently widely accepted. These views are consistent with stakeholder responses provided in Chou et al. (2022).The extent to which this argument is still valid has been challenged by recent developments. Notably, on 7 September 2021, El Salvador made Bitcoin an alternate legal tender, and become the first country to adopt Bitcoin as a currency.7 Similarly, other nations are considering developing digital currencies, and there has been an emergence of stable coins backed by fiat currency, such as Tether.A significant accounting issue that arises with treating cryptocurrencies as cash is in terms of how changes in valuation would need to be accounted for. In accordance with IAS21 – The Effects of Changes in Foreign Exchange Rates – transactions would need to be translated from the cryptocurrency to the functional currency. However, under such treatment, timely and reliable valuation can be made difficult given the volatility observed in this market (Luo and Yu 2022).Financial assetsAccording to Paragraph 11 of IAS 32, financial assets are defined as:cash;an equity instrument of another entity;a contractual right to receive cash or another financial asset from another entity;a contractual right to exchange financial assets or financial liabilities with another entity under particular conditions; ora particular contract that will or may be settled in the entity's own equity instruments.In their agenda decision, the IC concluded that cryptocurrencies are not financial assets as they are not cash, as previously discussed, nor are they an equity instrument of another entity, nor do they involve a contract so they do not vest a contractual right of any kind upon the holder. Where this is largely true for cryptocurrencies, this line of argument does not appear to hold true for other types of digital assets.As mentioned earlier, there is little justification provided by those entities identified as classifying their digital asset holdings as financial instruments to assess the assumptions and justifications behind their classification. Therefore, it is difficult to ascertain the factors that some practitioners use to refute the position of the IFRS IC. One potential explanation provided by a standard setter and academic interviewee in Chou et al. (2022) is that cryptocurrencies have a market value, and their fundamental structure renders them as financial instruments in substance.In the case of security tokens, the rights provided to holders in the form of cash, dividends or other financial instruments, with voting rights and a residual interest in the entity, suggest the nature of these items is consistent with the definition of financial instruments. This view is also supported by practitioners (Chou et al. 2022). This highlights the importance of considering and understanding all types of digital assets, not just the narrow definition used by the IFRS IC. Companies also need to be more forthcoming in their disclosures if they do hold these tokens, hence justifying their classifications.Alternatively, the treatment of derivatives under financial instruments may be relevant. Within IAS 39, a derivative is a financial instrument or other contract within the scope of the standard that (i) its value changes in response to some other variable. While the value of many types of digital assets may be derived from an underlying asset, since that asset is not considered a financial instrument the context of derivatives would not be applicable. Further, it is not clear in practice how much digital assets may be used in hedging activities. As Corbet et al. (2018) note, cryptocurrencies are rather isolated from other markets, indicating that financial market conditions are less important influences on cryptocurrencies than the structural conditions related to the design, operation and clearing of cryptocurrencies. The features of cryptocurrencies provide their own idiosyncratic risks that are difficult to hedge against.Similarly, Dong et al. (2023) demonstrate that cryptocurrencies, and Bitcoin in particular, are limited in their ability to be used in a hedging transaction, finding little evidence of shocks in cryptocurrencies being transmitted to stocks, but significant volatility spill overs in reverse. Following US policy responses to the COVID‐19 pandemic, they find a growing presence of institutional investors in the crypto market whose trades are sensitive to monetary policy changes, which is suggestive of these assets being affected by the same macroeconomic conditions as traditional assets. The result of these factors is that the potential of cryptocurrencies to be used in a hedging transaction are limited.InventoryAccording to Paragraph 6 of IAS 2, inventories are:held for sale in the ordinary course of business;in the process of production for such sale; orin the form of materials or supplies to be consumed in the production process or in the rendering of services.Thus, the IFRS IC is of the view that if an entity is holding digital currencies for sale in the ordinary course of business, the digital currency should be recognised as inventories in accordance with IAS 2. The IFRS IC is also of the view that if an entity principally acquires and holds cryptocurrencies for the purpose of selling them in the near future to generate a profit from the fluctuations in prices or traders’ margin, the entity may be considered a ‘commodity broker‐trader’ of cryptocurrencies. As such, the entity should consider the requirements in paragraph 39(b) of IAS 2, which requires commodity broker‐traders to measure inventories at fair value less costs to sell.8According to US GAAP, however, cryptocurrencies may not be considered as inventories because inventory must be tangible, which excludes digital assets as they do not have a physical form.Intangible assetAccording to IFRS, an intangible asset is ‘an identifiable non‐monetary asset without physical substance’ (IAS 38, Paragraph 8). Paragraph 12 then defines an asset as being identifiable if it is ‘separable or arises from contractual or other legal rights’, and an asset is separable if it is ‘capable to being separated or divided from the entity and sold, transferred, licensed, rented or exchanged either individually or together with a related contract, identifiable asset or liability’. Further, an essential feature of a non‐monetary item is ‘the absence of a right to receive (or obligation to deliver) a fixed or determinable number of units of currency’ (IAS 21, Paragraph 16).Hence, the IFRS IC concluded that cryptocurrencies are intangible assets as they are identifiable and non‐monetary items. Additionally, they do not have a physical substance as they exist digitally and meet the definition of an asset. The same conclusions would be reached following US GAAP. Chou et al. (2022) report that stakeholders express caution on classifying digital assets, particularly cryptocurrencies, as intangible assets. They quote a practitioner as stating that cryptocurrencies are treated as an intangible as a residual category, as IAS 38 is the closest after applying definitions in other standards.The treatment of cryptocurrencies as an intangible asset may not fairly present a company's liquidity position (Luo and Yu 2022). Luo and Yu (2022) present the example of Tesla which, consistent with US GAAP, reports its holdings of cryptocurrencies as an indefinite‐life intangible asset, even though the purpose of holding these are as a liquid alternative to cash. Since cryptocurrencies are trading at highly volatile prices, with 40% price swings possible in one day (Luo and Yu 2022), under US GAAP it is inevitable that impairment losses will be required to be reported. Under IFRS, the effect is not as severe if firms elect to use a revaluation model with upwards movements being able to be recognised. However, upwards price movements will be required to be recognised through other comprehensive income, and not in net profit. With cryptocurrencies, the prevalence of the use of the revaluation model would depend on the liquidity of the particular currency involved, since firms are more likely to use fair values when cryptocurrencies are more liquid (Anderson et al. 2022).Non‐cryptocurrenciesThe previous discussion has been centred around cryptocurrencies, as these are the only type of digital assets that the IFRS IC has considered. However, other types of digital assets possess other criteria, which may make the existing guidance moot.Utility tokens typically convey to their holders a right to attain some underlying utility in the future, such as the right to receive a particular good or service, which are often based on distributed ledger technology. Thus, these tokens can be regarded as prepayments for future goods or services. If the underlying asset meets the definition of an intangible asset, IAS38 would apply, otherwise the accounting would be similar to the treatment of other prepaid assets.Security tokens, on the other hand, exhibit similar properties to traditional securities and financial instruments. Although these vary from token to token, they have been observed to vest holders with: (i) an equity interest in an entity; (ii) the right to cash, dividends, or other financial assets; (iii) a residual interest in the company's net assets; and (iv) the right to vote on the entity's decisions. Since a contractual right to cash or some financial asset is usually involved, most security tokens can be accounted for as financial assets.Non‐fungible tokens (NFTs) give holders an interest in some underlying asset. Here, the tokens are a digital representation of the holder's ownership of an asset. The key with NFTs is that the asset is non‐fungible, that is, it cannot be replaced with a similar asset. The classification of these tokens will depend on the nature of the underlying asset. At present, the market for NFTs appears to be limited to private collectors, including art galleries or museums. However, as this area is rapidly developing and companies further develop their digital presence, this may quickly change. Similarly, the complexity in ownership and usage rights with NFTs differs markedly from tangible assets, such as artwork, meaning that there are added complexities in the accounting and valuation of these assets.Finally, stable coins are the last of the main types of digital assets available at present. These coins have their prices pegged using different items as collateral, hence the accounting treatment will vary depending on the specific stable coin. Where the stable coin is fiat‐collateralised (e.g. Tether), a contractual right to cash or financial asset may exist, indicating their classification as financial assets. Some commentators, however, have observed that, in practice, the redemption rights and process of redemption are complicated by complex terms and conditions that may ultimately mean that holders are not actually allowed to redeem their coin for a financial asset.9Potential accounting issuesThree main accounting treatments are potentially available for digital assets: inventory, intangible assets and financial assets. Within inventory, it is only countries following IFRS that would be allowed to make use of this treatment due to the requirement in the US that inventory be tangible.Under IAS 2, digital assets would need to be recorded initially at cost, and then subsequently measured at the lower of cost and net realisable value. Any unrealised movements in fair value are not recognised to the extent it is above cost, while movements below cost are recorded in the Income Statement. Due to the acknowledged volatility in digital assets, increases in fair value above cost not being recognised in income may lead to useful information not being communicated to users of financial statements. This may also lead to greater levels of conservatism for firms investing in digital assets, which have been previously recognised as being problematic for valuation (Govindarajan et al. 2018). If a firm, however, holds cryptocurrencies for the purpose of trading to generate a profit, the commodity broker‐trader exception may apply, which would lead to subsequent valuations being at fair value less costs to sell, with all unrealised movements in fair value being reflected in income.Under IAS 38 entities can apply a revaluation model to accounting for digital assets as there is an active market. The only differences in accounting under the revaluation model is that subsequent measurement will be at fair value less any accumulated impairment losses, and upwards movements will be recorded in other comprehensive income. While reflecting upwards movements in digital asset values in the balance sheet, some commentators have argued this still does not go far enough in that it still does not adequately reflect the value of cryptocurrencies in particular, and digital assets more generally (Dupuis et al. 2021). Such a viewpoint would consider it appropriate for all movements in digital asset values to be tabulated in net profit on the income statement.In the case digital assets are classified as a financial instrument, the accounting treatment will then depend on the particular classification of financial instrument used. Under IFRS 9, financial assets must be classified as amortised cost, FVTPL, FVTOCI for debt and FVTOCI for equity. The classification decision for non‐equity financial assets is dependent on two key criteria: (a) the business model within which the asset is held (the business model test); and (b) the contractual cash flows for the asset (the Solely Payments of Principal and Interest ‘SPPI’ test). Accordingly, the specific accounting treatment would then be determined by how the entity classifies its digital asset holdings within IFRS 9.The three approaches – historical cost, FVOCI and FVPL – have implications for decision‐making purposes. Questions around how changes in value should be accounted for is not a new question (see Dickens and Blackburn 1964; Zeff and Maxwell 1965, as an example of the debate around holding gains on fixed assets). To assess the impact on decision makers, it is important to consider the purpose of general‐purpose financial reporting, which is to provide information useful in making informed economic decisions that result in an efficient allocation of scarce resources. While there are many potential users of financial statements, Dickens and Blackburn (1964) identify accounting information should provide the best possible basis for the stockholder to project its earnings and financial condition, and for evaluation of the performance of management as the two main purposes. In doing so, it is important to facilitate a separation of a measure of the firm's holding activities from a measure of the success of a firm's operating activities (Edwards and Bell 1961).The relevance of these considerations is important as we consider how users of financial statements are able to discern reported net income of different firms that are largely due to operating activities or to reserves of holding gains that have been accumulated over several periods (Zeff and Maxwell 1965). The importance of separating out operating income from other sources of income is shown to be important in improving forecasts of future earnings (Esplin et al. 2014). Applying these arguments, to improve the decision making around firms that hold digital assets, it becomes important to consider the purpose of holding these items. To the extent that the purpose of holding digital assets is a part of the operating activities of a firm, and where fair values are available in a liquid market, it would appear that applying FVPL would lead to a more accurate measure of the operating results of the firm allowing for better decision making. Where firms are largely holding digital assets, particularly cryptocurrencies, as a liquid alternative to cash (Luo and Yu 2022) the treatment of unrealised gains and losses through profit and loss would be consistent with anecdotal evidence for FVPL to be the preferred recognition, especially where there are liquid markets that allow for fair value measurements to be readily available (Anderson et al. 2022).In conclusion, various accounting methods will have varying consequences on the financial statements and, as a result, the comparability of financial information is compromised. If movements in value are below cost, under inventory, intangible asset and financial instrument recognition rules, these downwards movements in value will all be reflected in income. Where the inconsistencies arise, however, is where there are upwards movements in value. Under IFRS, upwards movements in value would not be recognised for inventory or intangible assets applying the cost model; however, they would be recognised in other comprehensive income for intangible assets using the revaluation model and for financial assets available for sale. Finally, these upwards movements would be recognised as income for inventories using the broker‐trader exemption, and for financial instruments at fair value through profit and loss. Further, asset values will be understated for the case of inventory or intangible assets using the cost model where no upwards movements in value are recognised.Policy adviceThe previous discussions provide a summary of the state of accounting for digital assets. Little guidance has been provided, not surprisingly given the relative novelty and recent development in technology to enable the establishment of digital assets, and the small number of companies with disclosed holdings. Early adopters of digital assets have been required to develop accounting policies in line with existing standards, which are arguably unsuited to the specific characteristics of digital assets. Standard setters are then left with three options.The first option is to allow companies the current discretion to set their own accounting policies. Preparers would continue to apply existing GAAP. Essentially, digital assets would largely be accounted for under inventory or intangible assets. From the firms identified as reporting digital assets, US firms in their 10Q and 10K reporting appear to acknowledge the financial risks from holding digital assets. However, overall, disclosures remain limited, with the result that users may not fully understand the exposure firms have with respect to these holdings. As more firms start to hold digital assets, or allow for some payments in cryptocurrencies, the status quo does not appear a sustainable position to hold.The second option available to standard setters is to make amendments to or clarify current standards. Several amendments and clarification guidance would need to be made to make IFRS or US GAAP clear in how preparers need to account for their holdings. Presumably, this would also require improvements in required disclosures. It is not clear, however, whether amending existing standards would ensure that consistency is applied across the reporting space, rather than the various accounting treatments that firms can currently elect to take.The final option would require standard setters to develop a new accounting standard to address digital assets and liabilities, consistent with the policy recommendation made by Luo and Yu (2022). A new stand‐alone standard would need to be developed on the premise that digital assets and liabilities are unique. As previously described, the accounting issues behind digital assets are complex, and it does not follow that existing standards are adequately able to meet the needs of preparers and users. Standard setters have precedent in developing stand‐alone standards for assets with unique characteristics, for example self‐generating and regenerating assets (AAS35).In developing a new standard, standard setters can promote consistency across firms in how they report their digital assets and regulate for stricter disclosure requirements. The usefulness of combining digital assets into inventory or intangible balances is argued to be of limited use. Further, a new standard dedicated to digital assets will enable consistency not only in how firms account for their holdings, but also within the overall philosophy across standards. Of importance is how unrealised holding gains are treated, keeping in mind the rationale for holding these assets. If the underlying purpose is more in line with the nature of financial assets, a new standard will be able to address this. However, as illustrated, not all digital assets share the same characteristics, with a stand‐alone standard being able to address these differences. It is unlikely that amendments to other standards would serve the purpose of the standard setters and would allow firms greater discretion than would be intended.In the absence of any desire to draft a new standard dedicated to digital assets, there are opportunities to amend existing standards to more adequately capture the nature and purpose of holding digital assets. The current treatment of classifying holdings as intangible assets and inventory, however, is not the appropriate direction. As previously described, the nature and purpose of holding digital assets appears to be more consistent with that of a financial instrument. Here, the standard setters have the ability to extend the definition of financial instruments to specifically include crypto‐assets. The trader‐broker exception within IAS 2 could still be applied for the case of firms involved in the mining and selling of cryptocurrencies.ConclusionThe grouping of digital assets into different categories has been based on the common characteristics they share in the absence of any substantive definitions. When determining the appropriate accounting treatment of holdings, entities need to exercise judgement and clearly understand the nuanced features of the specific asset they hold. The potential applications of blockchain are undeniably large, and it is inevitable that there will be new types of digital assets that will be introduced.This poses a substantial hurdle for regulators to adequately update existing accounting standards or draft a new stand‐alone standard as the developments in the digital assets industry are unpredictable. Yet, it also provides standard setters an opportunity from the start to develop a comprehensive and consistent set of rules that proscribes the appropriate treatment consistent with the overall philosophy within the broad array of current standards and concept statements. Regulators need to act swiftly to retain the confidence of investors, creditors and governments to ensure that financial statements prepared by entities continue to present an accurate representation of their financial position and performance.AcknowledgementsOpen access publishing facilitated by University of New South Wales, as part of the Wiley ‐ University of New South Wales agreement via the Council of Australian University Librarians.Notes1Digital assets and crypto‐assets are used interchangeably throughout the paper to refer to a digital representation of value that can be transferred, stored or traded electronically. Technically, crypto‐assets are a subset of digital assets that use cryptography to protect digital data and distributed ledger technology to record transactions.2https://www.globalinvestorgroup.com/articles/3697937/the‐digital‐asset‐market‐in‐2022.3For a summary of the fundamentals of blockchain technologies and their implication for accounting and auditing, refer to Cai (2018), Karajovic et al. (2019), Schmitz and Leoni (2019) and Tan and Low (2019).4https://www.buybitcoinworldwide.com/treasuries/.5See, for example the 2021 10‐K of Enigma MPC Inc.6Terms used include ‘crypto‐assets’, ‘cryptographic assets’, ‘cryptocurrencies’ and ‘digital currencies’.7https://www.investopedia.com/el‐salvador‐accepts‐bitcoin‐as‐legal‐tender‐5200470#:~:text=Key%20Takeaways,abroad%20and%20bolster%20the%20economy.8Paragraph five of IAS 2 defines ‘broker‐traders’ as those who buy or sell commodities for others or on their own account, and while the term ‘commodity’ is not defined, a broker‐trader can determine cryptocurrencies to be a commodity.9https://micky.com.au/irredeemable‐why‐is‐it‐so‐difficult‐to‐sell‐one‐tether‐for‐1/#:~:text=%E2%80%9CExchanges%20that%20trade%20in%20Tether,from%20Tether%20to%20US%20dollars.ReferencesACCA. 2021, ‘Accounting for Cryptocurrencies’, https://www.accaglobal.com/in/en/student/exam‐support‐resources/professional‐exams‐study‐resources/strategic‐business‐reporting/technical‐articles/cryptocurrencies.htmlAnderson, C.M., Fang, V.W., Moon, J. and Shipman, J.E. 2022, ‘Accounting for Cryptocurrencies’, Working Paper, University of Arkansas.Cai, C.W. 2018, ‘Disruption of Financial Intermediation by FinTech: A Review on Crowdfunding and Blockchain’, Accounting & Finance, 58(4): 965–92.Chou, J.H., Agrawal, P. and Birt, J. 2022, ‘Accounting for Crypto‐assets: Stakeholders’ Perceptions’, Studies in Economics and Finance, 39(3): 471–89.CleanSpark. 2020, ‘Form 10‐K’, https://app.quotemedia.com/data/downloadFiling?webmasterId=103727&ref=115504352&type=HTML&symbol=CLSK&companyName=CleanSpark+Inc.&formType=10‐K&formDescription=Annual+report+pursuant+to+Section+13+or+15%28d%29&dateFiled=2020‐12‐17&CK=827876Corbet, S., Meegan, A., Larkin, C., Lucey, B. and Yarovaya, L. 2018, ‘Exploring the Dynamic Relationships Between Cryptocurrencies and Other Financial Assets’, Economics Letters, 165: 28–34.Deloitte, U.S. 2021, Corporates Investing in Crypto, https://www2.deloitte.com/us/en/pages/audit/articles/corporates‐investing‐in‐crypto.htmlDickens, R.L. and Blackburn, J.O. 1964, ‘Holding Gains on Fixed Assets: An Element of Business Income?’, The Accounting Review, 39(2): 312–29.Dong, S., Fang, V.E. and Lin, W. 2023, ‘Tracing Contagion Risk: From Crypto or Stock?’, Working Paper, New York University.Dupuis, D., Gleason, K.C. and Kannan, Y.H. 2021, ‘Bitcoin and Beyond: Crypto Asset Considerations for Auditors’, Working Paper, American University of Sharjah.Edwards, E.O. and Bell, P.W. 1961, The Theory and Measurement of Business Income, University of California Press, Berkeley, CA.Esplin, A., Hewitt, M., Plumlee, M. and Yohn, T.L. 2014, ‘Disaggregating Operating and Financial Activities: Implications for Forecasts of Profitability’, Review of Accounting Studies, 19(1): 328–62.Govindarajan, V., Rajgopal, S. and Srivastava, A. 2018, ‘Why Financial Statements Don't Work for Digital Companies, Harvard Business Review’, 26 February 2018, https://hbr.org/2018/02/why‐financial‐statements‐dont‐work‐for‐digital‐companiesIFRS. 2019, Holdings of Cryptocurrencies. https://www.ifrs.org/content/dam/ifrs/supporting‐implementation/agenda‐decisions/2019/holdings‐of‐cryptocurrencies‐june‐2019.pdfKarajovic, M., Kim, H.M. and Lasjowski, M. 2019, ‘Thinking Outside the Block: Projected Phases of Blockchain Integration in the Accounting Industry’, Australian Accounting Review, 29(2): 319–30.KPMG. 2019, ‘Accounting for Cryptoassets – What's the Impact on Your Financial Statements?’, https://assets.kpmg/content/dam/kpmg/xx/pdf/2019/04/cryptoassets‐accounting‐tax.pdfLuo, M. and Yu, S. 2022, ‘Financial Reporting for Cryptocurrencies’, Review of Accounting Studies, forthcoming.Moore, T. 2021, ‘Digital Assets Sector “Too Big to Ignore”: Bank of America', Australian Financial Review’, 5 October, 2021, https://www.afr.com/companies/financial‐services/digital‐assets‐sector‐too‐big‐to‐ignore‐bank‐of‐america‐20211005‐p58x7wProchazka, D. 2018, ‘Accounting for Bitcoin and Other Cryptocurrencies Under IFRS: A Comparison and Assessment of Competing Models’, The International Journal of Digital Accounting Research, 18: 161–88.PWC. 2019, Cryptographic Assets and Related Transactions: Accounting Considerations Under IFRS, https://www.pwc.com/gx/en/audit‐services/ifrs/publications/ifrs‐16/cryptographic‐assets‐related‐transactions‐accounting‐considerations‐ifrs‐pwc‐in‐depth.pdfRamassa, P. and Leoni, G. 2022, ‘Standard Setting in Times of Technological Change: Accounting for Cryptocurrency Holdings’, Accounting Auditing and Accountability Journal, 35(7): 1598–624.Schmitz, J. and Leoni, G. 2019, ‘Accounting and Auditing at the Time of Blockchain Technology: A Research Agenda’, Australian Accounting Review, 29(2): 331–42.Sixt, E. and Himmer, K. 2019, ‘Accounting and Taxation of Cryptoassets’. Working Paper, SSRN, available at: https://ssrn.com/abstract=3419691Tan, B.S. and Low, K.Y. 2019, ‘Blockchain as the Database Engine in the Accounting System’, Australian Accounting Review, 29(2): 312–8.Ventner, H. 2016, ‘Digital Currency – A Case for Standard Setting Activity’, Australian Accounting Standards Board, available at www.aasb.gov.au/admin/file/content102/c3/AASB_ASAF_DigitalCurrency.pdfVincent, N. and Wilkins, A. 2020, ‘Challenges when Auditing Cryptocurrencies’, Current Issues in Auditing, 14(1): A46–A58.Zeff, S.A. and Maxwell, W.D. 1965, ‘Holding Gains on Fixed Assets – A Demurrer’, The Accounting Review, 40(1): 65–75. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Australian Accounting Review Wiley

Accounting For Digital Assets

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Wiley
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© 2023 CPA Australia Ltd (CPA Australia).
ISSN
1035-6908
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1835-2561
DOI
10.1111/auar.12402
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Abstract

IntroductionRecent years have seen a significant growth in the number and type of digital assets.1 This is in line with ongoing structural transformations in technology and reflects the preferences of investors and consumers. While standard setters continue to debate the best way forward, different forms of crypto‐asset classes, such as non‐fungible tokens (NFTs), continue to emerge. In November 2021, the global market value of digital assets was estimated at around US$3 trillion.2 The Bank of America estimated that 14% (21.2 million) of US adults owned digital assets in 2021, with an additional 13% (19.3 million) planning to buy that same year. The shift has also been noted by corporate America, with companies not taking the risk of ignoring digital assets and applications (Moore 2021).These figures highlight that crypto‐assets are no longer viewed as solely a hotbed for criminal activity, as alluded to in comments by the secretary of the US Department of Treasury, Janet Yellen, due to their fluctuating value and use on the dark web. Looking ahead, we are likely to see crypto‐assets define themselves as an integral medium of exchange or a store of value in the financial system. Already, some companies are accepting payment in digital currencies, such as Wikipedia, Microsoft and AT&T with Bitcoin, and Tesla with Dogecoin. For this reason, it is important that there are clearly agreed upon accounting and reporting requirements, and that auditors carefully consider how to audit these assets.Prior literature has documented the diversity in practice in the application of the current accounting standards on the holding of cryptocurrencies (Sixt and Himmer 2019) and the perceptions of stakeholders on the best way to account for crypto‐assets (Chou et al. 2022). The objective of this paper is to describe the current accounting treatment of crypto‐assets in practice, to analyse potential accounting treatments under various accounting standards, and provide policy advice as to the most appropriate accounting treatment for these types of assets. Where Chou et al. (2022) provide recommendations, they do so based mainly on the perceptions of stakeholders. Instead, our approach is to analyse current accounting standards to assess the most appropriate treatment and consider how amendments may be required to best account for the purpose and nature of crypto‐assets.While the technology behind blockchain is complex, it is important to note that blockchain is a technology and not a type of asset. However, the newness, uncertainty in usage and lack of clear tangible benefit and value can lead to complexity in accounting. Coupled with this, it is not the nature of the token, but the purpose of use that makes the accounting issues more complicated. This poses a substantial hurdle for regulators to adequately update existing accounting standards or to draft a new stand‐alone standard, as the developments in the digital assets industry is unpredictable. The results of our analysis largely support two positions. First, develop a new standard that is able to address the nuances in the nature of the different types of digital assets. Second, in the absence of a new standard, amend existing standards, particularly on financial assets as the nature and purpose of holding digital assets appear to be more consistent with these, particularly in terms of derivatives.Definition and CategoriesA digital asset is anything that is stored digitally and is uniquely identifiable that organisations can use to realise value. More formally, the European Financial Reporting Advisory Group (EFRAG) defined a crypto‐asset as ‘a digital representation of value or contractual rights created, transferred and stored on some type of distributed ledger technology (DLT) network (e.g. blockchain) and authenticated through cryptography’ (IFRS 2019).3 Similarly, EFRAG defines a crypto‐liability as being an ‘obligation that arises from the issuance of crypto‐assets resulting in a present obligation for the issuing entity to transfer or grant access to an economic resource in the digital or non‐digital form’ (IFRS 2019).While cryptocurrencies represent a significant portion of the overall crypto‐assets by market capitalisation, there are many other types. Despite not being formally differentiated, there are two categories of digital assets. ‘Coins’ are assets issued directly by the blockchain protocol on which it runs, while ‘tokens’ are built upon existing blockchains.When cryptocurrencies were first introduced it may have been accurate to use the term ‘digital currencies’ synonymously with ‘digital assets’. However, this is no longer valid because the coins and tokens have grown exponentially since then, each having unique characteristics and purposes. Hence, coins and tokens can be classified based on their intended purpose and how they derive their inherent value, as summarised in Table 1.1TableTypes and features of digital assetsType of digital assetPurpose and characteristicsBasis for valuingExamplesCryptocurrencies/digital currenciesDigital/virtual currencies that exist and are traded using DLT. Poses an alternative to fiat currency, except not being issued by a central governing authority.Entities hold them as investments and mediums of exchangeValue is derived from the market forces of supply and demandBitcoinEthereumUtility tokensTokens that are based on DLT and provide the holder with a right to attain some underlying utility in the future. While the ownership of these tokens is legitimised using blockchain, the goods/services that are accessed using these tokens are also usually based on DLTRight to access the issuer's service/product. Hence, its value is derived from the demand for the particular good/service to which the token grants rightsFunfairBasic attention tokenSecurity tokensTokens based on DLT with characteristics similar to traditional securities and financial instruments. It usually provides holders with an economic interest in assets, typically a company. Common security tokens can also vest holders with the right to: (i) receive cash, dividends, or another financial asset; (ii) the ability to vote; and (iii) a residual interest in an entityEconomic stake in the entity with rights to certain financial assets. Like traditional shares debt has contractual value and its value is dependent on the success of the issuing entitySia fundsBcapAsset‐backed tokensIn essence, digital, liquid contracts for ownership of some asset, such as a house, commodities, artwork, or equity in a company. Holders are provided with an interest in an underlying asset. Instead of trading on the underlying asset itself, the token is exchanged. Here, DLT functions to guarantee ownership of tokens, which represents part ownership of an assetThe value derives from the supply and demand for the underlying asset. It should be noted that while the token guarantees the holder's ownership of the asset, the asset's existence cannot be assuredDIAMERC‐20 tokensNon‐fungible tokens (NFTs)Tokens that are unique digital identifiers that use DLT to legitimise ownership of a specific item that can either be tangible or non‐tangible. The difference between NFTs and other asset‐backed tokens is that the underlying asset is not fungible, that is, it cannot be replaced with another identical itemNFTs are valuable because it guarantees authenticity of the underlying asset because it cannot be exchanged with another oneTwitter founder Jack Dorsey's first tweet NFTBeepleStable coinsIts transfer and ownership is based on DLT, with the distinguishing characteristic that its price is pegged. There are three main types of stable coins:Fiat‐collateralised: coin is backed by a fiat currency.Crypto‐collateralised: crypto‐currency is backed by another cypto‐currency.Non‐collateralised: not collateralised to another asset but relies on a smart contract to buy/sell the stable coin in order to manipulate the supply and keep its price constant.Stable coins aim to remedy the volatility that is a significant limitation of other cryptocurrencies being used as a medium of exchange. By pegging it to an asset and attempting to keep its price stable, merchants can denominate its prices in stable coinsDepending on the type of stable coin, it can be backed by the issuer holding a certain amount of the collateralised asset. The issuers curtail price movements and maintain the coin's peg by trading the token and collateralised assetTetherUSD CoinCurrent Accounting TreatmentAs there is no specific accounting standard addressing digital assets, there are diverse accounting treatments in practice. To collect data for this study on how public entities treat and disclose their holdings of digital assets, two methods were used. For US entities, we used directEDGAR to search Form 10‐K, 10‐Q and 8‐K over the period 2016 to 2021. Search terms ‘(digital asset* or cryptoasset* or crypto asset* or crypotgraphic asset*) w/15 (account* or record*)’ returned 121 results. From reading the search results, only 18 entities were identified as disclosing meaningful information in the notes regarding how the company treated its digital asset holdings. The majority of the remaining documents merely quoted digital assets because they were a material risk factor that ought to be disclosed, or the company's business operations involved traditional digital assets that do not concern blockchain, such as videos, photographs and music.Wallabit Media4 was used to identify entities from jurisdictions other than the US that had material holdings of digital assets. Subsequently, the financial reports of each identified entity were individually examined to extract the relevant information regarding the accounting policy that was adopted for digital assets. From the search for companies reporting digital assets, it is clear that the proportion of firms disclosing their holdings of digital holdings is low. The International Accounting Standards Board (IASB) has interpreted this as meaning that the issue of how to account for digital assets is not currently significant. However, there have been calls from practice for guidance to be provided as this is a rapidly evolving state and there is expected to be growth in the holdings of digital assets in the future. It is therefore important to consider the appropriate accounting treatment for these items, especially given limitations in the IASB's lengthy regulatory process when faced with emerging accounting issues and rapidly evolving technology (Prochazka 2018; Ramassa and Leoni 2022).In June 2019, the International Financial Reporting Standards (IFRS) Interpretation Committee (IC) issued an agenda decision clarifying the appropriate IFRS‐based accounting treatment for cryptocurrencies. They concluded that cryptocurrencies should be accounted for under IAS 38 – Intangible Assets – unless they are also held for sale in the ordinary course of business, in which case IAS 2 – Inventories – would apply (IFRS 2019). A 2016 staff paper from the Australian Accounting Standards Board (AASB) reached the same opinion (Chou et al. 2022). The characteristics of the cryptocurrencies they examined, however, were quite narrow and it is unclear whether this focus is currently appropriate.This guidance appears to have been followed in a number of jurisdictions, summarised in Table 2. Firms listed in Canada, Germany, Japan and Hong Kong classified digital assets as intangible assets; and firms in Canada and the UK classified them as inventory. The only country reporting digital assets that does not follow this guidance is Australia, with the one listed firm disaggregating their holdings across intangible assets, financial assets and inventory.2TableClassification of accounting treatment of digital assetsClassificationCountryIntangible assetsFinancial assetsInventoryTotalUS153018Australia0.330.330.331Canada1023Germany1001UK0011Japan1001Hong Kong1001Total19.333.333.3326Despite crypto‐currencies falling within the scope of the definition of an intangible asset and inventory under current standards, its substance may not fit the standards (Chou et al. 2022). The main argument against applying IAS 38 is that the standard expects production of cash flows, but does not address intangible assets being held for speculative or investment purposes, or with cash‐like features used for the payments of goods and services (Ventner 2016). Similarly, while the IAS 2 broker‐trader guidance can apply to crypto‐currencies held for sale in the ordinary course of business, concerns have been raised that the non‐value additive feature does not fit within the principle of IAS 2 (Prochazka 2018).Under US GAAP, holdings of digital assets appear to be most consistent with indefinite‐lived intangible assets in accordance with Accounting Standard Codification 350 (ASC350). The majority of US firms reporting digital assets used this method. This classification, however, has not been universally accepted, with Deloitte US (2021) summarising the sentiment:When companies use digital assets that are accounted as intangibles for business transactions, such as paying vendors, these transactions will require a different accounting treatment, which is more complex. That is a consequence of the intangible asset now being used as a tangible one – i.e. a financial versus nonfinancial asset. The resulting financial reporting oftentimes does not align or make sense. Many have expressed concerns that the financial reporting may be misleading, rather than useful, to investors.An alternate treatment has been recognition as a financial asset, which four US firms apply. In their 2020 10‐K, CleanSpark 2020 stated that ‘by analogy we intend to record digital assets similar to financial instruments under ASC825 – Financial Instruments – because the economic nature of these digital assets is most closely related to a financial instrument such as an investment in a foreign currency’. They subsequently considered guidance issued by the IRS, requirements of the Foreign Account Tax Compliance Act (FATCA), legal precedent and sections of the Inland Revenue Code, but did not clearly justify their decision further. Within Australia, Digital X in their 2020 Annual Report did not provide the basis that explains the recognition of their digital asset portfolio as financial assets.General IssuesThe issues surrounding current practices in accounting for digital assets are largely centred around the qualitative characteristics of understandability and comparability. The newness, uncertainty in usage and lack of clear tangible benefit can lead to complexity in accounting, resulting in the nature of the various types of digital assets being highly sophisticated.Recall that there are many different types of digital assets, with different nature and purpose. Other than a few firms that provided a breakdown of their holdings,5 most entities failed to clearly disclose the constituent parts of their investments in digital assets. As it is expected that investments in digital assets will grow, the lack of adequacy in accounting policies in relation to digital assets is unable to be properly evaluated, impairing users from acquiring a complete understanding of the company.Further, due to the lack of authoritative guidance and accounting standards addressing digital assets, entities are required to exercise significant judgement and rely on concept statements, principle‐based accounting and non‐authoritative information (Vincent and Wilkins 2020). Consequently, great diversity exists across entities. This is particularly an issue when entities are recognising digital assets as financial assets, with none of the entities identified as adequately explaining their position in the notes to the accounts. This lack of consistency, coupled with diverse terms used to describe digital assets,6 inhibits the comparability of financial reports across firms and over time.In recent years, digital assets on the subject of cryptocurrencies were discussed by the IFRS IC. The IC defined cryptocurrencies as exhibiting the following characteristics:A digital or virtual currency recorded on a distributed ledger that uses cryptography for security.Not issued by a jurisdictional authority or party.Does not give rise to a contract between the holder and another party.This guidance, therefore, does not apply to any other type of digital asset. The IFRS IC concluded that cryptocurrencies, depending on their purpose of holding, should be treated as an intangible asset or inventory.Potential Accounting TreatmentsCashAlthough there is no substantive definition of cash provided by IFRS Accounting Standards the IC did consider whether cryptocurrencies could be classified as cash. They concluded cryptocurrencies are not cash by drawing analogies with IAS 32 – Financial Instruments: Presentation. While digital assets have been observed to be used in exchange for goods and services, they are not being ‘used as medium of exchange and as the monetary unit in pricing goods or services to such an extent that it would be the basis on which all transactions are measured and recognised in financial statements’ (IFRS 2019). PWC (2019) further argued cryptocurrencies do not share the common characteristics of what is traditionally considered as cash, such as ‘not being legal tender’ and ‘mostly not backed by any government or state, and currently not capable of setting prices for goods and services directly’. KPMG (2019) noted that cryptocurrencies are a ‘poor store of value because their value is based on demand and supply‘, which has proven to be highly volatile over the past decade. ACCA (2021) also concurred that cryptocurrencies are not cash because they are not readily exchangeable for goods and services and their use as a medium of exchange is not sufficiently widely accepted. These views are consistent with stakeholder responses provided in Chou et al. (2022).The extent to which this argument is still valid has been challenged by recent developments. Notably, on 7 September 2021, El Salvador made Bitcoin an alternate legal tender, and become the first country to adopt Bitcoin as a currency.7 Similarly, other nations are considering developing digital currencies, and there has been an emergence of stable coins backed by fiat currency, such as Tether.A significant accounting issue that arises with treating cryptocurrencies as cash is in terms of how changes in valuation would need to be accounted for. In accordance with IAS21 – The Effects of Changes in Foreign Exchange Rates – transactions would need to be translated from the cryptocurrency to the functional currency. However, under such treatment, timely and reliable valuation can be made difficult given the volatility observed in this market (Luo and Yu 2022).Financial assetsAccording to Paragraph 11 of IAS 32, financial assets are defined as:cash;an equity instrument of another entity;a contractual right to receive cash or another financial asset from another entity;a contractual right to exchange financial assets or financial liabilities with another entity under particular conditions; ora particular contract that will or may be settled in the entity's own equity instruments.In their agenda decision, the IC concluded that cryptocurrencies are not financial assets as they are not cash, as previously discussed, nor are they an equity instrument of another entity, nor do they involve a contract so they do not vest a contractual right of any kind upon the holder. Where this is largely true for cryptocurrencies, this line of argument does not appear to hold true for other types of digital assets.As mentioned earlier, there is little justification provided by those entities identified as classifying their digital asset holdings as financial instruments to assess the assumptions and justifications behind their classification. Therefore, it is difficult to ascertain the factors that some practitioners use to refute the position of the IFRS IC. One potential explanation provided by a standard setter and academic interviewee in Chou et al. (2022) is that cryptocurrencies have a market value, and their fundamental structure renders them as financial instruments in substance.In the case of security tokens, the rights provided to holders in the form of cash, dividends or other financial instruments, with voting rights and a residual interest in the entity, suggest the nature of these items is consistent with the definition of financial instruments. This view is also supported by practitioners (Chou et al. 2022). This highlights the importance of considering and understanding all types of digital assets, not just the narrow definition used by the IFRS IC. Companies also need to be more forthcoming in their disclosures if they do hold these tokens, hence justifying their classifications.Alternatively, the treatment of derivatives under financial instruments may be relevant. Within IAS 39, a derivative is a financial instrument or other contract within the scope of the standard that (i) its value changes in response to some other variable. While the value of many types of digital assets may be derived from an underlying asset, since that asset is not considered a financial instrument the context of derivatives would not be applicable. Further, it is not clear in practice how much digital assets may be used in hedging activities. As Corbet et al. (2018) note, cryptocurrencies are rather isolated from other markets, indicating that financial market conditions are less important influences on cryptocurrencies than the structural conditions related to the design, operation and clearing of cryptocurrencies. The features of cryptocurrencies provide their own idiosyncratic risks that are difficult to hedge against.Similarly, Dong et al. (2023) demonstrate that cryptocurrencies, and Bitcoin in particular, are limited in their ability to be used in a hedging transaction, finding little evidence of shocks in cryptocurrencies being transmitted to stocks, but significant volatility spill overs in reverse. Following US policy responses to the COVID‐19 pandemic, they find a growing presence of institutional investors in the crypto market whose trades are sensitive to monetary policy changes, which is suggestive of these assets being affected by the same macroeconomic conditions as traditional assets. The result of these factors is that the potential of cryptocurrencies to be used in a hedging transaction are limited.InventoryAccording to Paragraph 6 of IAS 2, inventories are:held for sale in the ordinary course of business;in the process of production for such sale; orin the form of materials or supplies to be consumed in the production process or in the rendering of services.Thus, the IFRS IC is of the view that if an entity is holding digital currencies for sale in the ordinary course of business, the digital currency should be recognised as inventories in accordance with IAS 2. The IFRS IC is also of the view that if an entity principally acquires and holds cryptocurrencies for the purpose of selling them in the near future to generate a profit from the fluctuations in prices or traders’ margin, the entity may be considered a ‘commodity broker‐trader’ of cryptocurrencies. As such, the entity should consider the requirements in paragraph 39(b) of IAS 2, which requires commodity broker‐traders to measure inventories at fair value less costs to sell.8According to US GAAP, however, cryptocurrencies may not be considered as inventories because inventory must be tangible, which excludes digital assets as they do not have a physical form.Intangible assetAccording to IFRS, an intangible asset is ‘an identifiable non‐monetary asset without physical substance’ (IAS 38, Paragraph 8). Paragraph 12 then defines an asset as being identifiable if it is ‘separable or arises from contractual or other legal rights’, and an asset is separable if it is ‘capable to being separated or divided from the entity and sold, transferred, licensed, rented or exchanged either individually or together with a related contract, identifiable asset or liability’. Further, an essential feature of a non‐monetary item is ‘the absence of a right to receive (or obligation to deliver) a fixed or determinable number of units of currency’ (IAS 21, Paragraph 16).Hence, the IFRS IC concluded that cryptocurrencies are intangible assets as they are identifiable and non‐monetary items. Additionally, they do not have a physical substance as they exist digitally and meet the definition of an asset. The same conclusions would be reached following US GAAP. Chou et al. (2022) report that stakeholders express caution on classifying digital assets, particularly cryptocurrencies, as intangible assets. They quote a practitioner as stating that cryptocurrencies are treated as an intangible as a residual category, as IAS 38 is the closest after applying definitions in other standards.The treatment of cryptocurrencies as an intangible asset may not fairly present a company's liquidity position (Luo and Yu 2022). Luo and Yu (2022) present the example of Tesla which, consistent with US GAAP, reports its holdings of cryptocurrencies as an indefinite‐life intangible asset, even though the purpose of holding these are as a liquid alternative to cash. Since cryptocurrencies are trading at highly volatile prices, with 40% price swings possible in one day (Luo and Yu 2022), under US GAAP it is inevitable that impairment losses will be required to be reported. Under IFRS, the effect is not as severe if firms elect to use a revaluation model with upwards movements being able to be recognised. However, upwards price movements will be required to be recognised through other comprehensive income, and not in net profit. With cryptocurrencies, the prevalence of the use of the revaluation model would depend on the liquidity of the particular currency involved, since firms are more likely to use fair values when cryptocurrencies are more liquid (Anderson et al. 2022).Non‐cryptocurrenciesThe previous discussion has been centred around cryptocurrencies, as these are the only type of digital assets that the IFRS IC has considered. However, other types of digital assets possess other criteria, which may make the existing guidance moot.Utility tokens typically convey to their holders a right to attain some underlying utility in the future, such as the right to receive a particular good or service, which are often based on distributed ledger technology. Thus, these tokens can be regarded as prepayments for future goods or services. If the underlying asset meets the definition of an intangible asset, IAS38 would apply, otherwise the accounting would be similar to the treatment of other prepaid assets.Security tokens, on the other hand, exhibit similar properties to traditional securities and financial instruments. Although these vary from token to token, they have been observed to vest holders with: (i) an equity interest in an entity; (ii) the right to cash, dividends, or other financial assets; (iii) a residual interest in the company's net assets; and (iv) the right to vote on the entity's decisions. Since a contractual right to cash or some financial asset is usually involved, most security tokens can be accounted for as financial assets.Non‐fungible tokens (NFTs) give holders an interest in some underlying asset. Here, the tokens are a digital representation of the holder's ownership of an asset. The key with NFTs is that the asset is non‐fungible, that is, it cannot be replaced with a similar asset. The classification of these tokens will depend on the nature of the underlying asset. At present, the market for NFTs appears to be limited to private collectors, including art galleries or museums. However, as this area is rapidly developing and companies further develop their digital presence, this may quickly change. Similarly, the complexity in ownership and usage rights with NFTs differs markedly from tangible assets, such as artwork, meaning that there are added complexities in the accounting and valuation of these assets.Finally, stable coins are the last of the main types of digital assets available at present. These coins have their prices pegged using different items as collateral, hence the accounting treatment will vary depending on the specific stable coin. Where the stable coin is fiat‐collateralised (e.g. Tether), a contractual right to cash or financial asset may exist, indicating their classification as financial assets. Some commentators, however, have observed that, in practice, the redemption rights and process of redemption are complicated by complex terms and conditions that may ultimately mean that holders are not actually allowed to redeem their coin for a financial asset.9Potential accounting issuesThree main accounting treatments are potentially available for digital assets: inventory, intangible assets and financial assets. Within inventory, it is only countries following IFRS that would be allowed to make use of this treatment due to the requirement in the US that inventory be tangible.Under IAS 2, digital assets would need to be recorded initially at cost, and then subsequently measured at the lower of cost and net realisable value. Any unrealised movements in fair value are not recognised to the extent it is above cost, while movements below cost are recorded in the Income Statement. Due to the acknowledged volatility in digital assets, increases in fair value above cost not being recognised in income may lead to useful information not being communicated to users of financial statements. This may also lead to greater levels of conservatism for firms investing in digital assets, which have been previously recognised as being problematic for valuation (Govindarajan et al. 2018). If a firm, however, holds cryptocurrencies for the purpose of trading to generate a profit, the commodity broker‐trader exception may apply, which would lead to subsequent valuations being at fair value less costs to sell, with all unrealised movements in fair value being reflected in income.Under IAS 38 entities can apply a revaluation model to accounting for digital assets as there is an active market. The only differences in accounting under the revaluation model is that subsequent measurement will be at fair value less any accumulated impairment losses, and upwards movements will be recorded in other comprehensive income. While reflecting upwards movements in digital asset values in the balance sheet, some commentators have argued this still does not go far enough in that it still does not adequately reflect the value of cryptocurrencies in particular, and digital assets more generally (Dupuis et al. 2021). Such a viewpoint would consider it appropriate for all movements in digital asset values to be tabulated in net profit on the income statement.In the case digital assets are classified as a financial instrument, the accounting treatment will then depend on the particular classification of financial instrument used. Under IFRS 9, financial assets must be classified as amortised cost, FVTPL, FVTOCI for debt and FVTOCI for equity. The classification decision for non‐equity financial assets is dependent on two key criteria: (a) the business model within which the asset is held (the business model test); and (b) the contractual cash flows for the asset (the Solely Payments of Principal and Interest ‘SPPI’ test). Accordingly, the specific accounting treatment would then be determined by how the entity classifies its digital asset holdings within IFRS 9.The three approaches – historical cost, FVOCI and FVPL – have implications for decision‐making purposes. Questions around how changes in value should be accounted for is not a new question (see Dickens and Blackburn 1964; Zeff and Maxwell 1965, as an example of the debate around holding gains on fixed assets). To assess the impact on decision makers, it is important to consider the purpose of general‐purpose financial reporting, which is to provide information useful in making informed economic decisions that result in an efficient allocation of scarce resources. While there are many potential users of financial statements, Dickens and Blackburn (1964) identify accounting information should provide the best possible basis for the stockholder to project its earnings and financial condition, and for evaluation of the performance of management as the two main purposes. In doing so, it is important to facilitate a separation of a measure of the firm's holding activities from a measure of the success of a firm's operating activities (Edwards and Bell 1961).The relevance of these considerations is important as we consider how users of financial statements are able to discern reported net income of different firms that are largely due to operating activities or to reserves of holding gains that have been accumulated over several periods (Zeff and Maxwell 1965). The importance of separating out operating income from other sources of income is shown to be important in improving forecasts of future earnings (Esplin et al. 2014). Applying these arguments, to improve the decision making around firms that hold digital assets, it becomes important to consider the purpose of holding these items. To the extent that the purpose of holding digital assets is a part of the operating activities of a firm, and where fair values are available in a liquid market, it would appear that applying FVPL would lead to a more accurate measure of the operating results of the firm allowing for better decision making. Where firms are largely holding digital assets, particularly cryptocurrencies, as a liquid alternative to cash (Luo and Yu 2022) the treatment of unrealised gains and losses through profit and loss would be consistent with anecdotal evidence for FVPL to be the preferred recognition, especially where there are liquid markets that allow for fair value measurements to be readily available (Anderson et al. 2022).In conclusion, various accounting methods will have varying consequences on the financial statements and, as a result, the comparability of financial information is compromised. If movements in value are below cost, under inventory, intangible asset and financial instrument recognition rules, these downwards movements in value will all be reflected in income. Where the inconsistencies arise, however, is where there are upwards movements in value. Under IFRS, upwards movements in value would not be recognised for inventory or intangible assets applying the cost model; however, they would be recognised in other comprehensive income for intangible assets using the revaluation model and for financial assets available for sale. Finally, these upwards movements would be recognised as income for inventories using the broker‐trader exemption, and for financial instruments at fair value through profit and loss. Further, asset values will be understated for the case of inventory or intangible assets using the cost model where no upwards movements in value are recognised.Policy adviceThe previous discussions provide a summary of the state of accounting for digital assets. Little guidance has been provided, not surprisingly given the relative novelty and recent development in technology to enable the establishment of digital assets, and the small number of companies with disclosed holdings. Early adopters of digital assets have been required to develop accounting policies in line with existing standards, which are arguably unsuited to the specific characteristics of digital assets. Standard setters are then left with three options.The first option is to allow companies the current discretion to set their own accounting policies. Preparers would continue to apply existing GAAP. Essentially, digital assets would largely be accounted for under inventory or intangible assets. From the firms identified as reporting digital assets, US firms in their 10Q and 10K reporting appear to acknowledge the financial risks from holding digital assets. However, overall, disclosures remain limited, with the result that users may not fully understand the exposure firms have with respect to these holdings. As more firms start to hold digital assets, or allow for some payments in cryptocurrencies, the status quo does not appear a sustainable position to hold.The second option available to standard setters is to make amendments to or clarify current standards. Several amendments and clarification guidance would need to be made to make IFRS or US GAAP clear in how preparers need to account for their holdings. Presumably, this would also require improvements in required disclosures. It is not clear, however, whether amending existing standards would ensure that consistency is applied across the reporting space, rather than the various accounting treatments that firms can currently elect to take.The final option would require standard setters to develop a new accounting standard to address digital assets and liabilities, consistent with the policy recommendation made by Luo and Yu (2022). A new stand‐alone standard would need to be developed on the premise that digital assets and liabilities are unique. As previously described, the accounting issues behind digital assets are complex, and it does not follow that existing standards are adequately able to meet the needs of preparers and users. Standard setters have precedent in developing stand‐alone standards for assets with unique characteristics, for example self‐generating and regenerating assets (AAS35).In developing a new standard, standard setters can promote consistency across firms in how they report their digital assets and regulate for stricter disclosure requirements. The usefulness of combining digital assets into inventory or intangible balances is argued to be of limited use. Further, a new standard dedicated to digital assets will enable consistency not only in how firms account for their holdings, but also within the overall philosophy across standards. Of importance is how unrealised holding gains are treated, keeping in mind the rationale for holding these assets. If the underlying purpose is more in line with the nature of financial assets, a new standard will be able to address this. However, as illustrated, not all digital assets share the same characteristics, with a stand‐alone standard being able to address these differences. It is unlikely that amendments to other standards would serve the purpose of the standard setters and would allow firms greater discretion than would be intended.In the absence of any desire to draft a new standard dedicated to digital assets, there are opportunities to amend existing standards to more adequately capture the nature and purpose of holding digital assets. The current treatment of classifying holdings as intangible assets and inventory, however, is not the appropriate direction. As previously described, the nature and purpose of holding digital assets appears to be more consistent with that of a financial instrument. Here, the standard setters have the ability to extend the definition of financial instruments to specifically include crypto‐assets. The trader‐broker exception within IAS 2 could still be applied for the case of firms involved in the mining and selling of cryptocurrencies.ConclusionThe grouping of digital assets into different categories has been based on the common characteristics they share in the absence of any substantive definitions. When determining the appropriate accounting treatment of holdings, entities need to exercise judgement and clearly understand the nuanced features of the specific asset they hold. The potential applications of blockchain are undeniably large, and it is inevitable that there will be new types of digital assets that will be introduced.This poses a substantial hurdle for regulators to adequately update existing accounting standards or draft a new stand‐alone standard as the developments in the digital assets industry are unpredictable. Yet, it also provides standard setters an opportunity from the start to develop a comprehensive and consistent set of rules that proscribes the appropriate treatment consistent with the overall philosophy within the broad array of current standards and concept statements. Regulators need to act swiftly to retain the confidence of investors, creditors and governments to ensure that financial statements prepared by entities continue to present an accurate representation of their financial position and performance.AcknowledgementsOpen access publishing facilitated by University of New South Wales, as part of the Wiley ‐ University of New South Wales agreement via the Council of Australian University Librarians.Notes1Digital assets and crypto‐assets are used interchangeably throughout the paper to refer to a digital representation of value that can be transferred, stored or traded electronically. Technically, crypto‐assets are a subset of digital assets that use cryptography to protect digital data and distributed ledger technology to record transactions.2https://www.globalinvestorgroup.com/articles/3697937/the‐digital‐asset‐market‐in‐2022.3For a summary of the fundamentals of blockchain technologies and their implication for accounting and auditing, refer to Cai (2018), Karajovic et al. (2019), Schmitz and Leoni (2019) and Tan and Low (2019).4https://www.buybitcoinworldwide.com/treasuries/.5See, for example the 2021 10‐K of Enigma MPC Inc.6Terms used include ‘crypto‐assets’, ‘cryptographic assets’, ‘cryptocurrencies’ and ‘digital currencies’.7https://www.investopedia.com/el‐salvador‐accepts‐bitcoin‐as‐legal‐tender‐5200470#:~:text=Key%20Takeaways,abroad%20and%20bolster%20the%20economy.8Paragraph five of IAS 2 defines ‘broker‐traders’ as those who buy or sell commodities for others or on their own account, and while the term ‘commodity’ is not defined, a broker‐trader can determine cryptocurrencies to be a commodity.9https://micky.com.au/irredeemable‐why‐is‐it‐so‐difficult‐to‐sell‐one‐tether‐for‐1/#:~:text=%E2%80%9CExchanges%20that%20trade%20in%20Tether,from%20Tether%20to%20US%20dollars.ReferencesACCA. 2021, ‘Accounting for Cryptocurrencies’, https://www.accaglobal.com/in/en/student/exam‐support‐resources/professional‐exams‐study‐resources/strategic‐business‐reporting/technical‐articles/cryptocurrencies.htmlAnderson, C.M., Fang, V.W., Moon, J. and Shipman, J.E. 2022, ‘Accounting for Cryptocurrencies’, Working Paper, University of Arkansas.Cai, C.W. 2018, ‘Disruption of Financial Intermediation by FinTech: A Review on Crowdfunding and Blockchain’, Accounting & Finance, 58(4): 965–92.Chou, J.H., Agrawal, P. and Birt, J. 2022, ‘Accounting for Crypto‐assets: Stakeholders’ Perceptions’, Studies in Economics and Finance, 39(3): 471–89.CleanSpark. 2020, ‘Form 10‐K’, https://app.quotemedia.com/data/downloadFiling?webmasterId=103727&ref=115504352&type=HTML&symbol=CLSK&companyName=CleanSpark+Inc.&formType=10‐K&formDescription=Annual+report+pursuant+to+Section+13+or+15%28d%29&dateFiled=2020‐12‐17&CK=827876Corbet, S., Meegan, A., Larkin, C., Lucey, B. and Yarovaya, L. 2018, ‘Exploring the Dynamic Relationships Between Cryptocurrencies and Other Financial Assets’, Economics Letters, 165: 28–34.Deloitte, U.S. 2021, Corporates Investing in Crypto, https://www2.deloitte.com/us/en/pages/audit/articles/corporates‐investing‐in‐crypto.htmlDickens, R.L. and Blackburn, J.O. 1964, ‘Holding Gains on Fixed Assets: An Element of Business Income?’, The Accounting Review, 39(2): 312–29.Dong, S., Fang, V.E. and Lin, W. 2023, ‘Tracing Contagion Risk: From Crypto or Stock?’, Working Paper, New York University.Dupuis, D., Gleason, K.C. and Kannan, Y.H. 2021, ‘Bitcoin and Beyond: Crypto Asset Considerations for Auditors’, Working Paper, American University of Sharjah.Edwards, E.O. and Bell, P.W. 1961, The Theory and Measurement of Business Income, University of California Press, Berkeley, CA.Esplin, A., Hewitt, M., Plumlee, M. and Yohn, T.L. 2014, ‘Disaggregating Operating and Financial Activities: Implications for Forecasts of Profitability’, Review of Accounting Studies, 19(1): 328–62.Govindarajan, V., Rajgopal, S. and Srivastava, A. 2018, ‘Why Financial Statements Don't Work for Digital Companies, Harvard Business Review’, 26 February 2018, https://hbr.org/2018/02/why‐financial‐statements‐dont‐work‐for‐digital‐companiesIFRS. 2019, Holdings of Cryptocurrencies. https://www.ifrs.org/content/dam/ifrs/supporting‐implementation/agenda‐decisions/2019/holdings‐of‐cryptocurrencies‐june‐2019.pdfKarajovic, M., Kim, H.M. and Lasjowski, M. 2019, ‘Thinking Outside the Block: Projected Phases of Blockchain Integration in the Accounting Industry’, Australian Accounting Review, 29(2): 319–30.KPMG. 2019, ‘Accounting for Cryptoassets – What's the Impact on Your Financial Statements?’, https://assets.kpmg/content/dam/kpmg/xx/pdf/2019/04/cryptoassets‐accounting‐tax.pdfLuo, M. and Yu, S. 2022, ‘Financial Reporting for Cryptocurrencies’, Review of Accounting Studies, forthcoming.Moore, T. 2021, ‘Digital Assets Sector “Too Big to Ignore”: Bank of America', Australian Financial Review’, 5 October, 2021, https://www.afr.com/companies/financial‐services/digital‐assets‐sector‐too‐big‐to‐ignore‐bank‐of‐america‐20211005‐p58x7wProchazka, D. 2018, ‘Accounting for Bitcoin and Other Cryptocurrencies Under IFRS: A Comparison and Assessment of Competing Models’, The International Journal of Digital Accounting Research, 18: 161–88.PWC. 2019, Cryptographic Assets and Related Transactions: Accounting Considerations Under IFRS, https://www.pwc.com/gx/en/audit‐services/ifrs/publications/ifrs‐16/cryptographic‐assets‐related‐transactions‐accounting‐considerations‐ifrs‐pwc‐in‐depth.pdfRamassa, P. and Leoni, G. 2022, ‘Standard Setting in Times of Technological Change: Accounting for Cryptocurrency Holdings’, Accounting Auditing and Accountability Journal, 35(7): 1598–624.Schmitz, J. and Leoni, G. 2019, ‘Accounting and Auditing at the Time of Blockchain Technology: A Research Agenda’, Australian Accounting Review, 29(2): 331–42.Sixt, E. and Himmer, K. 2019, ‘Accounting and Taxation of Cryptoassets’. 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Australian Accounting ReviewWiley

Published: Sep 1, 2023

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