Cryptocurrencies are increasingly found in various financial statements of smaller and larger companies. A brief overview of cryptocurrency as well as implications for annual audits will be briefly presented here in the most important topics:
What are cryptocurrencies
Virtual currencies understand themselves as digital representations of values. Virtual currencies has no issuance by a central authority but their management via a network of computers. They are means of payment, but no legal currency or money and have no intrinsic value.
The Federal Financial Supervisory Authority in Germany (BaFin) classifies cryptocurrencies as financial instruments, which means that certain transactions are subject to authorization and the provisions of the German Governance Banking Act (Kreditwesengesetz – KWG) apply. The legal certainty of Cryptocurrencies requires supreme court rulings or legislator in Germany.
Cryptocurrencies should only be able to be used by their respective owner or beneficiary and only once (cryptographic controls).
Business transactions or creation of cryptocurrency is based on blockchain or distributed ledger technology.
Cryptocurrencies allow individuals and companies to transact directly with each other (peer to peer) – without a bank and without revealing their identity. Cryptocurrencies presence of business partners only with their “wallet-addresses” – as pseudonyms. Pseudonyms can be tracked through public blockchain (recording and disclosing the entire transaction history). I.e. without knowledge of the assignment of the real acting persons, the true identity of the persons remains hidden (pseudonymity) (!).
Cryptocurrencies are not subject to monetary control mechanisms as is the case with listed currencies
Scope of cryptocurrencies
Cryptocurrencies are becoming increasingly important. The volume in Germany amounts to a market capitalization of around 1.9 tr. USD.
Most widespread are: Bitcoin (BTC) with a market share of approx. 41 %. Another 19,000 different cryptocurrencies in circulation (e.g. Ether, Litecoin, Ripple, etc.). We can see an increase in companies holding cryptocurrencies (in financial statements!).
Types of cryptocurrencies
Coins: Purpose solely as a medium of exchange
Tokens: In addition to means of exchange, also other functions:
– Security tokens (=asset, equity, security or investment tokens) convey a claim under school law
– Usage tokens represent a tradable service (comparable to a voucher) – according to BaFin no cryptocurrency, since no (value) development is apparent
Summarized wie can see a Trend towards “tokenization” of assets in rights (fungible/non-fungible tokens – NFT).
Acquisition types
The generation of cryptocurrencies has many types:
Provision of computing power (mining process) – consideration is the cryptocurrency.
Holding cryptocurrency for a long period of time is called “staking”. The currency is locked for a certain period of time (cf. time deposit).
Splitting cryptocurrency is called “fork” or “split” when the blockchain is changed
Acquisition also via Initial Coin Offerings (ICO) (=companies collect cryptocurrency and issue tokens – similar to IPO with the issuance of shares)
Airdrop – cryptocurrency without consideration
Digital keys and signatures
essentially, a distinction is made between two access keys:
Public keys with lower secuity public keys (cf. with IBAN or e-mail). Private keys (cf. with PIN or password). This key is very dangerous if the keys are lost!
Cryptocurrency Wallets
To perform cryptocurrency transactions (and to track them), users need a wallet. There are many types of wallets.
Online/WEB wallets are managed by a wallet provider on a server (hot wallets). Software wallets are located on their own local hardware. Hardware wallets are standalone wallets on local hardware that connect to the Internet independently. Paper wallets print out private and public keys on paper (cold wallet) – comparable to the “Post-it with password under the keyboard”.
Trading platforms/exchanges
Custodial trading platforms allow access to cryptocurrency holdings on the platform. Non-custodial trading platforms allow transactions without holding stocks there.
Risks in connection with cryptocurrencies (in the annual financial statements)
in addition to personal risks, there are also IT risks:
Risks from third-party involvement (e.g., service provision for transactions and custody of cryptocurrencies and their keys)
Legal and regulatory risks from regulatory efforts and lack of legal classification of cryptocurrencies; remedy: “crypto value transfer regulation” by removing pseudonymity.
Volatility and valuation: cryptocurrencies are subject to high price volatility, i.e. total loss is possible. Valuation based on trading data/crypto exchanges due to lack of payment flows/basic values.
Effects in the annual financial statements and audit
Clarification at the time of acceptance of the engagement for the annual audit whether material cryptocurrency is traded or included in the annual financial statements.
Verification of power of disposal (E), existence (V) and process description for tracking the cryptocurrency using the blockchain (=audit evidence).
Examination of the actual business purpose (money laundering?)
Existence of an ICS (audit obstacle?)
Disclosure of cryptocurrency: If cryptocurrency is held as a means of payment, it must be reported under current assets – otherwise fixed assets (> 4 years) if the holding period is longer – the subjective assessment of the merchant is decisive, as cryptocurrency does not have a holding period/maturity.
Intangible assets under “concessions acquired for consideration….” if there is an acquisition for consideration.
Financial assets if “capital employed outside the company” – indirect benefit to the company.
Other assets, as no cash and cash equivalents and no security of the current assets.
Initial measurement: Acquisition cost in the amount of the currency given (Sec. 253 (1) S1. in conjunction with Sec. 255 (1) HGB – german GAAP).
Subsequent valuation: Acquisition costs are the upper valuation limit. Devaluations possibly due to exchange rate losses, if cryptocurrency acquired in foreign currency.
Cryptocurrency business model?
AUREN may have the following options in terms of advice:
Securing the functionality and reliability of the underlying blockchain.
Service for the proper execution of the Key Ceremony (=provision of corresponding IT infrastructure for cryptocurrencies).
Services within the scope of compliance with the crypto control system ICS (ISAE 3000 revised).
Ensuring prevention of money laundering, terrorist financing.
ESG-compliant mining for better (ESG) rating
In summary, cryptocurrencies are only at the beginning of their development. It is important to take care of the topic and to provide as much information as possible when preparing and auditing annual financial statements – as well as providing legal advice. There is a lot of movement in this segment. It is therefore important to further develop your knowledge in this regard.
Stefan Amberg, Wirtschaftsprüfer Certified Public Auditor from Auren Germany
Performance of mandatory audits from the private sector and voluntary audits
stefan.amberg@fra-auren.de