BY MEGAN J. PENICK, SAMUEL M. LICKER
Cryptocurrency is a volatile investment, to say the least. But despite their unpredictable nature, Bitcoin (BTC), Ethereum, Dogecoin and the like are now widely owned and traded not only by individuals, but by private and public companies as well, all of whom see the clear value in this nascent asset class. That being said, when it comes to classification for reporting purposes, holders of crypto take a vastly different approach from the government—namely, the U.S. Securities and Exchange Commission.
The SEC Has Spoken
In late January, shares of MicroStrategy Incorporated (Nasdaq: MSTR) plummeted nearly 20%—this after the SEC appears to have announced its position in a publicly available letter to MSTR that suggests how companies must recognize gains and losses attributed to cryptocurrencies in Form 10-Q filings, the comprehensive report of financial performance that must be submitted quarterly to the SEC by all public companies. For its part, MSTR, a business software analytics company that has been acquiring Bitcoin since 2020, has invested roughly $3.75 billion (yes, billion with a “b”) in BTC. As of this writing, the company’s crypto holdings are worth close to $4.5 billion, which puts into perspective the significance of the SEC’s classification announcement.
An Asset Like No Other
No doubt, businesses like MSTR want to treat cryptocurrencies like normal assets and recognize gains and losses in real time, particularly gains to the extent they positively reflect upon a company’s financial health. But the SEC has other ideas. The oversight agency has determined that—due to the extraordinary volatility within the asset class—gains in Bitcoin and the like may only be recognized upon a sale, yet losses (or impairments) must be reported quarterly.
Technically speaking, the SEC has seemingly classified crypto as an intangible, which means that in the eyes of the SEC, these assets can only be held in a neutral or a losing position until sold at which time gains, if any, can be fully realized. This is apparent in the SEC’s aforementioned letter to MSTR ordering the company to remove certain non-GAAP (Generally Accepted Accounting Principles) adjustments in its financials that accounted for surging Bitcoin values in excess of the losses as reported on MSTR’s most recent 10-Q filing (more on that below).
To illustrate the SEC’s position on cryptocurrency classification, consider the following:
A company that purchases a single Bitcoin for $30,000 would have to report a loss of $1,000 on its 10-Q in the event BTC later drops in value to a low of $29,000. This is true even if the asset rebounds and jumps to—say—$38,531.80 (the closing price as of February 1) or even $29,500, as no incremental gain can be reported. Because Bitcoin and every other form of cyber cash have been characterized as intangible assets, holders are bound to recognize losses (or test for impairment) at least on a yearly basis (in this example, $1,000) and are unable to capture any subsequent gains in quarterly 10-Q or annual 10-K filings when prices recover. Without question, this classification is far from ideal for companies with meaningful stakes in crypto since upward swings in valuation cannot serve to shine a positive light on their financials.
MSTR Strikes Back, at Least It Tried
In its latest 10-Q, MSTR abided by the SEC’s edict and GAAP requirements by not recognizing its BTC gains and reporting associated losses, as short-term as they may have been. Nevertheless, in an attempt to show investors what its income would have looked like if it was not required to impair its crypto holdings, the company supplemented its 10-Q filing with certain non-GAAP adjustments that accounted for surging Bitcoin values in excess of the losses reported. In so doing, MSTR was able to demonstrate that its reported net loss of over $36 million—mainly the result of a short-lived $65 million Bitcoin impairment loss—actually translated to net income in excess of $18 million when accounting for the actual valuation of the cryptocurrency at the end of the quarter.
The SEC objected to this manner of reporting. In the letter to MSTR’s management referenced above, the agency demanded that the company not include appended financials like these in future filings.
The Shortcomings of the SEC’s Stance
There are practical problems with the SEC’s characterization of cryptocurrency as an intangible asset. Unlike other intangibles like brand equity, goodwill or customer lists, crypto is liquid and, although highly volatile, works similarly to cash or gold. Clearly, treating Bitcoin and other forms of cryptocurrency as an intangible does not capture this intrinsic liquidity.
Also, and as MSTR would surely attest to, being unable to report the rise in value of digital assets does not allow companies to accurately reflect their financial strength, which could serve to scare off investors. Indeed, the SEC’s conservative approach requires businesses to oftentimes show poor operating results on financial statements, even if their holdings in a digital asset have recovered or ballooned. Consequently, investor confidence dwindles, likely bringing lower stock prices along for the ride.
Eyes Wide Open
MSTR’s tug of war with the SEC is but one recent example of a problem that will likely escalate over time. That is because several public companies—Tesla and Block, Inc. (formerly, Square), among them—have relatively large crypto holdings. As such, investors and companies alike must keep a close watch on how the SEC approaches cryptocurrency-related disclosures these and other companies make in their quarterly reports and otherwise. In the meantime, as more high-profile public companies expand their portfolios of investments to include digital assets (let us not forget about NFTs), stakeholders should keep their fingers crossed that newer and more equitable rules from the SEC to emerge sooner rather than later.
This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations.