Valuation of nonfungible tokens (NFTs) became a hot topic when digital artist Beeple sold an NFT for almost $70 million earlier this year.
The high price commanded in that sale and numerous other transactions led to a difficult question for CPAs. What is an NFT’s value when it’s on a company balance sheet, or held in an individual’s collection, or even when it’s in the possession of a digital artist and ready for sale?
As with many emerging asset classes, the answers to these questions aren’t easy, and they present some difficult issues for CPAs to consider.
NFTs are created (minted) from digital objects that represent both tangible and intangible items. Each NFT has a unique digital signature and certifies that an asset is unique and not interchangeable for another.
Blockchain technology is used to create tokens that can be sold and traded. The record of ownership of the NFT is stored and transferred on these digital ledgers. Ownership of the underlying asset may never leave the creator, and the NFT represents a bundle of rights (either exclusive or shared with others) to access the asset and potentially exploit it for commercial purposes.
Because of their nature and relatively new use, valuation of NFTs is an evolving and challenging area. What makes NFTs popular also makes their valuation more difficult. Value is based on perceptions of owners and buyers, scarcity, access, and the distribution channel. There are no physical limitations on NFTs, and they have broader visibility and liquidity because they can be accessed and distributed across a global landscape in an instant.
None of the basic metrics you would use to value private companies or traditional investment vehicles like shares or warrants are available for NFTs. For an NFT, what the last buyer paid for it gives you an indication of what the value is, but the next buyer could pay something else, and it is the amount the next buyer will pay that determines the value.
There is no specific guidance today in U.S. GAAP on how to account for an NFT. To date, FASB has decided not to add a project on accounting for cryptocurrencies and digital assets to its agenda. As a result, there is a question of which asset accounting model to apply to an NFT.
NFTs do not meet the GAAP definitions of cash or cash equivalents, marketable securities, financial instruments, or inventory. Based on GAAP definitions, cryptocurrencies fall under intangible assets, which are recorded at cost, can’t be written up as they go up in value, and are tested at least annually for impairment in value.
The challenge with an intangible accounting model for digital assets is their tremendous volatility and their speculative marketplace. Values have been increasing, and historical costs are not very useful to financial statement users.
Impairment accounting is based on the lower of cost or fair value. There are challenges establishing fair value if there is no market or recent transactions and no similar assets that can be used as a proxy.
There are significant risks related to security over digital assets and internal controls over transactions. These include general IT, security, fraud, and accounting controls, along with unique controls over wallets and digital transactions. Risks for companies and their auditors to be aware of include how to verify the existence of NFTs, who are the interested parties, how are transactions initiated and executed, and what blockchain is used. Existence is another issue. What if the purchaser loses the digital key to the digital wallet?
There are a number of indirect tax implications, including sales taxes, for the creator, buyers, and resellers of NFTs. This area requires care around what the underlying asset being sold is and which jurisdiction it is attached to. There are considerations about whether NFTs should be taxed like investment property at capital gains rates, taxed as income at ordinary tax rates, or not taxed at all in certain jurisdictions or based on how they are used or transferred. At the moment there are no specific tax rules on point. For now, regulators, lawyers, and accountants are building analogies to existing case law and concepts, but there is a lot about NFTs that is different from other types of assets.
