Digital Assets – What Are They and Can They Be Reliably Valued?

Overview

In the realm of digital assets, recent headlines have included:

  • Cryptocurrencies and digital assets create fair value headaches
  • Crypto not a threat to the traditional monetary system, say experts
  • Digital currency operators must comply with rules governing money laundering

Such headlines are just the tip of the iceberg in seeking to understand some of the key uses of blockchain technology such as tokens, coins, initial coin offerings (ICOs) and virtual currencies. Governments, regulators, tax authorities, accounting standard setters, law enforcement and, of course, institutional and individual investors all have an interest in understanding, controlling and profiting from the emerging world of digital assets.

While topics such as anti-money laundering, know your customer, security, existence, ownership, etc., all are critically important when considering digital assets, the focus of this article is on some of the issues inherent in valuing digital assets.

Valuing Digital Assets

When considering the valuation of digital assets, one of the first questions is to determine the basis of value. For example, we need to consider if the valuation is for transaction purposes, taxation, financial reporting or some other purpose. Depending on the basis of value, classifying a digital asset in the relevant framework can drive how it is to be valued. For financial reporting, consideration must be given to whether the digital asset is considered cash or cash equivalent, a financial instrument, an intangible asset, inventory or something else. Both the basis of valuation and classification in the relevant framework impact the ultimate approach to determining value.

The world of digital assets is not one size fits all. Examples include:

  • Currency tokens or cryptocurrencies (Bitcoin, Ether, etc.)
  • Tokens (digital assets other than cryptocurrencies) –

Security tokens: that represent an ownership interest

–Utility tokens: that are exchangeable for some resource (goods or services)
–Others (such as asset-backed token)

FASB and IASB have indicated they consider many digital assets to be most similar to indefinite-lived intangible assets or possibly inventory. That could impact how they are measured and reported depending on the accounting framework used. Investment companies that hold digital assets, for example, must measure and report all investments at fair value no matter how they are classified.

Valuation Approaches

As noted, the basis of valuation is critical in assessing how to value a digital asset. For those digital assets that are most like a “security” or interest in a business, see the AICPA Accounting and Valuation Guide: Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies; this may provide additional guidance on valuation.
Depending on the appropriate basis, in general, value can be determined using one or more of the following approaches:

Market Approach:

  • The traded market price for the digital asset, potentially adjusted as appropriate
  • For a utility token, the market price for the underlying resource or function
  • Quotes from the OTC market
  • Metrics for judging value relative to other traded (priced) assets

Network Value Method: Value is determined using (1) the fundamental idea that the value of a network is derived from the people who use it and (2) Metcalfe’s Law in which a network’s value is proportional to the square of the number of its users.

Income Approach: For a digital asset with security-like features, value is based on discounting the cash flows associated with the digital asset over time.

Cost of Production Approach: The average variable cost of production provides a lower bound for the perceived value of the digital asset by rational miners. Where markets for mining cryptocurrencies are robust and reasonably competitive, the relative difficulty of mining such altcoins could also be considered as a possible indicator of their relative value.

Equation of Exchange: A macroeconomic model of a market in equilibrium (coin supply equals coin demand). The supply is the value of all coins in circulation times the velocity. Demand is the network “GDP.” Value is estimated based on the impact of an increase in coin supply on coin price; used where reliable velocity data is available, and can be used in a value-relative-to-comparables analysis.

Conclusion

Sound practices with respect to valuing digital assets is an emerging body of thought. Care should be taken in understanding the basis of value and using valuation techniques appropriate to basis and use of the valuation.

For more information, contact:

David Larsen | +1 415-693-5330 | [email protected]
Lynne Weber | +1 650 798 5565 | [email protected]

 
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