Crypto Audits: How to Prepare in 4 Steps

The Migration to Web3

Blockchain is becoming increasingly adopted by companies of all sizes, and for good reason. By migrating into the Web3 space and incorporating cryptocurrency transactions, companies are experiencing several benefits: faster transactions, lower fees, enhanced security, and new revenue streams. Major global payment platforms like PayPal are taking notice of this trend and  hastening the implementation of necessary infrastructure to support blockchain-based payments.

Despite all of the benefits, blockchain-based operations can add significant accounting complexity. Companies that adequately prepare and incorporate enterprise-level software will discover that they can now make real-time business decisions rather than relying on delayed quarterly tax reports. They’ll also find that their associated accounting costs are reduced, and they have a more holistic view of their operations. 

This article will dive into the above and highlight common questions, including:

1. What is a crypto audit and what triggers them?

2. If transactions are public, why are crypto audits needed?

3. What does the process look like?

4. What affects applicable timelines

What is a crypto audit and what triggers them?

A crypto audit is an examination of an organization’s web3 financial records to ensure that they are accurate, secure, and compliant with relevant laws and regulations. 

As business operations and cryptocurrency transactions become more integrated, there has been a corresponding increase in regulatory oversight. Tax authorities are looking to set a strong precedent in this area, making crypto tax audits more commonplace. The IRS is now clamping down on blockchain-related companies and the same can be expected in other jurisdictions globally. Furthermore, the IRS has been on a hiring frenzy, with experts predicting that both tech and crypto will be big targets. It can be expected that they will be diligent in their work, and those caught unprepared may find their business operations disrupted.

In practice, this might unfold similarly to a traditional audit, albeit with some differences. For one, there will be greater scrutiny over both asset valuations and complex transactions, such as cross-chain bridging. Additionally, assets will need to be reconciled against their fiat counterparts, which may require various documentation.

Proactively managing one’s accounts can mean the difference between a fast, painless audit process, and a long, costly one. 

So, what might actually trigger a crypto tax audit?

There are typical three triggers:

1. Tax authorities such as the IRS or CRA looking to dispute calculations.

2. Third parties, such as a new investor or bank, wishing to perform business due diligence.

3. Internal audits, such as for the purpose of evaluating the effectiveness of internal controls, risk management, and governance processes.

It’s worth noting that the likelihood of the first type of trigger is severely reduced when companies rely on trusted professionals. For example, an entity that submits their taxes through a certified accounting firm is much less likely to become audited. 

The same is true in web3, which is a big reason that world-class enterprises rely on crypto accounting software like Integral.

If transactions are public, why are crypto audits needed?

Blockchain transactions are public, which might lead to the false conclusion that managing transactions and being prepared for an audit is a simple process.

Why might companies still need to prepare?

• Nature of Transactions: things aren’t always clear. For example, it may be unclear whether funds received are business revenue, a loan repayment, or something else entirely.

• Cost Basis: typically determined via complex asset valuation rules and valuation methods.

• Supporting Documentation: companies must ensure that supporting documentation (e.g. account statements) are readily available. Relying upon blockchain transaction data alone is insufficient. 

• Complexity: preparation may be simpler when dealing with only one wallet address across a few different chains. However, it can quickly get complex as more wallet addresses and networks are used, and both transaction complexity and volume also increase.

Despite all of the above, those that properly prepare will find that it’s not an overly strenuous exercise.

How to Prepare for a Crypto Audit

1. Ensure Detailed Bookkeeping

Companies should maintain an accurate, up-to-date general ledger of all crypto-related transactions, including swaps, LP rewards, and NFT-related transactions. For example, day-to-day transactions should be properly reconciled, with information such as the date of the transaction, the amount of crypto involved, the proper valuation, and any fees or commissions paid.

Additionally, when beginning to conduct business in cryptocurrencies, it’s prudent to reconcile opening balances. Everything on one’s balance sheet at the beginning of a given period should be explainable and reconcilable. For fiat-based companies this may entail reviewing bank statements, matching inventory balances with inventory counts, confirming that retained earnings are accurately reflected, and so on. For companies operating with crypto, further complexity is added as various crypto-related holdings across various blockchain networks must now be accounted for as well.

For companies operating in crypto, this may include manually comparing account statements with blockchain data provided by a block explorer or automatically using platforms such as Integral.

One good way to evaluate whether you are bookkeeping at an appropriate level is through our next suggestion: reporting regularly. Doing so will make it clear where there are gaps in your internal processes, and where to adjust.‍

2. Report Regularly

It’s a good idea to periodically confirm that financial records are accurate and up-to-date, with monthly revisions being a good frequency. Price fluctuations, unrecorded transactions, and error corrections are just a few reasons for doing so. Furthermore, confirming ongoing compliance with applicable tax regulations is always a good idea as things are moving swiftly.

If performed correctly initially, this should be a straightforward process that will make it clear if you have been bookkeeping properly. It will be an ideal time to check-in on your internal processes too, enabling the proper monitoring of your financial health and business operations.

By conducting regular revisions, companies can stay on top of their crypto accounting, monitor business operations, and avoid potential issues during a tax audit.

3. Maintain Data Visibility

In the event of an audit, it’s common that auditors will conduct a stress test whereby a random selection of transactions is scrutinized to ensure compliance. If inconclusive, auditors will dig deeper into a client’s records, consuming more time and resources for all involved.

Having quick and accurate access to all relevant data will make this process much more pain-free.

A holistic data view can provide unique business insights that can set companies apart from the competition. It’s also important because traditional finance entails the reconciliation of transactions against a trusted 3rd party (i.e. bank), whereas in crypto there are no trusted third parties. That means that projects must reconcile against multiple data sources in order to have an accurate understanding of their current state of affairs.

This is certainly possible through manual processes, but may entail tedious effort and potential errors, and can be streamlined through accounting software.

4. Implement Appropriate Software

For early-stage firms, all of the above may be feasible without relying upon external software, especially if operations are more simple in scope and meticulous bookkeeping is maintained. 

That being said, typically the time and cost associated with that may not outweigh the cost of a crypto accounting software subscription. Additionally, one’s business may be at-risk should any accounting errors slip in, and sources of error may be hard to locate.

Here’s a recent example of how this played out for Orange Comet, creators of The Walking Dead NFT collection. They spent over 30 days closing their books each month– racking up significant costs and delaying financial decision-making. They needed real-time visibility to keep up with the rapidly-changing NFT markets. With Integral, they were able to reduce the manual review process by 50%, representing $50,000 in annual savings. Any crypto company operating at scale needs to implement software-based solutions to accurately track, classify and value their transactions & assets. Real-time & automated solutions will become the backbone of financial infrastructure and lead to cost savings and more informed decision-making.

What Affects Applicable Timelines?

Even if you have trusted software, it’s still possible that your company may be selected for an audit.

The length of a crypto audit typically depends upon several factors:

1. Transaction Volume: Greater transaction volumes result in a lengthier process to review

2. Accounting Standards: Various jurisdictions may have their own respective accounting standards when it comes to crypto taxation. The complexity of applicable accounting standards will directly impact the process length, as valuing an asset at cost is much simpler than relying upon average cost.

3. Third-Party Corroboration: It is possible that firms may create fraudulent or deceptive transactions. Having 3rd parties, such as one’s supplier, confirm the validity of transactions will contribute to a faster process. Proper documentation and bookkeeping help greatly here.

4. Tools & Processes: It’s important that organizations have the right tools in place to properly document their business history, starting as early as possible. While spreadsheets may do the trick for a business with a handful of transactions, things can quickly become complex so it's recommended to use accounting software like Integral.

Companies should have an effective process in place in order to correctly book all of their transactions. A failure to do so can result in a long and expensive audit process that disrupts business operations.

Blockchain’s Future is Exciting - But Requires Careful Tax Planning

Tax authorities will be rigorous in their assessments, meaning that companies should anticipate and prepare for audits as soon as possible. Poor accounting practices can have disastrous consequences, such as Silvergate Bank’s recent large-scale meltdown. Additionally, new regulations are being proposed weekly which may have unintended consequences for businesses caught unprepared.

Having proper blockchain accounting practices in motion will not only save valuable time but also reduce accounting costs and reduce the likelihood of errors. While smaller companies may be able to meet these needs through manual bookkeeping and regular reconciliations, the process can be simplified significantly through the implementation of crypto accounting software like Integral.