Impairment Testing for Intangibles: Your Web3 Guide

In traditional finance, impairment testing is an essential process to prevent the overstatement of financial assets on corporate balance sheets. However, crypto impairment testing has no specific guidance under US generally accepted accounting principles (GAAP). 

Impairment is a complex and controversial practice in crypto, as market volatility often undervalues organizations’ digital assets.

That's why we will be discussing impairment testing, covering the following topics:

• An overview of impairment testing (what it is)

• Crypto's categorization under US GAAP

• Crypto impairment’s future outlook (positive changes are coming)

• Whether impairment testing is mandatory for your organization

• Testing intangible assets for impairment in crypto (and how to automate)

What is Impairment Testing?

Impairment testing refers to the process of reviewing assets on a corporate balance sheet to assess their true value.

In accounting, an impairment occurs when a corporate asset's carrying value (the value listed on balance sheets) is permanently reduced. 

This instrument can be a:

1. Tangible asset: An item that holds value and has a physical form (e.g., cash, vehicles, real estate, machinery, office supplies)

2. Intangible asset: An asset with value but no physical form (e.g., intellectual property, patents, licenses, brand recognition, crypto)

Impairment can take place as a consequence of unexpected events, such as:

• Natural disasters

• Accidents and crime

• An economic crisis or major economic changes

• A significant shift in consumer demands

• Asset price volatility

As per ASC 350, impairment testing must be performed at regular intervals for intangible assets. Its goal is to evaluate the value of financial instruments on an organization's balance sheet to avoid overstatements.

After confirming it through a test, ASC 350-30-35-19 requires organizations to recognize an impairment loss in an amount equal to the difference between the carrying value and the fair value of an intangible asset. Recording that for the current period reduces the value of the impaired asset on the balance sheet and appears on the income statement.

It’s important to note that impairment loss can't be deducted as an expense for tax purposes in most jurisdictions.

Why Should Organizations Test Crypto for Impairment?

Due to the lack of crypto-specific rules in existing guidance, the Financial Accounting Standards Board (FASB) considers cryptocurrencies intangible assets with an indefinite life based on the factors listed in ASC 350-30-35-18B.

So, all organizations following the US GAAP must test their digital asset holdings for impairment at least once at the end of every reporting period (monthly, quarterly, or yearly). Impairment may also be assessed during significant market changes.

But how do you know if your organization needs to comply with GAAP's impairment testing rules (or any accounting standards at all)?

According to the US Securities and Exchange Commission's (SEC) Regulation S-K, all publicly-traded companies in the US are required to comply with GAAP's rules to maintain their listings on stock exchanges. Failing to do so could lead to crypto tax audits, fines, and other negative outcomes.

Based on the above, you have to do regular impairment tests if your organization:

1. Is a publicly-traded company listed on a US stock exchange

2. Holds cryptocurrency or other intangible assets on its balance sheet

If your organization is a smaller private firm and is not voluntarily following GAAP, it may not be required to impair its intangible assets.

However, GAAP is not the only accounting standard that requires periodic impairment testing of intangible assets.

The International Financial Reporting Standards (IFRS) also considers crypto an intangible asset with an indefinite life. It also introduces mandatory impairment testing for organizations holding such assets on their balance sheets at least once a year.

As per IAS 36, the IFRS allows for the reversal of an impairment loss, and its rules are enforced in multiple jurisdictions. This includes the European Economic Area (EEA), where all EEA companies whose debt or securities trade on a regulated EEA-based exchange must comply with the IFRS.

In any case, it's best to consult with an expert to ensure compliance with local regulations.

Volatility: The Primary Reason to Impair Crypto

Impairment testing has the same goal in crypto as in traditional finance (TradFi), but it often yields different results due to the unique aspects of digital assets. Once a cryptocurrency is impaired, it cannot recover in value, even if the market price increases significantly within the same reporting period.

This is where the issue of volatility comes into play. Cryptocurrencies are often subject to sudden and extreme price changes due to increased market volatility. 

But how does the volatile nature of crypto impact impairment testing?

Let's consider an example from traditional finance and another from cryptocurrencies to better understand this.

In traditional finance, an organization purchases an apartment for $100,000. A fire breaks out in the property, causing $50,000 of irreparable damage. The organization confirms the impairment via a test and writes off the $50,000 as a loss, reducing the carrying value of the apartment from $100,000 to $50,000.

A similar scenario in crypto occurs when the value of a digital asset in a company’s balance sheet falls below the cost basis. In this case, the organization must write off this difference as a loss even if the coin’s price recovers by the end of the reporting period. Under GAAP, crypto impairment is permanent, with no option to reflect positive changes in value once an asset has been impaired.

Upcoming GAAP Crypto Impairment Guidance

Impairment testing can often become an unnecessary burden for crypto organizations due to the lack of specific guidance. However, there is a change on the horizon for US companies.

On March 23, 2023, the FASB issued a new proposal that would no longer make impairment testing mandatory for cryptocurrencies that meet certain criteria. The GAAP would still consider them intangible instruments, but eligible digital assets should be presented separately from other intangibles on the balance sheet.

Most importantly, organizations must measure in-scope crypto assets at fair value and record fair value-related changes through earnings at each reporting date.

A digital asset must fulfill the following criteria to become eligible:

1. Meets the GAAP's definition of intangible assets

2. Should not provide the asset holder with enforceable rights to or claims on underlying goods, services, or other assets

3. Created or resides on a blockchain

4. Secured via cryptography

5. Fungible

6. Not created or issued by the reporting entity or its related parties

In simple terms, a digital asset on your balance sheet does not need to be impaired unless it is:

• A non-fungible token (NFT)

• Your organization's native token or another cryptocurrency issued by your company

• A utility token provides its holder with rights to goods or services

• A stablecoin meeting the criteria of a financial instrument (as it is not considered an intangible asset under GAAP)

• A wrapped token (tokens like wBTC and wETH could provide the holder with a right to another asset)

The GAAP's new rules could relieve some of the impairment-related burdens from compliant organizations. However, they still consider most cryptocurrencies intangible assets.

When to Test Intangible Assets for Impairment

Until the FASB begins to enforce its newly proposed rules, impairment testing may remain a mandatory requirement for your organization. It’s a mandatory task if your business follows the GAAP's rules and holds crypto or other intangible assets on its balance sheet.

Even after the proposed changes go live, not all of your company's crypto holdings may become eligible for the new rules. Instead, you may have to follow the "old" process to impair your NFTs, stablecoins, wrapped tokens, native coins, and other digital assets that do not meet the FASB's criteria. 

There, it's vital to know how to test your organization's digital assets for impairment. You can do that by following the steps:

1. Define a time period for impairment.

2. Take each lot of digital assets (an amount of the same asset you purchased at the same price and at the same time) that you are holding on your balance sheet at the end of the reporting period and the amount you bought them for (cost basis).

3. Find the lowest price at which each token traded on the market during the reporting period. This is called the fair value price.

4. Check each lot to see whether its cost basis exceeds the fair value price. If it does, bring its value in the books (carrying value) down to the lowest price it traded at during the reporting period (fair value price). Otherwise, keep the asset at its cost basis.

5. Adjust all your tax calculations after that date.

Let's take a look at an example to better understand the above process.

Suppose your organization purchased 10 BTC in 5 lots throughout 2022. As a result, your balance sheet would show the following:

Based on the above example, let's see when you need to impair your organization’s Bitcoin holdings through different scenarios.

1. Fall Without Recovery

In this scenario, Bitcoin’s market price fell to $5,000 at the end of the reporting period on December 31. This is the lowest price the cryptocurrency recorded throughout the year. Therefore, we have to apply it as the fair value to impair all our lots, resulting in the following carrying values:

• Lot 1: $5,000

• Lot 2: $15,000

• Lot 3: $10,000

• Lot 4: $5,000

• Lot 5: $15,000

As the carrying value of your BTC holdings becomes $50,000, your organization realizes a $220,000 ($270,000 - $50,000) impairment loss.

2. Recovery Before Reporting Period’s End

On December 1, Bitcoin’s price decreased to $8,000 in a flash crash. Your organization identifies this as a triggering event for impairment. As so, you record an impairment loss for the decline in value and write down the carrying value of the BTC units on the balance sheet to:

• Lot 1: $8,000

• Lot 2: $24,000

• Lot 3: $16,000

• Lot 4: $8,000

• Lot 5: $24,000

By December 31, BTC fully recovered from the fall and was trading at the pre-crash value of $20,000 at the end of the reporting period.

3. The Average Carrying Value Is Lower Than the Fair Value

On November 15, Bitcoin’s price reached its lowest level at $30,000 during the reporting period between July 1 and December 31. As so, it should be applied as the fair value.

Based on the above, the fair value ($30,000) becomes lower than the average carrying value per unit ($27,000). Considering that, can you use the average carrying value to avoid the impairment of your organization’s assets?

No. It is incorrect to compare the average carrying value per unit to the fair value. Instead, you should test your assets for impairment based on the difference between the fair value and the carrying value of each individual unit on the balance sheet.

Consequently, the carrying value of your organization's BTC holdings would be as follows:

• Lot 1: $20,000

• Lot 2: $30,000

• Lot 3: $30,000

• Lot 4: $30,000

• Lot 5: $90,000

At the end of the reporting period, your organization must recognize a $70,000 ($270,000 - $200,000) impairment loss impacting Lot 4 and Lot 5.

4. Selling BTC Holdings Before the Reporting Period's End

What happens if you sell all your organization’s Bitcoin holdings before the end of the reporting period?

Unless a major market change occurs, you don't have to perform any impairment testing at all. This is because GAAP requires businesses to impair their intangible assets at the end of reporting periods.

Considering the above, current accounting rules incentivize organizations to get rid of their crypto sooner.

How to Simplify and Automate Impairment Testing

The goal of impairment testing is to avoid overstating the carrying value of your organization's assets. However, the lack of crypto-specific guidance and the volatility of the market often result in undervalued balance sheets.

For most crypto projects, mandatory impairment testing is also a tedious and time-consuming task. Tracking the prices of massive asset volumes can make the process complex.

But with Integral’s newest module, impairing your organization's digital assets can be conducted with a single click. Financial operators can simply define their policy by selecting how frequently impairment should run and for which assets. With our intuitive rule engine, you can even specify triggers like running impairment whenever the price of ETH changes by 25% or more. It will automatically run moving forward as you defined it. Organizations can also manually but easily run impairment if preferred.

Once the test is complete, you can generate a report and then apply the results to your organization's gains or losses.

Let Integral simplify your crypto impairment testing with enterprise-grade accounting that puts you in control. Book a demo with us and we’ll show you how quickly it can be done.