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New standards for ICOs needed

Accounting rules need to evolve to adequately provide assurance for Initial Coin Offerings

Kanagasabai Haridas
Kanagasabai Haridas, Audit and Assurance Partner, Deloitte Singapore

Adam Gerrard
Adam Gerrard, Partner, Assurance, Financial Services, Ernst & Young LLP

While the emergence of Initial Coin Offerings (ICOs) has opened up exciting new avenues for raising funds, some experts are concerned that regulations have not kept up with this new digital phenomenon. Based on recent estimates, the total amount of funds raised through ICOs in the first quarter of 2018 reached US$6.3 billion, more than double the total raised for the whole of 2017.

Simply put, ICOs involve the creation of digital “tokens” using blockchain technology that and offered for sale to the public. These tokens are usually a type of smart contract, which is a customisable set of rules that governs how the token will operate.

“Think of an IPO and then remove the regulators, accountants, lawyers, bankers, fiat money, prospectus and shares, and add in blockchain, Ethereum, cryptocurrency, free-form whitepaper, tokens and you got yourself an ICO sprinkled with a generous amount of caveat emptor,” said Kanagasabai Haridas, Audit and Assurance Partner, Deloitte Singapore.

Smart contracts enable the tokens to be set up in whatever manner the issuer wants. For example, they can give rights similar to share capital, bonds, or a right to redeem the token in exchange for a service. Some tokens can be set up purely as a means of exchange; such as in the case of Bitcoin. Currently, the most widely issued type of token is what is known as a “utility token”.

Utility tokens typically provide the holder with rights to a product or service in the future. For example, a company which provides customer screening services might issue a token that the token-holder can use in exchange for the screening services. Likewise, a company offering cloud-based storage could issue a token that entitles the user to a defined amount of storage per month. 

A non-digital analogy of how an ICO works is the issuing of gift vouchers by department stores. In this case, the purchaser pays cash up front and receives a voucher in return. This can then be used by the holder of the voucher as payment for goods in the future. Tokens that are issued as part of an ICO are often much the same as the gift voucher. The difference is that tokens are almost always able to be traded on a secondary market, which means that their value is visible and can change dependent on supply and demand factors.

Playing catch up

Some industry experts believe that current accounting approaches are not adequate in dealing with ICOs and could create a bubble for companies issuing them. As such, there are now calls for the profession to start an in-depth review of accounting principles for ICOs. 

As global accounting standards were mostly written prior to the advent of blockchain technology, accountants have had to resort to applying existing accounting standards to this modern technology.

“The question that is most challenging for accountants to answer is: what type of asset or liability is the token? ICOs are based on smart contracts, and therefore by definition, each one has unique characteristics. Accounting principles often require accountants to look to the substance of the transaction; in this case, what obligations does the token issuer create when it issues the tokens?. The economic substance of a token is dependent on exactly what benefits it confers to the token-holders, and conversely, what obligations it creates for the issuer,” explains Adam Gerrard, Partner, Assurance, Financial Services, Ernst & Young LLP.

Some key matters for accountants to consider include whether the token confers any rights to assets, dividends, interest or residual assets on winding up, as the presence of these characteristics could fundamentally change the judgment that an accountant makes.

“The lack of a specific accounting framework for ICOs presents the risk that there will be divergences in practice, which reduces the level of comparability between company financial statements,” said Mr Gerrard.

As new accounting standards and financial reporting requirements take several years to develop, Mr Haridas urged the International Accounting Standards Board (IASB), through its research programme, to test the resilience of International Financial Reporting Standards (IFRS) standards in the digital world and the challenges it brings with it. He noted that the IASB has already started to consider whether to provide better guidance to account for assets such as cryptocurrencies.

More disclosure

For publicly-listed companies in Singapore who wish to use ICOs to raise funds, the Singapore Exchange (SGX) imposes additional requirements for disclosure to ensure the process remains transparent to all stakeholders.

“When a listed company raises funds by way of giving ownership rights, this would be akin to the issuance of shares. Such an exercise would therefore fall within the definition of securities under the Securities & Futures Act and our rules on the issuance of shares will therefore apply. However, when the listed company raises funds, such as via an ICO which does not provide the token-holders with any ownership rights, SGX would expect the company to disclose information at a relevant time to enable share investors to make an informed decision about the company,” an SGX spokesperson told BT.

Among other areas, the disclosure would include the rationale for the issue, the total value of the funds to be raised, the accounting and valuation treatment for the tokens offered and the financial impact arising from such issue. The company should also be transparent about how the ICO will be audited during the relevant financial reporting periods to provide assurance on financial reporting, the spokesperson added.

Despite the various concerns, experts believe that with most standard setters around the world now looking at ICOs, greater clarity will eventually emerge regarding the classification and treatment for different types of tokens.

“Regulation is not a matter of ‘if but ‘when’, as the current ICO market is rife with more than its fair share of bad apples. The Fintech Regulatory Sandbox administered by the Monetary Authority of Singapore (MAS) could be one such avenue for potential ICOs to provide a safe space for the entrepreneurs to work with MAS, but the sandbox could potentially be expanded to also include accountants and lawyers,” says Mr Haridas.

He adds that the emergence of ICOs could also mean new employment opportunities in areas such as in the auditing of smart contracts. “Therefore, a careful study of the risks should be done to identify the gaps and practitioners should upskill accordingly.”

A brave use of ICOs

While there have been concerns over the use of Initial Coin Offerings (ICOs) as a way to raise capital, some experts believe that the digital solution could be used for more than just fund raising.

For example, Brave is a company that uses ICOs to build and scale an ecosystem of users and stakeholders. The firm developed a new web browser that removed all advertisements so that its users could experience a much faster browsing experience. 

Brave then launched an ICO where it sold tokens worth US$36 million to advertisers who could use them to advertise exclusively on the Brave browser. If an advertisement receives user attention and the user clicks on it, the advertiser gets further tokens, which can then be used to purchase advertisement space. This incentivises advertisers to only provide meaningful and relevant content. 

Meanwhile, Brave users who agree to see advertisements will also get tokens that they can use to reward publishers of content they think is useful or unlock premium features within Brave. In this case, the use of token went far beyond fund raising, and helped to develop a business and an ecosystem with the use of smart contracts.

This article is part of a series brought to you by CPA Australia to share knowledge on topical issues relevant to business, finance and accounting.

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