Token of complexities
ZALDY D. AGUIRRE
Early this year, Sen. Manny Pacquiao signed a contract with a Singaporean-based blockchain firm so he could offer “Celebrity Tokens” called “PAC Coin”. Fans can use the PAC Coin to gain access to exclusive live streams of Pacquiao or buy exclusive Team Pacquiao merchandise.
ICO, the new way to raise funds
The world is evolving at lightning speed in so many dimensions that even capital or fundraising for a business venture nowadays is done in an entirely new fashion.Traditionally, companies would borrow money, issue debts, or do an initial public offering (IPO) to fund their business expansion programs. But tech startups, true to their disruptive nature, introduced a rather revolutionary way of raising funds – through an initial coin offering (ICO) that has given birth to digital tokens.The crypto community saw its first ICO in 2014, pioneered by Ethereum, a blockchain-based distributed computing platform and operating system.
So, what’s ICO? For first-timers, ICO is a means employed by tech startups to raise funds to develop a particular platform or ‘Solution’ via issuance of its own digital ‘tokens’. As part of the initial offering, the startup comes up with a plan described in a ‘Whitepaper’ that outlines the nature of the project, the objective of the Solution, the technology used (usually blockchain), how much funding is needed, and a description of the long-term business, among others.The number of tokens is predetermined and can be acquired in exchange for cryptocurrencies (e.g. Bitcoin) or fiat money (e.g. US Dollar).
What are digital tokens for? Tokens have different purposes and uses. Some tokens can enable their investor-holder to participate in developing or using the Solution. Other tokens can offer future returns in the form of possible value appreciation or financial payouts that bear some investment appeal to potential investors.
2017 was the year when ICO went mainstream, with startups reportedly raking up close to US$6 billion globally via ICO. About a third of funding went to blockchain startups.These ICOs are hosted in various countries with Singapore and Switzerland standing out as jurisdictions of choice. Currently, there are no prohibitive regulations for ICO in Singapore although the Monetary Authority of Singapore (MAS) is continuously monitoring the ICO activities there.
How to report ICO in financial statements
The ICO process and the underlying blockchain technology are mind-boggling for me. Frankly, I have more questions than answers. I’m afraid that writing this article and the ensuing conversations would be tantamount to opening the proverbial Pandora’s Box. But I’ll dare touch on it as far as how the issuing startup company should report tokens in their financial statements.
Are tokens considered “securities” like debentures or shares? If so, should the startup company issuing those tokens account them as debt or equity? This can be tricky as tokens are not created equal. Some tokens offered in ICO can represent equity or ownership interest in the business of the issuer equivalent to “shares” of an ordinary corporation. Likewise, token holders can enjoy certain rights like the right to receive dividends and the right to participate in the distribution of the issuer’s net assets upon liquidation. In this case, tokens may qualify as equity instrument for accounting purposes.
On the other hand, some tokens can be a proof of the token issuer’s debt or liability if he is required to repay investors the principal investment on a specified date or upon redemption plus interests. These mandatory payouts can constitute future obligations that may support the financial liability classification.
The current accounting principles on financial instruments require a detailed analysis of the “contractual” terms of the instrument to establish whether a security is a debt or an equity instrument. Contracts defining financial instruments may take a variety of forms. Would digital tokens as supported by a white paper qualify as a “contract” under the accounting standards?
Wait, there’s more. What if tokens solely provide utility value to the investor such as future access to, or use of, the platform? Will the ICO become a revenue-generating activity and therefore, the issuer should account funds raised from token issuance as “deferred revenue” attributable to the unperformed “service” obligation? Simply put, proceeds from token issuance are recorded as revenue because the startup will provide future service or access to investors. Well, that’s assuming that the planned platform or solution will succeed.
These are just some of the contentious accounting issues that companies would have to confront when they tread the ICO route. Clearly, digital tokens and cryptocurrencies alike are nascent funding models outside the current accounting realm. For now, in the absence of explicit accounting standards, Big Four accounting firms have released papers offering some guidance on how tokens and cryptocurrencies can be reported in the financial statements by applying existing accounting principles on inventory and intangible assets.
ICO and the regulators
Regulators around the world are still playing catch-up in understanding the workings of tokens and other digital currencies. Some countries have taken a liberal approach on ICOs while others have banned them completely – at least for now. Sadly, due to their unregulated status, many ICOs turned out as scams, leaving victimized investors with no clear legal recourse. Many regulators around the world believe that if tokens are deemed “securities” based on their features and design, the ICO activity should be regulated just like a typical debt or equity offering.
Interestingly, here in the Philippines, the cryptocurrency landscape is quite upbeat. Case in point: the Bangko Sentral ng Pilipinas (BSP) has already issued licenses to at least three entities to operate as virtual currency exchanges (VCE) in the country.The VCE license allows these companies to trade cryptocurrencies, such as Bitcoin and Ethereum, with clients subject to customary anti-money laundering (AML) and know-your-customer (KYC) rules.
At present, the monthly VC trading volume of Bitcoin in the country is estimated at US$6 million, up from US$2 million in 2016. The huge jump is attributed to the growing popularity of Bitcoin among overseas Filipino workers who now use it to send remittances to their families in the Philippines because of cheaper transaction fees. BSP has reportedly received 29 VCE license applications as of April 2018 – more than 100% increase from 12 as of end of 2017 – quite a rosy outlook for the cryptocurrency sector.
For its part, while the Securities and Exchange Commission (SEC) has issued cease-and-desist order on the supposed local ICOs of four Filipino-owned companies, it’s not entirely closing the doors on ICO. As a matter of fact, to demonstrate its commitment to innovation and support to the crypto community, the SEC has already formed a working group tasked to study and eventually craft the legal and reporting framework for ICO. One of the criticisms against ICOs is that the amount of available information is scant since there are no established rules requiring the publication of reports or financial data. Ultimately, any regulatory intervention should be aimed at leveling the playing field for those tapping the capital market and providing transparency in the ICO process through standard disclosures and reports.
Let me share some of my thoughts for those contemplating to invest their hard-earned money on digital tokens.
Remember, tokens marketed as investment products are not without risks. A pessimistic observer said that ICO is akin to giving money to a man in a pub for tickets to a film that he says he will make. In ICO, the proponent-startup usually does not have relevant track record, and the risk that the venture may not work out smoothly or could end up a flop could be even greater.
Digital tokens are meant for sophisticated and well-informed investors. Deciding to put your eggs into the ICO basket should come after a thorough understanding of the ICO process, careful analysis of the viability of the proposed venture and most importantly, with necessary regulations already in place. After all, as Benjamin Franklin once said, “An investment in knowledge pays the best interest.”
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Zaldy D. Aguirre is an Assurance Partner and concurrently Accounting Consulting Services Lead Partner of Isla Lipana & Co., a member firm of the PwC network. For more information, please email markets@ph.pwc.com.
This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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