NFTs

6 Things To Know About Accounting For NFTs

6 Things To Know About Accounting For NFTs
by 
Amy Kalnoki

Although the NFT market is relatively new, it has grown exponentially in recent years. For example, total NFT sales topped $44 billion last year. And digital artist Beeple sold an NFT for $69 million through the Christie’s auction house in March of 2021. Interestingly, Beeple’s record-breaking sale consisted of a JPEG file that pictured a collage of nearly all of his artwork. Needless to say, the NFT space has seen an immense amount of interest and activity during this time period. However, less interest has been paid to NFT accounting practices. In this article, we plan to fill in some of the gaps and get you up to speed on the latest in NFT best practices. 

What are NFTs?

NFTs, or non-fungible tokens, are digital cryptographic assets stored on a blockchain. Each NFT has a unique identification code and metadata that helps to distinguish one from another. Admittedly, the definition of NFTs is quite technical. So, let’s break it down and make it a bit more manageable.

In general, a token is simply a unit of value issued by an organization. And in the case of NFTs, a token is digital and representative of an asset of some kind. In most cases, an NFT provides usage or access rights to some kind of intellectual property, real estate, event, service, etc. Today, the most popular NFT categories include “...collectibles, digital art, game items, music, event tickets, domain names, and ownership records for physical assets.” NFTs are non-fungible, meaning that they are all distinct from one another and cannot be used interchangeably as Bitcoins or pennies can, for example. Additionally, NFTs are stored or recorded on a blockchain. While any blockchain can store NFTs, the Ethereum network is currently the most popular option. It is during the process of creation and storage on a blockchain that each NFT receives its unique identification codes and metadata. 

Considerations for NFT Accounting

What is the accounting treatment for NFTs?

Unfortunately, there is no specific accounting guidance for NFTs under U.S. GAAP (U.S. Generally Accepted Accounting Practices). As a result, it is unclear which asset accounting model should be applied to NFTs. “NFTs do not meet the definition of cash and cash equivalents, marketable securities, financial instruments, or securities. ‘Based on GAAP definitions, cryptocurrencies fall under intangible assets, which are recorded at cost, can’t be written up as they go up in value, and are tested at least annually for impairment in value…’” Some argue that NFTs are most similar in nature to indefinite-lived intangible assets. Indefinite lived intangible assets are “...a category that includes trademarks and perpetual franchises. This is the same accounting treatment given to “goodwill,” an accounting asset that results from one organization paying a premium (over-paying) for another organization." The challenge with NFTs is that they are all different and can contain a wide range of rights or assets. Accordingly, the accounting treatment can vary depending entirely on the subject matter and specifications of the NFT. For example, an event ticket NFT may fall into a different category than an NFT involving real property. And the accounting treatment may change between two NFTs of the same subject area depending upon the underlying terms agreed upon by the NFT seller and the NFT buyer. One music-related  NFT may involve song ownership rights, another might simply involve usage rights, and another may include provisions for future royalty payments. 

Where in the Balance Sheet should an NFT be reported?

Typically, NFTs show up on a balance sheet as intangible assets. However, each NFT is different and should be analyzed separately for accounting purposes. As mentioned earlier, certain NFTs come with provisions that may shift them from one accounting category to another. As a result, these NFTs would show up in a different area of the balance sheet. The important thing to remember with regard to NFTs is that they are simply a vehicle for the underlying asset or rights (usage rights, access rights, property rights, etc.). Sometimes it is helpful to consider how an asset or right would be categorized if it was not an NFT. 

How is an NFT valued?

As mentioned above, NFTs are typically considered intangible assets with an indefinite life. For reporting purposes, the value of an NFT is its carrying value, which is simply the acquisition cost of the NFT minus the impairment loss. To test for impairment, you must first determine fair market value. 

While fair market value can be challenging to pin down precisely, one method is to bring predictable valuation to the NFT market using valuation theory.

In valuation theory, two primary approaches are relevant with regard to NFTs:

  • Discounted cash flow 
  • Market 

The Discounted Cash Flow (DCF) Approach

The discounted cash flow approach considers future revenue that will be received as the result of owning an NFT. For example, cash flows derived from the ownership of an NFT might include licensing and royalty payments. This approach to obtaining fair market value can be beneficial for NFTs that grant rights to a share of royalty income. Current applications of the DCF approach can be seen in the music NFT space, where NFT holders may earn a percentage of the royalty income on any songs that they own shares of. 

The Market Approach

While the DCF valuation approach is applicable in certain situations, the market approach is the more commonly used technique. When using the market approach, fair market value can be determined by the price at which an NFT changes hands from a buyer to a seller. In other words, past sales of a similar NFT can help to determine its present value.

What are the tax implications of NFTs?

In most cases, NFTs are taxed similarly to cryptocurrencies. Generally speaking, NFTs are treated as property and taxed accordingly. However, this can vary depending on whether the taxpayer at issue is the NFT creator, NFT buyer, or NFT seller. For example, NFT creators assume tax liability the moment the NFT is sold and pay taxes on the sale as if the proceeds were ordinary income. On the other hand, “...buyers and sellers of NFTs are taxed similarly to how other cryptocurrencies are taxed, with long-term capital gains rates, or short-term (ordinary income) rates coming into play.” 

It is important to keep in mind that all NFTs are different. As a result, some NFTs will be out of the ordinary and involve a more complicated tax analysis. According to Forbes, “taxpayers can be assessed tax rates at either the ordinary tax rate, at the capital gains rates, or as a collectible asset depending on the specifics of the tax situation. The lack of standards and clarity on these issues from the IRS or other tax authorities continues to complicate these questions.” The best advice here is always to consult a tax professional and prepare as if you will be taxed at the higher rate (which is generally the rate for ordinary income). Last year, a significant number of crypto and NFT investors were caught unaware and had to shoulder the burden of higher-than-expected taxes.

What are the legal considerations of NFTs?

While blockchain technology has created additional clarity around proof of ownership, it has also created legal complexity, especially when the NFT  in question is tied to physical property. For example, “...if there are NFT issuances connected to commercial real estate, with ownership also being subdivided, would these NFT holders be considered owners or simply investors/holders of some assets at fair market value?” These and other novel legal questions are emerging as new players enter the NFT space and innovative ways to use NFTs enter the market. Whether you are currently involved in buying and selling NFTs or are considering entering the market in the future, it is helpful to consider some of the more prominent legal risks and questions in order to avoid unintended consequences.

Are NFTs commodities or securities?

As discussed above, NFTs can be linked to many different types of rights, obligations, or property. As a result, there is some question about what type of asset class they inhabit. Most experts agree that NFTs generally fall under the securities category. However, NFTs could also be considered commodities if “...designed to provide an expectation of profit to the buyer based on the efforts of others and were marketed as such. One potential example of such an arrangement could be a "fractional" NFT ("f-NFT"), where an investor would share a partial interest in an NFT with others.” 

The question of whether an NFT is a security or a commodity is not just a theoretical exercise, as it can have real-world implications for creators, buyers, and sellers. Depending on the answer, NFTs can be governed by a different set of laws and regulations. For example, “If an NFT (or f-NFT) is considered a security, then common securities law issues would be present—e.g., registration or exemption of the offering under the Securities Act of 1933; registration of the sellers of those instruments as broker-dealers under the Securities Exchange Act of 1934 ("Exchange Act"); registration of the marketplaces on which the instruments are sold as securities exchanges under the Exchange Act; securities law liability for material omissions or misstatements and insider trading; restrictions on short sales and market stabilization around an initial offering; and so on.” 

Which intellectual property rights are included in the sale of NFTs?

Intellectual property rights should be a significant consideration when buying or selling NFTs. Although intellectual property rights are involved in many NFT sales, the intellectual property rights of the underlying asset do not necessarily transfer to the buyer. “If the issuer of an NFT is a content creator, then the issuer will have all rights in the content and can create NFTs that correspond to that content assigning any of those rights to a buyer—for example, the right to use, copy, display, and modify the content. If an issuer obtains content from a creator, then the issuer would only receive the rights such creator assigned or licensed to the issuer, and will only be able to assign or license those limited rights to the buyer.” Other NFTs, however, do transfer intellectual property rights to the buyer. Generally, the terms of the NFT are determined by the seller. As a result, it is critical that both buyer and seller fully understand all of the rights that are involved before entering into an agreement. 

While the transfer of intellectual property rights is the main consideration when it comes to buying and selling NFTs, it is also important to consider whether any intellectual property rights are being infringed upon during the creation of the underlying NFT asset. For example, “if an NFT is created that uses copyrighted artwork without permission, that could be considered copyright infringement.” Not only is copyright infringement an important consideration for ethical reasons, but its existence can also involve the NFT buyer and seller in costly litigation. If proven, copyright infringement will invalidate the sale of the NFT and deprive both the buyer and seller of the benefits they sought to achieve with the NFT sale. Additionally, the infringing party will most likely be forced to pay sizable damages to the copyright owner to compensate them for the use of their intellectual property. 

Are NFTs subject to U.S. sanctions and money laundering law?

The U.S. Office of Foreign Assets Controls (OFAC) has not issued specific guidance with regard to NFTs. However, OFAC has stated that U.S. sanctions do apply to digital transactions and currencies in the same way that they do to traditional financial transactions. “The possibility of persons subject to U.S. sanctions participating or benefitting, directly or indirectly, from activities involving NFTs present the primary avenue of risk exposure; moreover, NFTs present circumstances that OFAC has identified in other scenarios as presenting heightened risks for potential violations.” While it may seem far-fetched that you or your business could inadvertently violate U.S. sanctions law, first consider that the blockchain’s decentralized and anonymous structure provides significant advantages for individuals trying to evade U.S. law. This is part of the reason why NFT and cryptocurrency markets are so appealing to hackers. And recent events, notably Russia’s invasion of Ukraine and the U.S. regulatory response, have significantly increased the number of individuals sanctioned by the U.S. government. As a result, the chances of unintentionally violating U.S. sanctions law have increased in the recent past and could become a more significant risk in the future.

The risk of running into problems with U.S. money laundering law is similar to U.S. sanctions concerns. The nature of DeFi and the blockchain has attracted many bad actors. “Considering that crypto offers decent anonymity to both sellers and buyers, ill-intentioned actors could benefit from NFTs in laundering money more easily than the standard channels. NFT marketplaces must be aware and promptly respond to such risks and ensure that they comply with the relevant regulatory framework.” Because NFT marketplaces have attracted bad actors, the U.S. government has taken notice and increased its scrutiny of cryptocurrency and NFT markets as a whole. While specific laws and regulations targeting money laundering in NFT markets have not emerged yet, it seems as though already existing U.S. money laundering law would apply to cases involving certain NFTs. The question of whether existing U.S. money laundering law applies to NFTs swings on whether or not NFTs are considered substitutes for currency. As discussed above, NFTs are all different - some are more like assets, while others have more in common with currencies. NFTs that share qualities with currencies are likely subject to money laundering laws and will attract increased attention from U.S. regulators in the near future. 

Are NFTs subject to state virtual currency and money transmission laws?

If certain NFTs are considered substitutes for currency, the possibility exists that they are subject to state virtual currency and money transmission laws. Several states have begun regulating cryptocurrency marketplaces, and this development has led many to question whether those laws apply to NFTs as well. “New York and Louisiana are two examples. Each state has a list of activities it deems under its laws to constitute virtual currency business activities, which can include, for example: exchanging, transferring, controlling, administering, or issuing virtual currency. Both states require companies that engage in such activities to obtain a license or charter and post surety bonds or fund an account for the protection of customers.” While it seems unlikely that these laws apply to all NFTs, there is a strong possibility that they do apply to some NFTs. As a result, NFT marketplaces and businesses that are heavily involved in NFT trading would be smart to consider how they can reshape their processes to comply with emerging state virtual currency and money transmission laws.

What are the data privacy concerns related to NFTs?

Although blockchain technology provides many opportunities for bad actors to shield their identities, it can also publicly reveal the identities of millions of average users. Nearly all NFT transactions are stored on a blockchain and are, therefore, publicly available. Clearly, “This could pose a problem for those wishing to keep their NFT purchases private. For example, someone buying an NFT related to a sensitive topic (such as pornography or political activism) may not want their name attached to that purchase.” This problem can be avoided in future transactions by creating and using a pseudonym for NFT transactions. However, past transactions remain on the blockchain indefinitely and cannot be altered or “cured” after the fact by changing the identifiable information. This is a significant problem, especially under European Union regulations. In most instances, the EU’s General Data Protection Regulation framework gives citizens the right to remove their data held by public and private companies. “Blockchain technology’s immutable property might make this privilege impossible to exercise or burdensome to implement. For this reason, nonfungible tokens that contain personal data might infringe data protection laws.” As a result, markets and businesses using blockchain technology are likely to see significant litigation and regulatory attention in the future regarding personal privacy and data security.

What are the common use cases of NFTs?

The use cases for NFTs are expanding every day. In fact, the blistering pace of NFT adoption has led many to question whether our economy is moving toward a digital tokenization of all physical goods and property. While this transition is likely years or decades away, the development underscores the vast array of NFT varieties entering the market. Let’s take a look at some of the most prominent types.

Works of Art

Thus far, art-related NFTs are the most common type sold on the market. Although digital art accounts for a larger percentage of NFT sales, traditional art is also being sold in NFT form as well. NFTs have significant appeal and usefulness in the art industry for several reasons. Stated simply - NFTs solve several problems that have created inefficiencies in the art market for years. Since the emergence of the internet, most artists have seen the value of their work decline. The internet allowed the public to view, copy, and reproduce their work without permission and, importantly, without payment. The problem has become so widespread in the digital art space that it is often difficult to prove which version of the artwork is the original and who owns the rights to use and sell the piece. With the help of smart contracts and blockchain technology, “...an artist can mint an NFT representing a piece of art, thereby giving the customer sufficient evidence that the NFT-based art file is the most effective one which exists. This level of rarity and uniqueness of a digital record is possible thanks to blockchain’s immutability. Furthermore, NFTs enable artists to get a cut on the secondary sale of their virtual art, as royalties can be programmed into the NFT smart contract, supplying a percentage of the sale back to the original artist.” In fact, NFT sales sometimes have very little to do with actually possessing the art in a traditional sense. “When it comes to NFTs, the value isn’t necessarily about the attached artwork. Sometimes, what is more important is proving ownership of that particular asset. This aspect is what makes crypto art one of the most popular NFT use cases out there.”

Music

Music NFTs have much in common with art NFTs. Primarily, the rapid rise in their popularity has a lot to do with solving existing problems within the traditional industry. Much like art in the internet age, music has become far too easy to copy and sell without permission. And music labels and streaming services take the vast majority of revenue that flows into the industry, leaving significantly less for the musicians themselves. “Among other benefits, fans are willing to invest in NFT independent artists, as all funds go directly to the creators. Unlike the traditional music scene, where ticket sales benefit venues, publishers, and record labels, NFTs provide new opportunities to directly support favorite artists and help them stay independent.” Additionally, music NFTs are particularly attractive to musicians because they allow for the inclusion of perpetual royalties. These royalties help ensure that musicians will continue to benefit from their work well into the future.

Clearly, NFTs can be very appealing to musicians. The high level of participation by musicians has fueled much of the increase in NFT popularity. However, what do consumers get out of purchasing NFTs as opposed to buying music on more traditional platforms? The answer has to do with the creative ways that musicians have found to connect with their fans. “Like an image file or video, you can also attach audio to an NFT to create a collectible piece of music. Think of it as a digital “first edition” of a record.” NFTs also provide fans with a digital method of collecting special perks and unique band memorabilia. For example, “artists provide NFT owners with exclusive discounts and events and tickets to VIP sections. The NFT is the first technology to develop autographs. Now fans can invest in a unique work of art created by a band or singer such as Taylor Swift and Camila Cabello.”

Gaming

As a whole, the gaming industry is one of the fastest-growing industries in the global economy. And NFTs, while relatively new to the gaming industry, are experiencing rapid adoption. “NFT-based play-to-earn games have gained enormous attraction over the last year. For instance, Axie Infinity is such a game with more than 2 million active daily players.” As it stands today, NFTs are primarily being bought as a way of gaining advantages within the game itself. For example, “in-game items such as avatars, skins, and weapons can be created on blockchain to provide game-altering or cosmetic benefits to the players. NFT marketplaces enable players to buy, sell or swap these items with each other.” In fact, early research suggests that the time an individual gamer spends playing a particular game increases as much as fivefold if the game is blockchain-enabled. Recent developments, such as cross-platform NFT compatibility, seem to be popular with gamers as well. Interestingly, gamers are more likely to start playing a new game if they already own a character purchased while using a different game. 

Events and Ticketing

Much like art and music, event NFTs seek to rectify long-standing problems in the ticketing industry. For quite some time, large ticketing platforms have controlled the event marketplace. They take a significant percentage of the revenue away from artists, musicians, companies, and organizations. While these ticketing companies do provide a valuable service, they also manipulate ticket prices, often to the detriment of the event itself. For example, ticketing companies raise ticket prices significantly if their algorithm suggests an event is in-demand. Unfortunately, their algorithms are sometimes incorrect, leaving the event half-full because ticket prices were raised too high. In addition to large ticketing platforms, events must also contend with so-called ticket bots. Ticket bots are automated software used to purchase event tickets in bulk with the intent of re-selling those tickets later at a markup. It is estimated that up to 40% of event tickets today are purchased by ticket bots. Despite laws enacted to curtail their influence, ticket bots continue to flourish. Unfortunately, ticket bots deprive event holders of revenue and artificially drive ticket prices up for consumers. And as consumers have grown accustomed to purchasing re-sold tickets from third-party vendors, they unknowingly expose themselves to the possibility of ticketing scams. In fact, “It is estimated that 12% of concert ticket buyers have been scammed (e.g., sold fake tickets).”

Needless to say, the event ticketing industry shows significant room for improvement. When they are well constructed, NFTs have the potential to solve or improve all of the problems discussed above. For example, NFTs can be exchanged directly between the artist/venue and the fans, thereby cutting out third-party ticketing platforms. Blockchain technology can also help to reduce ticketing scams. “NFT transactions on a blockchain will be on a public ledger making secondary sales trackable and enabling rules-based validations before purchases.” It is also possible to eliminate the problem of ticket scalping altogether by making event NFTs nontransferrable. In addition to solving these problems, NFTs can also provide additional value to fans. Event NFTs can come with collectible artwork that can retain value over time as memorabilia. Once inside the event, fans can use their NFT as a pass to access special perks like backstage access or complimentary food and drinks. Event NFTs can even be structured to provide shareholder benefits which return a small part of the revenue generated by the event to the fans that attend. 

Bitwave Can Provide Complete Visibility Into NFT Accounting

It’s easy to see why NFTs have generated so much interest in recent years. The value of NFTs is clear, and they have the potential to change the way our economy works. Unfortunately, U.S. accounting and tax standards have not kept pace with the advances in the NFT market. As a result, NFT accounting and taxes have become a quagmire for many blockchain-facing businesses, forcing them to devote immense time and resources to untangle the mess. That’s where Bitwave comes in - enterprise organizations can leverage our software to automate accounting, tax calculation, and reporting for NFTs. With our help, your business can shake off accounting and tax challenges and get back to capturing your share of the growing NFT market. 

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