What CPAs need to know about NFTs

Even though bitcoin was introduced to the world over a decade ago and nonfungible tokens (NFTs) have been in development since 2014, argument persists over the underlying value of digital assets, including NFTs. Many accountants express skepticism over digital assets. Yet, despite the doubt, digital assets are foundational to the evolving Web3 vision of the internet, e-commerce, and peer-to-peer transactions. By 2030, many companies, public and private, as well as individuals, will likely have accounting and financial reporting challenges related to digital assets.

NFTs are a method of demonstrating ownership of physical, intangible, and digital assets. They have far more uses than buying and selling pixelated JPEGs. For instance, visual artists and musicians can use them to sell works directly to fans. Venues are selling NFT tickets to events as a way to reduce scalping and give more revenue to artists. Real estate professionals are exploring using NFT deeds and contracts to streamline the process of buying and selling property. CPAs who work in these areas may soon face questions from clients about NFTs.

NFT records kept on blockchains are crucial to auditors evaluating assertions around the existence and valuation of digital assets and the rights and obligations held by those who own them. Many startups and other “digital native” companies are already seeking accountants, tax specialists, auditors, regulatory personnel, and CFOs who can help them correctly record and report NFTs and other digital assets. Enterprising CPAs have teamed up with developers to bring crypto modules to market that can hook up to an existing accounting system.

This article explores what CPAs need to know about NFTs today and why there is so much hype around them. What problems do they solve? What differentiates an NFT from other digital assets and gives it value? How are they created? And for accounting purposes, what are the types of NFTs?

A NEW PHASE IN THE HISTORY OF THE INTERNET

A little history is valuable at this point. The terms Web1, Web2, and Web3 are used to describe distinct stages in the evolution of the internet. Web1 was the first iteration of the internet developed for private military and institutional use starting in the 1970s. It provided users with the ability to share information and little more. Web2 emerged in the late 1990s and is the iteration of the internet that is allowing you to read this article. It is characterized by ease of use and high interactivity, as well as widespread application of encryption to provide security for internet-based activities.

A fundamental problem with Web2 is that it can be very difficult to prove the authenticity or ownership of data on the internet. Data is easy to steal and easy to duplicate. Images, videos, and audio are easy to “deep fake” and manipulate.

Web3 leverages blockchain and public key cryptography to demonstrate and protect the ownership, authenticity, and integrity of digital data. Each participant on a blockchain ledger can hold a copy of all the transactions in the ledger, and new transactions are added through complex cryptographic protocols, making it practically impossible to falsify or change data recorded on a blockchain. Ownership and authenticity in the internet’s anonymous zero-trust environment is far easier to prove with blockchains, which are further protected from loss or destruction simply because, in certain cases, the complete ledger is held by thousands of participants around the globe.

CHARACTERISTICS OF AN NFT

NFTs are a cornerstone of Web3. NFTs are controllable digital records that allow for digital and physical assets to be represented as unique, valuable, and easy-to-transfer “tokens.” NFTs can also be described as the tokenization of anything and everything, whether physical or intangible, to enable blockchain-based recording. NFTs have two distinct traits: They are unique (nonfungible), and they are always linked to a physical, intangible, or digital item.

NFTs are unique or ‘nonfungible’

Fungibility is a characteristic of a digital or physical object that refers to its ability to be interchanged or replaced with another item of the same type, a concept called mutual interchangeability. Dollar bills and shares of the same class of stock are examples of fungible items.

The term nonfungible means an item is unique and cannot be replaced with another item of the same type. NFTs are nonfungible due to complex encryption techniques that assign a unique ID, called a “hash value,” to the underlying object. A blockchain NFT transaction will typically contain, at a minimum, the unique ID and associated wallet addresses. (The term “wallet,” in this context, refers to the online accounts where digital assets are held, similar to logging in to a bank website and seeing the balances of different accounts.)

NFTs are linked to an underlying item

NFTs are distinguished from other digital assets in that they are always linked to an underlying item that could be digital, intangible, or physical. The most common type of NFTs in existence in 2022 are those linked to a graphic art file (e.g., JPEG, PNG, GIF). NFTs’ ability to prove ownership and provide an auditable trail of activity via a blockchain has been revolutionary for graphic artists because it allows them to have irrefutable proof that they created and own or have rights to an image.

Creating an NFT for a physical item starts with generating a document with information about the item and its ownership. For example, if a group of people want to jointly own a Pablo Picasso painting, they could generate a document with ownership details and use agreements and then use the document as the underlying file to generate an NFT hash value that is linked to the blockchain record. The file’s hash value becomes part of the NFT.

NFTs GENERATE REVENUE AND CREATE VALUE

CPAs should be aware that NFTs can be used to generate taxable revenue and create value (see the graphic “How NFTs Generate Accounting Events,” below). A prime use case for NFTs is allowing visual artists or musicians to earn royalties each time their creation is used, say in a game or played on a streaming service. Currently, artists receive less than pennies on the dollar for each play or sale of their work, and nothing for resales. NFTs solve this by providing a cryptographically protected immutable Web3-enabled code that tracks the use of the artistic product and financially rewards the artist each time their work is used. These rights and processes are established at the time of “minting,” or creation. The value of this kind of NFT can be approximated as the value of the future cash flows (i.e., the royalties) from the NFT for views and plays plus value for the accompanying music, art, or other content.

How NFTs generate accounting events

Beyond just the buying and selling of NFTs, participating in the validation of NFT transactions to add them to a given blockchain also generates taxable revenues. In order to mint an NFT, the minter must pay a fee to the blockchain network. The computers/users that mine or validate the transaction receive the minting fee as a type of taxable ordinary income.

HOW TO MINT AN NFT

NFTs are created through a process called “minting” (see the graphic “How to Mint an NFT,” below). The minter first identifies the NFT marketplace where they want to display, sell, or use the NFT. When making this decision, the minter may consider the size of the marketplace, the cryptoasset accepted in the marketplace, and the marketplace’s fees, among other things. The marketplace may require the minter to create an account and provide state-issued proof of their identity (e.g., driver’s license, passport, etc.).

NFT minting platforms are a type of decentralized/distributed application (a “Dapp”) that provides minting capability and a marketplace in which to list, buy, and sell NFTs. To an average person, a Dapp would appear to be a website or a downloadable phone app. Dapps leverage smart contracts, which are automated executable programs that enable the creation of NFTs, their ongoing operation, and subsequent sales and transfers. When the minter is ready to create an NFT, they upload a file to mint and then link their crypto wallet to the Dapp to pay a processing fee.

NFT MARKETPLACES

An NFT’s value is subjectively set when it is listed for sale by the owner on an NFT marketplace. These marketplaces are built on the automated actions of web applications and smart contracts, which execute transactions as users initiate them and meet preset parameters (e.g., transferring the necessary amount of cryptoassets to pay for an NFT). Once a buyer deposits the necessary amount of cryptoassets with the market’s smart contract, the market will then transfer the NFT record to the buyer’s wallet. The NFT record is linked to all prior blockchain sales records for it, which show the buyer, seller, and price paid.

CURRENT ACCOUNTING GUIDANCE FOR NFTs

Currently, a GAAP standard over digital assets, including NFTs, does not exist; however, accounting standards bodies and government regulatory agencies are aware of the gap and are evaluating the area. Until a formal standard cements the definitions and treatment of all types of digital assets, CPAs can look to the AICPA’s Digital Assets Working Group’s practice aid Accounting for and Auditing of Digital Assets for information. The practice aid defines a digital asset and provides the specific characteristics of digital assets that meet the definition of an intangible asset. Those digital assets are generally classified as indefinite-lived intangible assets and are measured at cost and tested for impairment.

SIMPLIFYING THE TYPES OF NFTs

GAAP often relies on the life of an asset and/or its period of use as a major factor that drives the selection of appropriate accounting treatment. Identifying the period of use or asset life allows a practitioner to match revenues to expenses and guides ledger account selection for various events (i.e., balance sheet vs. income statement accounts). Cryptoassets are not attached to a specific underlying asset and exist indefinitely; however, NFTs are attached to a file or a physical asset and are not necessarily indefinite-lived assets. In fact, an NFT’s value can be destroyed if the underlying asset loses value or is damaged or destroyed.

There is tremendous variability in the types, purpose, appearance, and operation of NFTs. To help clarify the NFT landscape for accounting purposes, we analyzed the existing range of NFTs as well as numerous articles and academic studies that attempted to define the types of NFTs. From this examination, we identified four main groups of NFTs.

We classified NFTs into these groups according to their period of usability and degree of reusability: single use, reusables, perpetuals, and real assets. (These naming conventions are subject to change as standards emerge.) Most NFTs will fall solidly into one category, with reusables representing the vast majority of present-day NFTs. Down the road, complex NFTs may be created that have dual elements that cause them to fall into more than one category.

The four groups are:

Single use: These are NFTs with limited resale or reuse value, whose reuse values degrade significantly after initial use or lose almost all their value in under a year. It would also include NFTs that are “burned” (removed from circulation) after limited use. Examples include:

• Virtual event tickets (if the ticket may be retained and has collectible value, it may fall into the reusables category).
• Memberships that must be renewed each year or can only be used for a single entity.
• Game items usable in only one game or one family of games.

Reusables: The most common types of NFT now, these are NFTs that have collectible, display, or reusable value. They can be bought and resold on marketplaces, and royalties can be collected on their repeated sales or use. Examples include:

• Artwork.
• Collectible digital items for display/use in virtual worlds.
• Profile picture collections and avatars.
• Memes (GIFs).
• Music.
• Virtual fashion.
• Trading cards.
• Text-based NFTs or literary works.
• Game items that are usable across multiple platforms and in future games (consider whether the item loses usefulness in under a year, in which case it is likely a single-use NFT).

Perpetuals: These are NFTs that represent permanent digital locations, primarily domain names and metaverse “land,” which is a specific location in a virtual world (e.g., Decentraland). The recordkeeper for these might be a state or federal government leveraging a private blockchain, or it could be a public blockchain privately developed and maintained by its decentralized community. One interesting issue that may arise in the future of decentralized finance, or DeFi, is whether virtual properties can be mortgaged.

Real assets: These are NFTs tied to a real-world physical asset and are used solely for the purpose of ease of transfer and ownership authentication. The accounting for these types of NFTs is most likely to follow the accounting applicable to the underlying physical asset.

HOW NFTs WILL SHAPE THE FUTURE OF THE WEB

NFTs have evolved dramatically since they were first envisioned less than a decade ago. As digital spaces become increasingly intertwined with real life, accountants, tax specialists, auditors, regulators, and CFOs will find they must track, record, and report NFTs and other digital assets. NFTs are positioned as a building block for future growth in web-based tools and digital spaces; however, trying to predict what will be even a few years from now is as futile as trying to predict social media in 1999. What is most useful to CPAs at this juncture is a basic understanding of how NFTs are created and function, and the framework provided in this article for categorizing and ordering the many types of NFTs they may encounter.

About the authors

Stacey Ferris, CPA, CFE, is an associate director with HKA’s blockchain group and government contracts group in Washington, D.C. She is also an adjunct accounting faculty member with the University of Maryland Robert H. Smith School of Business, teaching blockchain and its impact on accounting and audit for graduate accounting students. Peter Rehm, CPA (retired), is an independent consultant in Atlanta, providing CFO advisory services to enterprises interested in or actively transacting in cryptoasset-focused businesses. He is an AICPA-designated subject-matter expert on blockchain. To comment on this article or to suggest an idea for another article, contact Courtney Vien at Courtney.Vien@aicpa-cima.com.

AICPA RESOURCES

Articles

“A Take on Cryptoasset Transactions, Investments, and Risk,” JofA, Sept. 2021

“NFTs Come With Big Valuation Challenges,” JofA, July 15, 2021

“Tax Consequences of Nonfungible Tokens,” JofA, June 24, 2021

Podcast episode

“What CPAs Should Know, and Ask, About NFTs,” JofA, April 28, 2022

Video

“Digital Assets — Into the Ether”

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