Valuation of nonfungible tokens (NFTs) became a hot topic when digital artist Beeple sold an NFT for almost $70 million earlier this year.
The high price commanded in that sale and numerous other transactions led to a difficult question for CPAs. What is an NFT’s value when it’s on a company balance sheet, or held in an individual’s collection, or even when it’s in the possession of a digital artist and ready for sale?
As with many emerging asset classes, the answers to these questions aren’t easy, and they present some difficult issues for CPAs to consider.
A new, growing market
The market for NFTs is relatively new and growing. NFTs are a type of digital cryptoasset. They are unique digital representations and establish the ownership and authenticity of assets.
In March, a blockchain investor bought a file of a digital collage by Beeple at a Christie’s auction for more than $69 million, the first digital NFT artwork sold by a major auction house and the third-highest price ever reached for a work by a living artist.
A reason for the popularity of NFTs is that they give artists and creators a way to confirm their rights, to ensure their NFTs will be used or exploited only in the manner they set forth and that they will get compensated for their future use.
Questions have been raised about the high prices of certain NFTs because it seems the image could be copied from a public website and used without paying for it. But having unique rights to the asset seems to drive the market and value for NFTs. Purchasers buy NFTs for sentimental reasons and/or as an investment.
What is an NFT?
NFTs are created (minted) from digital objects that represent both tangible and intangible items. Each NFT has a unique digital signature and certifies that an asset is unique and not interchangeable for another.
Blockchain technology is used to create tokens that can be sold and traded. The record of ownership of the NFT is stored and transferred on these digital ledgers. Ownership of the underlying asset may never leave the creator, and the NFT represents a bundle of rights (either exclusive or shared with others) to access the asset and potentially exploit it for commercial purposes.
“NFTs are an offshoot of blockchain technology,” said Mark DiMichael, CPA, partner in Citrin Cooperman’s Forensic, Litigation, and Valuation Services Department. “One bitcoin represents one bitcoin and nothing else, but NFTs represent something else,” he said.
A common example is a collectible digital work of art that gives the purchaser ownership and bragging rights, is easier to transfer than the physical asset, and does not deteriorate with age. “The owner can create a digital work of art, make a PDF file, and sell a blockchain-based asset that is representative of that PDF file,” DiMichael said. “The owner is usually not selling the intellectual property rights to that art and could sell that image to someone else or use it in another way.” Other NFT examples include digital reproductions of events like “NBA Moments,” music, trading cards and sports memorabilia, videos, photos, tweets, real estate, and even designer sneakers.
“The concept of NFTs is sometimes misunderstood, as NFTs can come in different forms and represent different rights,” said Rob Massey, CPA, partner and Global and U.S. Tax Blockchain and Digital Assets leader at Deloitte Tax LLP. “What is exciting about this space is that it is proving another blockchain concept that can be utilized across many areas.”
There are a number of NFT marketplaces for buying and selling NFTs.
NFT platforms geared to first-time users include Rarible, AtomicMarket, OpenSea, and Mintable. Others for seasoned users and popular artists that require an application process are SuperRare and Nifty Gateway (partnered with Sotheby’s), Enjin (for gaming and art), and NBA Top Shot (only NBA collectibles).
Because of their nature and relatively new use, valuation of NFTs is an evolving and challenging area. What makes NFTs popular also makes their valuation more difficult. “Value is based on perceptions of owners and buyers, scarcity, access, and the distribution channel,” Massey said. “There are no physical limitations on NFTs, and they have broader visibility and liquidity because they can be accessed and distributed across a global landscape in an instant.”
There are different valuation considerations for the creator, purchasers, and owners of NFTs at the beginning of their existence and on an ongoing basis as these assets are included on balance sheets and subject to financial statement audits. At the time of its creation, the value of an NFT may be dependent on the characteristics of its creator and of the NFT itself, among other things.
For example, the broader marketability and recognition of a celebrity artist will affect the value of their NFT over that of another, unknown artist. These sources of influence on value may be highly speculative, however, until the NFT is actually sold.
“The value of an NFT is based on a third-party transaction between a willing buyer and seller,” Massey said. “If using cryptocurrency that is actively traded to buy an NFT, the value of the asset is likely determined by the value of the cryptocurrency used in the transaction, at the time of the transaction, as it has the more readily ascertainable fair market value.”
“None of the basic metrics you would use to value private companies or traditional investment vehicles like shares or warrants are available for NFTs,” said David Larsen, CPA/ABV, managing director of the Alternative Asset Advisory Practice at Duff & Phelps, a Kroll business. “For an NFT, what the last buyer paid for it gives you an indication of what the value is, but the next buyer could pay something else, and it is the amount the next buyer will pay that determines the value.”
Larsen notes it is not easy to ascertain who the next buyer will be or to obtain information on why they would pay what they would pay. Values can fluctuate based on perceptions over time.
“If an NFT for art was trading and its price went up so the value increased, but then potential buyers decided at a point in time they can look at the digital image on their phones or computers for free and there are no new buyers, does that mean the NFT’s value is now zero?” Larsen asked.
There may not always be third-party transactions in an NFT to use. Sales by the owner of other similar NFTs may be used as datapoints. Because the value of digital assets can fluctuate greatly, the date and time of valuation is important.
This market approach raises the question of what the value of a self-created NFT is for the owner at the time it is created. The value may be based on the intrinsic value to the holder or the cost to create it.
Many CPAs cannot and do not value NFTs at this time, and there are few — if any — appraisal companies valuing digital assets. For artwork NFTs, art marketplaces can be a valuation source based on selling prices of the underlying art or other works of art by that artist.
“NFTs are new and there are not a lot of comparables today, but some day there might be more,” DiMichael said. A new judgment area is whether a digital representation of an asset is worth more or less than the asset itself, and there can be multiple digital images of the same asset.
Accounting for NFTs
There is no specific guidance today in U.S. GAAP on how to account for an NFT. To date, FASB has decided not to add a project on accounting for cryptocurrencies and digital assets to its agenda. As a result, there is a question of which asset accounting model to apply to an NFT.
NFTs do not meet the GAAP definitions of cash or cash equivalents, marketable securities, financial instruments, or inventory. “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,” DiMichael said.
The challenge with an intangible accounting model for digital assets is their tremendous volatility and their speculative marketplace. “Values have been increasing, and historical costs are not very useful to financial statement users,” DiMichael noted. “These assets can be immediately sold, and the price of bitcoin can be looked up with a click on a cellphone, unlike most other intangibles where valuation is more difficult and very subjective, and the asset may or may not be able to be liquidated.”
Impairment accounting is based on the lower of cost or fair value. “There are challenges establishing fair value if there is no market or recent transactions and no similar assets that can be used as a proxy,” Larsen said. In addition, different accounting models apply for investment companies and hedge funds that do not have intangible assets and must report NFTs at fair value, based on what they would receive for them or similar NFTs trading in the market.
For the creator of an NFT, there is no GAAP standard that specifies the accounting when the asset is created and whether to capitalize or expense the costs and expenses related to creating (minting) the NFT until it is sold. An inventory accounting model could be applied. Because it is a digital creation, the costs tend to be small, but there may be fees for putting the NFT on a blockchain and transaction processing.
Buyers record NFTs at their cost based on the purchase price. Exchange gains or losses are recognized related to the cryptocurrency used to pay for NFTs based on the difference between the fair market value of the cryptocurrency at the date of the exchange and the price originally paid for it.
Owners recognize income when they receive cryptocurrency for their digital asset. New revenue recognition challenges can arise under FASB ASC Topic 606, Revenue From Contracts With Customers, relating to sales of NFTs. Some creators sell limited memberships to their assets (e.g., subscribers accessing blog content). Other artists create NFTs that give them the right to receive a recurring revenue stream if there are future resales of the NFT by the purchaser to others.
Risk considerations can affect valuation
There are significant risks related to security over digital assets and internal controls over transactions. These include general IT, security, fraud, and accounting controls, along with unique controls over wallets and digital transactions. “Risks for companies and their auditors to be aware of include how to verify the existence of NFTs, who are the interested parties, how are transactions initiated and executed, and what blockchain is used,” DiMichael said.
Companies and auditors may have significant issues with proving the ownership of NFTs. “You can create a new digital wallet in seconds,” DiMichael said. “With blockchain and cryptoassets, on publicly available websites, you can see who owns every NFT on the Ethereum blockchain based on the 42-digit address.” Auditors need to verify ownership of the addresses, and some companies may have hundreds of them. They may need to bring in IT specialists to verify ownership from a technology standpoint.
Existence is another issue, Larsen noted. “Is it really there on the platform? What if the purchaser loses the digital key to the digital wallet?”
There is lack of consistent regulation over digital assets. But many regulators, including the SEC, IRS, and Commodity Futures Trading Commission, have issued statements about issues related to issuing, owning, and trading digital assets.
There are a number of indirect tax implications, including sales taxes, for the creator, buyers, and resellers of NFTs. “This area requires care around what the underlying asset being sold is and which jurisdiction it is attached to,” Massey said. There are considerations about whether NFTs should be taxed like investment property at capital gains rates, taxed as income at ordinary tax rates, or not taxed at all in certain jurisdictions or based on how they are used or transferred.
“At the moment there are no specific U.S. tax rules on point,” Massey said. For now, he notes that regulators, lawyers, and accountants are building analogies to existing case law and concepts, but there is a lot about NFTs that is different from other types of assets. (For more, see “Tax Consequences of Nonfungible Tokens (NFTs),” JofA, June 24, 2021.)
Because of the unique nature of NFTs and the markets where they exist and trade, corporations, boards, and institutional investors need to evaluate whether they should invest in NFTs at all.
“Individuals decide whether to speculate or spend their money on NFTs based on the intrinsic value of the digital interest to them as a holder or what they think someone else would pay for them, but institutions and boards must consider whether the NFT investment is suitable for its purpose, such as investment returns, returns to shareholders, or pension funding, and whether they should speculate,” Larsen said.
— Maria L. Murphy, CPA, is a freelance writer based in North Carolina. To comment on this article or to submit an idea for another article, contact Ken Tysiac, the JofA’s editorial director, at Kenneth.Tysiac@aicpa-cima.com.
Related resource: The AICPA offers the Certified in the Valuation of Financial Instruments (CVFI) credential for those who work with financial instruments, from investment and securities managers, and other financial advisory professionals, to auditors and valuation practitioners. Candidates must complete experience, education, and exam requirements to become Certified in the Valuation of Financial Instruments. For more information, visit www.aicpa.org/cvfi.