SEC Objects To MicroStrategy Accurately Valuing Its Billion-Dollar Bitcoin Stash

What Happened

MicroStrategy has been purchasing bitcoin since 2020 as a part of its capital allocation strategy. The company holds over 120,000 BTC as of the end of December 2021. As a U.S. public company, MicroStrategy is required to report earnings and transactions related to bitcoin under Generally Accepted Accounting Principles (GAAP) standard. However, properly accounting for these transactions in GAAP financial statements is an emerging area. The current GAAP standards that classify digital assets as intangible assets with indefinite lives (similar to goodwill and trademarks of a business), fail to capture the true financial behavior of bitcoin holdings. This treatment requires companies to report a loss when digital assets’ prices fall below the cost; however it prohibits marking up digital assets to it’s true value when prices later recover. This discrepancy can negatively impact a company’s net income, which could incorrectly translate into lower price per share. 

To address the shortcomings of GAAP earnings due to bitcoin impairment losses, MicroStrategy added a “Non-GAAP Financial measures” section to Form 10-Q (Quarterly financial report public companies file with the SEC) for the quarter ended September 20, 2021. However, the SEC objected to this new treatment

Key Concepts

The Financial Accounting Standards Board (FASB) is the IRS of the accounting world. The FASB is responsible for creating Generally Accepted Accounting Principles (GAAP). As of the date of posting, there are still no cryptocurrency specific GAAP rules.

In the absence of these crypto specific rules set by the FASB, in 2020, a working group formed by the American Institute of CPAs (AICPA) came up with a Digital Asset Practitioner Guide addressing how to classify cryptocurrencies in GAAP financial statements.

How Cryptocurrencies are Classified on GAAP Financials

According to the white paper issued by the AICPA, crypto assets cannot be classified as “cash or cash equivalents” on GAAP financial statements because they are not backed by a sovereign government or considered legal tender. They cannot be classified as a financial instrument or a financial asset because they are not cash (see above why) and do not represent any contractual right to receive cash or another financial instrument. Additionally, since cryptocurrencies are intangible, they do not clearly meet the definition of inventory and cannot be labeled as inventory on the balance sheet either.

After going through the process of elimination, we are left with only one category to classify cryptocurrencies under: intangible assets with indefinite life. This is how MicroStrategy currently classifies bitcoin in their financial statements. 

(3) Digital Assets: The Company accounts for its digital assets as indefinite-lived intangible assets in accordance with Accounting Standards Codification (“ASC”) 350, Intangibles—Goodwill and Other. The Company’s digital assets are initially recorded at cost. Subsequently, they are measured at cost, net of any impairment losses incurred since acquisition” (10-Q, page 11)

Practical Mismatches with Intangible Asset Treatment

There are a few problems with classifying cryptocurrencies as intangible assets with indefinite life. Practically speaking, this accounting treatment does not align with the reality. Cryptocurrencies like bitcoin are liquid and work extremely similar to cash. The purpose of GAAP financial statements is to paint an accurate, unbiased picture of the underlying entity’s financial situation. By treating crypto assets as intangible assets, GAAP financials fails to communicate the high liquidity of crypto assets. 

Second, once an item is classified as an indefinite life intangible asset, it should be tested for impairment. This means, if the value of the crypto asset has gone down at the end of the reporting period, the business gets to write off that amount as an impairment loss (not to be confused with tax losses) on the income statement. However, if the value goes back up (which is common due to high volatility), the business does NOT get to mark up the value of the asset. This overly conservative approach often results in businesses showing poor operating results under GAAP which negative affects investor sentiment and stock price. 

For example, MicroStrategy reported $65,165,000 of impairment losses for the three months ending September 30, 2021, because the market value of bitcoins went below their purchase price. Although this 65M impairment loss was not a cash outflow from the business, it was the largest operating expense which contributed to a net loss of $36,136,000.     

Similarly, during the three months ending September 30, 2021, Tesla reported 51M of impairment loss. Square reported 6M of bitcoin impairment loss in the same period. 

To clarify the situation and show the true performance of the business to investors, MicroStrategy added a section named, “Non-GAAP Financial Measures” in their 10-Q. This section shows what would their operating income be without taking impairment and few other non-GAAP amounts (not related to digital assets) into consideration. 

According to this schedule, if impairment loss was not considered (and few other items not relevant to bitcoin), the company would have a net income of $18,566,000. 

SEC Letter to MicroStrategy

The SEC objected MicroStrategy’s Reconciliation of non-GAAP net income schedule above. On December 3, 2021, it sent the company a comment letter and advised the company to remove it under the Rule 100 of Regulation G.

Reg G requires public companies to “disclose or release such non-GAAP financial measures to include, in that disclosure or release, a presentation of the most directly comparable GAAP financial measure and a reconciliation of the disclosed non-GAAP financial measure to the most directly comparable GAAP financial measure”. 

Although we don’t know the specifics of the situation, it is clear that MicroStrategy’s 10-Q includes GAAP financials & a reconciliation of non-GAAP net income schedule allowing readers to compare numbers easily. The company’s goal is to clearly communicate the true operating performance of the company minus the “paper bitcoin losses” which is required to report under incompatible GAAP rules. Therefore, the specific concern the SEC has with the presentation is unclear. It is also interesting to see that the letter is only talking about the “adjustment for bitcoin impairment charges” among other items included in the Reconciliation of non-GAAP net income schedule such as share-based compensation, interest expense and income tax effects. 

On a subsequent letter from MicroStrategy dated December 16, 2021, the company accepted SEC’s comments and removed the adjustment for bitcoin impairment on the reconciliation of non-GAAP net income schedule. 

Finally, the rising inflation and the uncertainly of interest rates have moved the market sentiment from investing in risky companies to value stocks of profitable companies. Microstrategy may find it challenging to show a net profit under GAAP in the coming months if the price of BTC moves sideways in a bearish market or declines further creating more impairment losses. Even when BTC goes up, Microstrategy will not be able to show a profit under GAAP unless they sell it. This situation could unfairly affect the stock price of the company. If a spot BTC ETF gets approved, investors might be better off directly investing in the ETF compared to using Microstrategy as a way to get exposure to BTC.

Next Steps

Keep an eye on how SEC approaches Non-GAAP disclosures related to bitcoin for other public companies holding bitcoin. 

Further Reading

·      Quick Guide To Filing Your 2021 Cryptocurrency & NFT Taxes

·      How The Infrastructure Bill Is Brewing A Crypto Tax Compliance Nightmare

·      How To Avoid Common NFT Tax Pitfalls.