What is a crypto subledger and why do you need one?

This article is Part 1 of Loop Crypto’s web3 Financial Operations blog series. The author is Mackenzie Patel, founding partner of Hash Basis, a crypto native accounting firm.‍

Introduction

As financial operations in web3 have matured, crypto accounting has become an essential topic for any entity that is interacting with public blockchains and transacting on-chain. In this piece, we dive into the fundamentals of how cryptocurrency is treated from an accounting and tax perspective. We also dig into managing your accounting operations as you interact with crypto and why the emerging class of subledger platforms is becoming a critical tool for web3 accounting and finance teams.

US Accounting Rules Around Digital Assets

Under current US GAAP (Generally Accepted Accounting Principles) rules, digital assets are treated as indefinite-life intangible assets. One of the quirks of intangibles is impairment, which means you have to continually write your assets down to the lowest price with no possibility of writing them back up. This has produced some lopsided balance sheets, particularly for companies that hold large treasuries in crypto (think MicroStrategy). If the market recovers and prices rise, the crypto is still sitting on your books at its lowest price.

Luckily for crypto companies though, change is likely coming in 2023 or early 2024. The FASB (the board that sets US GAAP rules) is slated to change the treatment of crypto assets from impaired cost to fair market value. This means digital assets (likely excluding stablecoins, wrapped tokens, and NFTs) will be valued at their current price as of the reporting date. Any change in fair value will flow through earnings. For the first time, financials will reveal the true crypto holdings of a company, with additional disclosures required around the amounts held, cost basis, and how the tokens “roll” period over period. Read the FASB’s exposure draft here (and we recommend reading all the entertaining comment letters as well!).

Another key principle in crypto accounting is that of the “principal market.” This means that fair market value is determined by the price in the market with the highest volume. For crypto, the markets include exchanges like Coinbase or Kraken and DEXs like Uniswap or Osmosis. If a company is earning revenue in crypto, it has to be priced according to this market at the time the revenue was received. And if the company holds several digital assets, a separate principal market analysis has to be conducted on each one (which can be time-consuming if you’re holding multiple assets). This concept is going to become more critical than ever as we shift to fair market value under the new FASB rules. And since crypto prices are volatile, a quarterly analysis might be necessary since principal markets can shift rapidly (i.e. FTX evaporated from the list overnight).

Crypto Tax Rules in the U.S.

Similar to the accounting rules for crypto, the tax rules are also opaque, especially when it comes to more niche areas like DeFi or protocol staking. Per the IRC (Internal Revenue Code), digital assets are treated as property (think of a house or apartment). Despite the differences in physicality, crypto is subject to the same rules around property including capital gains tax. Any time crypto is traded, sold, or sent, the difference between the current price and the cost basis is treated as a capital gain or loss. And depending on the duration for which it was held, these gains are either subject to preferential rates (0%,15%, or 20%) or ordinary short-term rates. Impairment here is a key difference — although it’s factored into the net value of your digital assets on US GAAP books, it’s left out of the tax calculation since it’s a non-cash expense like depreciation and amortization.

Unfortunately for taxpayers, there is scant tax guidance related to anything more complicated than mining rewards, hard forks, airdrops, or payments for services in crypto. For transactions like margin trading, liquidity providing, or collateralized NFTs, the tax code is a gray area and subject to different interpretations (i.e. read about all of the hullabaloo surrounding the Josh Jarrett Tezos staking rewards case here).

However, it’s not all doom and gloom for crypto taxes. There are certain crypto activities that are nontaxable such as buying crypto with fiat, donating to qualified 501(c)(3) charities, and gifting crypto (up to $17,000 per person per year for 2023). There is also more tax clarity coming down the pike. The IRS recently released a notice regarding NFTs and their potential status as a collectible under the tax code. If this notice becomes law, NFTs that represent a collectible under the definition in Section 408(m) would be subject to a 28% capital gains tax rate. The IRS is calling this a “look through” analysis (i.e. “look through” the digital NFT to see what it actually represents), but it presents a snafu since an NFT could contain a menagerie of different rights.

Like US GAAP rules, change is coming for crypto taxes, especially with the IRS receiving its slew of new funding over the next ten years. And with new enforcement agents being hired, companies will want to ensure their crypto taxes are all buttoned up.

Importance of a Crypto Subledger for Crypto Companies

To have accurate crypto accounting and tax reporting, companies should implement a crypto subledger solution (unless they have the resources to build what’s essentially an Enterprise Resource Planning (ERP) system in-house). A crypto subledger is a big database that houses all on-chain activity related to a predefined set of wallet addresses. Accounting functionality is then layered on top of the data to generate reports needed for tax & accounting purposes.

While the subledger market is still developing, it’s worth calling out two main market subdivisions: software for individual crypto tax (think Koinly and Cointracker) and tools for enterprises like Integral, Bitwave, Cryptio, Entendre Finance, and Headquarters. For crypto companies, it’s important they onramp onto an enterprise product that can handle scale and complex activity.

There are a few reasons a crypto subledger is needed (for both businesses and individuals):

1) Captures and Organizes all of your On-Chain Activity + Accounting Calculations

Subledgers track all transactions, cost basis, lot detail, wallet addresses, gains and losses (both realized and unrealized), and impairment. There’s also flexibility in the cost basis methodology so your GAAP books can be under one method (i.e. FIFO) while tax books are under a separate method like Spec ID. Essentially, subledgers contain all the nitty gritty detail that you don’t necessarily want to clutter your main ERP system with (although you can sync in transactions if you choose).

Without a subledger to organize everything, it becomes cumbersome and nearly impossible to track all of this on-chain data (plus calculated data like impairment) in a simple excel file. The crypto data directly feeds into your financial statements and tax return, so without it, a company can’t function.

2) Allows Companies to Reconcile Between Cash-Basis Blockchain and Accrual GAAP Books

Subledgers also help companies reconcile between the fundamental mismatch between a cash-basis blockchain and accrual accounting books (learn more about this divergence here). Most subledgers have some type of invoice or bill pay feature that lets users match invoices and bills to crypto transactions. So while you can’t “book” accruals directly in crypto subledgers, at least you can settle them and have the necessary on-chain trail.

3) Provides Detailed Reporting

While all subledgers have the basic reporting of transaction history, cost basis, and gains and losses, the enterprise solutions typically have more advanced reporting such as:

• Journal entry reports: This is an incredibly valuable report since you can see exactly how your on-chain data affects your books at the transaction level (the crypto activity is translated into debits and credits, both in tokens and reporting currency).
• Detailed asset rollforward: Showing the beginning balance, a breakdown of all acquisitions (i.e. staking rewards, buying crypto, NFT royalties) and dispositions (i.e. trading crypto, paying for services), gains and losses, the report tells you exactly how your crypto balance changed over a period.
• Fee analysis: This report reveals network fees by blockchain and by contact, so you can see exactly what chains are costing the most and how that cost has changed over time
• Principal Market Report: Some subledgers provide extreme detail around where they’re pulling token prices from (i.e. the principal market), which is needed for companies undergoing audits in the US.

Overall, subledgers are the special sauce in crypto accounting and tax that help companies stay compliant and wrap their heads around all the “degen” happening in the ether. A truly crypto native ERP system has yet to be built, so in the meantime, subledgers are a crypto accountant’s best friend.