8.3 Crypto Asset Borrowing

8.3.1 Background

The fact pattern related to the crypto asset borrowing transaction in Question 26 in the AICPA Practice Aid is the same as that in Question 25, but Question 26 is from the perspective of the borrower (see Section 8.2.1 for considerations related to the lender’s perspective detailed in Question 25). In that scenario, the borrower recognizes the crypto asset borrowed, as well as an obligation to return the asset (see Section 8.3.2), and evaluates whether that obligation contains an embedded feature that must be bifurcated as a derivative (see Section 8.3.3). Unlike crypto asset lending, crypto asset borrowing has not been publicly addressed by the SEC staff.1

8.3.2 Recognition of Crypto Asset Borrowed and Obligation to Return the Asset

Nonauthoritative AICPA Guidance

AICPA Practice Aid, Accounting for and Auditing of Digital Assets

Crypto Asset Borrowing

Question 26:

Assume identical facts to Q&A 25. How should the borrower account for the loan?

Response 26:

Crypto asset lending transactions can be complex, and the accounting for a particular transaction depends on the facts and circumstances. In this example, it is assumed that the borrower has obtained control because it has the right to transfer, encumber, or pledge the crypto asset in any way it chooses. The borrower should recognize the units of Crypto Asset ABC received at fair value on its balance sheet at the date it obtains control of the crypto asset. See Q&A 10 in AC chapter 1, “Classification, measurement, and recognition,” for additional guidance on making the judgment about whether the borrower has obtained control of a crypto asset.

If it is determined the borrower obtained control of the crypto asset, the borrower also should record an offsetting obligation to return Crypto Asset ABC to the lender, which should be recognized at the fair value of Crypto Asset ABC on the date the borrower obtains control. Subsequently, the borrowed Crypto Asset ABC should be accounted for pursuant to the measurement and impairment guidance in FASB ASC 350, Intangibles — Goodwill and Other, and the obligation to return should be accounted for as a liability.

In Question 26 of the AICPA Practice Aid, “it is assumed that the borrower has obtained control” of the crypto asset borrowed, since it is able to “transfer, encumber, or pledge” the asset. Question 26 refers readers to Question 10 of the Practice Aid for additional guidance on how to assess whether to recognize a crypto asset, which would also apply to crypto assets borrowed.

Upon obtaining control of the crypto asset, the entity should recognize (1) the asset at fair value and (2) a liability for the offsetting obligation to return the asset to the lender. Before adopting ASU 2023-08, the borrower should subsequently account for the crypto asset as an indefinite-lived intangible asset in accordance with ASC 350-30. Before adopting ASU 2023-08, because of a potential accounting mismatch between the accounting for the borrowed crypto asset (measured as an intangible asset at cost less impairment) and the accounting for the obligation to return the asset (accounted for as a debt host with a bifurcated embedded derivative that reflects changes in the fair value of the crypto asset), an entity could potentially designate these crypto asset borrowings as a hedged item in a fair value hedge, thereby allowing the crypto asset to be remeasured at fair value. For example, if the obligation to return the crypto assets contains a bifurcated embedded derivative indexed to the fair value of the crypto assets borrowed (see Section 8.3.3), that derivative could potentially be designated as an all-in-one hedge of the crypto assets borrowed (see Example 4-31 of Deloitte’s Roadmap Hedge Accounting).

After the adoption of ASU 2023-08, the borrower should subsequently measure crypto assets within the ASU’s scope at fair value, with changes in fair value recognized in earnings in accordance with ASC 820 (see Section 4.2). Upon adoption of the ASU, crypto assets within its scope are not eligible to be designated as hedged items under ASC 815-20-25-43(c)(3). For more information about the guidance on hedging, see Deloitte’s Roadmap Hedge Accounting.

8.3.3 Considerations Related to Embedded Derivatives

Nonauthoritative AICPA Guidance

AICPA Practice Aid, Accounting for and Auditing of Digital Assets

Crypto Asset Borrowing

Response 26: . . .

Pursuant to FASB ASC 815, Derivatives and Hedging, the obligation to return should be viewed as a hybrid instrument with a debt host contract and embedded derivatives linked to the fair value of Crypto Assets ABC loaned. Because the obligation is denominated in units of Crypto Asset ABC, the borrower will generally identify Crypto Asset ABC indexed embedded features in the hybrid instrument that may need to be bifurcated and marked to market pursuant to the provisions of FASB ASC 815. This analysis of the obligation to deliver a fixed number of crypto assets in satisfaction of the obligation is similar to the example in FASB ASC 815-10-55-76, in which an obligation to deliver shares in the future is viewed as a hybrid instrument with a debt host and embedded forward derivative feature.

The borrower identifies the host contract as a dollar-denominated debt obligation with a fixed interest rate following the principles in FASB ASC 815-15-25-24. Consistent with that judgment, the Crypto Asset ABC indexed elements of the obligation are viewed as embedded features with an initial fair value of zero pursuant to FASB ASC 815-15-30-4. Specifically, if the host contract is a fixed rate debt instrument, the embedded features represent pay crypto, receive dollar forward contract elements that should be evaluated for bifurcation. The bifurcation analysis under FASB ASC 815 depends on a number of factors, including whether the embedded feature can be net settled. In contracts that require gross settlement, the net settlement criterion may be met, for instance, if delivery of Crypto Asset ABC would be readily convertible to cash under that standard (refer to Q&A 24 for details). If the forward embedded features are required to be bifurcated, the features would be marked to market through net income each period as a derivative in accordance with FASB ASC 815-10.

Although the related asset would not otherwise be marked to market in a similar way under FASB ASC 350, the bifurcated embedded feature (crypto ABC derivative) related to the liability may be considered a hedging instrument in a fair value hedging relationship of the Crypto Asset ABC if designated, documented, and found to qualify for hedge accounting under the provisions of FASB ASC 815.

Under ASC 815, the liability recognized by a crypto asset borrower for the obligation to return a specified number of crypto assets is analyzed as a hybrid instrument comprising a debt host contract and an embedded feature indexed to the fair value of the borrowed crypto asset. The debt host contract is considered a fixed-rate debt instrument, and the embedded feature is identified as a forward contract under which the borrower pays a fixed number of crypto units and receives a fixed amount of fiat currency on the maturity date of the crypto asset borrowing arrangement.

Under ASC 815-15-25-1, three criteria must be met for a crypto forward to be bifurcated as an embedded derivative:

An embedded derivative shall be separated from the host contract and accounted for as a derivative instrument pursuant to Subtopic 815-10 if and only if all of the following criteria are met:

The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.
The hybrid instrument is not remeasured at fair value under otherwise applicable generally accepted accounting principles (GAAP) with changes in fair value reported in earnings as they occur.
A separate instrument with the same terms as the embedded derivative would, pursuant to Section 815-10-15, be a derivative instrument subject to the requirements of Subtopic 815-10 and this Subtopic. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)

Typically, the first and second bifurcation criteria in ASC 815-15-25-1 are met for the crypto forward, because (1) an embedded feature indexed to the fair value of crypto assets is not clearly and closely related to a debt host and (2) the obligation to return the crypto assets borrowed is not accounted for at fair value with changes in fair value recognized in earnings under GAAP.

Whether the third bifurcation criterion is met depends on whether the feature meets the definition of a derivative and whether any scope exception from derivative accounting applies. ASC 815-10-15-83 defines a derivative as follows:

A derivative instrument is a financial instrument or other contract with all of the following characteristics:

Underlying, notional amount, payment provision. The contract has both of the following terms, which determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required:
1. One or more underlyings
2. One or more notional amounts or payment provisions or both.
Initial net investment. The contract requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
Net settlement. The contract can be settled net by any of the following means:
1. Its terms implicitly or explicitly require or permit net settlement.
2. It can readily be settled net by a means outside the contract.
3. It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

Typically, the crypto asset forward would possess the first two characteristics of a derivative, because it has a notional amount (the number of crypto units borrowed), an underlying (the price or fair value of the crypto asset borrowed), and an initial net investment that is smaller than would be required for other types of contracts that would be expected to respond similarly to changes in market prices (the fair value of the host contract would not be considered the initial net investment in the crypto asset forward in accordance with ASC 815-15-25-1(c)). The net settlement criterion would be met if the crypto asset borrowed is actively traded in such a way that it can be readily converted to cash or the contractual terms otherwise allow net settlement (e.g., the contractual terms require or permit the settlement of the crypto forward in cash). If bifurcation is required, an entity would apply ASC 815-10 to account for the embedded feature as a derivative at fair value, with changes in fair value recognized in net income each period.

8.3.4 Example

The example below illustrates the accounting for crypto asset borrowing.

Example 8-2

Assume the same facts as in Example 8-1, except that Entity C recognizes $300,000 of accrued interest and a $200,000 gain related to the change in fair value of the derivative instrument as of December 31, 20X0. This example focuses on the borrower’s side.

At inception (i.e., November 13, 20X0), C records the journal entry below to recognize the units of digital assets received at fair value on its balance sheet as of the date on which it obtains control of the crypto asset. In addition, C records an offsetting obligation to return the digital asset to the lender, which should be recognized at the fair value of the crypto asset on the date the borrower obtains control. Subsequently, the borrowed crypto asset should be accounted for in accordance with the measurement and impairment guidance in ASC 350, and the obligation to return should be accounted for as a liability.

Journal Entry: November 13, 20X0

If the embedded feature is assumed to represent a forward contract, no entry is required at initial recognition because its initial fair value would be zero under ASC 815.

In accordance with ASC 815, the obligation to return the crypto assets should be viewed as a hybrid instrument with a debt host contract and an embedded derivative linked to the fair value of the crypto asset loaned. Because the obligation is denominated in units of crypto asset, C identifies the crypto asset indexed embedded features in the hybrid instrument that may need to be bifurcated and marked to market under ASC 815. The journal entries below reflect the activity during the year ended December 31, 20X0.

Journal Entries: December 31, 20X0

Footnotes

The SEC staff has indicated its belief that, in a crypto asset lending transaction, the lender typically loses control of and the borrower obtains control of the crypto asset.

Confidential and Proprietary — for Use Solely by Authorized Personnel

This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.