Can SEC Comment Letters Shed Light on Crypto Accounting?
Section 408 of the Sarbanes-Oxley Act requires that the SEC’s Division of Corporate Finance (Corp Fin) review company financial statements at least once every three years. If the disclosure is inconsistent or ambiguous, the SEC may ask companies to enhance the disclosure.
Most of the SEC's comments clarify minor issues and have limited interest to investors. Yet, several recent SEC inquiries led to significant changes to disclosure and received wide media coverage (see, for example, WSJ article about SEC scrutiny of non-GAAP reporting).
In this blog, we dive into accounting and disclosure of digital assets to illustrate how analysts can use SEC comment letters to predict material changes in financial reporting. In the past several years crypto accounting and disclosure received significant regulatory attention from both FASB and the SEC. In December 2022, the SEC released a sample letter, identifying bankruptcies and volatility in crypto markets as risk factors that should be prominently disclosed. FASB, on the other hand, released a proposal in March 2023 that changes accounting treatment of digital assets from cost-less-impairment ‑ which has been the prevailing accepted practice ‑ to fair value model.
Digital assets are relatively new, complex financial instruments, with accounting guidance still evolving. Complexity, limited accounting guidance, and volatile market conditions may lead to divergence in the interpretation of accounting rules, diversity in practice, and, in some cases, violations of GAAP.
In this blog we focus on using comment letters to shed light on a thorny area of accounting. In one blog we can tackle only a fraction of complexity and defer to other analysts to cover other facets of crypto accounting - for instance, The Dig discussed complexity of accounting for digital assets in a series of blogs that span over several years.
But first, let’s discuss the overall accounting framework. Currently, digital assets are reported using the cost-less-impairment model. Citing PwC interpretation guidance:
“Reporting entities will need to have processes in place to monitor for events (e.g., trades that occur below the reporting entity’s cost) that indicate that the fair value of the crypto assets may be below their carrying value.”
Saying it differently, digital assets should be marked to the lowest trading price. Given the price volatility of digital assets, using a non-current price could lead to lower impairment charges and inflated asset and net income values.
Several SEC comment letters emphasized that companies should use the lowest intraday price in impairment testing. Using different pricing would be an accounting error that requires a restatement of previously filed financial statements.
Let’s look at an example. On February 28, 2023, Marathon Digital Holdings (MARA) disclosed in an 8-K Item 4.02 filing that, following SEC comments, the company will need to restate financial statements to correct, among other errors, calculations of impairment of digital assets (emphasize added):
“The Company recently determined that its method of calculating impairment on a daily basis using a standard cutoff time was not in compliance with the ASC 350-30-35-19 requirement to recognize impairment whenever carrying value exceeds fair value, which effectively calls for the intraday low price to be utilized in calculating impairment whenever events or changes in circumstances indicate it is more likely than not that the asset is impaired.”
(Bloomberg article discussed other error corrections of Marathon Digital, including a revenue recognition issue.)
Item 1B, Unresolved Staff Comments of the 10-K filed on March 16, 2023, provided more details about the outstanding SEC comments. “The Company received Staff comments during 2022 which are material and still under review as set forth below. We additionally have described below certain comments more recently received which relate to certain restatement items in this Form 10-K in order to provide complete disclosure and not imply that the restated items set forth below have been fully resolved.”
In particular, the company noted that some of the SEC comments related to bitcoin used as collateral are still outstanding:
“Bitcoin as collateral. The Staff has raised several comments on the Company’s accounting for bitcoin used as collateral within the Company’s lending arrangements. The Company continues to respond to the Staff’s comments based on its application of U.S. GAAP and has not changed its classification of such bitcoin used as collateral as Digital assets, restricted.”
Item 1B requires that accelerated and large accelerated filers disclose unresolved SEC comments outstanding for at least 180 days prior to the fiscal year end. If true, it would mean that the first SEC comments were issued no later than in June and that as of March 16, 2023, the conversation with the SEC was ongoing for more than 240 days, or more than 6 times longer than a typical 30–40-day average review. Item 1B disclosures are notable because they point to more complex or harder-to-resolve issues. (It is also possible that the review started later in 2022, and the company provided Item 1B disclosure voluntarily).
Comment letters are released at least 20 business days after the resolution of all comments. As of July 31, 2023, no SEC comment letters to Marathon were publicly available on EDGAR. Counting back, it means that as of June 30, 2023, at least some SEC comments were still unresolved.
On August 08, 2023, the company filed a second 8-K Item 4.02 disclosing that following SEC’s July 12 comments the company will need to restate financial statements to correct its cash flow statement classification of proceeds from the sale of digital assets.
In Marathon Digital’s case the 10-Q disclosure preceded the release of the comment letters (which, as of the date of this blog, are still not available on EDGAR). However, looking at comments received by peer companies could serve as an early indicator of upcoming material changes in disclosure. Let’s look at a comment letter to Bit Digital, Inc (BTBT) publicly released on EDGAR on May 11, 2023 (nearly three months earlier than Marathon Digital’s Item 4.02 disclosure of a Big "R" restatement).
Notably, the question (and the subsequent revision) appears similar to the restatement disclosed by Marathon Digital:
“1. We note you present the purchase of digital assets (USDC) as an investing activity. Please tell us how you considered the guidance in ASC 230 in determining to present this activity as an investing activity.
In response to the Staff’s comment, we will revise future filings to present purchase of digital assets (USDC) as operating activities since the Company purchased and held USDC for operational purposes.”
Finally, while we would not have a complete picture of the scope of the review without seeing the actual letters, prior academic research tells that we can reasonably infer the issues raised by looking at the changes in the disclosure of two consecutive filings (see, for example, Lowry et al., 2020).
We used Calcbench’s Company Detail page to compare Marathon Digital’s disclosure of Digital Currencies Policy between 10-Q filings for the three months ending on March 31, 2023, and June 30, 2023, and identified the following language added to the June 30, 2023 filing:
“Digital assets are included in current assets in the condensed consolidated balance sheets. In addition, digital assets provided as collateral for long-term loans were reported as Digital assets, restricted at December 31, 2022 and classified as long-term assets in the condensed consolidated balance sheets. During the first quarter of 2023, the long-term loan was terminated and the restrictions on digital assets lapsed (refer to NOTE 12 – DEBT, for further discussion).”
The added language could be related to the unresolved comments disclosed in Item 1B of the 10-K filing discussed above. (Interestingly, an SEC comment letter to Microstrategy (MSTR) publicly released on June 9, 2023, also raised questions about bitcoin used as collateral.)
Another notable disclosure for Marathon Digital involves a change in accounting principle from LIFO to FIFO, enacted in the quarter ended March 31, 2023. Although we would not know whether this disclosure was prompted by SEC comments, voluntary changes in accounting principles are uncommon and are therefore noteworthy:
“During the quarter ended March 31, 2023 and effective January 1, 2023, we enacted a voluntary change in accounting principle from last-in-first-out (“LIFO”) to first-in-first-out (“FIFO”) in order to more accurately reflect the disposition of our digital assets. The change from LIFO to FIFO increased the carrying value of digital assets, resulting in additional impairment of digital assets during the quarter ended March 31, 2022.”
According to the preferability letter issued by the audit firm, while both LIFO and FIFO methods of accounting for digital assets are acceptable under GAAP, FIFO is preferable:
“There are no authoritative criteria for determining a “preferable” method based on the particular circumstances, however, we conclude that such change in the method of accounting is to an acceptable alternative method, which based on your business judgment to make this change and for the stated reasons, is preferable in your circumstances.”
Choice of inventory method may affect taxable income – for instance, when prices are falling, FIFO method generally generates lower taxable income.
To summarize, accounting for digital assets is likely to remain complex in the near future. For instance, the FASB proposal to change accounting model from cost-less-impairment to fair value is likely to introduce challenges embedded in fair value accounting, such as establishing a methodology for valuing securities that are traded in an inactive market (while tokens such as bitcoin are likely to be classified as Level 1 securities, other instruments may not be traded in an active market). SEC comment letters could be used as a supplemental source of information for a forward-looking insight into complex accounting matters.