Bitcoin’s Accounting Treatment Is Artificially Degrading MicroStrategy’s Bottom-Line

What Happened

MicroStrategy ($MSTR) reported a ~131M net loss in Q1 2022 despite having strong core-business performances. This was mainly due to its multi-billion dollar bitcoin stash which generated a staggering ~170M impairment loss under the crypto-incompatible Generally Accepted Accounting Principles (GAAP). The company would have generated a ~39M net profit had it not factored in the impairment loss mandated by GAAP.

Key Concepts

How are bitcoins classified in GAAP financial statements?

Currently, digital assets like bitcoins are classified as “intangible assets with indefinite lives” under GAAP. In simple terms, this accounting treatment requires companies to report a loss when digital asset prices fall below the cost; however, it prohibits marking up digital assets to it’s true value if prices later recover.

How $MSTR financials are affected by impairment losses

This accounting treatment has caused $MSTR to report a massive loss once again. In Q1 2022, the company reported a total net loss of ~131M. Notably, this included a ~170M of impairment losses resulting from depreciated BTC holdings. The impact of BTC impairment loss on the company’s overall bottom-line was so significant that if $MSTR didn’t own any BTC, the company would have ended the quarter with ~39M net profit.

Per $MSTR Form 10-Q, “We generated a net loss for the three months ended March 31, 2022, primarily due to digital asset impairment losses, and we may not be able to regain or increase profitability on a quarterly or annual basis in the future.”

BTC impairment losses have also been a long-term contributor to the company’s net losses for some time now.

“Our digital asset impairment losses have significantly contributed to our operating expenses and net loss. For the three months ended March 31, 2022, digital asset impairment losses of $170.1 million represented 64.5% of our operating expenses, contributing to our net loss of $130.8 million for the three months ended March 31, 2022, compared to digital asset impairment losses of $194.1 million in the three months ended March 31, 2021, representing 68.5% of our operating expenses and contributing to our net loss of $110.0 million for the three months ended March 31, 2021”

As of May 2, 2022, $MSTR’s average cost basis per BTC is approximately $30,000 a coin (10-Q, Pg. 21). If BTC prices fall below this carrying value later in the year, we can expect the company to report more impairment losses and bigger net losses despite having a strong software business. Again, $MSTR will not be able to mark up the assets if the market recovers towards the end of the year.

To address the above shortcomings of GAAP earnings due to bitcoin impairment losses, $MSTR added a “Non-GAAP Financial measures” section to its Form 10-Q (Quarterly financial report public companies file with the SEC) for the quarter ended September 20, 2021. This section showed the net income without factoring in the impairment losses related to BTC. However, the SEC objected to this new treatment and the company had to later remove that section from SEC filings.

Currently, $MSTR is trading at $235 a share. A sharp decline in stock price is also apparent after the Q1 earnings call which took place on the May 3rd.

It is worth noting that many companies other than $MSTR are being impacted by this accounting standard. According to SEC filings, Tesla reported an impairment loss of ~27M In Q1 2022 for bitcoin held on its balance sheet. Crypto giant Coinbase announced a massive impairment loss of over $250 million, even more than $MSTR for Q1 2022. On the other hand, Block did not experience any impairment losses in Q1 because their BTC position was valued at 365.5 M as of March 31, 2022. This was 216.5M above its cost basis of 149M. However, Block did not get to mark up the assets to 365.5M due to GAAP limitations.

US GAAP Vs. International Financial Reporting Standards (IFRS)

It is worth noting that not every company follows GAAP standards, although publicly-trading US companies are required to, which means that some firms have the flexibility to mark crypto assets to market. Certain firms like Voyager Digital Ltd. use the IFRS, an alternative accounting framework followed by over 140 countries when reporting financial information. To be fair, there are many similarities between the standards. For instance, IFRS does not specifically address digital assets accounting either. In the absence of specific guidance, it is reasonable to conclude that digital assets are likely treated as intangible assets under IFRS (similar to US GAAP treatment).

However, a key difference between IFRS and US GAAP is the treatment of the reversals of past impairment losses. Under IFRS, companies are allowed to markup the asset and report a profit if the price later recovers.

For example, say a corporation that follows IFRS purchased 1 BTC for $50,000 in 2021. In 2022, this BTC is worth $30,000. Under both IFRS and GAAP, the company would report an impairment loss of $20,000 ($50,000 – $30,000) and mark down the BTC to $20,000.

Assume in 2023, the market recovers and BTC price goes up to $30,000. Under IFRS, you can markup the previously impaired BTC to $30,000 by reversing the previously reported $20,000 impairment loss. However, under GAAP, you still have to maintain the asset at $20,000 book value despite the increase in market value.

Change Could Be Coming

The Financial Accounting Standards Board (FASB) is responsible for creating & updating GAAP. Over the years, FASB has received a lot of feedback from industry participants to come up with a more tailored accounting framework for digital assets. On May 11, 2022, FASB unanimously voted to add digital asset accounting to its technical agenda.

The crypto industry is expecting the board to adapt a fair-market-value-based approach to digital asset reporting. Although the specifics are yet to be determined, it is reasonable to think that the new framework will reflect the true value and properties of digital assets reported in financial statements by allowing the holder to markup and down the assets, if/when necessary. This updated accounting framework will hopefully enable companies like $MSTR to properly report their BTC holdings without having any adverse effect on stock prices.

Impact on Stock Price

Investors in shares of publicly-traded companies that keep large amounts of crypto on their balance sheets should remain aware that the reported value of these assets may be different than their fair value on open markets. The good news is that most professional analysts that cover the industry are aware of these discrepancies and can calculate the fair value themselves before making price targets and recommendations. For instance, Mark Palmer, Managing Director at BTIG, told Forbes that “inevitably, we see media sources pick up on the impairment charges, which can be quite large, and they lead with those numbers as if they are somehow a significant negative for the company in the stock. The reality is quite different in that the inherent value of MicroStrategy is based on the value of the company’s business intelligence software, and the value of the Bitcoin on its balance sheet, which can be easily calculated simply by looking at where the price point is given point in time.”

Owen Lau, Executive Director at Oppenheimer & Co, echoes those sentiments and urges investors to also consider how material the level of crypto held on a balance sheet is to the underlying business. For instance, even though Coinbase had an impairment charge of over $250 million last quarter, it was just a small percentage of its $1.7 billion operating expense base for the time period. “At the end of the day, unless you’re like MicroStrategy, or bitcoin miner, if you just hold these tokens on the balance sheet in a non-material way, I felt like people and analysts would just adjust that out from the equation.

Next Steps

· Watch out for FASB updated accounting guidance on digital assets in the next coming months.

Further Reading

· Quick Guide To Filing Your 2021 Cryptocurrency & NFT Taxes

· Large Crypto Losses May Not Become Instant Tax Write-0ffs, But Here’s What You Can Do

· IRS May Not Tax Passive Income From Holding Crypto Right Away