Evaluating NFTs Using Accounting (Part I)

Accounting is unified nowadays and utilized in an almost identical approach anywhere in the world, with the integration of the international accounting standards.

Perhaps some readers may already possess knowledge of the practical issues it deals with and in particular when evaluating assets (tangible, intangible, and financial) or the basic rules accounting practices use.

With this article, I attempt to examine NFTs under the prism of accounting for businesses, describe the accounts NFTs can be registered, and eventually explain how we will be able to evaluate NFTs in a reasonable approach (in the next part).

A warning, though, this article contains accounting terms, so it will be difficult to comprehend for those unaware of accounting rules, financial statements, and accounting theory.

NFTs as Assets: Balance Sheet Accounts Of NFTs

A tokenized real-life asset into an NFT doesn't turn the NFT into an asset. The car will always remain as the asset in question, whether tokenized or not. The asset will always be the product or merchandise the NFT grants ownership rights concerning real-life assets.

And tokenization of real-life assets is not applicable anywhere (yet) since no jurisdiction has ruled an NFT would grand ownership rights to a home or a car and replace the current process of registrations and paperwork. In this case, if NFTs apply, they will reduce the cost of required third parties and lead to reduced taxation.

When we discuss NFTs, we accept the use case of this technology in a digital environment and call NFTs digital assets. As a focal point, we can bring the NFTs sold by digital artists like Beeple as a form of art.

(image: source)

Yet, generating art and sales in the form of NFTs combines the art with the NFT and gives it a unique identity as an asset. The art is the asset, yet we integrate the asset into a smart contract (code) granting access to the art ownership rights.

In the strict approach, the code and the private key are not the assets themselves, but grand access to the ownership rights of the asset, which could be a Beeple’s artwork, as in our example.

Accounting applies in businesses, and we can take some lessons from the approach of identifying the value of assets, merchandise, and raw material and take some lessons when evaluating our NFTs.

A company of any size can integrate NFTs into balance sheet accounts, depending on its approach towards each NFT.

NFTs describe assets, although not an asset class, as they express a process (tokenization) which grants access to ownership rights.

Digital Asset Markets (Official and Black Markets)

(image: Pixabay)

NFTs have multiple use cases, but we only examine the scope of NFTs as artwork or digital assets that exist only in the digital realm.

In particular, we examine NFTs as the ownership rights of digital assets like a digital painting or a digital item in a virtual world, which is currently dominating the use case of this technology.

Digital items in games or virtual worlds contain a value. They include a production cost and a commercial value. Gamers sell gaming items like weapon skins, gear, and characters of games in black markets for fiat money since the beginning of the internet.

We can't deny the existence of these online black markets, which in combination with a regulated market (if it exists), define the actual price of a digital asset.

Each online game contains a black market. 

The users of online games trade in-game items and currency for real money (via Paypal) or cryptocurrency.

If we consider these online black markets insignificant, perhaps Brock Pierce (EOS, Bitcoin Foundation, etc.) might change our point of view since he made a fortune from running such a black market of digital assets (IGE) between 2001 and 2006.

Work of Art vs Investment

(image: source)

• Works of Art in the non-current (intangible) assets section, or

• An investment (short or long term) and categorized a) in the financial assets section as current (liquid) assets (short term), or b) non-current financial assets (long term)

Works of Art: NFT are intangible assets since this is code and digital images. NFTs definitely belong to the "works of art" subaccount if the company bought them in this approach.

Beeple's NFTs are included in this category (Digital Art - NFTs) if a corporation has purchased one.

Example:

(Twitter)

For Visa, the purchase of this Punk NFT was a marketing activity.

Visa could catalog this Ape NFT in the "works of art" subcategory of the intangible assets in the non-current part of its balance sheet or as a digital asset depending on the purpose it purchased it. If Visa bought it to facilitate marketing, it still presents an asset that should be recorded and holds value as Visa can resell it later.

The "Useful Life" of works of art is infinite, as works of art are not subject to wear and tear or foreseeable obsolescence.

While amortization and depreciation don't apply in works of art, impairment of assets always applies. NFTs don't contain amortization and depreciation, yet their commercial value is volatile and may drop or increase significantly.

NFTs as Financial Assets

(image: source)

Current financial assets (or liquid financial assets): Current assets contain various accounts, and another one is available for sale financial assets. These are financial assets like stocks the company plans to sell during the current accounting year. 

This class contains assets the company plans to liquidate (sell) in the current year. It includes investments aiming for short-term market speculation or long-term investments the company decided to "offload" for its reasons. 

In case a company trades NFTs, it becomes difficult to categorize these purchases in this section. NFTs are not liquid assets. Depending on volumes generated, though, we can estimate if there will be liquidity available and at which price.

NFTs as non-current financial assets: This category contains financial assets that present a long-term investment in another business. It contains shares in other businesses in the form of stock ownership and participation in the decision process of other companies, as well as participating in the profit/losses of the third business. By purchasing stocks of a company, the buyer becomes an owner of this company to the percentage of stocks purchased. Still, this has little to do with NFTs. 

If we consider NFTs investing (financial) assets with a long-term vision of reselling for profit, they belong in this subcategory. It is a de-facto rule that investments (assets) that don't correspond to the will of a company to liquidate them during the current year, they fall in the non-current financial assets category.

When a company does not correctly display its assets and current position in its accounting statement, it will transmit a wrong impression to the market.

Of course, an NFT will take the accounting entry of digital assets instead of a general NFT title. "Digital Assets" - NFTs" should work when it concerns virtual world assets and images.

In this case, it will not be a work of art but a unique identifier in the non-current non-tangible assets class.

Accounting has strict rules, but it is all based on correctly interpreting the decisions and model of a business.

NFTs are assets, and accounting has only recently started taking them seriously.

NFT-Producing Businesses: NFTs as Merchandise

(image: source)

NFTs will always drop in either intangible assets or financial assets (either long-term or short-term) unless the company plans to generate and sell NFTs as part of its production and business plan process.

Sorare is a company with a business plan to produce NFTs for football athletes and clubs, and its whole business model depends on selling and accommodating trading of these types of NFTs.

In this case, NFTs are the goods (the merchandise) a company sells.

The product, or the merchandise, it produces and sells to the public is NFTs. 

Business merchandise in the balance sheet is depicted in the Current Assets part of the balance sheet as Merchandise Inventory.

The inventory (products and merchandise in the warehouse) of a business stands as assets (current).

Current assets are liquid assets, meaning the company plans to sell them within the current year and profit from selling them to customers.

Of course, the Sorare NFTs are liquid assets. It doesn't matter if Sorare doesn't manage to sell its entire stock of NFTs during the current year. It will sell a lot, nonetheless. Otherwise, it won't manage to survive as a business model and will fail as a business.

The above is what accounting describes, the logic behind the business decisions taken by a company's board of directors.

NFTs are assets because what remains is not the jpeg images that remain but the overall interpretation of an NFT.

We don't claim the paperwork of a sale is the sale itself in real-world assets, but with NFTs defining digital assets, we generally accept that the term has evolved to describe both the code and the assets an NFT may represent.

As mentioned above, NFTs should be a different category from any other type of digital asset. It is a subcategory of digital assets, with its suggestive subcategories.

In this article, I've mentioned the use cases of NFTs in general, and while in digital 3D universes, perhaps each platform will represent the use case of each NFT.

End of Part I

(image: source)

It all depends on the use case.

An NFT is a tokenized form presenting ownership rights to digital assets, and while it is not a digital asset itself, it represents the ownership rights to this asset.

These are all logical assumptions, considering the type of asset NFTs represent and how accounting should deal with NFTs. The code (the smart contract) also represents the uniqueness of the asset in terms of categorizing it and giving it a mint number.

This number alone alters the collective value proposition. For example, when the number ID of an NFT is 0 or 1 out of a series of 10,000 NFTs inside the same collection, then this number will be considered collectible (by collectors) and contain value on its own without any special feature requirements.

A corporation can name a subaccount under the given names for clarity, however, NFTs are not yet officially recognized in jurisdictions as assets.

Accounting depicts actions and decisions of the management of businesses under a set of accounting rules and financial regulator decisions. Since NFTs can be considered an investment, perhaps it would be a mistake to always represent them as a work of art.

the accounting outcome for each use case might hinge on subtle differences in contracts or customary practices

Matthew Schell - Forbes

While many will claim all NFTs are heading to zero, can we claim the same about Beeple's NFTs? In the next part, we discuss price recognition and calculation of the commercial value for NFTs under the prism of accounting rules.

• Cover Photo by " KELLEPICS" on Pixabay

Notes:

*I've been studying accounting again as part of some exams I'll take, which I already studied in depth during university. Although, I still have a lot to refresh since I never practiced the craft afterward. It is way easier to remember, though, and after a while, it got me thinking about how to relate part of this knowledge with NFTs.

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