MicroStrategy didn't early adopt new accounting for its Bitcoin; CEO Saylor may be scared of big taxes
New accounting rules for crypto assets are expected to increase Microstrategy’s net income, yet it’s not jumping onboard. Is the extra profit not worth paying a 15% AMT?
We previously published this in Deep Quarry.
Public companies that invest in digital assets such as bitcoin as a key business strategy face challenges in implementing long-term tax strategies. That’s because, as I reported for CoinDesk in February 2022, insufficient guidance from tax authorities and other regulators on financial reporting are making tax planning tough:
“…it took five years after bitcoin launched in 2009 before tax authorities issued any substantive guidance. Multinationals face significant tax uncertainty when investing in digital assets, transacting with crypto, facilitating crypto purchases and sales and using crypto to pay interest.”
New accounting guidance for crypto assets, adopted by FASB on December 13, 2023, was intended to support the growing presence of crypto assets on balance sheets, but ironically may further complicate tax treatment for the public company most invested in bitcoin as a business model: MicroStrategy (Ticker: MSTR).
ASU 2023-08: Background and adoption
On December 13, 2023, FASB adopted ASU 2023-08, which requires companies to report certain digital assets at fair value on the balance sheet, with period-over-period changes in the fair value reported as income or loss on the income statement.
Before ASU 2023-08, guidance suggested that companies use a cost-less-impairment model and report the value of digital assets at the lowest price since the acquisition. The impairment could not be reversed even if the price of the assets recovered. The new standard was expected to be a positive development for bitcoin holders because it allows recognition of both gains and losses.
Although the standard is effective as of January 1, 2025, early adoption is permitted for any period that has yet to be reported. If the standard is adopted early in an interim period—for example, in the fourth quarter of 2023—an entity must adopt the standard as of the beginning of the fiscal year that includes the interim period.
We looked at a sample of 70 companies that mentioned ASU 2023-08 in their annual reports for fiscal 2023. The key statistics are:
Number of companies evaluated: 70
Number of companies that early adopted the standard: 23
Number of early adopters recognizing a cumulative impact on retained earnings: 14
Number of companies that did not adopt early but indicated that the standard may have an impact on retained earnings: 3
Table 1 below reflects the top five companies with the greatest anticipated impact on retained earnings.
MicroStrategy and tax implications of ASU 2023-08
MicroStrategy was expected to be one of the primary beneficiaries of the new rule because, according to Bloomberg, the company was holding $14 billion worth of bitcoin – or more than 1% of all bitcoin that will ever be issued. In a February 6, 2024, interview with Bloomberg, Lance Vitanza, an analyst at Cowen, wrote that he believed that adopting the new standard early would be in MicroStrategy’s interests:
“I think it would be in the company’s best interests, I think they should adopt right away,” Vitanza said. “They fought for this, so why not do it.”
Surprisingly, as of January 1, 2024, MicroStrategy had not adopted the new standard (emphasis ended):
The Company is currently evaluating early adoption of ASU 2023-08 and the potential implications of unrealized fair value gains and losses as they relate to the changing global tax landscape. If the Company were to adopt this guidance during 2024, it estimates that its 2024 beginning retained earnings balance would increase by approximately $3.1 billion.
Additionally, MicroStrategy was the only company in our sample that mentioned tax implications as a potential ASU 2023-08 risk. The Risk Factors section provides more context:
The U.S. also enacted the Inflation Reduction Act of 2022 (“IRA”) in August 2022. The IRA applies to tax years beginning after December 31, 2022, and introduces a 15% corporate alternative minimum tax for corporations whose average annual adjusted financial statement income for any consecutive three-tax-year period preceding the tax year exceeds $1 billion and a 1% excise tax on certain stock repurchases made by publicly traded U.S. corporations after December 31, 2022.
Subject to the release and content of the final regulations by the IRS with respect to the application of the minimum tax and treatment of unrealized fair value gains, upon our adoption of Accounting Standards Update No. 2023-08, Intangibles—Goodwill and Other—Crypto Assets (Subtopic 350-60): Accounting for and Disclosure of Crypto Assets (“ASU 2023-08”), we could become subject to the alternative minimum tax if, for example, we experience significant unrealized gains on our bitcoin holdings.
If we become subject to these new taxes under the IRA for these or any other reasons, it could materially affect our financial results, including our earnings and cash flow, and our financial condition.
What does this mean?
MicroStrategy is concerned that unrealized gains on bitcoin holdings following the adoption of ASU 2023-08 may cause its GAAP income to exceed $1 billion for three consecutive years. If that happens MicroStrategy is expected to be subject to a corporate alternative minimum tax of 15% (“CAMT”).
MicroStrategy’s Net Income (Loss) before Income Taxes from US Operations was ($157.8) million and ($1,362.2) million for the years 2023 and 2022, respectively. MicroStrategy held 132,500 and 189,150 bitcoins as of December 31, 2022, and December 31, 2023, respectively.
While it is difficult to estimate the tax impact, it would be safe to say that, given a sharp increase in bitcoin prices from roughly $16,500 to $44,000 in 2023, adopting the new fair value standard as of January 1, 2023, would have added several billions in unrealized gains to MicroStrategy’s 2023 bottom line. It is important to note that even though unrealized gains do not affect cash flow and liquidity, additional tax liabilities do have a negative cash flow and liquidity impact.
Moreover, MicroStrategy’s CEO Michael Saylor has declared on more than one occasion that he is planning to acquire more Bitcoin and hold the asset “forever”:
At this time the IRS has not yet finalized the AMT rule. The CAMT is only potentially applicable to companies with three trailing years of $1 billion income. For MicroStrategy, such significantly increased GAAP net income as a result of unrealized gains on bitcoin would imply a significant, sustained increase in bitcoin prices for at least three years.
But let’s assume that prices do continue to climb for several years, Saylor adheres to his “buy-and-hold-for-decades” strategy, and IRS adopts the 15% CAMT tax while including unrealized gains on crypto assets in the GAAP net income for CAMT purposes. Under this scenario, unrealized gains will continue to accumulate annually, making CAMT a cost that investors should take into consideration while evaluating MicroStrategy’s fundamentals.
MicroStrategy and its tax valuation allowance
Volatile bitcoin prices affected MicroStrategy’s tax planning and accounting in at least one more way. In fiscal 2022, following a sharp decline in bitcoin prices, MicroStrategy recorded an additional tax valuation allowance of $510 million against a balance of $724 million of deferred tax assets. Establishing a tax valuation reserve of more than 70% of its deferred tax assets implied MicroStrategy believed it would be unable to realize the tax benefits against future tax liabilities in the future. For example, this belief could have been based on the idea it did not expect to have sufficient future taxable income to utilize the specific deferred tax assets.
From the 10-K filing for the year ending December 31, 2022:
As of December 31, 2022, we had a valuation allowance of $511.4 million primarily related to our deferred tax asset related to the impairment of our bitcoin holdings that, in our present estimation, more likely than not will not be realized. If the market value of bitcoin continues to decline or we are unable to regain profitability in future periods, we may be required to increase further the valuation allowance against our deferred tax assets, which could result in a charge that would materially adversely affect net income (loss) in the period in which the charge is incurred. To the extent the market value of bitcoin rises we may decrease the valuation allowance against our deferred tax asset. We will continue to regularly assess the realizability of deferred tax assets.
However, in fiscal 2023, Bitcoin prices recovered, so MicroStrategy reversed the previous year’s accounting decision and released the valuation allowance.
From the 10-K filing for the year December 31, 2023:
As of December 31, 2023, we had a valuation allowance of $1.4 million primarily related to our deferred tax assets related to foreign tax credits in certain jurisdictions. This is a significant change from the valuation allowance as of December 31, 2022 of $511.4 million. The largest deferred tax asset relates to the impairment on our bitcoin holdings. During 2023, the value of bitcoin increased substantially which allowed us to release the valuation allowance recorded against the deferred tax asset for impairment on our bitcoin holdings. Changes to the valuation allowance against the deferred tax asset are largely dependent on the change in the market value of bitcoin from the previous reporting date. If the market value of bitcoin declines or we are unable to regain profitability in future periods, we may be required to increase the valuation allowance against our deferred tax assets, which could result in a charge that would materially adversely affect net income (loss) in the period in which the charge is incurred. We routinely consider actions necessary to preserve or utilize tax attributes. We will continue to regularly assess the realizability of deferred tax assets.
Accounting guidance leaves substantial room for the judgement related to timing of the establishment of the allowance. As I reported for CoinDesk — citing Andrew Schmidt, an associate professor of accounting at North Carolina State University— MicroStrategy may not have needed to establish the reserve while the Bitcoin prices were high:
If prices remain high, the company can sell bitcoin at any time to generate enough taxable income to use its existing deferred tax assets.
Creating such a massive tax reserve just to release it a year later is unusual. As we noted in our discussion of Tesla’s release of the tax valuation allowance, companies might be reluctant to release the reserve too soon for fear that they may need to re-establish it should the business conditions deteriorate.
But for companies with large holding of crypto assets, sharp swings in valuation allowance — prompted by volatility in prices of crypto assets — appear to be a new normal.
Coinbase, second largest holder of crypto assets in our sample, had roughly $405 million of crypto assets on its December 31, 2023, balance sheet - with a fair value of $1.2 billion. The Company had a tax valuation allowance of $54 million, $252 million, and $102 million as of December 31, 2021, December 31, 2022, and December 31, 2023, respectively.
According to the Coinbase’s 10-K filing, the changes in valuation allowances were primarily related to the changes in the fair value of crypto assets:
The Company’s valuation allowance as of December 31, 2023 was lower compared to 2022 driven by the increase in the fair value of crypto assets held during the reporting period. The valuation allowance as of December 31, 2023 includes allowances primarily related to California R&D credits, and realized and unrealized capital losses on crypto assets and Coinbase Ventures investments.
Income volatility and non-GAAP presentation
Recognition of bitcoin gains and losses following ASU 2023-08 is bound to introduce significant volatility to the quarterly earnings. Importantly, companies - including MicroStrategy - would not be able to negate the impact of the additional net income or loss from unrealized gains or taxes by presenting tailored non-GAAP metrics.
While Regulation G does not explicitly address crypto assets, smoothing the net income effect of the fair value accounting is likely to be prohibited.
On October 7, 2021, the SEC issued a comment letter to MicroStrategy requesting that the company refrains from adjusting for bitcoin-related impairments. MicroStrategy agreed with SEC’s comments and modified the presentation.
Additionally, the SEC warned against smoothing earnings volatility following the adoption of fair value accounting in the context of the Current Expected Credit Losses (CECL) standard.
For more discussion, see my discussion of crypto-specific SEC comments to Microstrategy in The Financial Times and DeepQuarry’s analysis of CECL-related SEC comment letters :
First, let’s consider how companies currently disclose non-GAAP crypto adjustments. Under the current cost-less-impairment model, digital assets are reported on the balance sheet at the lowest price since the acquisition. Notably, in at least two comment letters threads, the SEC challenged non-GAAP adjustments that removed bitcoin impairments.
· On September 22, 2022, the SEC issued a comment letter to Bit Digital, Inc (BTBT) questioning whether, given the recurring nature of impairments of digital assets, adjusting for the impairments would substitute individually tailored metrics and violate Question 100.04 of Regulation G.
· On October 7, 2021, the SEC issued a comment letter to MicroStrategy (MSTR) asking the company to clarify why adjusting for bitcoin impairments is useful to investors. On December 3, 2021, the SEC issued a follow-up letter objecting to the adjustment (we discussed SEC comment letters to MicroStrategy in our blog with Calcbench).
Bit Digital, Inc. and MicroStrategy agreed to remove bitcoin impairments from future non-GAAP presentations.
Under the proposed new standard, companies would be required to record changes in fair value of digital assets on the income statement instead of testing the assets for impairment. To the best of our knowledge, there is no crypto-specific non-GAAP guidance that would apply to the changes in the fair value of crypto assets. However, earnings volatility following the adoption of fair value accounting was widely discussed in the context of the Current Expected Credit Losses (CECL) standard.
Nicola White of Bloomberg reported that the SEC warned companies to be mindful of Regulation G when considering CECL-related non-GAAP adjustments:
“Before CECL went live for public companies in 2020, the SEC added another warning: Companies can’t use just unofficial metrics showing their earnings as if they hadn’t switched over to the new accounting.”
Can we learn from past SEC comment letters about the dos and don’ts of presenting fair value-related non-GAAP adjustments? Using the Audit Analytics Comment Letters database, we found a few examples that could be helpful.
· On November 19, 2020, the SEC issued a comment letter to Heartland Financial USA, INC (HTLF) asking the company to “to refrain from disclosing performance measures that exclude the provision for credit losses” because provision for credit losses is a normal and recurring business charge. The company agreed to avoid using the metric in future filings.
· On June 24, 2020, the SEC issued a comment letter to Fifth Third Bancorp (FITB) requesting that the company refrains from disclosing the Adjusted Net Income metric that excludes credit losses because the metric “which exclude a portion of the provision for credit losses, substitute individually tailored recognition and measurement methods for those of GAAP”. The company agreed to refrain from using this metric in future filings.
· On June 4, 2020, the SEC issued a comment letter to American Express, Co (AXP) requesting that the company refrains from disclosing Adjusted Diluted EPS that excludes credit reserve builds because the metric that “…excludes a portion of the provision for credit losses, substitutes individually tailored recognition and measurement methods for those of GAAP”. The company agreed to refrain from disclosing Adjusted EPS excluding provisions for credit losses attributable to reserve builds in future filings.
In the cases described above, the primary objections of the SEC appeared to be related to either the recurring nature of the provision of credit losses or because removing parts of provisions of credit losses would create a tailored accounting that substitutes GAAP.
The SEC comment letter to Credit Acceptance Corp (CACC) is a notable exception. On December 9, 2020, the SEC issued comments to Credit Acceptance requesting that the company refrains from disclosing non-GAAP measurements that exclude provision for credit losses. In contrast to Heartland Financial, Fifth Third, and Amex, Credit Acceptance explained that the metrics are not misleading because of the unique characteristics of the company’s business:
“On January 1, 2020, we adopted Accounting Standards Update 2016-13, Measurement of Credit Losses on Financial Instruments, which is known as the current expected credit loss model, or CECL. Our response to the Staff’s 2017 comment letter explained why we believe the GAAP methodology we employed prior to January 1, 2020, did not provide sufficient transparency into the economics of our business due to its asymmetrical treatment of favorable and unfavorable changes to expected future net cash flows. While CECL eliminated that asymmetrical treatment of changes in expected future net cash flows from the GAAP methodology we employ, it introduced a different asymmetry by requiring us to recognize at the time of the loan’s assignment to us a significant provision for credit losses expense for amounts we never expect to realize and to recognize in subsequent periods finance charge revenue that is significantly in excess of our expected yields. Our floating yield adjustment enables us to provide measures of income that are not impacted by GAAP’s asymmetrical treatments of estimates.”
To summarize, the discussion of crypto non-GAAP accounting under the fair value model is currently hypothetical because the new standard is not applicable until 2025. We do not know if comparing CECL and crypto no-GAAP accounting is the best approach because the standards and instruments are different. Yet, it would be safe to assume that companies would need to consider SEC December 13, 2022, C&DI, including questions 100.01 through 100.04, should they elect to modify the non-GAAP metrics for the new crypto accounting standard.
© Francine McKenna, The Digging Company LLC, 2024