Bitcoin and the SMSF audit dilemma
Regardless of what you think about bitcoin and other cryptocurrencies, they’re here to stay. SMSF auditors need to understand how to manage the unique issues that arise from this new generation of asset.
We’ve all read the headlines of bitcoin millionaires, quick wins, and even quicker losses. The news is full of articles about kids investing cash from their grandmothers when bitcoin was $12 to reap the rewards years later as teenage millionaires. The stock is up one day and drops the next as the technology forks and diversifies with multiple entrants in the market – ethereum, ripple, etc.
Nobel prize winning economist Robert Shiller recently suggested that bitcoin is the bubble of our time. Warren Buffet says that cryptocurrencies will come to a bad ending. And yet, clients are lining up to invest, and often invest using their retirement savings.
This artificial world becomes real when a client calls to tell you they are planning on investing in bitcoin, or even better, that they have done so already.
As an auditor, bitcoin makes me nervous, but this doesn’t mean that it is not an allowable SMSF asset.
The main areas of concern are:
- Does the trust deed and investment strategy allow for this type of investment?
- Can ownership and existence be confirmed?
- What is the market value at balance date?
- Separation of assets and the sole purpose test
Does the trust deed and investment strategy allow for this type of investment?
Most trust deeds are silent on bitcoin. This does not preclude the fund from owning these assets, and depending on the wording used, there may be a provision for the ownership of other asset classes that bitcoin can slot into.
Similarly, bitcoin can fall under the other asset class on the investment strategy. Ideally, the investment matrix will specifically list cryptocurrencies, and trustees need to ensure that the investment strategy is updated prior to acquiring any bitcoin.
There is a legal debate raging about whether the deed and investment strategy must specifically list cryptocurrencies as an asset class. My preference is to update the deed and to include it in the investment matrix.
Can ownership and existence be confirmed?
Establishing the ownership and existence of these cryptocurrencies presents a new challenge for auditors.
SMSF assets must be held in the name of the fund but many popular cryptocurrency trading sites only allow investments to be recorded in an individual’s name. In this event, the onus is on the trustees to verify that this investment is kept separate from their personal assets. An acknowledgement of trust at the time of entering into the transaction may be required, and the trustees need to ensure that there are no links to any personal credit cards or bank accounts.
Ownership of bitcoin is recorded through a distributed ledger - accountants are best placed to understand how these ledgers work since they are essentially a series of debits and credits. All transactions are maintained on a ledger that is open sourced in a decentralised location and available to the public — this is the key to maintaining the integrity of the ledger, everyone can see it.
There is a general consensus that these ledgers are impenetrable but this is not entirely true — soft ‘forks’ can create windows for hackers. Soft forks are the result of software updates or other software incompatibilities that can lead to a disruption of the decentralised ledgers, potentially creating a new ledger if the bugs are not eradicated. Auditors need to be on the lookout for these, to determine if the fund’s investment has been affected.
Cryptocurrencies can be stored in online or offline wallets; online wallets are referred to as hot storage and offline wallets are referred to as cold storage.
Hot storage is riskier as the currency is susceptible to hacking – a lot of the articles you read about bitcoin hacking centre around these online storage facilities. Cold storage is more secure as the key to accessing the bitcoin is stored on a piece of hardware, such as Trezor.io, Ledger Nano S and KeepKey. This is akin to having a USB with all the relevant data on it. Unless appropriate safeguards are put in place, losing this cold wallet could mean that the bitcoin is lost for good, and cannot be recovered. SMSFs with material balances should ensure that these cold wallets are stored securely.
In order to trade, the bitcoin must be in the hot wallet, it helps to think of the hot wallet as the transaction account, and the cold wallet as the savings account. The wallets consist of a public address and a private key. The public key acts like an account number that is shared with people to receive funds whilst the private key acts like a password used to make payments. These wallets have different addresses in the distributed ledger, so transactions between these accounts will need to be monitored. The auditor can access the distributed ledger via sites such as www.smartbit.com.au the address will generally be around 32 characters long e.g. 12XTtbb7A1B2Ni4VBRFybCSDDuBHoMkEiL.
The trustees should prepare a declaration each year confirming ownership, existence, and providing confirmation that they have kept their bitcoin separate from any other personal holdings. The auditor can use the distributed ledger to verify the amounts and further audit tests can be conducted if necessary. Funds with substantial holdings with secure cold wallet storage should also be able to provide storage records from the relevant third party.
Determining the market value at balance date
There is no industry standard for valuation of bitcoin. Yet based on the high volume of daily transactions and the multiple online facilities, it is not difficult to obtain a fairly accurate gauge of the price at balance date. For example, www.coindesk.com price gives a clear history of the price movements in bitcoin going back multiple years. The ATO’s valuation guidelines state the following:
“You must be able to demonstrate that the valuation has been arrived at using a 'fair and reasonable' process. Generally, a valuation is considered fair and reasonable where it meets all the following:
- It takes into account all relevant factors and considerations likely to affect the value of the asset.
- It has been undertaken in good faith.
- It uses a rational and reasoned process.
- It is capable of explanation to a third party.”
A trustee declaration, with support from a reputable online source should be sufficient to establish market value in line with SIS Regulation 8.02B.
Auditors also need to consider if any subsequent movements in market value after the balance date are large enough to be material and need to be disclosed in the audit report. This is a real risk due to the volatility of these assets.
Separation of assets and the sole purpose test
It is imperative that any bitcoin owned by the fund is kept separate from any personal holdings. There should be an SMSF bank account linked to the bitcoin wallets, and there should be no transactions with personal accounts. Bitcoin and other cryptocurrencies do not qualify for any of the exemptions outlined in s66 of the SIS Act, as a result, acquisitions from related parties are prohibited.
The trustees should ensure that the sole purpose for the bitcoin investment is to provide benefits for the fund members in retirement. Auditors need to be wary of any kickbacks that an individual may receive through referral schemes and discount incentives provided by brokers.
So there you have it, the fear of the unknown is usually worse than the reality, and auditing funds with bitcoin isn’t going to be that bad after all. Just make sure your clients keep everything to do with the SMSF to one side, and try not to say I told you so if all comes crashing down in flames.
Ray Itaoui, director, SMSF services, Hayes Knight