Throughout 2021, we have seen an explosion in the Non-Fungible Tokens (NFT) market. NFTs have come out of nowhere and become one of the hottest tech sensations of 2021. This initial buildup and hype may die down, but there is no doubt that this use of blockchain technology will be here to stay.
The power that NFTs hold create opportunities for artist and entrepreneurs to directly monetize their audience. Allowing them to sell their creations peer-to-peer through a streamlined gateway for equitable digital ownership. In the past, numerous artists, musicians, and creators have been burned by terrible contracts.
Now with the power of blockchain cutting out the middle man, these creators can collect much larger pieces of the pie while adding greater value to their communities. The creation and sale of these digitally native goods and collectibles is nothing new. Although, the implementation of these smart contracts providing provable ownership to these creators is. In this post, we will be addressing what exactly NFTs are, how to account for them, their use cases, and their future.
NFTs are one-of-a-kind cryptographic assets existing on blockchain technology. A cryptographic asset is simply a transferable digital representation. What's special about them is that their design prohibits duplication, removal, or destruction. They are based on Defi, in which assets and market players act on a decentralized peer-to-peer basis. Originally, NFTs were created on the Ethereum Blockchain using the ERC-721 standard. This means that each NFT is uniquely identifiable by a 256-bit (32 bytes) number (or "id"), and can store additional information about itself to eliminate the need for third-party verifications. This information includes how many times it has sold, the price it has sold for, and who the original owner/seller was.
In contrast with fungible assets such as a dollar bill or bitcoin that one can use transactionally, NFTs are non-fungible. The reason they are non-fungible is that whoever owns them cannot trade one for another. For example, 1 bitcoin=1 bitcoin, and 1 dollar=1 dollar, because they are identical. An NFTs unique 256-bit number makes its transactional use impossible. The only way to acquire or do away with an NFT is through purchase and sale. A few examples of NFTs that we will be talking about today are collectibles, art, music, gaming, real-world assets, domain names, and documentation; but before we get into that we must gain a better understanding of how to account for these new assets.
At the moment there are no standards that are specifically for NFT accounting. However, it’s clear that these digital assets should be classified as intangible assets, and recorded at their purchase price. A question that is sure to arise is whether one should amortize their NFTs. Since an NFT is an asset with an indefinite lifespan, such as trademarks or perpetual franchises, there is no need to record a monthly amortization change.
Even though the value of these assets continues to increase, we can expect this hype to wear off and its market value to fall. At this moment, if you are someone who is still holding onto NFTs you may need to record an impairment charge to reduce the initial purchase cost to a similar asset’s current market value. Because of how new this market is, prices are extremely volatile. As a result, properly assessing their value could become more difficult than expected.
On the other hand, if you are the creator of the NFT, accounting can be a bit different. In this case, a sale is immediately recorded as revenue, considering there will be no delayed obligations connected with the sale. There are currently no GAAP standards defining the process preceding the creation of the asset, and whether to capitalize or expense the costs and expenses related to creating the NFT. However, an inventory accounting model would make sense. The sale price will be roughly the same as the profit considering there are very few expenses in this process, but creators may have to pay a fee for placing the NFT on a blockchain as well as transactional processing. Now let’s get into what use cases NFTs provide.
Bringing together creativity and technology, art is the most common non-fungible token use case. When it comes to value, it isn’t necessarily related to the specific work, but to the ability to verify its authenticity and prove ownership. There are currently various special editions of artwork in circulation that allow modification of programmability according to certain situations.
Collectables are also one of the most profound uses for non-fungible tokens, making up a large portion of sales on NFT marketplaces. A few examples of collectible NFTs are NBA trading cards, Pancake Bunny (a native token to PancakeSwap), Zed Run (digital horse racing NFT with unique digital genes, and breading capability), and even tokenized tweets. These tokenized tweets are created using a platform called Valuables. Think of it as an online auction, except instead of placing bids on a physical asset, you are placing bids on 1-1 tweets minted on the blockchain. Each NFT even includes a signature by its verified creator’s Twitter handle, essentially creating a digital autograph.
Blockchain domain NFTs enable easy trading as well as customizable domain names with the use of private keys. They are recorded permanently in a public registry and cannot be deleted or altered by a third party. This eliminates the concerns of censorship and security. The use of the Ethereum Name Service (ENS) and Unstoppable Domains offer a decentralized alternative to the standard (DNS) that provides a crypto address, very similar to an Instagram or Twitter handle. Unlike Instagram and Twitter, ENS and Unstoppable Domains even allow users to buy and sell their crypto addresses. The more popular or desirable the name is, the more value it holds.
Micro-transactions and in-game purchases have already created a multi-billion dollar industry within modern-day gaming. This enormous demand for unique tradeable and purchasable items all comes down to their rarity which directly affects their value. Tokens for video games combine aspects of art, collectability, and utility for players. NFTs and blockchain technology have already taken action to infiltrate the gaming community. An example of this could be Battle Pets and Axie Infinity, which are both Pokémon-style games with tradable pets. However, NFT implementation is still a long way off when it comes to big-budget video games such as Battlefield, GTA, and Call of Duty.
Compared to an image or video file, musicians can even create a collectible by attaching audio to an NFT. One could think of it as a “first edition” of a record. The reason behind music NFTs’ growth and popularity is due to their ability to obtain a fair share of royalties. Many artists have been burned by terrible contracts, "Signing their life away," as many people in the industry call it. That is where blockchain technology comes into play. An example of this is Rocki on Binance Smart Chain. What Rocki does is offer independent artists a platform to sell royalties and stream their music. Whether this model will become successful or not all comes down to its adoption and support from larger streaming services and music labels.
Linking real-world assets with NFTs can reinvent the way that we prove ownership and legitimacy. Many people assume NFTs can only represent digital assets. Did you know they could also represent real-world assets like real estate, or jewelry? In real estate, we generally deal with physical property deeds, but now we can tokenize these digital assets. These highly liquid assets would then live on the blockchain and be easily stored on our physical cold storage wallet.
When it comes to smaller items, such as jewelry, an NFT can help prove legitimacy when attempting to resell. This acts as a certificate proving ownership and rights, eliminating the concerns of buyers. When possessing an NFT associated with an item, owning the NFT can become just as important as owning the actual asset. Unfortunately, this is still very much in development due to the lack of support from regulators but is something to look out for as the future unfolds.
Similar to real-world assets, personal identity management is an area in which NFTs can flourish. As we know, NFTs contain a unique 256-bit number. These unique Ids can be used to tokenize documentation such as licenses, degrees, medical records, and birth/death certificates. These documents and certifications can be issued directly over the blockchain and are easily traced back to their owners to assist in identity theft prevention. A comparable application is the use of NFTs to create tokenized vaccine passports. These tokenized vaccine reports have already been adopted by The Republic of San Marino which proves authentication and decreases counterfeits. In the future, a similar concept could be applied to driver’s licenses and passports yet details about how this would work have yet to be established.
By becoming smarter, more strategic, and offering utility to diminish short-term engagement, NFTs will become the key to unlocking unique experiences both on and offline. To continue the growth and value of this industry, NFT companies must stay focused on consumers. They need to continue to bring value to the industry and prevent it from sinking under a perception of ill-advised cash grabs. In due time, people will become more knowledgeable about NFTs and the value they deliver. Consumers will seek to better comprehend the technology and “so what” component behind NFTs. What can it do for me? What value can I expect from ownership of this NFT? The expectation is that the industry will continue to progress as key innovators turn their attention to community development, game mechanics, and narrative storytelling to drive value and utility from the NFTs that go to market.
The future for many NFT use cases can be a bit foggy, but the overall industry will continue to progress. As the popularity of NFTs continues to grow we can expect to see more ideas and use cases come up. At this time many applications for NFTs have not had enough time to develop into more than an idea or small project. Obviously many will fail, turning out not to be practical or popular enough, but we know one thing for sure… NFTs are changing the world, and their use cases will continue to generate and evolve.
When it comes to accounting for NFTs, there is a lot to think about before starting. Should I record it as a tangible or intangible item? Should I be recording a monthly amortization change? How do I value my NFTs? What if its market value falls?
With SoftLedgers’ cloud-native accounting platform and APIs, you have the ability to:
No matter if you’re a buyer, artist, musician, creator, or represent a marketplace, it is crucial to accurately record and report your NFT transactions. Tax implications when incorrectly accounting for NFTs could result in financial impact. Therefore, it’s extremely important to have your books right to avoid this legal nightmare.
A CPA with more than 10 years of varied public and private accounting experience, Ben has led many complex financial projects to successful outcomes.
Ben holds a B.S. in Accounting from the University of Maryland.