MicroStrategy's accounting treatment and risk analysis of Bitcoin assets in the 10-Q form
MicroStrategy's 10-Q report provides valuable information about its strategy and its impact on financial condition.Author: MicroStrategy
MicroStrategy is a well-known enterprise analytics software company that has garnered widespread attention in recent years for its unique approach to Bitcoin management. The company's financial statements, particularly its 10-Q report, provide valuable insights into its strategies and their impact on its financial condition. This article compiles and analyzes the key aspects of Bitcoin assets presented by MicroStrategy in its third-quarter financial report.
Asset Classification and Measurement:
MicroStrategy records and measures its digital assets (which only include Bitcoin) in accordance with Accounting Standards Codification ("ASC") 350, the accounting rules for indefinite-lived intangible assets. These digital assets are initially recorded at cost and subsequently measured based on their net cost since acquisition. Impairment losses are recorded as "Digital Asset Impairment Loss" in the company's consolidated income statement for the period in which the impairment occurs. Gains (if any) are only recognized upon sale, at which point the gains are presented in the company's consolidated income statement net of any impairment losses. In determining the gains recognized upon sale, the company calculates the difference between the sales price of specific Bitcoins sold immediately prior to the sale and their carrying value.
The company's digital asset holdings are shown in the table below (in thousands, excluding the number of Bitcoins):
As of:
December 31, 2022, the company held 132,500 Bitcoins;
September 30, 2023, the company held approximately 158,245 Bitcoins. The carrying value of Bitcoin was $2,451,374,000, an increase from $1,840,028,000 as of December 31, 2022. The cumulative digital asset impairment loss was $2,229,775,000, slightly up from $2,153,162,000 as of December 31, 2022.
Digital Asset Purchase Situation
The company's digital asset purchase situation is shown in the table below (in thousands, excluding the number of Bitcoins):
For the specified periods:
In the third quarter of 2022, the company purchased only 301 Bitcoins for a total of $5,978,000;
In the same period of 2023, the company purchased 5,912 Bitcoins for a total of $161,681,000.
In the first nine months of 2022, the company purchased only 5,609 Bitcoins for a total of $231,478,000;
In the same period of 2023, the company purchased a total of 25,745 Bitcoins for a total of $687,959,000.
Additionally, the company may obtain short-term credit lines from Coinbase or other executing partners to purchase Bitcoins in advance before using cash funds. These transaction credit lines should be paid in cash within a few days of being provided. As of September 30, 2023, the company had no outstanding transaction credit lines. As of September 30, 2023, the carrying value of approximately 15,731 Bitcoins held by the company was about $251.1 million, which are part of the company's 6.125% senior secured notes due in 2028 on the consolidated balance sheet. All of the company's Bitcoins were previously pledged as collateral for a $205 million term loan issued by MacroStrategy LLC, a wholly-owned subsidiary of MicroStrategy, to Silvergate Bank, and were released from collateral after repaying the secured loan due in 2025 in the first quarter of 2023. The company's Bitcoin acquisition strategy generally involves using liquid assets in excess of working capital requirements to acquire Bitcoins, sometimes issuing debt or equity securities or engaging in other capital-raising transactions depending on market conditions, with the aim of using the proceeds to purchase Bitcoins. The company views its Bitcoin holdings as long-term and expects to continue accumulating Bitcoins. The company has not set specific Bitcoin holding targets and will continue to monitor market conditions to determine whether to raise additional funds to purchase more Bitcoins. This overall strategy also includes the possibility that the company may (i) periodically sell Bitcoins for general corporate purposes, including generating cash for financial management or tax advantages in accordance with applicable laws, (ii) engage in additional capital-raising transactions secured by the company's Bitcoin holdings, and (iii) consider pursuing additional strategies to create income streams or otherwise generate funds utilizing the company's Bitcoin holdings.
The company believes Bitcoin is attractive because it can serve as a store of value, supported by a robust and publicly available open-source architecture, and is not influenced by sovereign monetary policies. Furthermore, the company believes that due to the limited supply of Bitcoin, there is an opportunity for appreciation if its adoption increases, while also having the potential to act as a hedge against inflation. Additionally, the company believes its Bitcoin acquisition strategy complements its enterprise analytics software business, as it believes its Bitcoin holdings and activities related to supporting the Bitcoin network help enhance its brand recognition. The company is also exploring integrating features into its software products to leverage the Lightning Network, a distributed second-layer payment protocol built on the Bitcoin blockchain designed for fast and low-cost transactions.
Impairment Losses:
Digital asset impairment losses are a significant component of the company's operating expenses. In the three months ended September 30, 2023, digital asset impairment losses reached $336,000, accounting for 26.2% of the company's operating expenses, while in the three months ended September 30, 2022, digital asset impairment losses were $7,000, accounting for 0.8% of operating expenses. For the nine months ended September 30, 2023, digital asset impairment losses were $766,000, accounting for 21.1% of operating expenses, while for the nine months ended September 30, 2022, digital asset impairment losses reached $1.089 billion, accounting for 79.3% of operating expenses.
Related Taxes
The company calculates its cumulative income tax liabilities or tax benefits by applying the estimated annual effective tax rate to the annual cumulative pre-tax income or loss and adjusts the income tax liabilities or tax benefits to reflect discrete tax items recorded during the period.
The estimated effective tax rate fluctuates based on the levels of income and losses in various tax jurisdictions, foreign tax rate differences, and the relative impact of permanent book and tax differences. Each quarter, cumulative adjustments are recorded based on any fluctuations compared to the estimated annual effective tax rate from the previous quarter. Due to these factors and the possibility of changes in the company's results during the period, the company's effective tax rate and corresponding income tax liabilities or tax benefits may fluctuate.
As of the nine months ended September 30, 2023, the company recorded an income tax benefit of $403.9 million based on a pre-tax loss of $63.9 million, resulting in an effective tax rate of 632.2%. As of the nine months ended September 30, 2022, the company recorded an income tax liability of $112 million based on a pre-tax loss of $11.08 billion, resulting in an effective tax rate of (-10.1%). The change in effective tax rate compared to the same period last year is primarily due to (i) the release of a portion of the valuation allowance related to deferred tax assets associated with the company's Bitcoin holdings, as the market value of Bitcoin increased from September 30, 2023, compared to December 31, 2022, and (ii) the establishment of a valuation allowance related to deferred tax assets associated with the company's Bitcoin holdings, as the market value of Bitcoin decreased from September 30, 2022, compared to December 31, 2021.
As of September 30, 2023, the company's valuation allowance was $118.4 million, primarily related to deferred tax assets associated with the company's Bitcoin holdings, which, according to the company's current estimates, are more likely than not to be unrealized. If the market value of Bitcoin declines or the company does not achieve profitability in future periods, the company may need to increase the valuation allowance for deferred tax assets, which could have a significant adverse effect on net income (loss). If the market value of Bitcoin increases, the company may reduce the valuation allowance for deferred tax assets. The company will continue to assess the realizability of deferred tax assets on a regular basis.
The company records liabilities related to its uncertain tax positions. As of September 30, 2023, and December 31, 2022, the total unrecognized tax benefits, including accrued interest, were $6.3 million and $6.1 million, respectively, all of which are recorded in the company's balance sheet under "Other Long-Term Liabilities."
Risk Analysis
The company faces various risks related to Bitcoin, including but not limited to the following:
Bitcoin is a highly volatile asset. Bitcoin is a highly volatile asset, with prices on the Coinbase exchange (the company's primary market for Bitcoin) having been below $20,000 and above $35,000 in the 12 months preceding this quarterly report date.
Bitcoin does not pay interest or dividends. Bitcoin does not pay interest or other returns, and the company can only generate cash flow from its Bitcoin holdings by selling Bitcoin or implementing strategies to create cash flow or otherwise utilize its Bitcoin holdings. Even if the company undertakes such strategies, it may not be able to generate cash flow from its Bitcoin holdings, and any such strategies may expose the company to additional risks.
The company's Bitcoin holdings significantly impact its financial results and the market price of its Class A common stock. The company's Bitcoin holdings have significantly affected its financial results, and if the company continues to increase its total Bitcoin holdings in the future, they will have an even greater impact on the company's financial results and the market price of its Class A common stock. See "Risks Related to the Company's Bitcoin Acquisition Strategy and Holdings - The Company's Historical Financial Statements Do Not Reflect the Potential for Changes in Earnings the Company May Experience in the Future Due to Bitcoin Holdings."
The company's Bitcoin acquisition strategy has not been tested over a long period or under different market conditions. The company is continuously studying the risks and rewards of its Bitcoin acquisition strategy. This strategy has not been tested over a long period or under different market conditions. For example, while the company believes Bitcoin has the potential to serve as a hedge against inflation in the long term due to its limited supply, the short-term price of Bitcoin has declined during recent periods of rising inflation. Some investors and other market participants may disagree with the company's Bitcoin acquisition strategy or the actions taken by the company to execute it. If the price of Bitcoin declines or the company's Bitcoin acquisition strategy performs poorly, the company's financial condition, operating results, and the market price of its Class A common stock could be adversely affected.
The company bears counterparty risk, including risks related to its custodians. Although the company has taken various measures to mitigate its counterparty risk, including storing nearly all of its Bitcoin in custodial accounts with institutional custodians in the U.S. and negotiating contractual arrangements aimed at establishing the ownership rights of the Bitcoin held by the custodian free from claims by the custodian's creditors, the bankruptcy law regarding the holding of digital assets in custodial accounts has not been fully developed. If the custodian were to go bankrupt, be seized, or undergo similar bankruptcy proceedings, the company's Bitcoin may be deemed to be part of the custodian's bankruptcy estate, and the company may be treated as a general unsecured creditor of such custodian, limiting the company's ability to exercise ownership rights related to that Bitcoin, which could ultimately result in the loss of some or all of the value of the Bitcoin. Even if the company is able to prevent its Bitcoin from being treated as part of the custodian's bankruptcy estate during the pendency of the bankruptcy proceedings, there may still be delays or other difficulties in accessing the company's Bitcoin during the custodian's affected period. Any such outcome could have a significant adverse effect on the company's financial condition and the market price of its Class A common stock.
Changes in the accounting treatment of the company's Bitcoin holdings could have significant accounting implications, including increased volatility in the company's results. On March 23, 2023, the Financial Accounting Standards Board (FASB) issued a proposed statement for comment requiring that crypto assets within the scope, such as Bitcoin, be measured at fair value, with changes in fair value recorded in current earnings. On September 6, 2023, the FASB held a meeting to review feedback received on comment letters and other issues for reconsideration. At the end of the meeting, the FASB determined that the expected benefits of the ASU would outweigh the expected costs and directed FASB staff to draft the final ASU for written vote. Under the current proposal, the ASU would be effective for fiscal years after December 15, 2024, including interim fiscal years within those fiscal years. The FASB also confirmed that the proposed ASU would allow for early adoption. The FASB indicated that it expects to hold a vote in the fourth quarter of 2023 to approve the final ASU. Changes in the accounting treatment of Bitcoin holdings, such as adopting a final ASU similar to the proposed statement, could have a significant impact on the company's operating results in future periods, potentially increasing the volatility of the operating results reported by the company, affecting the carrying value of Bitcoin on the company's balance sheet, and potentially resulting in adverse tax consequences, which could in turn have a significant adverse effect on the company's financial results and the market price of its Class A common stock.
