Accounting for Virtual Assets - Essay Example

Running header: Virtual goods Student’s name: Instructor’s name: Subject code: Date of submission: Accounting for virtual assets Virtual assets Executive summary Of late, there has been increasing interest in virtual assets/goods and this demand is expected to in crease in future. The increase in the activities of the virtual world and hence virtual assets is largely attributed to the increase in internet connectivity especially among the young. Income from the virtual world has also increased and nowadays, billions are made from virtual world transactions. Being a new field however, accounting for transactions of the virtual world has been a challenging task for accountants given that the existing accounting standards were developed for real world accounting. For instance, should virtual assets be classified as intangible assets? This paper seeks to define virtual assets as well as give guidance on how virtual goods should be accounted for. In this regard, the paper will examine whether virtual assets meet the criteria laid down for assets and whether this class of assets should be recognized in the financial statements. In a bid to regulate the market and widen its tax base, the government has also gained interest in the virtual income earned in the virtual world. As such, this paper will explain whether virtual income is real income and if so how it should be measured. Introduction Generally speaking, virtual items are digital representations of objects whether real or imaginary that are created and used only with virtual worlds and other social media applications. In other words, they are images which look and act like real things though they are not real (Rankin, etal., 2012). Similarly, virtual assets are the assets possessed in these virtual worlds. They are the electronic information stored online through a computer aided/related technology and include items like digital images from photographs, emails, social media accounts like Facebook, online bank account statements and electronic investment accounts among others. Mostly, these assets are use d in communication as is the case with social media and email accounts. However, sometimes these assets are important and have tremendous aesthetic financial and emotional value. In these regard, those with sentimental and economic value as is the case with online games should be recognized as assets and hence included in the firm’s assets for the purpose of taxation. Are virtual assets similar to intangible assets? It should be noted that virtual assets are interconnected implying that they do not cease to exist when the owner/creator logs off the virtual environment. As stated above they also do not have physical presence in real world. The assets can also be delivered electronically in which case both the buyer and the seller doo not have physical contact with the goods as the virtual goods do not have physical presence. It is also worth noting that the user of virtual assets may be represented by several avatars implying that the buyer is an avatar and is not the actual user. On the other hand, intangible assets are none scarce and their deployment is possible to multiple users at the same time. Their value increases when their scale of use increases and has increasing returns. In addition, they do not have any physical existence (Rout, 2010). They can not be owned apart from legal property rights and neither can they be evidenced by financial transactions. International accounting standards board (IASB 38) defines intangible assets as identifiable non monetary assets that lack physical substance. This is in addition to the standard asset definition of assets that necessitate a past event giving rise to the resource that the firm controls and/or derives future economic benefits to have occurred. Based on the above definition by the accounting standards board and the characteristics above, it can be concluded that virtual assets are largely similar to intangible assets. For instance, in real world, both lack physical existence and both possess interconnectedness (Grimmelmann, 2007). However, they differ in some aspects in that intangible assets can not be owned or evidenced by a financial transaction unlike virtual assets which can be owned by the user through the avatars and are traded through financial transactions sometimes even involving real money. This can be seen in the case of gaming or electronic investment transactions where real money is involved. This means that although both the types of assets may be similar, accounting for them may not be similar. Whether virtual assets meet the definition of assets contained in the framework The international financial reporting standard (IFRS) defines an asset as an economic resource which is controlled by the enterprise resulting from past events and from which the firm expects economic benefits to flow from. As such, an asset can be either tangible or intangible but must fulfill the above criteria. Does a virtual asset fulfill the above criteria? The above characteristics are examined below; a) An asset is an economic resource – it is known that economic resources are scarce and are held for the sake of carrying out economic activities that may include satisfaction of a need or a want, production, exchange and consumption. In other words, it is expected that after being used to satisfy these needs and wants, the firm will experience cash inflows or outflows. In this regard, a virtual asset can be considered to have met this definition. For instance, a gaming company will sell its virtual games to the player with the hope of making an economic return (Terdiman, D2006). Although the sale may be made using virtual money, the actual subscription into the site is done using real money. In this case, the company’s reason for developing and owning an online gaming site as well as the various virtual assets sold in the site is to make an economic gain through the subscriptions. On the other hand, the player/user will experience cash outflow by paying the subscription fees so that he can have social satisfaction through playing the game or economic gains through winning the various prizes offered in the game. As such, virtual assets meet the ‘economic resource’ characteristic of an asset defined in the framework. b) Right and/ or privileged access to an economic resource – without a right or privileged access to a resource may render it useless to the firm since the firm will then not be able to use it as an economic resource. Rights are what helps us to distinguish between who is entitled to the asset/resource and hence facilitate exchange of resources. Virtual assets also have rights/privileged assess associated to them in line with the framework’s definition (Bansal, 2009). For instance, the company that owns a particular gaming site possesses all the rights associated to the site. However, through subscription, users are given access/ privileged access to the site. It is because of this reason that not everyone accesses the gaming sites or owns particular virtual assets since there are rights/ privileged access associated with virtual assets. Without the rights and privileges, these assets will not be able to fulfill the economic goals of the owners. c) Control- this is the ability of directing and managing the asset in a bid to obtain the above economic benefits, to increase, protect or maintain the economic benefits arising from the asset. Virtual assets also meet this definition criterion. For instance, a company owning a certain online gaming site has full control of the site and it is able to manage the site and increase, decrease or maintain the economic benefits gained from the site (Dilla, etal., 2013). On the other hand, a person who subscribes to the site gains control to the asset to the extent of his/ her subscription. In this respect, virtual assets meet this aspect of the framework’s definition. Whether the virtual items should be recognized on the financial statement or their disclosure in the notes would be sufficient; The conceptual framework provides the criteria for recognition of elements in the financial statement. For an element to be recognized in the financial statement, it has to meet the definition criteria for the element provided in the conceptual framework in addition to satisfying the criteria below; i) It must be probable that any future economic benefit associated with the element will flow to or from the firm. ii) The items cost or value should be measurable reliably. In respect to meeting the criteria for asset definition provided in the framework, virtual assets have met the criteria as explained above. In addition, it has been shown that future economic benefits can be expected to flow to or from the entity as a result of owning the assets (Taylor, 2001). In other words, one entity which is the owner of the asset can expect cash inflow from selling the virtual assets to another party. The party that buys the virtual asset using real money experiences cash outflow but then gains control and rights associated with the virtual asset to the extent of its payment. As such, virtual items meet these recognition criteria. The item’s value ought to be measurable reliably if the item is to be recognized in the financial statements. In this regard, the returns obtained from possessing or selling the virtual assets can be measured reliably. For instance, an online casino/ virtual gaming company is able to reliably measure the revenue it derives from selling its various virtual assets (Jeffery, 2005). It is in respect to these revenues that virtual items should be recognized in the financial statements. It should be noted that unlike intangible assets which are only disclosed through notes to the financial statements, virtual items can be measured reliably as explained above. However, it is not possible to for instance measure the amount of revenue that results from copyrights and not any other factors (Nasser, 2010). On the contrally, it is possible to for instance measure from selling virtual items in the virtual world. It is also possible to give them value and hence measure profitable attributable from them. It has therefore been established that virtual items meet the recognition criteria outlined by the conceptual framework and as such they should be recognized in the financial statements as opposed to just disclosing them through notes (Jeffery, 2005). Failing to recognize them would mean that any taxes attributable to trading in them goes unreported and hence unremitted. Whether income earned in a virtual world is real and whether such profits should be reported; Many people are nowadays making profits through undertaking transactions within a virtual world. Although the initial intent might be that of enjoyment and hence the amount of income earned might be insignificant, various companies and site owners are making billions of shillings through selling of virtual goods (Whittington, 2008). In most cases, the participants create and sell virtual goods through virtual currencies. However, in order to use virtual currency so as to purchase the virtual items, real money is involved. The value of the virtual goods is dependent on what the avatars prefer to pay for them as opposed to the price set by the owners. Just like real world goods, owners of virtual goods are faced with competition and have to adjust their prices accordingly. Although the goods are virtual in nature, their owners make a lot of real cash and hence profits from the sale of the goods using real money and the participants can cash their points for real cash. This means that the profits made from transactions in a virtual world though it may involve virtual cash at some point is real. This being the case, the profits ought to be reported (Australian Accounting Standards Board 2009). This will ensure that participants in virtual transactions remit taxes on the profits made. This is because in some cases, trading in the virtual world may even generate more income than that which is made in a real world. Furthermore, there is need to regulate it in a bid to prevent money laundering in addition to stopping illegal gambling in cases where this is against local regulations. Measurement criteria If we are required to recognize these items on the financial statements then we need to be able to measure them. The measurement model I would recommend would have to meet the following criteria; It is worth noting that although a virtual asset may be sold today, its life may extend beyond the current financial period and hence there is need to come up with an appropriate revenue recognition criterion after which a revenue measurement model will be applied to measure the revenue gained from the good in a financial period (Egan and Frost, 2009). There many methods that may be applied in this regard including using the life of the virtual good and using the life of the user of the virtual good. However, in this case, the life of the virtual good criteria will be used. Under the model, the revenue obtained from selling a virtual good will be recognized over the period during which the user will be expected to continue accessing and drawing the benefits inherent in the virtual good purchased. In this case, the virtual good will be deemed a separate deliverable in the arrangement as it will provide the user with a specified benefit which will be consumed at a specific time or during specified number of usages (Deloitte, 2013). In this case, revenue will be recognized over the virtual good’s estimated life on a straight-line basis provided that the firm is able to reasonably estimate the good’s life. Incase the virtual good is consumed immediately upon its delivery to the user; the revenue is recognized shortly after delivery. However, before such a determination is made, it would be advisable for the firm to consider specific facts and circumstances carefully (Bonaci, 2010). Owing to the volume and the increasing characteristics of virtual goods, it may be difficult to track the differing behaviors of users including their possibility of being traded in secondary market. As such, the firm may need to invest in sophisticated systems for gathering and main training the data necessary for reasonably estimating the virtual good’s life. After the relevant period over which the revenue will be recognized is determined. Where the above model can not be applied due to estimation difficulties, it would be advisable to use the life of the user. This is the period within which the user is expected to use the good. This recognition criterion is expected to ensure that revenue is recognized at the right period and that the revenue given to one period is the right amount. This way, the firm will avoid over/understatement of revenue at any given period. One challenge encountered in measuring virtual income is the rapid changes in prices encountered in the virtual world on a daily basis. However, given that it is possible to estimate the life of a virtual good or the life of the user as the recognition criteria, the fair price model should be used in measuring the virtual income. AASB 13 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between participants at the measurement date. Assuming the fair value model would ensure that the income is always measured at the prevailing market conditions given that the virtual world is very dynamic and yesterday’s price may be different from today’s. Recommendations As observed above, accounting for virtual assets is a relatively new field in accounting. As such, accountants are bound to encounter problems in performing various accounting tasks related to virtual goods. This may lead to over/understatement of revenues and amounts of virtual assets. As such, there is need for the various accounting bodies to develop accounting standards that will be used in accounting for virtual assets. They should come up with guidelines for recognizing, measuring and reporting virtual assets. This way, revenue from virtual assets as well as asset values will be fairly accounted for. Conclusion It has been observed that although virtual goods do not have are largely similar to intangible assets with both lacking physical existence and both possessing interconnectedness. It has also been observed that they meet the definition for assets contained in the framework to a large extent. Furthermore, it has been noted that although transactions in virtual assets is by way of virtual money, real currency is used in acquiring virtual assets. As such, revenues in the virtual world are real and hence it should be accounted for. Measurement of virtual income should bear in mind the life of the virtual good as well as the fair value of the virtual good. This will ensure proper reporting and accounting for the income. However, there is need for development of accounting standards and policies specifically targeted at accounting for virtual goods in a bid to eliminate any confusion that may exist regarding their accounting issues. References: Australian Accounting Standards Board 2009, AASB comments on IASB exposure draft ED/2009/05 Fair Value Measurement, Retrieved on 28th September 2013, from; www.aasb.com.au. Bansal, S2009, New challenges of accounting and auditing in E-Environment, London, Rutledge. Bonaci, C2010, Current debates on accounting for financial instruments: Perspectives in the aftermath of a crisis, Review of business research, vol. 10, no. 2, pp. 12-16. Deloitte, 2013, Recognizing revenue from sales in a virtual world, Technology Spotlight, Issue 4, May 2013. 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