Cryptocurrency, blockchain, mining, wallet… This sounds somewhat familiar, yet I’m not quite sure about the exact nature of cryptocurrency. Take a few minutes and let’s boost our knowledge together! The below post provides answers to questions such as “What is the nature of cryptocurrency?” and “Where can I use cryptocurrency?” The post also briefly touches upon how cryptocurrency is reflected in accounting.
The payment system in question constitutes a decentralized self-regulating payment system, i.e. a third (central) party, e.g. a bank, is not required for conducting transactions. As there is no central party involved, users themselves control the cryptocurrency system. The system operates based on the P2P (peer-to-peer) network, enabling cryptocurrency to be transferred among users across the internet.
Cryptocurrency constitutes a digital asset related to certain fixed currencies. Digital currency (e.g. cryptocurrency) serves as an alternative to physical money (e.g. the euro). The main difference is that physical money is, indeed, physically tangible. Paying for ice cream at the store, for example, we hand the cashier a € 5 bill. Digital currency, however, only exist in a digital format and you cannot physically hold it in your hand. Another difference relates to the fact that physical money enjoys the status of an official means of payment established at the state level and is issued (put into circulation) by the central bank. The official-means-of-payment status is not attached to cryptocurrency and this type of currency is issued virtually, using blockchain technology. The value of cryptocurrency is formed based on market supply and demand. The most widely used cryptocurrency is Bitcoin.
What is blockchain? The blockchain system as a type of public ledger was established for the purpose of reliable and regular functioning of cryptocurrency. The name blockchain derives from the fact that the system groups all transactions in blocks. Each new block is attached to existing blocks in a chronological order, forming a chain of blocks.
To conduct transactions with cryptocurrency, you’ll need a wallet in addition to relevant hardware and software. A wallet constitutes independent software, essentially a file in which cryptocurrency is kept and that is connected to trading platforms. Each wallet contains a private key and a public key: these keys constitute means to identify a wallet’s owner by way of which the owner of relevant cryptocurrency can access their money, is able to conduct transaction and view their cryptocurrency balance.
The public key is known to everyone and functions as the number of an account to which money can be transferred. The private key is known only to its owner and is used to confirm transactions, i.e. to open encryptions. Both keys are composed of a combination of letters and number. Simply put, the public key constitutes an account number, while the private key is the PIN code for that account.
Transactions with cryptocurrency
Each transaction commences by preparing a so-called transaction base that contains both the sender’s address and the receiver’s address as well as the amount transferred. For example, Carl buys a car from Mary, paying for his purchase in Bitcoins. Carl sends Mary cryptocurrency. By doing that, Carl thereby creates an encrypted message, called a transaction, that contains Mary’s public key. To make sure the transaction actually takes place, Carl must confirm the transaction, i.e. sign it by using his private key. If the transaction is successful, the transfer appears in Mary’s wallet. While this is happening, miners engage in mining, i.e. the miners verify and confirm the transaction and save it in a blockchain viewable by everyone in a public ledger.
Mining is done automatically based on a relevant system and commences upon activation of the related software program. During mining, new Bitcoins are brought into circulation. The objective of this process is to confirm and save new transactions in the ledger, thereby sustaining the cryptocurrency network.
To mine Bitcoins, the proof of work system is used. The miners’ task is to solve a cryptographic problem – this takes a lot of computer resources – to form another link in the blockchain. The answer to the problem proves that all transactions contained in that particular blockchain are legitimate for relevant network purposes. Each new block is added to an existing blockchain in the course of mining. Whoever solves the cryptographic problem first and enters the transaction in the ledger, is remunerated with a certain amount of cryptocurrency. Consequently, bringing Bitcoins to light is not the actual main objective but an incentive to miners. The outcome of such calculation – the so called proof of work – is added to a new block, proving that the miner used a significant amount of computer resources.
By putting new Bitcoins into circulation, the miners’ contribution in maintaining the system is compensated. Upon formation of each new block, a fixed amount of Bitcoins that diminishes in time is shot into circulation. Bitcoins are created in cycles where 210,000 transaction blocks are confirmed in each cycle. Currently, one can obtain 12.5 Bitcoins for each block. Today, Bitcoin amounts to 140 million U.S. dollars in market capital and the value of one Bitcoin is approximately 8,000 U.S. dollars (June 2019). All of the transactions added to the chain are deemed to be confirmed, making related Bitcoins available for use to their new owners.
Payment in cryptocurrency
More and more people all over the world use Bitcoins on a daily basis to pay for goods and services. Cryptocurrency can be used as a means of payment at some retailers’ as well as in e-businesses. AirBaltic, for example, allows you to pay for your plane tickets in Bitcoins. Bitcoin payments are also enabled by Microsoft, Amazon, Shopify Stores, and a number of other big companies. Furthermore, the very first Bitcoin debit card Xapo is now also available. This card functions as your normal debit card. The main difference is that instead of euros or dollars, the account related to Xapo holds Bitcoins. Xapo can be used anywhere where debit or credit cards are accepted. Once the purchase is made, the trader receives their money in local currency, not in cryptocurrency. So, visiting a restaurant, you can now pay in Bitcoins if you wish.
As mentioned above, Bitcoin serves as a means of payment that you can use to pay for different goods and services. Paying for goods and/or services in Bitcoins is not a problem if you are a private individual. However, companies are obligated to reflect in their accounting all of the transactions conducted, including transactions concluded in Bitcoins.
Although there are no clear-cut accounting rules on how cryptocurrency should be reflected, it must nevertheless be kept in mind that any information reflected should be understood by those reading the statement. Another aspect that must be considered is the economic content of relevant instruments and it should be possible to compare relevant data to accounting policies related to analogous instruments. Reflecting cryptocurrency, it is also important to revaluate monetary assets, fixed in foreign currency, based on the exchange rate valid on the reference date. The exchange rate differences that emerge at revaluation are reflected in the income statement as the profit/loss of the exchange rate.