Non-fungible tokens (NFTs) make headlines in areas like artwork, music, sports collectibles, gaming, and event tickets. They give assets’ creators a means to control how assets are used and compensation for that use.
NFTs can take many forms. There are potential business applications already in use, and many more are being developed as technology evolves.
“There is no shortage of hype about NFTs,” said Vikas Agarwal, risk and regulatory financial services leader at PwC. “Our clients are figuring out the use cases and the right methods for their applications.”
What are NFTs?
An NFT is a digital asset used to represent and establish ownership of assets and can include a bundle of rights. Units of data, including the digital item, owner, origin, and custody chain, are stored (“tokenized”) and locked on a digital ledger (blockchain). Each NFT is unique and cannot be replicated; it can only be transferred if its holder authorizes it, and its authenticity and ownership are verified through the blockchain.
How are companies using NFTs?
“We are squinting at the future but have not yet seen the full manifestation of potential of NFTs,” said Tim Davis, principal at Deloitte Risk and Financial Advisory Services.
Potential commercial uses of NFTs include:
- Owning and transferring artwork, photographs, music, IP, and other collectibles.
- “Super wallets,” a verified record of owners’ rights and licenses for home and work (e.g., warranties, tickets, access passes).
- Monetizing brands and offering customers exclusive rights and discounts.
- Ticket industry applications (e.g., fraud security, commissioning event performers or venues, keepsakes for ticket purchasers).
- Evidence of access authorization for software or transportation.
- Digital items for avatars in gaming and virtual worlds.
- Digital certificates of ownership or authenticity.
- Automobile ownership, repair record, and history.
- Proof of education, document authenticity, literary protection.
“In a commercial context, NFTs could represent the future of contracting … [o]r they might revolutionize our concepts of ownership,” said a recent Deloitte report. “[T]he legal basis of ownership might be … more easily verifiable and programmed to allow for … new forms of commercial arrangements that are faster, cheaper, and more secure.”
Blockchains enable the use of smart contracts. “Applying blockchain to contract information is the same concept as NFTs because it takes a piece of information that is secured and can’t be altered and passes it through owners more efficiently than using paper or digital signatures,” Agarwal said.
“NFTs are cryptographically verified ways to articulate rights and responsibilities and transfer them on a blockchain,” Davis said. “One of the most logical extensions is a contract. Putting contract terms and conditions on a blockchain provides for transfers of rights and responsibilities that are verifiable, immediate, and link the contract to the underlying assets.”
Are NFTs right for your business?
An NFT strategy should support a company’s overall strategy for achieving goals, including driving revenue by monetizing digital assets and improving customer engagement (existing and prospective). NFTs might be one of several available solutions to a company’s use case.
“Companies can get into trouble if programs evolve and they haven’t thought through the problem they want to solve and related risks,” Davis said. “An example is launching a collectible and then letting customers trade or exchange it.”
“To determine whether NFTs are the right answer, understand whether NFTs are fit for the purpose you’re trying to achieve, including for business-to-business or business-to-consumer,” Agarwal said. “NFTs are not for everyone, and more applications may be pushed on blockchain than it is made for. It is important to think broadly about regulatory implications and risks. Jumping in is not easy, and there can be implications of not doing it responsibly.”
What are the risks?
Use of NFTs is a new and evolving area, with many things to watch out for. Existing processes might have to change, with internal control, legal, and regulatory considerations.
“To determine whether NFTs are the right answer, understand whether NFTs are fit for the purpose you’re trying to achieve, including for business-to-business or business-to-consumer.”
Vikas Agarwal, Risk and Regulatory Financial Services Leader, PwC
Third party service providers: “We advise clients working with third-party service providers in this space to evaluate whether the providers understand the risks, compliance, and frameworks to apply and are not just doing a big hand wave around it,” Agarwal said.
Technical and practical challenges: “There is an entry blockchain with no inherent legal ownership over entry,” Agarwal said. “There can be control over who has the private key, which is essentially a password. For commercial applications of NFTs, users do not have to manage their own private keys, which are in a wallet, and they may not need a blockchain.
Issuers can choose between multiple blockchains when they create and launch NFTs. It is important to understand the blockchain’s capabilities when selecting one and consider whether controls need to be added based on assessed risk.
“Choose your blockchain carefully because NFTs do not transfer between blockchains but are locked to a blockchain,” Davis said. “Certain blockchains can have significantly higher fees than others.”
Marketing: “This can be an area where companies get into difficulties, if the marketing implies a greater level of NFT control or ownership than may be permitted in the legal terms,” Davis said. “Be careful consumers are not led to believe they are getting more than is really the case.”
Cybersecurity and data privacy: Companies should be alert to potential risk of cyberattacks and fraud. Underlying platforms or service providers can be hacked, and NFT holders can be subject to phishing attacks. Because of the public nature of blockchain transactions, there is increased risk of unauthorized access to NFT holders’ sensitive information.
“There can be real problems with marketplaces and third-party websites holding private keys that can be lost forever in a cyberattack,” Agarwal said. “Other issues include monitoring for cyber risks and how customer information is held and its confidentiality.”
Regulation: The current regulatory environment does not provide explicit guidance for NFTs. “[R]egulators tend to focus on a given NFT’s purpose and use case, [so] the potential utility of the NFT will likely dictate which regulatory considerations apply,” Deloitte stated in its report.
Because NFTs can provide an interest in, or a revenue share from, digital or physical assets, they may behave like securities and be subject to Securities and Exchange Commission (SEC) or Federal Trade Commission regulation under existing (or future) laws.
“Whether the NFT is a security depends on its structure and rights offered to the public,” Agarwal said. “We see the Consumer Financial Protection Bureau looking at how rights conveyed by NFTs are marketed to the public and whether the buyer of the NFT is getting control or true ownership. There have been SEC enforcement actions against NFT creators penalizing them for violating security regulations.”
Davis noted although NFTs are not fungible or a cryptocurrency, if used as a means to transfer value, they can fall under the purview of the Office of Foreign Assets Control. Any site offering futures or derivative products based on the value of NFTs might be considered a commodity subject to regulation by the Commodity Futures Trading Commission.
“The Financial Crimes Enforcement Network has guidelines warning sites that trade NFTs of the risk of money laundering,” Davis added.
“When the NFT is linked to things that replace a payment mechanism, so the NFT becomes like a virtual currency moving money between individuals very rapidly, there are potential issues of whether the company has become a money transmitter requiring a license,” Agarwal said. “Certain regulators are taking a keen interest in that.”
What capabilities are needed?
“We encourage clients to consider how they will integrate technology relating to use of the cloud and putting digital assets on the blockchain with their systems, how they will use digital assets to transform business strategy, related tax and accounting issues, cyber and privacy risks, and regulatory concerns,” Agarwal said.
Governance: Controls and policies are needed to protect the company and manage the process of implementing NFTs. The level of risk plays part in controls to be supplemented.
PwC recommends companies involved in the NFT space develop sustainable strategies that deliver benefits today and create long-term growth. Companies should assess their operational capabilities and their teams’ experience in dealing with the risks and implications of owning, issuing, and transferring these assets.
Accounting considerations: “To determine which accounting model to apply, the critical first step is to determine exactly what the NFT represents, the rights and obligations it comes with, what transfers to the purchaser, and where you are in the ecosystem,” said Sandie Kim Kulick, senior consultation partner in Deloitte’s Professional Practice Group.
For the issuer/developer, NFTs are often within the scope of Accounting Standards Codification Topic 606’s revenue recognition guidance.
“When there are multiple promises, you must identify the performance obligations and determine when and how the rights transfer—and how revenue is recognized—at a point in time or over time,” Kulick said.
“Variable fees or sales-based royalties for licensing functional or symbolic IP have specific recognition requirements,” she said.
Cryptocurrency is frequently used to pay for the NFT. “There can be noncash consideration to deal with, measured at fair value at the contract’s inception,” Kulick said.
Revenues can be recorded gross or net by marketplaces or external platforms. “If the issuer is the principal and controls the NFT before it is transferred to the customer, it recognizes gross revenues from the customer,” Kulick noted. “In many transactions, the marketplace serves as an agent and recognizes commissions on a net basis. If a marketplace offers wallets or converts fiat currencies to cryptocurrencies, there are other accounting issues.”
Tax considerations: The NFT’s rights and obligations determine its treatment for tax purposes. This determination will be used for tax decisions for revenue recognition, sourcing sales to jurisdictions, international reporting, informational reporting, and transaction (sales and use, VAT) and withholding taxes.
No comments yet