Senior Public Company Financial Audit: Taking Hashkey as an Example, Discussing Which Account to Include for Exchange Issued Platform Tokens?

Author: Viki_Nan.mp3

First of all, this article is not about FUD regarding Hashkey or HSK, but rather shares my understanding from the perspective of accounting treatment.

I have been deeply involved in the financial auditing work of A/H share listed companies.
I feel that there are very few people who can simultaneously: understand accounting standards, understand cryptocurrencies, and are willing and able to express their understanding without restrictions.

I hope my interpretation can help HSK token holders understand the accounting treatment of Hashkey's IPO regarding the classification of HSK tokens and its possible impacts from another dimension.

1. Background and Definition: What account should the exchange record for the issued token ------ Contract Liability or Financial Liability?

✅ Consensus on the asset side: relatively unified

Digital assets are recorded as inventory/intangible assets, and there is little controversy here. Although there are no clear international accounting standards yet, this is considered a reasonable classification method within the industry. You can refer to OSL's financial report; the classification of digital assets is basically not fundamentally different from Hashkey's prospectus. The differences in U.S. standards are slightly larger (you can look at Coinbase's financial report), but we won't discuss that here.

❓ Discrepancy on the liability side: How should the exchange record its issued platform token HSK?

First, understand why it is a "liability"? Because the exchange is the issuer of the token, and by issuing the token, it creates an "obligation."

However, since there are very few listed companies that issue platform tokens, this part of the treatment has almost no precedents. I found another Canadian listed exchange that issued its own platform token INX as a comparative case.

• HashKey (according to IFRS 15): Classified as a contract liability (defined as a "performance obligation," the company owes HSK holders not money, but future services, such as fee discounts, membership rights, etc.).

• INX (according to IFRS 9): Classified as a financial liability (the token represents a certain claim of INX holders on the company's future cash flows or assets).

Core: Why would a listed company define its own issued token, which is traded in the secondary market, as a "performance obligation"?

This classification can avoid the volatility of the financial market. If classified as a financial liability, the token must be measured at fair value, and an increase in token price would lead to an expansion of the company's liabilities and a sharp drop in profits (and vice versa would lead to a reduction in liabilities and a sharp increase in profits); whereas classified as a contract liability, it can be locked in at historical cost.

2. Accounting Perspective: Derivation of Accounting Entries Related to Platform Token HSK and Interpretation of Prospectus Text

Based on years of experience dealing with financial reports, there are several noteworthy phrases in the financial report section of the prospectus. These are important explanatory statements with clear directionality, interpreted together with the speculation on accounting entries:

Derivation of Accounting Entries:

1. Initial Recognition (when HashKey distributes HSK as rewards to employees, KOLs, or liquidity providers)

Debit: Operating Costs / Selling Expenses / Administrative Expenses / R&D Expenses (recorded at the fair value on the grant date)

Credit: Contract Liability

Note: This step is a cost expenditure and will materially reduce the current period's profit. The prospectus shows that the relevant costs for HSK in 2024 amount to HKD 176.7 million. This is why the prospectus includes these two statements:

The increase in contract liabilities is mainly due to the increase in the distribution volume of HSK. (Increase in distribution volume = more debt owed)

The fluctuations in HSK's operating costs and expenses have impacted our operating performance. (Using tokens to pay salaries/purchases, if more tokens are issued, costs will be higher)

2. Intermediate State (Holding Period): Price fluctuations do not affect the liability balance because historical costs have been locked in.

3. Termination Recognition (when a very small number of users redeem HSK for fee discounts, or when revenue is recognized based on Breakage rules):

Debit: Contract Liability

Credit: Operating Revenue

Note: "The fluctuations in the market price of HSK have no significant impact and are not expected to have any significant impact on our contract liabilities or related revenue recognized subsequently." (Historical cost measurement: even if it is mentioned that HSK's price will decline in 2025, the company's balance sheet will not shrink or benefit from it)

3. What is Breakage in Contract Liability? What effects will a 95% Breakage in HSK bring?

Concept Breakdown:

First, it is necessary to understand contract liabilities and what Breakage (loss/unexercised rights) is.

Contract liability is the service the company owes to users (such as fee discount rights), which is a performance obligation.

Breakage: The portion of rights that the company expects users will never exercise. In traditional industries (like Starbucks), this usually refers to users losing gift cards; in Web3, it may refer to users voluntarily giving up discounts to hoard tokens for speculation.

Data Perspective:

• Management estimates: 5% will be used (Utilization), 95% are dead tokens/will not be exercised (Breakage).

• Actual data: 0.49% - 1.71% actual utilization rate.

Financial Consequences:

According to the proportional recognition method of IFRS 15, the formula for recognizing revenue is essentially:

Recognized Revenue = Actual Amount Used / Expected Total Utilization Rate

Substituting HashKey's data (expected utilization rate 5%):

Recognized Revenue = Actual Amount Used / 5% = Actual Amount Used * 20

The financial statements will recognize revenue at a 20 times accelerated rate based on management's accounting estimates. For every real dollar redeemed by users, the statements recognize 20 dollars in revenue.

4. Two Key Misalignments ------ Why is there a 95% dead token?

• Misalignment One: Identity Misalignment (Analysis of Circulation Chain)

  • Company -> Suppliers/Employees: Distributed as salary (counted as Hashkey costs).

  • Suppliers -> Investors: Sold off for cash (disconnection occurs).

  • Investors: Hoarding tokens for appreciation (giving up usage).

  • Conclusion: Those who receive tokens do not hold them, and those who hold tokens do not "use" them, leading to a widespread failure of utility attributes (95% breakage).

• Misalignment Two: Token Positioning Misalignment

  • Company Perspective: For the company, the token is a contract liability.

  • Investor Perspective: For investors, the token is a financial asset.

  • The misalignment lies in: Normally, contract liabilities correspond to contract assets, and financial liabilities correspond to financial assets; this is how counterparties handle their respective accounts. Now the misalignment has become: contract liability VS financial asset.

5. Alternative Hypothesis ------ If not recorded as a contract liability, what other account could it be recorded in?

• Hypothetical Derivation: If classified as Financial Liability (similar to INX's treatment)?

  • Measurement Logic: Fair value measurement.

  • Financial Impact: Token price rise = big loss; token price drop = big gain.

  • Comparison: The income statement would shift from being "operating revenue driven" to "investment income driven," with very volatile fluctuations.

• Why choose contract liability?

  • To avoid the volatility of profit surges/drops caused by rising token prices.

  • To lay the groundwork for growth in main business revenue.

  • Utilizing IFRS 15 rules, it can achieve smooth profit release.

6. The Paradox of Auditing and Compliance ------ The "Gray Area" Caused by Accounting Standards Lagging Behind Web3 Development

• Substance over Form Challenge:

  • Legal Form: HSK does not meet the definition of a financial liability or equity instrument. As long as the discount function exists, it is a performance obligation.

  • Economic Substance: 95% or even more people view HSK as a stock to speculate on. One can interpret the phrase "houses are for living in, not for speculation" in the context of HSK tokens as "tokens are for use, not for speculation."

• Auditor's Dilemma:

  • Why accept a 5% expected utilization rate? Because the historical data of 0.49% is there, which is management's accounting estimate. It means that management bears this "burden," and the amount of recognized revenue from this part is not significant.

  • From an auditing perspective, it is compliant, but the logic needs further scrutiny. This reflects the lag of accounting standards in the face of Web3.

7. Thoughts for Token Investors

• The Dilemma of HSK Holders: You hold an asset that is clearly defined by the issuer as a "contract liability"; should you still view it as a "financial asset"?

• Risk Warning: If the ecosystem truly flourishes and users start using HSK for discounts in large quantities (though the possibility is extremely low), if the 95% breakage assumption collapses, will the company face revenue retraction?