Russia is set to become the world’s first country to issue state-backed virtual currency – the CryptoRuble. In Russia, the measure aims to both curtail the misuse of virtual currencies for illegal activities and bring virtual transactions under the tax net, but for the rest of the world, it is another sign that cryptocurrencies are becoming increasingly important in everyday life.

If you’ve heard of Bitcoin (or Ethereum, Zcash, or a number of others) but don’t completely understand how it applies to you, some basic accounting principles can help explain how cryptocurrencies and traditional currencies might interact.

While the United States does not have its own virtual currency, the IRS did issue guidelines on calculating taxes on Bitcoin transactions. According to those guidelines, bitcoins or any other virtual currency are considered “property." This means if you buy a pizza in the US using bitcoins, you'll need to calculate the capital gain or loss on the transaction and pay taxes accordingly.

So how does one go about calculating capital gains? Let's use a basic example: 

Oct 15    Rich buys 10 bitcoins for $10 each
Oct 17   Rich buys 10 bitcoins for $20 each
Oct 17   Now Rich has 20 bitcoins in his e-wallet
Oct 18   Rich buys a pizza worth $15
Oct 18   One bitcoin is worth $15

So, did Rich make a profit or a loss on bitcoin transaction on Oct 18? It will depend on whether Rich uses FIFO (First In, First Out), LIFO (Last In, First Out), or average costing method. Watch the following video from the HBX Financial Accounting Course to understand the difference:

Adjusting Journal Entries: Inventory Valuation

If Rich follows FIFO then he made a capital gain of $5 by using bitcoins to buy pizza. Why? He purchased one bitcoin for $10 and used it to buy a pizza worth $15. However, if Rich follows LIFO then he incurred a capital loss of $5 because he purchased a bitcoin for $20 and spent it on a pizza worth $15. When Rich files his taxes in April, he will have to account for this gain or loss.

Whether your wallet is full of cash or cryptocurrency, these essential accounting principles will help explain how currencies interact and how individuals and organizations must understand these relationships to make sound business decisions. 

Click here to learn more: Understand the numbers that drive business success
Malvika Jain

About the Author

Malvika is a member of the HBS Online Course Delivery Team, currently working on the Financial Accounting, Business Analytics, and Disruptive Strategy courses. Malvika holds a Masters in Human Resource Management degree from the Delhi School of Economics and a Bachelors in Commerce (Hons.) from Hindu College, Delhi University. In her spare time, Malvika enjoys following her passion for journalism, travelling and spending time with family & friends.