Navigating the Challenges of Tracking Cost Basis
Understand cost basis in DeFi, methods like FIFO & LIFO, and how to simplify tracking and calculation.
Cost basis is a term used in accounting and finance to refer to the original value of an asset. This value is used to determine the capital gain or loss on the asset when it is sold or disposed of. In other words, the cost basis is the starting point for calculating the profit or loss on an investment.
One of the challenges of tracking cost basis in DeFi is that these decentralized networks do not have central authorities or recordkeepers to track and record financial transactions. In traditional finance, cost basis is typically tracked by financial institutions, such as brokerage firms, which maintain records of the purchase and sale of assets. In DeFi, however, users must track their own transactions and maintain their own records.
DeFi transactions often involve complex financial instruments, such as derivatives and tokens representing various assets, which can make it difficult to accurately determine the cost basis of a particular asset. Additionally, DeFi transactions may involve multiple parties and may be conducted on multiple decentralized networks, which can further complicate the process of tracking cost basis.
There are several methods for calculating the cost basis of an asset, including the First-In-First-Out (FIFO) method, the Last-In-Last-Out (LIFO) method, the average cost method and the Specific Identification Method.
First-In-First-Out Method (FIFO)
The FIFO method is a way of calculating the cost basis of an asset that assumes that the first units of an asset acquired are the first units sold. This means that the cost of the units sold is based on the price at which the units were originally purchased, rather than the price at which they are sold.
To understand how the FIFO method works, consider the following example:
Suppose you own 100 tokens of XYZ and you have made the following purchases:
- Purchase 1: 50 tokens at $50 per token
- Purchase 2: 25 tokens at $55 per token
- Purchase 3: 25 tokens at $60 per token
If you sell 50 tokens of XYZ, the FIFO method would assume that the first 50 tokens sold are the 50 tokens that you originally purchased at $50 per token (Purchase 1). Therefore, the cost basis for these 50 tokens would be $50 per token. If you would decide to sell the remaining 50 tokens later, the cost basis for the remaining 50 tokens would be the average cost of $55 per token for 25 tokens (Purchase 2) and $60 per token for 25 tokens (Purchase 3), which is $57.50 per token.
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Last-In-First-Out Method (LIFO)
The last-in, first-out (LIFO) method is a way of calculating the cost basis of an asset that assumes that the last units of an asset acquired are the first units sold. This means that the cost of the units sold is based on the price at which the units were most recently purchased, rather than the price at which they are sold.
To understand how the LIFO method works, consider the following example:
Suppose you own 100 tokens of XYZ and you have made the following purchases:
- Purchase 1: 50 tokens at $50 per token
- Purchase 2: 25 tokens at $55 per token
- Purchase 3: 25 tokens at $60 per token
If you sell 50 tokens of XYZ, the LIFO method would assume that the first 50 tokens sold are the 25 tokens that you most recently purchased at $60 per token (Purchase 3) and the 25 tokens that you purchased at $55 per token (Purchase 2). Therefore, the cost basis would be the average cost of $60 for 25 tokens and $55 per token for 25 tokens, which is $57.50 per token. The cost basis of the remaining 50 tokens is $50 per token (Purchase 1).
Average Cost Method
The average cost method is a way of calculating the cost basis of an asset that takes into account all units of the asset that have been acquired and calculates the cost basis based on the average cost of all units.
To understand how the average cost method works, consider the following example:
Suppose you own 100 tokens of XYZ and you have made the following purchases:
- Purchase 1: 50 tokens at $50 per token
- Purchase 2: 25 tokens at $55 per token
- Purchase 3: 25 tokens at $60 per token
The average cost method uses the weighted average price for all historic purchases, which is $53.75 per token.
Specific Identification Method
The specific identification method is a way of calculating the cost basis of an asset that allows the investor to specify which units of the asset are being sold. This means that the investor can choose which units to sell based on the cost basis of each unit, rather than using a default method such as the FIFO or LIFO method.
How consola.finance can help
Consola.finance is an crypto accounting, bookkeeping and reporting platform that aims to solve the challenges of tracking cost basis in decentralized finance. By integrating with various protocols and networks, consola.finance is able to track companies’ on-chain transactions and automatically calculate their cost basis for various assets on multiple chains. With consola.finance, companies can choose the cost basis calculation that should be applied and can switch between those methods. One of the key features of consola.finance is the ability to handle complex transactions for various assets. Additionally, the platform offers tools for streamlining crypto bookkeeping and crypto reporting processes for multiple wallets and accounts, which can be helpful for users who have a large number of on-chain activity.
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