Since blockchain technology entered the mainstream in 2017, many have questioned its purpose and capabilities. What is blockchain? How does it work? What are its implications for the accounting profession? The author attempts to answer these and other questions, providing an entry point for interested professionals and demonstrating how this new technology could change the face of accounting and auditing in coming years.
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Much has been written about blockchain technology and the cryptocurrency applications that run on it, making it difficult for interested parties to know where to begin. Furthermore, many of the articles, publications, and discussions about blockchain are written at a high technical level; there are precious few step-by-step guides or discussions of real-world applications. This article provides CPAs with jargon-free, hands-on guidance on how to adapt to and successfully leverage blockchain technology in accounting and advisory services.
Technology and Accounting
Blockchain technology may seem arcane at first, but accounting professionals have been using technological platforms to improve upon and add to services offered for decades. Microsoft Excel, various enterprise resource planning (ERP) platforms, and the digitization of accounting information and processes have been used in accounting for years; blockchain is simply the next tool to be incorporated into the profession’s toolbox. Regardless of whether a CPA works in public practice, private industry, or academia, being able to understand, utilize, and implement blockchain will be increasingly essential. With many organizations, including the Big Four, already implementing blockchain prototypes, it is increasingly evident that blockchain is an important for accountants across industry lines. The technology has important implications for accounting information systems (AIS), specifically how information is consolidated and communicated from operations to end users. It is also important that the fundamental differences between different blockchain options are understood and applied to the business landscape.
The Basics of Blockchain
Blockchain is a decentralized ledger system developed by a person or persons working under the pseudonym Satoshi Nakamoto in October 2008 to facilitate Bitcoin trading. Nakamoto designed blockchain to solve the problem of duplicate spending in cybercurrencies, to enable exchanges in a low-trust environment without a third party, to create a distributed ledger of transactions that is robust against failure, and to provide an immutable audit trail. It has also been suggested that Nakamoto proposed blockchain as a response to the global financial crisis of 2008, in which the banks, through their capacity as third-party intermediaries, threatened the viability of the entire global financial system.
Put simply, blockchain is a decentralized database that enables real-time verification and communication of information. A helpful analogy may be to think of blockchain as a gigantic Google document accessible to network members, with some members granted different levels of access, and augmented with cryptography and other security tools to protect and secure information.
The “block” and “chain” components are connected, and together form the basis that supports cryptocurrencies. Akin to how certain traditional ledger entries (e.g, payables) are batched to streamline internal processes, individual records and transactions are batched into blocks. Each block contains a cryptographic hash that is both unique to that block and chains it to the immediately preceding block of information. This connection, cemented by the hash IDs and time stamp associated with each block, is the virtual glue that connects the blocks and forms the blockchain. Any alteration of the ledger or an individual block will make the code inoperable and thus would be detectable. To date, no blockchain has been breached or hacked, although several cryptocurrency platforms have suffered breaches, reinforcing the importance of robust password security and protocols.
Digging further down, each block is a mathematical cryptographic code recording the most recent transaction. As soon as a block completes the required information and is verified, any additional information or ensuing events chronologically link to that first block by becoming a subsequent block, in a chain-like fashion—hence the name “blockchain.” When a block is completed, it also creates a unique secure hash code, which connects it to the next block. The block also contains the Merkle Root of the transaction that it represents—a mathematical process used to organize multiple events in a more manageable fashion. The Merkle Root in a blockchain is a derivative of the hashes from the current block and a prespecified number of previous blocks or a prespecified time (this is unique for each chain). Exhibit 1 illustrates a simple blockchain.
A block can represent the latest cryptocurrency exchange, a derivatives market trade, a payment made on a loan, a vote, or any contract. Each block is linked to a prespecified number of previous blocks, identifies all of the information contained within, and is verified before being added to the chain, without an outside third party controlling the process. In the blockchain, each user or “node” possesses a complete record of the entire blockchain, and each transaction must be approved by a majority or a consensus of the users. The verification process can be computationally expensive, depending on the number of verifying members (called “nodes”) and the number of blocks in the hash. In Bitcoin, for example, the current verification time is 10 minutes for each transaction. This feature provides the tamper-proof nature of most blockchains; the block contents cannot be revised by the nodes, and the chain cannot be altered once the block has been approved and added. The chain propagates in one chronological direction, but it can be audited and read in both directions.
It is important to note that the verification process can be customized depending upon the blockchain option selected. The verification process consists of nodes that have volunteered to be verifiers confirming, via complicated mathematical association and problem solving, that the hash IDs and information referenced via those hash IDs are authentic. While this verification is difficult to achieve initially, once it has been approved, other nodes can verify it in short order. No individual node possesses more power than another node or permissioned user.
A proof-of-work verification protocol requires only a single node to submit a solution to an algorithmic problem—something that is very difficult to achieve but easy to verify once accomplished. This is the methodology used in both the Bitcoin and Ethereum blockchains, but it consumes more electricity than other options, reducing its applicability for large-scale implementation. In contrast, a proof-of-stake protocol uses a lottery system to decide which nodes (i.e., permissioned members of the blockchain) will approve the transactions and information in question. The probability of being selected for approving transactions and information depends upon the stake held by the organization or individual in question; for cryptocurrencies, this equals the number of Bitcoins or other altcoins held. While this may result in some of the larger stakeholders having outsize approval control over entries and blocks, these large stakeholders are also equally vested in the success and veracity of the network.
The last protocol used is proof of elapsed time, which assigns a random model to determine who will approve the block of pending information. The node with the shortest wait time wins the lottery, but will have to wait a certain amount of time before approving additional blocks. Note that, in order to utilize the proof of elapsed time, the nodes involved must run Intel Software Guard Extension (Intel SGX); because it is not feasible for many users to possess the expertise to incorporate Intel SGX, much of the Blockchain community uses the proof-of-work protocol.
Real World Applications
How does blockchain apply to real world auditing and accounting practice? Consider the hypothetical example of Top Dollar CPA, a midsize accounting firm that has set up a private blockchain organized by the firm, with its largest 20 audit clients as members of the network. Instead of manually confirming outstanding receivables, which can add days to the audit process and create a mountain of emails and other information that can get lost in the shuffle, blockchain enables this process to be done on a nearly instantaneous basis. As blocks of data are verified and added onto the blockchain, they are confirmed and verified on a continuous basis by network members. Specifically, confirmations can be augmented, improved, or even rendered unnecessary by the implementation of a private blockchain environment.
A core functionality of blockchain is that every member of the network can audit the blockchain and is thus aware of the terms, conditions, information, and agreements between counterparties. Therefore, if counterparties are aware of who owes money to whom, and the conditions of those payments, this could certainly change the process by which receivables are examined and confirmed. It is important to note that this private network, consisting only of known, approved members, is integral to this approach. Consider another example in which ABC Company sells goods to XYZ Company. Howard LaFarb, a CPA at ABC, has always used a general ledger in QuickBooks to track ABC’s sales with XYZ; all he typically needs to do to determine ABC’s status is to look at the most recent closing balance after the sale. With blockchain, however, a closing balance does not exist, and calculating the final balance of XYZ’s account means going backward through the general ledger from the most recent block to the very first transaction. He can, however, use a special blockchain developed for accounting, such as Balanc3 by ConsenSys or Libra Enterprise Platform, where double-entry accounting becomes a triple-entry ledger due to the participation of the blockchain in every accounting transaction. The benefit for both companies is that both parties can view the transaction at any time and agree that it is accurate; the benefit for Howard is that the numbers cannot be altered and he has to spend much less time reconciling accounts and verifying numbers. The transactions cannot be altered in any way, thereby greatly reducing the possibility of cutoff and reliability issues, not to mention making it harder to cook the books.
As blocks of data are verified and added onto the blockchain, they are confirmed and verified on a continuous basis by network members.
Verifying payroll information, including hours, salary, and fringe benefits, can be accomplished in the same manner and can be customized depending on the members of the network. For example, suppose that Steve Adams, CPA, also prepares payroll for 20 clients. Currently he spends at least one day a week using ADP software and client-provided data to generate the payments; he must verify hours, salaries, various withholdings, and any special payments for the employees. If Steve switches to using a private blockchain for each client, wherein all the third parties are permissioned participants, he will spend perhaps one or two hours a week performing verifications, as the 20 blockchains are autonomously enforcing the predetermined requirements of the payroll process as “smart contracts.” A smart contract is, in essence, a series of “if, then” statements and agreements that have been agreed to by all parties involved; thus, embedding this information on a blockchain platform is not far-fetched. While the Ethereum blockchain has taken the lead in this regard, there will inevitably be other options that arise over time.
Implementing a blockchain platform may seem like a departure from normal business procedures, especially when it comes to sensitive information such as employee salary and healthcare information. That said, to date no blockchain has been hacked, and if private blockchains are implemented, different clients can store information with their CPAs on individual private networks, which would prevent any accidental disclosure of confidential information. Note, however, that both parties in a business relationship would have to both implement blockchain and be a part of the same network after implementation.
Cryptocurrencies are traded on public blockchains, which secures them, but other associated information may be stored behind regular security protocols.
Another thing to keep in mind is that blockchain is software that can be installed on computers, laptops, individual servers, or server farms if so desired. Most blockchain software options are priced and operated much like other software, with some freely available (the Bitcoin blockchain), others charging fees for each piece of data added (Factom), and others built exclusively for commercial use (Ripple). As with any other software, there are always risks when downloading different blockchain platforms, such malware, viruses, and other malicious software programs. Over time, a mature market for blockchain software platforms will likely develop, with competitors offering different value propositions.
As noted above, several platforms where cryptocurrencies are traded have suffered breaches. These breaches have predominantly occurred at the end user level of public blockchains, where individuals have not maintained best security practices. Cryptocurrencies are traded on public blockchains, which secures them, but other associated information may be stored behind regular security protocols. Hacking a blockchain is still, fortunately, a theoretical possibility, but as with cloud-based data storage, it is also good to secure information as tightly and proactively as possible.
Public versus Private Blockchains
The first step in offering blockchain-enabled accounting and advisory services is the ability to actually download and use blockchain technology. Before this can occur, CPAs need to understand the differences between the public blockchain and the private blockchain. There is no one single blockchain; rather, there are hundreds of different options available for individuals and businesses. The public blockchain, which supports the cryptocurrency Bitcoin, allows anyone to join by simply by downloading the software (https://bitcoin.org/en/bitcoin-core/). Most organizations, however, do not appear to be choosing this option. CPAs would most likely opt for a private blockchain due to privacy and utility concerns.
Exhibit 2 provides a basic illustration of how a private blockchain could be constructed and set up, with the organizer having access to both invitees’ information and granting the CPA access to relevant data from the invited organizations.
Private blockchains place restrictions on who can join the network, and examples of private blockchains can already be found in the marketplace. In addition to products currently produced by IBM and others, several other large corporations are already experimenting and using blockchain technology to improve supply chain performance, information, and reporting, including FedEx, Maersk, Wal-Mart, UPS, and British Airways. An additional benefit, from the perspective of the accounting profession, is that private blockchains allow different levels of access and editing to different users.
Depending on what functionality the organizer wants to establish, the types of information stored and disseminated via the blockchain, and what levels of access different stakeholders require, private blockchains appear to be the most logical and business friendly option for organizations. Exhibit 3 shows some of the benefits. One of the biggest potential benefits is the reduction in time spent confirming and verifying information. Remember that as blocks are added to the blockchain and approved, each approved block of information is then posted for all network members to see. If the information on the blockchain has been approved, verified, and reviewed by network members, is there need for additional confirmation? In that scenario, and especially as blockchain networks become more widely implemented, it is possible to see a future state when confirmations are either vastly reduced, or potentially automated altogether.
Benefits of Blockchain to the CPA Profession
Although most accounting processes have not been moved to blockchain platforms yet, as more business processes occur in the blockchain space, this is bound to change. So far, many of the organizations that have adopted blockchain are large companies, but this mirrors similar adoption patterns of other emerging technologies. One of the authors spoke extensively with Brett Shear of Balanc3 about the current state of accounting and the blockchain. Most users of Balanc3 to date are firms in the blockchain/cyber-currency space and not companies that have converted to blockchain from traditional accounting formats, but Shear expects this to change once accountants and auditors start working with blockchain events as part of an assurance process.
Private blockchains offer business applications more suited for CPAs.
Choosing Blockchain Software
From a purely technical perspective, public blockchains may be worthy of additional analysis and consideration, but private blockchains offer business applications more suited for CPAs. The specifics of a private blockchain will vary, but upon downloading the appropriate software platform, and installing the technology on a server, the organization can sign up, write the code and protocol in alignment with its business need, and invite others to download the blockchain software and join the existing network. Several of the more popular blockchain options in the marketplace as of this writing include the following:
- Ethereum, specializing in the development and execution of smart contracts (https://www.ethereum.org)
- Ripple, built and designed for handling financial transactions, including currency exchanges (https://ripple.com)
- Factom, primarily used for reducing paperwork and processing time, such as that associated with mortgages and title insurance (https://www.factom.com)
- Hyperledger, an open source platform (https://hyperledger.github.io/composer/)
- Multichain, an open source private blockchain platform that can be used by many different businesses for different purposes (https://www.multichain.com).
Ethereum is a decentralized open source platform where interested parties may customize blockchain applications for smart contracts, or agreements that run exactly as programmed, without downtime, censorship, errors, fraud, or third-party oversight and intermediation. Ethereum enables users to negotiate loans, agreements, charters, wills, fund transfers, and other contractual matters without a third party, trustee, or counter-signer. The basic smart contract process begins by accessing the Ethereum platform, which is the gateway to accessing cryptoassets built on blockchain in addition to writing, enacting, and using smart contracts. The basic steps for getting started with Ethereum and other blockchain software discussed below can be found here: www.cpajournal.com/2018/06/29/getting-started-with-ethereum-and-dloc.
The real value that CPAs can deliver is to bring businesses blockchain-enabled accounting, attest, and advisory services.
One thing to keep in mind when considering Ripple is that it was designed for large financial services corporations; therefore, it may not be an appropriate option for other businesses. If, however, Ripple does sound like a good fit, the setup process is relatively straightforward:
- Go to gatehub.net, and sign up to join
- Enter your email to receive confirmation
- Save your recovery key (very important)
- Verify your email and identity
- Link Bitcoin and other cryptocurrency wallets to your account, if applicable.
Because Ripple is built to facilitate financial transactions, users are responsible for understanding and complying with regulations, including know-your-customer (KYC) and anti–money laundering (AML) rules.
Factom is a blockchain platform primarily used to reduce the volume and complexity of paperwork associated with complicated legal transactions by allowing these documents to be published on this blockchain platform. There are two main offerings, Harmony and DLoc. Harmony provides a secure blockchain-based documentation storage platform that allows lenders to quickly assemble loan underwriting packages. It claims to reduce the burdens of review and assembly of documents for underwriting and litigation, ease the process of mergers and acquisitions by reducing the time required for review, and reduce the number of document errors occurring from duplications, anomalies, and missing information. DLoc is a document authentication and verification system that reliably authenticates any essential documents, including birth certificates, land titles, and medical records. Any business that issues vital records, contracts, and tax records can use blockchain technology and the trust of well-established cryptography standards for data protection and security.
Hyperledger is an open source blockchain platform, complete with a graphic user interface (GUI) that makes using, experimenting, and building blockchain models possible for users even without technical expertise. Sponsored by the Linux foundation, it can also be used by practitioners, educators, and students to learn about blockchain in a real-world environment. Setting up a network or blockchain on Hyperledger is a relatively straightforward process that can be started by anyone with a computer and an Internet connection. It is important to remember that, although Hyperledger is supported by the Linux foundation and is certainly useful for experimenting and learning more about blockchain functionality, public blockchains may not be ideal for CPAs.
Multichain is an open source off-the-shelf platform for the creation and use of private blockchains, internally or shared across permissioned organizations. It claims to resolve the key issues — privacy and control—hindering the use of blockchain by financial and other sector institutions. It is designed to ensure that a blockchain’s activity is only visible to permissioned participants, to introduce controls as to which transactions are permitted, and most importantly, to allow verification to take place securely without proof-of-work and its associated costs. Since the blockchain is private and the size of the chain is controlled by the permissioned users, latencies and burdens related to the size of the chain are easily resolved. Furthermore, the chain only includes events that relate to the users. It is available for Windows, Mac, and Linux, with a simple command line interface and application program interface (API).
How Blockchain Will Change the Profession
Knowing how to set up different blockchain networks and platforms is an excellent skill to have, but the real value that CPAs can deliver is to bring businesses blockchain-enabled accounting, attest, and advisory services. To provide these services, however, CPAs should understand what the implications are, and provide examples of how blockchain will transform the profession, as shown in Exhibit 4.
Examples of Improved Accounting Processes using Blockchain
For CPAs working in industry, reconciling accounts and amounts can occupy a majority of staff and even supervisor time. Traditional reconciliations involve comparisons of book balances of information at an organization against external information, such as bank statements, documents provided by brokerages, or information generated by joint venture partners and affiliates. After acquiring and finalizing these different sources of information—which can be time consuming in and of itself—the inevitable differences will need to be identified and explained. In addition, the process is prone to error, and the final incremental value added via a routine reconciliation is usually minimal at best.
In a blockchain-enabled accounting environment, information is readily available and continually confirmed by all network participants. Instead of having to be confirmed manually and provided by third parties or internal colleagues, the information can be exported out of the blockchain environment. Because all members of the blockchain network have access to the data uploaded and verified by fellow members in real time, the need for periodic reconciliations is greatly diminished. Saving this time allows CPAs to spend more time on higher-level advisory services, elevating the value added.
Expansion of accounting function.
Blockchain technology is clearly in the opening stages of development, and CPAs are just beginning to experiment with how to generate benefits. In addition to benefits derived from saving time and effort on reconciliations, ad hoc reporting, and closing the books, there are several additional benefits and applications CPAs should keep in mind.
- Establishing a single source of data internally. Setting up a private blockchain network not only allows information to be distributed in real time, but since consensus protocols are established in advance, CPAs can more consistently rely on the information generated by system reports.
- Reducing paperwork. Accountants are routinely tasked with interpreting mountains of paperwork; for example, contracts for revenue recognition, lease contracts, and the nature of net assets. Converting these information sources, usually PDFs that can be hundreds of pages long, into a machine-readable format for analysis is a cumbersome and error-prone process.
Exhibit 5 illustrates how blockchain implementation connects directly to these challenges putting pressure on the accounting function.
Benefits of Blockchain for the Accounting Process and the CPA
One of the biggest criticisms of the profession is that a core component of the services offered to clients—audit and attest work—is greatly limited by two factors. First, despite some effort to conduct audits on an ongoing basis, the auditing process is a periodic event rather than a continuous cycle. Second, when an audit occurs, the eventual audit opinion is based on a sampling of entries, amounts, and other information. This creates a situation wherein not only do audits not reflect the rapidity and fluidity of contemporary business, but the audit opinion suffers from audit failures and a lack of audit efficiency. Even though audits are currently conducted via a sampling methodology, the disruption audits cause to business is significant because employees must assist auditors in gathering the necessary documentation for testing and other procedures. New and changing audit standards also tend to reduce efficiency.
Blockchain-enabled auditing enhances the efficiency, effectiveness, and reliability of the evidence collection process.
According to the PCAOB, audit evidence is “all of the information used by the auditor in arriving at the conclusions on which the audit opinion is based” [Auditing Standards (AS) 1105]. The standards also dictate that this evidence should be sufficient, appropriate, and reliable and should be generated by certain procedures. These processes, such as confirmations and recalculations/reperformance, can be time consuming.
Blockchain-enabled auditing enhances the efficiency, effectiveness, and reliability of the evidence collection process, as shown in Exhibit 6. If there is a blockchain network set up between the auditor, the client, and client’s third parties, all of them possess customized access to the information. Data is verified and approved by the network as it is added; once the information is validated via consensus, this data recording is immutable. With continuous data flows, all network participants can validate and receive real-time updates of transactions, and a batch process audit may not be necessary. The blockchain could provide automatic confirmations of payments, receivables, payables, and inventory, and confirmations could be automated out of the audit process. Furthermore, auditors would be able to examine 100% of the transactions during the consensus process, thereby providing a higher level of assurance.
Comparison of Traditional and Blockchain-Enabled Audit Procedures
It should be noted that auditing 100% of the transactions would likely lead to an expectation that the majority of material errors and frauds would be detected by any reasonably competent auditor. In addition, if an auditor joins the chain later in the process on a read-only basis, he could confirm the viability and design of the chain while vetting the network participants and the application controls established by all parties.
Blockchain technology has the potential to revolutionize and disrupt the accounting profession in ways that even now are not entirely clear. What is clear, however, is that blockchain will have an impact on the business landscape. Accounting professionals need to adjust to this new business paradigm, both in how they interact with clients and colleagues and the level of service they provide. Taking into account the fact that this technology is still in its early stages, other potential questions come into play.
What is blockchain’s time horizon?
Innovations in blockchain are occurring daily based on perceived business/social needs. Many businesses are studying its potential, with some sectors implementing it on a case-by-case basis (e.g., banking, mining, supply chain applications). During the next year, the authors expect to see more user-friendly applications as intuitive interfaces are developed and more use case studies emerge. Because accounting tells the story of business events, the accounting and auditing professions will likely engage with blockchain in the very near future.
When will CPAs encounter it in daily practice?
It may be smaller firms that encounter blockchain use by their clients or that may be requested to provide blockchain-assisted accounting services, since small-to-medium-sized businesses that are not publicly listed are generally more flexible and able to adopt new technologies with greater agility. Although most if not all of the major accounting firms are studying blockchain or running pilot programs, most of the innovation is occurring on the advisory side. Traditional accounting and assurance services for public companies may be a bit slower to adopt blockchain due to latencies of size, regulations, and bureaucracy. For example, a small firm or business may start using Factom to immutably record a contract and its timestamp, while larger firms and their clients could undergo months of discussion and risk analysis before using blockchain, and even then on a pilot basis.
Is widespread adoption still years away?
Given that the business world comprises many different sectors and entities with different feasibilities for blockchain use, blockchain could become more noticeable in some industries (e.g., banking, real estate, construction, government, mining, insurance, supply chain) during the next year. In the next five years, the authors predict that the blockchain landscape will evolve significantly as a means of providing data integrity, security, and history, and that several professions will realize significant efficiencies with contract and transaction validations.
Although most if not all of the major accounting firms are studying blockchain or running pilot programs, most of the innovation is occurring on the advisory side.
What are the results of a costs/benefit analysis?
Hypothetically speaking, factors such as ease of use, decreased time for activities such as confirmations, and the verification of data quality all need to be addressed. This is clearly an area for future research and use-case analysis; for example, from a forensic accounting perspective, if blockchain-enabled evidence were to be successfully accepted in a court case, that would provide a greater impetus towards reducing examination costs.
What factors might change the equation?
The speed of blockchain acceptance for accounting and auditing is contingent on several key events: when an audit firm successfully audits a blockchain and passes PCAOB inspection, when businesses demonstrate successful use cases, when blockchain developers build more user-friendly interfaces, and when blockchain-secured evidence is accepted in a court of law. All of these instances could serve to validate blockchain as a securer of accounting and auditing evidence, in addition to enabling its ease of use.
CPAs have adapted to technological changes before and will do so again the future. Professionals currently have an opportunity to leverage the advances in blockchain technology to elevate themselves, the services they provide, and the perception of the accounting and auditing profession at large.