Blockchain — The what and why for accountants

From the September/October 2018 issue of Disclosures magazine.

By Bennett Dean, CPA

In the past year, the terms “cryptocurrency,” “Bitcoin” and “Ethereum” have earned a spot in our vernacular. It is hard to go a day without seeing a headline referencing the prices of cryptocurrencies and speculating as to their future value. Much of this has to do with the massive boom Bitcoin experienced at the end of 2017, when its price shot upwards of $20,000 per Bitcoin on some exchanges.1 While cryptocurrencies have their proponents and critics, the blockchain technology underlying these virtual currencies has the potential to reshape our economy in the same way the Internet has over the last 25 years.

Blockchain — often thought to be synonymous with Bitcoin, the most popular cryptocurrency — is considered to be the next evolution of the Internet and has been dubbed “Internet 2.0” and the “Internet of value.” But it is important to differentiate the two: Bitcoin is synonymous with an “app” while blockchain is the underlying technology driving the app. Cryptocurrencies are just one way blockchain technology can be leveraged.

So what exactly is this revolutionary technology, what value does it offer beyond cryptocurrencies and how can it transform business functions and industries?

The blockchain, explained

At its core, blockchain is a distributed ledger technology. It is a ledger or database of transactions that is distributed over a computer network, with each computer participating in the network by maintaining an identical record of all the transactions that have occurred. In order to add a new transaction or group of transactions (a “block”) to the ledger, the network participants must verify the new block using a consensus mechanism. This allows the network participants to “agree on” the updated ledger. Once a block is verified, it is added to the chain of transactions and is linked to the previous block. In effect, all blocks of transactions are chronologically layered and linked to each other, from the very first transaction to the last.

Using this explanation, it is easy to identify a few key characteristics of blockchain technology:

Distributed/decentralized: The ledger of data is not stored in one location; rather, it is stored on a broad network of computers.
Immutable: Since each block of transactions is linked to the blocks before it, the network will not accept a change to prior blocks in the chain.
Transparency with security: The history of transactions is visible to every participant and all transactions are broadcasted to the network. Blockchain uses cryptography along with public and private keys to control who can access certain data.
Peer-to-peer: Transactions are processed without the presence of a third party.

The value

These characteristics described above, when combined and working together in one system, give blockchain its unique value. Each characteristic works together to create a tool for distributive consensus, allowing unknown, distrusting participants to transact with one another.

Distributed/decentralized

Since the ledger is stored across a network of computers, there is no need for a central authority to keep a “master file.” The value of having the ledger stored and maintained across a distributed network, though seemingly redundant, is two-fold.

First, there is no central point of failure. With the prevalence of hacking and the importance of having information available at all times, the distributed network can withstand attacks and outages. If any computer on the network fails or is temporarily unavailable, the others continue to verify transactions and build the blockchain.

Second, it prevents a user or group of users from manipulating the system. The data cannot be manipulated by a rogue user because all participants have a copy of the real-time ledger. Any attempt to change the historical data would need to be done across all computers participating in the network.

Immutable

Blockchain creates an immutable transaction history that is permanent and tamper-proof. Again, changing the historical data is nearly impossible since network participants will not accept a blockchain with a transaction history different than their own. Additionally, each block in the chain is mathematically linked to each one that came before it. Once verified, all the blocks in the chain — from the very first to the most recent — are inseparable, and the sequence of historical transactions is shared across all participants in the network. Changing or manipulating prior blocks in the chain proves nearly impossible.

This is extremely valuable when considering an audit of transactions. Using blockchain, auditors can be assured that when any transaction was initially recorded, it was agreed upon and verified by all parties to the transaction. Moreover, auditors can be certain that what was recorded has not changed. As discussed below, this could represent a significant shift in the work of auditors.

Transparency with security

Blockchain is a transparent history of all transactions. It is transparent in that there is a clear set of rules to which each network participant must adhere. The rules are known and available to all participants and must be followed for a new block to be verified. Not only are the “rules of play” enforced in an unbiased manner (after all, it is a computer algorithm enforcing them), the resulting transactions are visible to all participants, creating an auditable and trusted database.

Blockchain is secure in that it uses asymmetric cryptography to grant specified parties access to data or information. It uses a pair of keys: public keys that can be shared with anyone and private keys that are specific to the owner. It essentially controls who in the network has access to specific data, depending on who has the proper private keys.

Peer-to-peer

Perhaps the most significant aspect of blockchain is it works independent of any trusted third parties. This is where the network consensus provides value. All the facts that are known to one party are also known to the opposite party and to the entire network. In any given transaction, the parties have the exact same set of shared facts and can verify all details of the transaction without anyone else being involved. This creates a trust between unknown participants, without the need for a trusted intermediary.

One can see how this could add value to parties to a transaction. Intermediaries — and the fees associated with their services — are often involved in everyday transactions. Credit-card companies and banks are prime examples.

When these characteristics work together as they do in blockchain technology, it creates a mechanism by which value can be shared and transferred over the Internet. The fact that all parties in the network share the same information allows them to reach a consensus about the current state of the shared facts and how those facts came to be. This in turn creates a trust among disparate parties, without the need for a traditional third-party intermediary. Each party agrees on the shared, immutable, transparent facts.

Smart contracts

The term “facts” can refer to any number of data points. In finance or accounting, the shared facts might be the terms of a contract. A contract can be coded into a computer application, and using blockchain protocol, the terms of the contract can be programmed to auto-execute once certain milestones are met or inputs are received. These so-called “smart contracts” represent a valuable advancement in efficient automation. They can automatically execute any data-based business logic. It is similar to “if-then” logic, but the contracts can be programmed to handle complex business processes.

When a contract is, so to speak, built into blockchain, the terms of that contract take on the key characteristics discussed earlier. The terms are immutable — what was initially agreed on between the parties will not change. The terms are accessible and transparent — they can be shared with anyone needing access to them and adherence to the terms can be reviewed and audited automatically. The terms are distributed on a peer-to-peer network — the contract does not require verification by a third party or reliance on a third party to execute.

Blockchain in business

As accountants, whether in the public or private sector, understanding how this technology might disrupt various industries, including our own, will be crucial as its adoption spreads. However, before discussing its potential effects on the accounting industry, it is important to note not all blockchains function the same as Bitcoin and the other cryptocurrencies. There are two types of blockchains: public and private. The Bitcoin blockchain is an example of a public, or non-permissioned, blockchain.

Public versus private blockchains

When thinking about public and private blockchains, it can be helpful to compare them to the Internet and a corporate intranet. In this analogy, the Internet represents the public blockchain, and the corporate intranet represents the private blockchain. The Internet is available for all to access whereas a corporate intranet requires certain permissions to access.

The main difference between the two boils down to who owns and can access the network infrastructure. In a public blockchain, anyone is free to join and use the blockchain. It truly is a distributed, decentralized network with no prerequisites needed in order to participate. In a private blockchain, permission to access must be granted by a gatekeeper.

As businesses adopt blockchain technology, many will want to restrict access and visibility to their transactions and data. In these cases, a private blockchain in which participants are known, trusted and given permission to be in the network will be more suitable. The private blockchains are more centralized than their public counterparts, but they give businesses more control over their networks. Other advantages of a private blockchain that make them a better fit for business include:

No need for complex consensus mechanisms. In theory, the permissioned blockchain participants are known and trusted, so reaching consensus and verifying transactions is a simpler and less time-consuming process.
Businesses can customize and design a blockchain to fit their specific needs, including the consensus algorithm and level of encryption.
Businesses can give third parties (auditors, regulators, etc.) access to specific data information without compromising all the data stored on the blockchain.

Whether working with a public or private blockchain, certain limitations and issues still exist, including:

Scalability: Does the blockchain allow network participants to verify transactions fast enough to keep up with the speed of business?
Governance: Who makes decisions for the blockchain when all participants add value to the network?
Interoperability: To function efficiently, blockchains will eventually need to talk to other blockchains and outside systems. For instance, for the blockchain to auto-execute the terms of a smart contract, it will need to connect to data or inputs stored outside the blockchain. Blockchains will also need to connect to legacy systems to pull historical data.
Privacy: Customer data and corporate data needs to be protected and shared on a need-to-know basis. Transparency needs to be limited where appropriate.

Blockchain and the accounting industry

With the basic principles of blockchain technology and its capabilities now laid out, what should those in the accounting industry do in the near term and expect in the long term?

In the short term, accountants should continue educating themselves on what the technology is and how it is being implemented in various industries. Much like the adoption of the Internet, the adoption of blockchain will not happen overnight. But once it is in use, accountants will be expected to have a thorough understanding of what it is and what it offers. To prepare for this, expect more and more universities to start offering blockchain courses as part of their accounting programs.2 Indeed, the CFA Institute, in recognition of the growth of the technology, has already added cryptocurrency and blockchain topics to its CFA Exam.3

As blockchain gains more acceptance and its adoption spreads, it could shift the focus of auditors and tax practitioners to higher-value consulting services. Many would agree that administrative tasks divert too many resources away from value-added activities. If blockchain technology, particularly smart contracts, can take over these administrative functions (think accounts receivable, accounts payable, account reconciliations), it will free up resources to tackle more pressing needs like strategic planning.

Other traditional accounting services that will be affected, and how they might look in the future, include:

Bookkeeping: One of the common themes when reading about blockchain and accounting is the idea of a ledger that is shared between parties of a transaction (buyer and seller). With blockchain, the recording of transactions will occur in real time during the course of everyday business. As items and/or services are purchased or sold, they will be recorded in a ledger that is shared between the buyer and seller. The recorded entry will be the exact same for both parties, thus eliminating the likelihood of human error on either side. Over time, as the shared ledgers become more robust and can handle all types of transactions, the need for bookkeepers may be greatly reduced or eliminated altogether.
Auditing: One of the most significant services provided by public accounting firms, the audit of a company’s financial statements is necessary so the public can trust the financial information being reported. Each audit can be a very lengthy, costly and time-consuming project. In a blockchain environment, a company’s transactions would be verified and confirmed as they occur. Not only would auditors be able to verify most financial information automatically just by going to the blockchain, but real-time audits would be possible. Because the costs and time committed to audits would drastically decrease, audit teams would be able to expend additional resources on complex transactions, internal controls and IT audits. The focus of audits could shift from the financial transactions to an audit of the blockchain.
Tax preparation: Similar to the possible changes in the audit industry, the real-time recording of all financial transactions on a blockchain could completely change the way tax returns are prepared. At any point in time, a company’s taxable income and tax liability could be known. Could we reach a point where real-time tax reporting and payments are not only possible, but required?

The automation of traditional accounting processes will not render CPAs meaningless or jobless. Rather, it will shift the industry’s efforts away from lower-level services and toward higher-level advisory services. Some jobs will be lost, but others will be gained. But be warned: In the blockchain environment, accountants will need to find new ways to bring value to their companies and clients or risk being left behind. As Stephen Horan of the CFA Institute recently said regarding blockchain, “This is not a passing fad.”4 It is important to start paying attention to the shifting landscape sooner rather than later.

Bennett Dean, CPA is a tax manager at PIASCIK in Glen Allen. He focuses on domestic and international tax consulting and compliance for both individuals and businesses.

Footnotes

Imbert, Fred. “Warren Buffet on bitcoin: It doesn’t produce anything except more buyers looking to sell.” CNBC. May 7, 2018.
Paine, James. “How blockchain is disrupting the accounting industry.” Inc. March 30, 2018.
Patterson, Michael and Andrea Tan. “’This is not a passing fad’: CFA Exam adds crypto, blockchain topics.” Bloomberg. July 16, 2018.

Additional resources

Drew, Jeff. “Paving the Way to a New Digital World.” Journal of Accountancy, June 2018.
Tapscott, Don, and Alex Tapscott. Blockchain Revolution: How the Technology behind Bitcoin Is Changing Money, Business, and the World. Portfolio / Penguin, 2016.