Feature stories | Technology & innovation | Finance, business

When blockchain theory meets accounting reality

26 May '19
This article has been written by Carl Burch, an MBA, CMA, CIA, and ACCA holder and vocal supporter of blockchain. His enthusiasm for blockchain technology is only surpassed by his passion for teaching young business professionals, he says about himself.

While googling information about blockchain one can find a lot of discussion about its potential to upend entire industries. One of the industries mentioned is the accounting industry. Even Deloitte considered the topic important enough to write a whitepaper about it titled “Blockchain Technology – A game-changer in accounting?” Still, the questions remain:

❏ Does blockchain have the potential to upend the accounting industry?
❏ If so, how can we reconcile blockchain with the reality of accounting?

Blockchain - what is it?

Blockchain is the system that powers Bitcoin, Ethereum and other cryptocurrencies. Blockchain has made it possible to purchase and sell goods and services with cryptocurrencies; however, blockchain can do so much more than just power cryptocurrency transactions. Blockchain developers and users discovered that its applications could be relevant for a variety of other activities, such as conducting smart contracts, transferring shares of stock, performing real estate transactions, and even transferring voting rights. The uses of blockchain are growing daily.

Blockchain is different from other systems because it uses distributed ledger technology. Blockchain produces a digitized record of all cryptocurrency transactions and is then able to prove who possesses what at any time. Then, through a process referred to as mining, blockchain is made more secure.

Miners confirm the validity of processed transactions. The idea of one miner in the network confirming the validity of another means the entire network is simultaneously keeping consensus.

The fact that there has to be consensus for transactions to occur means that each transaction is open to viewing, which gives the whole blockchain system greater transparency.

The theory of what blockchain can do for accounting

When accountants look at the term “distributed ledger technology” (DLT), they might think that this is an accounting technology because accounting is all about ledgers.

Modern-day accounting is based on the principle of double-entry accounting, which simply means that every accounting transaction involves two or more accounts. For example, if a company borrows money from a bank, the company’s cash account increases, but so will its liability account. On the other hand, if a company pays a supplier, its cash account decreases, but so will its liability account.

When the smart contract was initiated, the transactions were also recorded on the blockchain - a secure 3rd party platform. In accounting terms, recording the transactions using third parties such as blockchain is referred to as triple-entry accounting. Even though the concept came before the advent of blockchain, it does lend itself nicely to an integration with blockchain because of DLT. This means that for every transaction, there are three parties involved.

Blockchain provides specific advantages for accountants and auditors, including:

1) All transactions and records are digitized, which allows transactions to be conducted in real time.

2) All transactions and records are consensus-based, which means they are validated by the majority.

3) There has to be consensus for transactions to occur, which means that each transaction is open to viewing. This gives the blockchain system greater transparency.

The reality of what blockchain can do for accounting

The advantages of blockchain listed above are legitimate. The question now is whether these advantages hold true across the financial reporting process - from initial recording to final reporting.

Theoretical impact on the accounting industry:

Real-time information means that accountants will be able to close their books quicker than they do today.

Impact: Decreased lag time in the presentation of financial reports to stakeholders.

Reality:

Not all financial transactions occur in real time.

======================================================

Theory:

Consensus-based transactions will improve the integrity and reliability of financial information.

Impact: It will be easier for auditors to review and verify financial information. Auditors can spend more time on more important matters, such as strengthening controls, providing recommendations on processes, etc.

Reality:

The transacting parties may not agree on the accounting of the transactions.

=======================================================

Theory:

Greater transparency means assets become more secure and traceable.

Impact: Fraud and asset theft will be reduced.

Reality:

Greater transparency creates confidentiality concerns.

More details of these issues are presented below.

1) Not all transactions occur in real time.

Part of the process entails making adjusting entries at the end of each reporting period. Some of these adjusting entries are going to be automated, but some will be strictly manual, such as checking for impairment of inventory, fixed assets, etc.

Besides adjusting entries, blockchain is also not capable of consolidating financial statements at this time. This consolidation is still going to be an internal process due to the complexity of intercompany transactions.

2) The transacting parties may not agree on the accounting of the transaction.

Blockchain’s distributed ledger assumes that all transacting parties agree on the accounting of the transactions, such as its ability to satisfy U.S. GAAP or IFRS. Unfortunately, this might not be the case due to:

Differences in applying the accounting principles.

An example: Company A uses a smart contract to purchase equipment from Company B. This is a simple buy-sell contract. However, suppose the smart contract is set up as a lease between Company A and Company B. From an accounting standpoint, each entity would have to decide how to categorize the lease, whether as an operating or finance lease.

What happens if Company A decides to account for the lease as a finance lease, whereas Company B accounts for it as an operating lease? This could happen if the companies disagree on the criteria to recognize a finance lease.

Cross-border transactions.

What happens if the transaction is cross-border and the country of Company A requires the lease to be reported based on its own accounting standards, whereas, the country of Company B requires a different accounting?

Not having consensus nullifies the advantage of blockchain. Based on this, accountants and auditors would have to spend additional time verifying the proper accounting of the smart contract.

3) Greater transparency creates confidentiality concerns.

One of blockchain’s more praised features is that it can represent a consolidated audit trail. Unfortunately, this does not seem to lend itself to keeping information confidential.

Companies usually have two types of confidentiality concerns: (1) transaction confidentiality, and (2) customer information privacy.

Transaction confidentiality

Let’s take another look at the smart contract example. Company A is purchasing new equipment to increase production so it can become a lower-cost producer. This is its strategy to become more competitive. However, if Company A’s competitor were able to know beforehand the specifics of the equipment purchased, then it’s possible that the competitor can guess Company A’s strategy and counter with some move of its own.

Customer information privacy

Additionally, some industries like financial services and healthcare have some legitimate privacy concerns since privacy is a regulatory and legal imperative. Using blockchain will most likely present some concerns since blockchain is an unchangeable shared record of past activity.

It seems likely that concerns about privacy and business confidentiality will only grow as blockchain becomes a more universally integrated system.

Final word

Is blockchain going to upend the accounting industry? Probably not to the extent envisioned by Deloitte and other accounting firms based on the limitations described above. However, blockchain will have an impact.

If we look at the basics of accounting, such as the classification of debits and credits, this part of accounting hasn’t changed over the centuries. But, what has changed is the technology that has made accounting more automated. Automation has meant that accountants don’t have to spend all their time posting transactions. They can now spend more time reviewing the reliability and accuracy of the transactions, which should lead to more trustworthy books.

It’s this idea of having more trustworthy books that excites accountants about blockchain. Blockchain is a new kind of ledger, and the basic idea of this ledger program is that no single entity controls the ledger. This makes the transaction system more transparent, and thus, more verifiable and accurate.

We believe that it is possible for smart contracts to be automated in such a way that they are executed automatically. Think of a system where inventory is ordered automatically when required, and then paid after receiving verification that the goods have been delivered and accepted according to the smart contract specifications and there are sufficient funds in the company’s bank account.

The situation described above is just one of numerous ways blockchain could impact the accounting industry. Based on its distributed ledger technology, it’s likely that there will be a cascade of new applications further impacting the way accountants and auditors do their job.
Oleg Kouzbit, managing editor: “I’m glad you join us here and take The Bridge walk for Marchmont’s weekly review of the Russian regions’ innovative present and future. Stay close and you’ll find out more of how Russia is bridging the existing gap between its researchers and businesses.”
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