Understanding Block Chain & Impact on Accounting and Audit Practices
Updated: Jun 3, 2018
What is Block Chain?
Block chain is a ledger technology that offers a new approach to recording transactions. It is different than the conventional ledger due to two key characteristics:
It is distributable
It is immutable
Block chains store information across the network of computers, therefore making the technology highly distributable and decentralized. There is no central entity/ person/ organization that owns the system yet everyone can use it and help to run it.
While bitcoin and block chain are often referred to interchangeably, bitcoin is only one unique application of block chain technology and actual technology can be used in several other applications.
Why is it important and what problem is it trying to solve?
Ledger is the fundamental way to store information about transactions. Ledger or bookkeeping is key to conducting commerce today. All transactions are recorded and maintained in a ledger. Examples include bank transactions, transactions related to a home, business transactions etc. Using the home example, we expect the ledger to include records of homeowners, improvements made to the home and any incidents (fire, robbery etc) to be reported in that ledger along with the dollar value associated with each transaction. For example: (1) Owner A bought the house for $200, (2) he made renovations worth of $20, but (3) the house lost $10 value in a fire incident, therefore the value of the house should be $200 + $20 - $10 = $210.
However, these conventional ledgers are not perfect as they are not immune to errors and fraud. Record entries can be easily made, deleted or edited in these ledgers; therefore these ledgers are highly tamper-able. This creates the problem of “Trust Gap” between the transacting parties.
We have learnt to base our decision making on one simple principal “trust but verify”. In order to bridge this “Trust Gap”, we rely heavily on the intermediaries to help us verify and conduct our due diligence on the counter-party and its claims. Intermediaries are the entities/organizations responsible for keeping a centralized copy of the ledgers in all of commercial activities. They facilitate the brokering of relationship between those who are looking to trust and those who are looking to be trusted. Examples include governments, banks, accountants, land title companies, notaries and credit reporting agencies. With the help of these entities, we try to minimize the “Trust Gap”, however, it is not absolutely purged.
Blockchain is a new ledger technology that is an enormous upgrade to our current ledger in two fundamental ways:
Every record that is written on a block chain ledger has a unique key that is associated with it
Every record is written and stamped by the trusted party that writes that record
Block chain Technology guarantees that everything that goes on block chain is going to be fully visible to everyone. We can see who wrote the record, we can add a key to that record and we can build dependencies between one record and another, essentially creating a chain of records. This is from where the term “chain” comes into “block chain”.
If anyone tries to tamper the data by adding/removing/editing any record, the algorithm is able to very quickly identify the compromised record. This creates an immutable ledger, where it is impossible to hide the act of tampering.
Quick comparison of Current and Future Ledger:
Power of Block chain:
Widespread usage of Block chain will allow humans to trust and transact in a different way. Clear benefits of Block chain include the following:
Minimization of time spent to conduct transactions
Minimization of friction involved with dealing with unknown counter-parties
Minimization of costs by removing intermediaries
Ability to connect the unbanked to the financial system, who otherwise don’t have access to basic financial services due to high fees associated
Creation of a permanent audit trail with an immutable transaction history
Creation of a permanent audit trail with improved transparency into asset origin for a “single source of truth”
Impact on Accounting and Audit Practices:
Block chain acts as an indispensable ledger – a single source of truth. It has the potential to remove the need for companies to keep and reconcile records of the same transaction in their privately managed ledgers, as both sides of the transactions can be easily recorded in a shared and decentralized ledger. Due to this functionality of the Block chain along with the power to record transactions in real-time, the conventional ways of invoicing, recording, contracts and payment processing for business is going to change forever.
Within the fields of Accounting and Audit, Blockchain is expected to reduce the potential for errors when reconciling complex information from numerous sources. Even the owners of the accounting system will not be able to meddle with the accounting records, once inputted into the blockchain. The integrity of the financial records is guaranteed as all transactions are recorded and verified in real-time. Therefore, this technology has the potential to greatly reduce or even eradicate the need for auditing resources – potentially disrupting the accounting profession as a whole. However, there are some hurdles to overcome including the cost of implementation, privacy issues, a lack of agreed standards, and limited scalability of Blockchain.
Hywell Ball, UK Head of Audit at EY says: “Accountants do a lot of transaction processing, reconciliation and control, and that could change significantly if this technology gets adopted on a widespread basis”. The implications for auditors are less clear. “Would we have to audit the chain itself or would we audit transactions?” asks Ball. “How much would we have to understand the advanced technology in the block chain to audit the start and the end of the chain? Do we have to rely on the block chain’s auditors? People are just starting to think about that now.”
It is still unclear what the precise impact of Block chain will be on the accounting and audit professions, but it is safe to assume that Block chain will greatly reduce the need for their services by automating most of their work.
Appendix 1 - Block chain technology enables complete, conclusive verification without a trusted party
Appendix 2 – Decentralized and Distributed Ledger
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