The Imperative for Blockchain Accounting

For hundreds of years, the basic flowchart of accounting information has been the same.  A firm records its own transactions, maintains a record of those transactions, and reports those transactions (Soll, 2014, xiv).  Trends in technology make it inevitable that this basic information flowchart will end.  In the future, multiple parties will record each transaction, and many more parties will maintain encrypted copies of each transaction.  Anyone with the required keys to access a firm’s records will be able to generate financial reports for the firm.

For historical reasons, the move to blockchain is inevitable.  Over the centuries, information records have become less able to survive as the record moved from stone to hand-written parchment, and then to printed paper.  For example, a single copy of the engraved Code of Hammurabi has survived for nearly 4,000 years.  Four copies of the hand-written Magna Carta have survived over eight centuries (number of originals is estimated between 13 and 40).  Twenty-six copies of the Declaration of Independence, out of the 200 printed by John Dunlap, have survived over the past two-and-a-half centuries.[1]

In the current computer age, each organization keeps at least one master record of its records, plus an unknown number of backup copies.  Computer storage of information has been around for only 70 years, a blip in the history of human records.  This masks the tenuous long-term survivability of computer records and their unsustainability in their current form.   Blockchain allows computer storage technology to compensate with sheer numbers of copies (nodes) for the inherent instability of any individual node in the network (Simonite, 2017).

The technology of blockchain is complicated but its function is very simple (Wizner, 2018).  Various organizations link their computer networks together.  The linked network can be either open for all (permission-less) or somehow restricted (permissioned).  Whenever two parties within the network engage in a transaction, a synchronized copy of the record is stored by both parties, as well as by all participants (nodes) in the network.  Depending on the size of the network, the number of copies of each record can approach infinity.

There are major problems with the current accounting model that blockchain will solve.  Current accounting records sit on corporate computer systems that are subject to data corruption.  Furthermore, corporations can easily alter their own computer records.  There is therefore no guarantee that corporate records are accurate: Just because a company has a spreadsheet listing their accounts receivable does not mean that it is accurate.

Relatedly, the auditing model suffers from an expectations gap between what the investing public thinks auditors are responsible for and what auditors themselves think they are responsible for (Cohen et al, 2017).   The standard auditor report, as it exists today, hardly inspires public confidence.  Investors expecting a clear vote of confidence will find nothing like it.  Auditors, who very well know that corporate records are subject entirely to the whims of management, state clearly, “management (not us) is responsible for financial statements.”  Our job, say the auditors, is “to express an opinion (not guarantee) on the fairness (not accuracy) of the financial statements.”  The public expects that auditors are responsible for the accuracy of financial statements.  They expect that financial statements are prepared by auditors themselves or at least guaranteed by them.  The auditor’s report actually assumes no such responsibility.  The expectations gap extends to a debate within the accounting academy about the extent of the profession’s responsibility for the public interest (DeFond et al, 2018).

Under the traditional auditing model, management unilaterally records transactions, maintains the records of these transactions, and then prepares financial statements based on these records.  There is no verification or reliable time-stamp at the time of transaction, and management can destroy or alter records, either willfully or through negligence.  Management can manipulate financial statements with opportunistic accounting policies and estimates.  Auditors are second-hand users of corporate data.  Management knows a lot more about its own data than even the most thorough auditor can.

A blockchain accounting system, known as a distributed ledger, will solve the problem of data reliability and will completely transform the role of the auditor.  Under blockchain, transactions are verified at the time of transaction with counterparties, resulting in a reliable time-stamp.  Accounting policies and estimates can be permanently embedded into the transaction record, making them free of opportunism by management.  Once the record is entered, management cannot alter or destroy it, as an infinite number of exact copies exist on the blockchain.

Blockchain accounting will bridge the expectation gap between investors and auditors.  Auditors will be in the position not just to review financial statements, but to actually prepare them using reliable data that does not rely on management assertions.  By automating financial statement preparation and verification, both management and auditors will be freed up to focus on more meaningful reporting.  Management will focus its reporting efforts on integrating financial and non-financial measures of performance, including measures of social responsibility.  Auditors will be freed to focus more heavily on internal controls.  Currently, auditors only express an opinion on internal controls over financial reporting.  However, the public expectation is that auditors and the audit committee also attest to compliance with operation and compliance controls.  For example, Boeing’s audit committee recently came under criticism for its poor oversight of the safety of the 737 Max (MacMillan 2019).  Traditionally, accountants would not have thought that safety oversight falls under the audit committee’s responsibility.

In summary, blockchain will allow for automated, reliable, and verifiable preparation of financial statements for routine business transactions.  Management and auditors will be able to focus more on qualitative aspects of financial reporting and to increase the scope of internal control audits.

ENDNOTE

[1] Sources: Code of Hammurabi (History.com); Magna Carta (O’Brien, 2015); Declaration of Independence (Declaration Resource Project).

REFERENCES

Declaration Resource Project (no date).  How many copies were originally made of the Declaration of Independence? Were they all signed?  Democratic Knowledge Project, Harvard University Edmond J. Safra Center for Ethics https://declaration.fas.harvard.edu/faq/how-many-copies-were-originally-made-declaration-independence-were-they-all-signed.

Cohen, J., Ding, Y., Lesage, C., Stolowy, H. (2017). Media Bias and the Persistence of the Expectation Gap: An Analysis of Press Articles on Corporate Fraud. Journal of Business Ethics, September, Volume 144, Issue 3, pp 637–659.

DeFond, M.L., Lennox, C.S., and Jieying Zhang, J. (2018) The Primacy of Fair Presentation: Evidence from PCAOB Standards, Federal Legislation, and the Courts. Accounting Horizons: September 2018, Vol. 32, No. 3, pp. 91-100.

History.com Editors (accessed November 13, 2018).  Code of Hammurabi.  HISTORY, https://www.history.com/topics/ancient-history/hammurabi.

MacMillan, D. (2019, May 5).  ‘Safety was just a given’: Inside Boeing’s boardroom amid the 737 Max crisis.  Washington Post  https://beta.washingtonpost.com/business/2019/05/06/safety-was-just-given-inside-boeings-boardroom-amid-max-crisis/?outputType=amp.

O’Brien, H. (2015, January 26).  Magna Carta: Where to visit the four surviving originals.  The Independent https://www.independent.co.uk/travel/news-and-advice/magna-carta-where-to-visit-the-four-surviving-originals-10002631.html.

Simonite, T. (2017).  Betting on the blockchain.  MIT Technology Review 120 (issue 1, January 18), 29-30.

Soll, J. 2014. The Reckoning: Financial accountability and the rise and fall of nations.  New York: Basic Books.

Wizner, B. (2018, November 20).  Edward Snowden explains Blockchain to his lawyer – and the rest of us.  ACLU Speech, Privacy and Technology Project. http://www.aclu.org.

This post comes to us from Professor Dov Fischer at Brooklyn College’s Murray Koppelman School of Business. It is based on his recent article, “Ethical and Professional Implications of Blockchain Accounting Ledgers,” available here.