Blockchain technology has accelerated transformations for all types of business functions—from enabling cryptocurrency and smart contracts to improving supply chain management and traceability to storing health data and medical records.
So it’s no surprise that many experts are eager to cast blockchain as the future of accounting record-keeping. One hope is that blockchains will be a more reliable alternative to traditional ledgers because, supposedly, no one can retroactively alter them. They praise blockchain’s potential to assure accurate transaction data, improve audit trails, and make financial transactions more transparent—all contributing to greater public confidence in published financial reports. It might even be possible for blockchain-based financial information to be made visible immediately to shareholders, creditors, business partners, government agencies, and other interested parties.
The Big 4 accounting firms (KPMG, Deloitte, PwC and EY) have suggested that accountants, auditors, and regulators will be significantly impacted by blockchain and consensus-driven distributed ledger technologies (DLT). These tools can affect how transactions are initiated, processed, recorded, reconciled, audited, and reported. The supply chain is a particular focus, because of how blockchain can encompass revenues, expenses, receivables, payables, inventory, and payment infrastructures representing the greatest number of transactions in most organizations. Business publications such as Forbes have touted the “unbreakable protection” blockchain can provide to accounting information and new roles for accountants and auditors.
However, the reasons for not using blockchain for financial systems are less widely discussed. The negative implications include the loss of organizational confidentiality, the reality that blockchain won’t decrease the likelihood of inappropriate revisions to information, and that transaction errors, manipulation, and accounting fraud are still possible.
So let’s further explore blockchain and amplify these concerns.
Blockchain Background
Accounting ledgers are necessary to track economic transactions, taking the form of databases, and several proprietary and open-source solutions exist with similar fundamental characteristics. The blockchain is another emerging database that functions as an alternative to conventional ledger technology.
Many authors suggest blockchain can be applied in accounting and enterprise resource planning (ERP) via DLTs. These are systems in which all nodes of a network have a duplicate copy of the database that can be read and modified independently. Copies of the database can be consulted by individual nodes in the so-called distributed database but must go through a central body (or more validators) to modify the data. And every member of the network can vote on the true set of transactions.
This system replaces the role of a central authority, and the set of transactions accepted by most of the network is treated as the accurate blockchain. Consensus algorithms are used to reach an agreement between the various ledger versions, even though they are updated independently by the network participants. Cryptography is applied to maintain the security and immutability of the distributed ledger and blockchain.
The primary and most interesting difference between traditional databases and the blockchain is blockchain’s novel solution to control. Each new block of transactions added to the end of the chain is linked to the prior block. Any attempt to manipulate a prior transaction requires a re-processing of all subsequent blocks in the chain, and this activity would need to outpace the rate at which new blocks are added to the chain. As a result, many view the blockchain as immune to manipulation, creating the main draw to adapt it to accounting as a transaction ledger.
Seeking Confidentiality
Conceptually, blockchaining the general ledger would allow financial information to be more transparent, secure, and permanent. And organizations implementing blockchain would gain public trust through confirmation of accurate numbers—without error or the chance to fail. With information posted to the public blockchain, anyone can become further nodes, auditors and lawyers could provide explanations about the information, and investors would be able conduct further research to make more informed decisions and develop improved strategies with their use of the blockchain. Also, firms would be posting source documents for the statements and balance sheets, and the information could then be generated into those different statements and ledgers. However, all of this is contrary to firms’ implied desire for confidentiality.
Confidentiality is not a feature of the blockchain solution because it relies on the distributed nature of its database. In the absence of a central authority, the network must agree on current account balances—the true list of past transactions. This requires open publication of the entire blockchain. Historically, firms have avoided publishing their ledgers, because they prefer the confidentiality that private ledgers provide. And that’s not surprising because vendor and customer lists, unit costs, and strategic transactions (such as details of R&D expenditures, capital investments, or marketing expenditures) are stored in ledgers and can constitute competitive trade secrets.
A permissionless blockchain is available to anyone who wishes to view it—and anyone can verify the next block in the chain. No access controls or authorization protect reading or writing to this blockchain. On the other hand, a private, permissioned blockchain is more like a traditional transaction ledger. The owner keeps its contents confidential, and only those users with read and write permissions have access to it. Although the security and confidentiality of a private blockchain might appeal to a firm, without the public distribution, investors can’t directly participate in this network. The network reverts to only two participants (firm and auditor). A blockchain that is private fails to offer advantages over existing systems.
Another network could involve the firm, its vendors and/or customers, and the auditor, but this would require that the supply chain network adopt the same blockchain technology. Even if all members of a single supply chain adopt the same technology, different supply chains might adopt different technologies which could force a single firm to have multiple duplicate blockchains. This is already a problem in the cryptocurrency area because different currencies have different, incompatible blockchains—and it would present a significant hurdle to adoption in this setting, too.
However, when compared to other limitations of blockchain in accounting, there are many ways to solve the problem of privacy. One of the basic tenets of cryptocurrency is to promote privacy. This may be accomplished by replacing transactions in a blockchain with hashes of these transactions to preserve transaction verification and consensus without revealing private data to third parties. As a result, confidentiality might not pose permanent risks to the adoption of public or private blockchains for accounting, but the desire for privacy inherently discourages the transition to blockchain for financial recordkeeping.
Retroactive Manipulation
Even firms that elect to distribute their blockchains to the public need protection from inappropriate revision, a protection that isn’t certain. So-called proof-of-work is designed to prevent retroactive modification of the blockchain because it requires a manipulator to amass 51% of the computing power to make revisions. A firm with a private blockchain automatically has 100% control over transaction validation, and it can rewrite any portion of the blockchain. A security breach could place this same 100% control in the hands of an unauthorized party, who could proceed to rewrite the blockchain.
If the firm used a distributed blockchain, the firm would likely retain much more than 50% control over the blockchain—and the role of primary maintainer would fall to the firm itself. There’s also a proof-of-stake model, where pledging cryptocurrency holdings, or possibly shares of stock, can vouch for the accuracy of newly added information. Whether the model is proof-of-work or proof-of-stake, current and potential investors would have little incentive to verify transactions because of the cost and/or the accounting knowledge and insider access needed to verify an accounting transaction. This would return most of the control to the firm, resulting in the same problem as with a private blockchain.
One method for restricting the amount of computing power left with the firm could be to require the auditor to actively participate in the transaction verification process. This could shift as much as 50% or more of the control away from the firm. Furthermore, even if the firm insisted on a private blockchain, it couldn’t restrict access from the external auditor, so this option would remain available in situations with both public and private blockchains. However, if the only transaction verification participants are the firm and the auditor, then blockchain oversight and verification levels would be little more than what already exists between a firm and its external auditor. Furthermore, if permissioned blockchains require a higher level of transaction verification by an auditor, then firms would need to pay significantly higher audit fees and regulators would need to evaluate the viability auditing their own verified transactions. Both unresolved issues discourage blockchain adoption for existing databases with the current level of auditor oversight.
Accounting Errors, Manipulation, and Fraud
Unfortunately, blockchain technology can’t prevent many accounting errors and is unlikely to significantly limit data manipulation or accounting fraud.
Blockchain verification methods are geared to prevent spending the same unit of currency more than once— not to determine transaction accounting validity. Data provenance—tracing and verifying the origin, history, and quality of it—is the problem confronted in financial reporting. The highest volume of transactions generally occurs in connection with sales (receivables) and expenses (payables). In both cases, two parties have access to this information and discrepancies are usually short-lived. Transactions that are likely to result in material errors or facilitate fraud don’t involve outside parties. Instead, sources of fraud are often found in estimates that are subject to judgment and not easily substantiated by unsophisticated, independent parties. Examples include accruals, lower-of-cost-or-market adjustments, write-offs, pension and warranty adjustments, and depreciation. Also, errors in original entries and schemes involving collusion among internal and with external parties might not be preventable.
Even if the auditor and the firm shared transaction verification responsibility that also couldn’t rewrite the blockchain, transaction verification would still remain ineffective. Transactions that involve financial, management, or tax accounting records occur independently of their measurement. A maintainer would need to confirm that the transaction captures a verifiable economic event, that its value is consistent with accounting principles, and that no economic events have been overlooked. And blockchain maintainers don’t know whether the amounts are reasonable or if an agreement exists between two parties that resulted in an asset transfer. Blockchain can only reveal whether the transaction uses unspent resources and is digitally signed.
Accountants already know that controls are necessary to prevent fraud, earnings management, and accounting errors—and the adoption of a blockchain will not dispense with the need for these. For example, a blockchain will not prevent asset misappropriation, nor will it prevent erroneous measurement or estimation of valid transactions. The difficulty arises mainly because of the difference between asset transfer (i.e., a transaction) and the recording of asset transfer (i.e., financial reporting). The blockchain as a database is not merely a record of transactions; it handles digital asset transfers. This is one reason why it’s useful for smart contracts. All cryptocurrency exists exclusively within the blockchain, so the blocks in the chain are asset transfers, not simply records of asset transfers. Financial accounting, however, is transaction measurement.
Following the model of smart contracts, it might be possible to program a blockchain to record a transaction according to predetermined accounting rules. Unfortunately, it’s not feasible to condense accounting regulations into a series of programmable, computer-interpretable commands. Why? Accounting standards are not rigid but often involve judgment in their application. If it ever becomes feasible, perhaps with the addition of an artificial intelligence component, automating the recording of transactions would apply to traditional databases and ERPs, as well. However, it’s highly unlikely that management would wish to cede its judgement to a machine.
Given the limitations, it’s not clear that a blockchain would be an improvement over a traditional ERP system that’s designed to solve specific accounting problems, such as tracking accounting transactions. Firms already have methods in place for verifying transactions. They also already restrict access and establish audit trails to prevent retroactive manipulation of traditional ledgers. Furthermore, auditors can receive distributed or shared copies of transaction ledgers and independently verify the transactions without the use of a blockchain. Investors can receive relevant information without access to transaction lists. Even if they desired and received transaction lists, it’s not clear that a blockchain would increase the reliability or transparency of the numbers.
Blockchain Quandary
Changes in the business world will always impact the accounting profession, but not every new business technology will lead to advancements in accounting. In this case, the fervor for blockchain doesn’t match its practical value. There’s no doubt that some of blockchain’s characteristics, such as encrypted accounts to promote counterparty confidentiality in financial transactions, might insight future accounting innovations. But for now, blockchain doesn’t compensate for the likelihood of errors, data manipulation, or fraud.
Blockchain technology continues to develop processes to verify transactions, compatibility across blockchain platforms, and the automation of financial reporting. But what are the true problems with accounting ledgers that blockchain technology might solve? Are we searching for a solution to a specific problem or for a problem to apply a new solution? It seems more the latter.
