Accounting on Blockchain
Existing System – Double Entry Systems of Accounting
Double Entry Accounting which evolved from Europe in 14th Century has been key to maintaining accounts across the economies of the world.
In the double-entry accounting system, at least two accounting entries are required to record each financial transaction. These entries may occur in asset, liability, equity, expense, or revenue accounts. Double-entry bookkeeping is based on balancing the accounting equation, which in simple terms states that all entries on the asset side must be equal to all assets on liabilities side. The accounting equation serves as an error detection tool; if at any point the sum of debits for all accounts does not equal the corresponding sum of credits for all accounts, an error has occurred. However, satisfying the equation does not guarantee a lack of errors; the ledger may still "balance" even if the wrong ledger accounts have been debited or credited.
The Primary issue, in Double Entry System of Accounting is that there is no connection between two separate sets of books of accounts. In case of 2 organizations which deal with each other have two separate independent books of accounts and in most cases, these never reconcile with each other. Generally, Finance Controllers or Managers or Independent Auditors of organizations in reconciling the difference of balances between two organizations. Consider the amount of time & resources spent by the organizations which have thousands of vendors or suppliers.
Everything is about automation in business. If there’s a task that’s still being performed manually, it’s costing companies time. To achieve its daily targets the industry still relies on mutual control mechanisms, checks and balances. This affects every day’s operations. Among other things there are systematic duplication of efforts, extensive documentations and periodical controls. Though modern day ERP systems most of these issues, to this day most of these are manual, labour-intensive tasks and they are far from being automated.
The Double Entry System does solve the problem of giving the true picture of an organization but does not authenticate the accuracy of the actual happening of those transactions. Double entry system does provide does provide the insiders of the organization an understanding and trust on their financial position/information. However, to gain the trust of outside stakeholders the organization has to rely independent audits, checks and controls to verify the financial information of the organization.
Speaking of which, Double Entry Accounting System is prone to frauds, which can be witnessed across the world in form of accounting scandals, which have led to massive loss to investors and shareholders across the world, which involved some of the biggest Auditing Firms in the world. An Accounting Fraud can happen by way of Misappropriation of assets or Fraudulent financial reporting.
A Look at the recent Accounting Scandals in a Snapshot.
A Note worthy point is that, not all accounting scandals are caused by those at the top management level. In fact, in 2015, 33% of all business bankruptcies were caused by employee theft. Often middle managers and employees are pressured to or willingly alter financial statements due to their debts or the possibility of personal benefit over that of the organization, respectively.
In most cases the auditors who are appointed by the investors or shareholders to verify the authenticity of the financial information of an organization itself are involved in the accounting scandals. Arthur Andersen formerly one of the Big 5Accounting Firms bite dust and filed for bankruptcy in the year 2001 after the Enron Accounting Scandal surfaced. In most of these cases the respective partners of these accounting firms involved in accounting scandals have been penalized or even imprisoned. However, the losses incurred by an investor or shareholder due to these accounting scandals are irrecoverable 90% of the cases.
Solution –Tripe Entry System of Accounting using Block Chain Technology
Way back in 1989Japanese accounting researcher Yuji Ijiri, who was also a professor of Accounting and Economics Carnegie Mellon University, published a monograph ,entitled “Momentum accounting and triple-entry bookkeeping,” but hadn’t found away to apply it.
In the year 2005Financial cryptographer Ian Grigg wrote a paper of Triple-Entry Accounting, where he states “The digitally signed receipt, an innovation from financial cryptography, presents a challenge to classical double entry book keeping. Rather than compete, the two melded together form a stronger system. Expanding the usage of accounting into the wider domain of digital cash gives 3 local entries for each of 3 roles, the result of which I call triple entry accounting.”
Ideally, from the Ian Grigg’s Paper on Triple Entry Accounting doesn’t necessarily mean a third entry has to replace the double entry system. The Third Entry is basically a cryptographically sealed entry on blockchain by 2 parties to a single transaction jointly instead of on separate books of accounts of each of the parties.
For Example: A(Seller) books a debit to account for cash received, while a B(Buyer)books a credit for cash spent in the same transaction, but in separate sets of accounting records. This is where the blockchain comes in, rather than these entries occurring separately in independent sets of books, they occur in the form of a transfer between wallet addresses in the same distributed, public ledger, creating an interlocking system of enduring accounting records. Since the entries are distributed and cryptographically sealed, falsifying them in a credible way or destroying them to conceal activity is practically impossible.
A Look at the above example gives us clear picture that to the regular double entry transactions of two parties A & B are recorded jointly into a blockchain as a third entry. The digitally signed third entry/receipt dominates the two entries of double entry because it is exportable, independently verifiable, and far easier for computers to work with.
Having a ledger that easily shows the entire string of related transactions would not only provide excellent audit records, it would allow both parties to a transaction to have real-time status updates. Every time the blockchain is updated with anew record, both parties to the transaction are able to immediately see the update. There by eliminating huge of amounts of resources & time incurred by organizations in reconciliation of ledgers between suppliers/vendors.
Features of Blockchain that can be used in accounting
Distributed ledger technology (DLT) is a digital system forrecording the transaction of assets in which the transactions and their detailsare recorded in multiple places at the same time. Unlike traditional databases,distributed ledgers have no central data store or administration functionality.Thevry nature of a decentralized ledger makes them immune to a cyber-crime, asall the copies stored across the network need to be attacked at the same timefor the attack to be successful. This means all stakeholders – accountant,auditor, client, regulator – will have an identical copy of the ledger at alltimes, shared across a peer-to-peer network of nodes (computers) spreadacrossmultiple sites.Additionally, the simultaneous (peer-to-peer) sharing andupdating of records make the whole process much faster, more effective, andcheaper.
Permissioned blockchains allow for a mixed bag between the public and private blockchains and support many customization options. These include allowing anyone to join the permissioned network after suitable verification of their identity, and allocation of select and designated permissions to perform only certain activities on the network. For example, Ripple, one of the largest cryptocurrencies, supports permission-based roles for participants.
Businesses are increasingly opting for permissioned blockchain networks, as this allows them to selectively place restrictions while configuring the networks, and control the activities of the various participants in the desired roles.
Publicly shared ledgers need an efficient, fair, real-time, functional, reliable, and secure mechanism to ensure that all the transactions occurring on the network are genuine and all participants agree on a consensus on the status of the ledger. This all-important task is performed by the consensus mechanism, which is a set of rules that decides on the legitimacy of contributions made by the various participants (i.e., nodes or transactors) of the blockchain. There are various consensus mechanism’s such as POW (Proof of Work), POS (Proof of Stake), POC (Proof of Capacity), POA (Proof of Activity)& POH (Proof of History/Elapsed Time). These can be tailored to business needs.
Smart contracts are simply programs stored on a blockchain that run when predetermined conditions are met. They typically are used to automate the execution of an agreement so that all participants can be immediately certain of the outcome, without any intermediary’s involvement or time loss. They can also automate a workflow, triggering the next action when conditions are met.
The Advantages of Accounting/Invoicing on Blockchain are
One of the biggest advantages of blockchain in accounting is its ability to make almost negligible errors. Once data is in the chain, smart contracts will make many accounting functions automatic, reducing human error.
Blockchain is fast and powerful database. Using blockchain, getting data into and out of the system can be done more efficiently than interacting with legacy accounting software applications.
Blockchain will lead to increased efficiency and reduction in errors which will eventually lead towards cost reduction. Following initial adoption cost, organizations can expect to see rapid cost savings over conventional accounting systems.
Reduction of Frauds
The immutable nature of blockchain makes it extremely difficult to perpetrate and difficult to manipulate. In order to modify a record, the same change would have to be made on all copies of the distributed ledger at the same time, which is highly infeasible.
One key feature of blockchain that organizations should be excited about is its ability to reduce audit time. With the use of smart contracts, many auditing functions can be automated which will reduce the time, an auditor needs to look after the records. The inherent traceability built into blockchain makes auditing fast and easy.
Problems in Mass Adoption of Blockchain in Accounting
Looking at the advantages and features that blockchain promises, one may think what stopping organizations from mass adoption of blocking in daily accounting. Here are some of the key factors to looked into in order for mass adoption of blockchain in Accounting Systems.
Resistance to Change
Organizations and Audit Firms have poured billions of dollars into traditional Accounting ERP systems for training of resources. Hence retraining of these resources into DLT based ERP systems will take time and resources.
ERP or Accounting Systems on DLT/Blockchain are still at a very nascent stage, whilethe blockchain technology itself got its prominence in last few years. The existing DApps built on various blockchains are yet to gain complete ease to use capabilities. Hence, innovators and investors would have come up with more user-friendly accounting solutions on Blockchain platforms to satisfy the needs of organizations at large.
Fearful of making transactions public
Organizations can be terrified at the concept having their transactions on public domain revealing many of their competitive advantages to the competitors. However, this issue can be solved by way of utilizing permissioned blockchains instead of permission less blockchains, where the organizations have ability to allocate specific permissions to various users similar the existing ERP Systems.
Although there are no specific restrictions on usage of blockchain accounting, mass adoption would definitely require the support of governments, as organizations tend to adopt technologies faster in form of pressure from the regulatory authorities than on self adoption basis. Government’s world over are typically slow in adoption of any new technologies, we have seen the same in case of Internet, they take their considerable time to analyze and understand the implications of any new technology before considering mass adoption.
Considering the emergence of blockchain technology over the last decade in a revolution by way of cryptocurrencies or payment systems and their mass adoption, several other sectors are looking at use cases on how blockchain or distributed ledger systems can transform each of those industries. We may not be far away from days where each transaction created in the books of every entity will reflect a single truth with the help of blockchain and distributed ledger technology.