Blockchain: What You Need to Know Now

20 key concepts for now. 5 key questions for the future.

By Hitendra Patil
Accountaneur

Social media. Big data. Automation. Artificial intelligence. Machine learning. There is already a lot of technological impact on the accounting profession. Now comes blockchain.

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As a CPA, should you worry about blockchain? Let's examine.

In 2008, a mysterious person using the pseudonym Satoshi Nakamoto published a paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System” (I would urge you to read the whitepaper, https://bitcoin.org/bitcoin.pdf). The word “blockchain” was not mentioned in the paper.
Bitcoin is sometimes considered synonymous with blockchain. But that's not true. Bitcoins (cryptocurrency) are just one of the 700 or so possible uses of the underlying blockchain technology.

What is blockchain technology and how does it work?

Here are 20 key concepts to understand before proceeding:

  1. In the same way that email software uses the internet, bitcoins use blockchain technology. In other words, blockchain is not an application. Blockchain is the foundational technology. One can build applications to use this technology.
  2. Blockchain is not one single “software platform.” There are and will be multiple blockchain networks.
  3. Essentially, blockchain is a type of database that keep a record of transactions, a ledger.
  4. That database keeps getting copied and synchronized onto all the computers, called “nodes,” in the participating network. Hence, it becomes kind of a “distributed ledger.”
  5. Blockchain has fixed structures, called the “blocks,” that store the transaction-related data periodically. In bitcoins, the time in between mined blocks is about 10 minutes.
  6. Each block contains a “header,” the actual transaction data and some technical stuff.
  7. The header consists of identifiers such as reference number or the “unique block number,” the link that forms the chain of blocks and information of the previous block and the “time stamp” – i.e., the date and time of the creation of the block.
  8. The transaction data can contain, depending on the use case, a validated list of digital assets and the transaction-related instructions such as amounts, rates, quantities, the unique identifiers of the transacting parties, etc.
  9. On the internet, we currently use usernames and passwords to protect our identity and data. Blockchain uses cryptography – i.e., encryption technology.
  10. Cryptography works with public keys and private keys. A public key is a long, randomly generated string of alphanumeric value. It is the address on the blockchain network. For example, when you send a bitcoin to someone, you are sending it to the public key. Others send bitcoins to your public key – your address.
  11. The private key mathematically derives the public key. Hashing technology turns an alphanumeric input via computational process into another alphanumeric value of a predetermined length to produce the address that other people can see.
  12. Thus, when someone sends you transactions over the blockchain network, they send you a “hashed” version of the “public key.”
  13. To prove to the receiver that you actually own the digital asset (say, a bitcoin), you need to prove that you are the true owner of it. So you, the sender, use your private key and the transaction message to create a digital signature – i.e., “sign the transaction” – and that proves the ownership.
  14. Using a different mathematical computation, other nodes in the blockchain network use the digital signature to verify or validate that it corresponds to your public key.
  15. The private key is like your password for a bank login and the digital signature proves to the bank or intermediary that you have the password without the need to actually reveal the password. Blockchain does not need the third-party centralized intermediaries like banks. Nodes in the network do that job in a decentralized way to collectively confirm that you are the owner of a digital asset and that you are not “double-spending” it.
  16. The proof-of-work process of validating transaction records to add to the public ledger and linking them to blocks of past transactions is called “mining.” Those who invest and use their resources (time, computing power, electricity) are called “miners” and they are rewarded for validating transaction records.
  17. The distributed ledger is like an open book in a public room. Those in the room can read it. The identities of transacting parties in a public network are “pseudonymous.”
  18. The beauty of blockchain is that because each node in the participating network has the exact same copy of the database as others in the network, if for any reason the database on any node is deleted, reinstalling the database on that node will start synchronizing all blocks from scratch and will update itself to the latest validated block in the network.
  19. The participating network of a blockchain can be a public network – accessible to any person with an internet access – or private and permissioned network with access to only those authorized. There can and will be multiple blockchain networks, like bitcoin and Ethereum.
  20. A private blockchain network can be based on industry, profession or vendor-customer networks, wherein the public will not have access to the network and only permitted entities will be authorized to access this network. Blockchain technology is, therefore, being explored to create peer-to-peer smart contracts – without involving third-party central administrators – via decentralized application platforms. The indelibility of transaction records will make it the trusted source of information.

Blockchain in the Accounting Profession

Think of your current cloud accounting software. The cloud hosts accounting databases of your clients, with each client having its own database. You are a user and the application is on a centralized server or servers of the company that creates the accounting software. Your accounting database on that central server does not exchange and validate transactions with any other accounting databases. Thus, the traditional, current way of maintaining the trusted, but unconnected, accounting databases is to have central administrators – like banks, governments and yes, CPAs – who incur the time, effort and cost to verify and vouch for the other leg of the transaction.

Today, you trust third parties. But tomorrow, you’ll trust an immutable technology.

Again, think of the accounting database (your accounting software). You enter data into it by either inputting from paper-based documents or by fetching from banks electronically.

Where does that data originate from? It is from another accounting database – either maintained by you, another accountant or a business. The accounting databases are just used for recordkeeping of the transactions between transacting parties. The two accounting databases are not connected and do not exchange transaction data between themselves.

The "transaction" between two contracting parties passes through a third party, in this case the bank. Banks are heavily regulated, financially mighty and hence heavily invested in secure technologies. Banks are trusted to keep trustworthy records of the financial legs of the transactions between two contracting parties.

You, as an accountant, trust the bank data. But even when you, the accountant, import transactions from bank data into the accounting software, you still “authorize” the update to the accounting software by checking those transactions yourself. You also do bank reconciliations as an authenticity check to satisfy yourself that what you enter in the accounting database has indeed happened.

The "trust" is outsourced to third parties like the bank, the central administrators or the accountants. It adds to cost and requires more time to ensure trust. Even third parties need to be audited to ensure trust.

But in accounting blockchain, the application platform will not only be on the computers of transacting parties but also be on several computers (decentralized nodes). The “users” might end up using a “cloud node” instead of their own computers. Those nodes will constantly interact with each other to validate the blocks of transactions. A not-so-accurate but nicely explaining analogy would be accounting ledgers that automatically transmit blocks of transactions to other accounting ledgers that continuously validate them, and keep the copy of each block.

The simplistic explanation of blockchain in accounting can, therefore, be the “triple-entry” system. Because blockchains are ledgers, technically each of the companies can automatically “keep books” by using an accounting app to “synchronize” its books with the blockchain network.

Now, imagine when millions of companies, banks and tax authorities are creating blocks of their transactions. Blockchain technology will automatically create a “distributed shared ledger” each time the two companies create a transaction in their private ledgers. Call it the third entry into a common block, shared by two companies – the “triple entry.”

In public blockchain networks, because every user of the ledger needs to be able to see the transaction data, it raises privacy issues. Hence, accounting blockchains would most likely be private/permissioned networks, i.e., identities of transacting parties will be known to those with permission to access their own transaction records. Auditors and regulators may get timebound temporary permissions to see the records.

The computing power of several people in the network ensures that everyone has a copy of the time-stamped block of transactions. It creates trust without involving banks, third parties, central administrators.

How does one delete or change a transaction in all the chained blocks of records in several computers at once?

It would need to reverse the entire chains of transactions, on several computers at once. And all the computers in the network would reconstruct the revised chain of transactions – which will need phenomenal computing power, more than that of all the networked computers together – and extremely expensive incentives for the networked computers to do so. Who would want to pay such disproportionate costs to reverse blockchain transactions?

That is why blockchain records are called immutable. In the financial world, they use a word: "non-repudiable." When trust is built into the technology itself, why would there be any need to reconcile transactions with any third source? In other words, a transaction record in a blockchain can be trusted to be entered into an accounting system without any need to reverify itself. There won’t be a need for, say, invoices, because the transactions automatically verify themselves with each other.

What’s the impact of blockchain on your accounting processes? For starters, there would be no need to send out purchase orders, invoices or bills, as the transactions are validated continuously on the blockchain networks. When banks rely on blockchain confirmation to release payments, there is no need for bill-payment processes. And because the same pre-validated transactions exist in every node out there, there is no need for auditing them for their authenticity. That leads to several questions about how it can impact the future of the accounting profession and the accountant.

For example:

  • Why would there be a need for both the transacting parties to enter the same data separately into their own accounting software?
  • Why won’t accounting software just connect with blockchains and continually update transaction data and at the same time continually keep reconciling with bank data just to ensure payments have been made against goods or services received?
  • Why would banks or lenders need outdated financial statements from businesses or their accountants, if they can independently verify real-time transactional history?
  • One of the aims of the audit is to independently establish trust. So imagine the colossal reduction of time, effort and hence costs in data collection, organization and verification processes. What, then, happens to the revenue from your audit services?
  • Why would tax departments need to wait until the end of the year to collect taxes due if every taxable transaction can be identified while it happens in blockchain?

When is it likely to start affecting your practice? At the top 100 firms, nearly 36 percent of revenue comes from audit. That’s about $25.5 billion annually that can potentially be under threat because of blockchain. No wonder the Big Four accounting firms are already investing in blockchain readiness and ownership.

 

First published by the Washington Society of CPAs.

 

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