Potentiality of Blockchain Technology in Accounting, Auditing and Corporate Governance
The author is an academician. He can be reached at eboard@icai.in.
1. Introduction: From Double-Entry to Triple-Entry Paradigm
The COVID-19 pandemic has upended the manual system of business process and people have commenced working digitally. When it comes to digitalization, blockchain technology cannot be ignored. This technology is storming in cryptocurrencies; there is no doubt that it may be adopted by many sectors. Especially, the finance sector may undergo transformation with this technology drastically.
“Blockchain technology may shape accounting from double entry to triple entry system. It is a foundational change in how records of financial transactions are maintained and updated.”
Blockchain technology may shape accounting from double entry to triple entry system. It is a foundational change in how records of financial transactions are maintained and updated. Rather than having one person access, blockchain records are accessible to every participant and stakeholder. A distributed ledger is a decentralised system that spreads the ownership of a ledger across multiple parties, instead of being held centrally, each with its own copy. This paper will explore some new areas where accounting records are tamper-proof, audit is reliable and consequently good corporate governance is established with blockchain technology.
2. Review of Literature & Research Objectives
Kaushal & Tyle (2016)
Examines that blockchain technology is not confined to Bitcoin, it may ignite to the content of blockchain to the height that it is in use today. Blockchain, as a technology on its own, is a more remarkable and wise innovation than that of Bitcoin.
Piscini (2017)
Propounded that there could be two main types of the blockchain accounting across the globe including public blockchains where every person has the access to the network and no permission is required to participate in the blockchain transactions; and private blockchains that are non-public and a complex form of accounting in which the permission must be permitted to an external person in order to access the network. Private Blockchains may be formed by the organisations working in a particular industry and authentication may be required.
Orcutt (2018)
Stated that blockchain was introduced to the world in 2008, and over the subsequent years it begun to fetch popularity in use due to its high level of security. The sophisticated math and innovative software technologies do not allow information to be altered in a blockchain.
Al-Jaroodi & Mohamed (2019)
Concluded that blockchain is decentralised ledger and has no central control, it has great potential benefits for many industries in terms of accounting, auditing and corporate governance.
Perera, Nanayakkara, Rodrigo, Senaratne, and Weinand (2020)
Suggested that private blockchain networks could provide reliable business software solutions to the construction industry as construction industry works with sensitive data.
Sebahattin Demirkan, Irem Demirkan & Andrew McKee (2021)
Attempted his study on “Blockchain technology in the future of business cyber security and accounting” and concluded that blockchain technology has appealing uses not only for a security system in the future with challenging threats to cyber security, but also as part of an accounting system based on its ability to be secure and transparent, and providing trust in a financial world.
Legislative & Regulatory Context: Recently, Finance Minister has also realised the safety of blockchain technology and committed to introduce ‘The Cryptocurrency and Regulation of Official Digital Currency Bill, 2021’. This may extend the use of blockchain technology to many business processes.
Objectives of the Study
- To understand the blockchain technology and its mechanism.
- To analyse the potentiality of blockchain in accounting, auditing and corporate governance.
- To examine the current issues and challenges of blockchain technology in respect to recent developments.
3. What is Blockchain? Mechanism & Taxonomy
Blockchain is a chain of blocks and distributed database which runs on many devices simultaneously through internet. Every record of transactions is accessible to all participants and one cannot alter any data without the consensus of 51% of users (Nodes). Transactions are cryptographically recorded in the blocks. Blocks are in chronological order and connected like a chain, the resulting ledger is accessed by all servers of participants. Blockchain is a ‘Chronological Distributed Immutable Ledger’ and not centralized which means it does not have a single owner. Any information added to a blockchain is stored into block form and connected together to form a chain. It securely transfers the data from one block to another block while recording any transaction without any need to rely on another intermediary. Let’s understand the blockchain coding information of transactions:
Fig. 1: Blockchain is a chain of blocks that contains information
The first block is always known as genesis block where the previous hash would be ‘Nil’. There are three things to be stored in each block. First in the form of information regarding supplier, receiver, amount, date, time etc., second is a hash, it is a unique number of blocks (similar to biometric number that one can have on Aadhar Card) and third is the hash of the previous block that links two blocks with each other. Bitcoin with blockchain is secure because every user has a copy of the database, and no one can tamper the data of any block. Similarly, accounting transactions of business concerns can also be recorded with the help of blockchain technology. Adding and verifying new transactions is done by a group of computers known as ‘Miners’. Digital contracts that execute the predefined terms and conditions are known as ‘Smart Contracts’.
Mechanism of Blockchain Technology
The following steps are derived from crypto currency mechanism to complete a transaction:
Types of Blockchain
There could be three types of blockchain applications recording different types of information. It assists to record accounting transaction, money, and store agreements between people called smart contracts.
1. Public Blockchain Network (Permissionless)
No permit is required to join Public Blockchain Network and public has direct access to this application such as cryptocurrencies like Bitcoin, Ethereum etc. It cannot use consensus algorithms as anyone can take part by verifying and adding data.
2. Private Blockchain Network (Permissioned)
Only permitted users hold a copy of a given ledger to ensure the integrity and efficiency of network like RippleNet, NASDAQ LINQ. It can use consensus algorithms as only authorised entities can participate and control network.
3. Hybrid Blockchain Network (Balanced)
It is mixture of both public and private blockchain. Participants in public or private network are granted to communicate with each other like Health- Care, Cross border payments for trade/financing.
Advantages of Blockchain Technology
Experts of blockchain are endorsing blockchain technology as it has the following advantages over the prevailing system of business process:
- Security: Security is the crux of blockchain. Since transactions are carried out using hash and previous hash of block of information on a decentralised network, it is considered tamper proof and highly secure.
- Immutable and Accuracy: All the transactions are recorded in real time through blockchain systematically with accuracy and reliability. It cannot be altered easily once the transaction is completed.
- Cost: Data recording takes place in real time and no intermediaries are involved, therefore cost is less as compared to cost involved in traditional systems.
- Transparency: Recording of all transactions into blocks is transparent to all participants involved in a system. The transaction originates with one user but propagates to a network of identical ledger, instead of being held centrally controlled.
4. Recent Developments Driving Long-Term Impact
There are some recent developments that could drive blockchain’s long term impact in key areas:
Multi-Organisational ERP
Linking ERP systems could create an over aching ‘super ERP’ for resource planning across organisations. Integration with ERP will bring in transparency of the origin, movement, and possession of goods.
Financial Transformation
Banks and other financial institutions can move assets with more efficiency and offer new investment alternatives/products. At the initial stage, blockchain is being used by the banking sector for tracing credit information (CIBIL) of loan applicants.
Tokenisation
It is a process of converting tangible and intangible assets into blockchain tokens. Digitally representing anything has recently acquired a lot of traction. It can be effective in conventional industries like real estate, artwork etc. Governments are piloting blockchain to record asset registries such as corporate shares and land.
Blockchain-Fuelled Artificial Intelligence
Unleashing machine learning algorithms on a flood of new, far-reaching data will drive more effective pattern matching and predictive analytics. It may assist in projection of any investment in the best possible manner.
Decentralised Identity Management
Tokenizing a person’s identity can give them more convenience and control over how they share credentials. Healthcare and life science are discovering the use of blockchain to secure the integrity of electronic medical records, claims, medical billing, etc.
Supply Chain Transparency
Improved interoperability and data integrity could give suppliers and consumers visibility into a product’s entire lifecycle starting with raw material.
5. Blockchain and Accounting: The Three-Dimensional Model & Triple-Entry System
After understanding blockchain, applying it to accounting is not difficult. Blockchain as a system of universal entry bookkeeping that can increase the efficiency of the process of accounting for assets, liabilities, capital, revenue and expenses. This would empower the accounting profession to explore its scope to record more types of business events than before and to drill down closer to the economic reality of transactions recorded on real time that may help in attaining the objective of ‘Substance over legal form’.
Three dimensional views of account under blockchain technology may be bifurcated into:
- Nature of Accounts
- Assets
- Equity and liabilities
In order to provide a better presentation, also mapped in figure 2, the possible three-dimensional graphic according to these three aforesaid perspectives: vertical axis – above - economic accounts, below - financial accounts; concentric circles – external circle - long term; inner circle - short term; horizontal axis –accounting equation / left side - Assets, right side - Equity and Liabilities are illustrated as follows:
Fig. 2: The possible three-dimensional outlook of account under blockchain environment
| Perspective / Axis | Left Side: ASSETS | Right Side: EQUITY + LIABILITIES |
|---|---|---|
|
Vertical Axis (Above): ECONOMIC ACCOUNTS |
External Circle (Long Term): Tangibles & Intangibles Inner Circle (Short Term): Inventory and other suspended resources |
External Circle (Long Term): Equity Capital Inner Circle (Short Term): Expenses accrued in the period; Revenues accrued in the period |
|
Vertical Axis (Below): FINANCIAL ACCOUNTS |
Inner Circle (Short Term): Cash; Receivables (operating & financing) External Circle (Long Term): Financial Investments |
Inner Circle (Short Term): Current Liabilities (operating & financing) External Circle (Long Term): Non-Current Liabilities |
The three-dimensional view is an extension of the double-entry system. The distributed registry and other features of the blockchain may benefit accounting wherein reduction in human error, low risk of fraud (as penetration and manipulation under blockchain is not possible), automation of system, increase in reliability in financial reports etc. could be possible. Many experts believe that fully automated accounting and audit can become a reality.
Fig. 3: Triple Entry Accounting Under Blockchain
Fig. 3 explains that Company A & Company B will record the transaction in their books in usual manner but the same will be recorded in the block of blockchain. This will be verified by the miner as per the smart contract, wherein all the details of transaction are shared between both the companies. The shared ledger in the blockchain is like a receipt as per which recording is done in the books of both the parties. Hence, there is no chance of error of commission in accounting.
Operative Business Transactions Facilitated by Blockchain
Accounting profession deals with recording, measurement, communication of financial transactions and interpreting the result thereof. Blockchain from accounting prospective, it has the potential to increase the efficiency of the accounting profession by bringing down the cost of maintaining, updating and reconciling ledgers. It may assist accountants to find out with clarity about the available resources and liabilities of their organizations. It may facilitate the operative business transactions in following manner:
- Secure to pay regarding purchase orders: Every purchase order can be recorded digitally on real time with acceptance of suppliers’ terms and conditions. Payment can be activated mechanically based on availability of funds and due date, once material is received as per the order parameter.
- Automated Customer Collections: Similarly, every sales order can be recorded into block and payment from customers can be activated automatically after receipt of goods or rendering of services by customers.
- Timely Books Closure: It can make possible to close books of account of business process on time. Transactions are digitally recorded and updated on a daily basis automatically under blockchain technology. Accountants need not work overtime for closure of books of account.
- Accurate GST Records & ITC Scam Eradication: Accurate records of supply under GST, whether received or supplied can be maintained, thereby smooth flow of Input Tax Credit (ITC) would be feasible. Moreover, automated recording of transaction into blocks, scam on ITC could be eradicated.
- Instantaneous Financial Planning & MIS: Effective financial planning, MIS, financial reporting etc. could be carried out instantaneously and in efficient manner as compared to prevalent accounting system.
- Smart Contract Revenue Recognition: Recognition of revenue for financial transactions can be booked in a perfect manner as it would be automatically triggered through smart contracts.
- Automated Tax Return Filing (CBDT & CBIC): Direct tax return filing and GST return filing would be done through automation and technology to control and monitor all these processes accurately. Hence, tax collection, the burden of Central Board of Direct Tax (CBDT) and Central Board of Indirect Tax and Custom (CBIC) would be eliminated. Direct access of public ledger by Government can be envisioned.
- Immutable Reliability: The best part of blockchain is that all users can have a copy of the ledger, but data will remain immutable. It cannot be altered after completion of transaction and ensures reliability and authenticity of data at any point of time in the future.
6. Blockchain and Auditing: Elimination of Redundancies & Continuous Assurance
Stakeholders believe in the auditor appointed by management to reach out to opinion for them. An inevitable question raised by this arrangement: Do auditors perform their duty for the management who pays them or for the stakeholders who rely on their opinion to make investment decisions? Such types of circumstances can be eliminated under blockchain environment.
“Blockchain technology will facilitate the organisation with traceability, easy retrieval and archives of all transactions entered through blocks at a lower cost.”
Having understood the structure of blockchain technology, the biggest advantage in accounting, is elimination of fraud and error while recording the financial transactions. Accounting procedures are secured, trustworthy and reliable in a blockchain environment and hence it is possible to eliminate many audit procedures while auditing books of account by auditors. Audit procedures like getting confirmation of balance from debtors and creditors, reconciliation of bank statement, intercompany transaction etc. will be removed from audit.
Auditors will be forming opinions on system controls and security of database of the organisation. There would be a possibility that audit work might be carried out by auditors as well as software engineers. ‘True and Fair’ view will be ensured for financial statements as well as types of blockchain technology adopted by organisation.
Blockchain technology will facilitate the organisation with traceability, easy retrieval and archives of all transactions entered through blocks at a lower cost. It also records the exact date and time of transactions when data was recorded. Recording back dated transactions will never be possible in such an environment. There will be always conclusive evidence for any financial transaction under the blockchain environment. It enables conclusive verification without confirmation from third party.
Triple Entry Accounting under blockchain being a source of trust can replace today’s accounting structures. It can be consolidated gradually with classic accounting processes: commencing from securing the reliability of records, to entirely transparent audit trails. Eventually, completely automated audits may be the factual and expected truth.
Fig. 4: Blockchain Technology Enables Automated Audits That Can Satisfy All Users
- Every transaction becomes “notarized”: The cryptographic attestation creates instant validity.
- Complete and automated audit of all transactions: Continuous real-time algorithmic auditing replaces periodic post-mortem sampling.
- Simultaneous Dual-Accounting: Blockchain entry serves simultaneously in both companies’ accounting ledgers.
- Unified Regulatory & Stakeholder Node Access: Automated audit procedure connects auditors, tax authority (CBDT/CBIC), banks, and courts as active participant nodes on the blockchain network.
7. Blockchain and Corporate Governance: Inculcating Unimpeachable Integrity
Corporate governance across industries plays a very crucial role in inculcating integrity of business concerns, especially in listed companies on stock exchanges in India. Ministry of Corporate Affairs (MCA)/Securities and Exchange Board of India (SEBI) has taken many initiatives and measures to implant better corporate governance in companies. In spite of that, regulators faces hurdles ensuring implementation of the governance procedures. There is a need of transparency in disclosure and reporting of all financial transactions with compliance of laws. The comprehensive solution for desired governance in corporate bodies could be blockchain technology.
“Payment of direct and indirect taxes can be self-operated and self-regulated. There will not be any scope of fraud and error in filing tax returns by business concerns.”
Transparency is one of the most important features in this technology. There will be transparency between stakeholders and the management of company under blockchain environment. Each required compliance can be updated timely in the system and automatically mechanised, which can also be transparent between regulatory body and the management. Annual General Meeting (AGM) and other flaws in disclosure and presentation of transactions in financial statements can be automated and mechanised. It may reduce shareholders’ voting cost and increase voter verification mechanism.
Payment of direct and indirect taxes can be self-operated and self-regulated. There will not be any scope of fraud and error in filing tax returns by business concerns. Any kind of ITC fraud or delay in tiresome rituals of finalising books of accounts can be avoided under blockchain scenario. Government may contemplate it for pellucid public records to escape from corruption or any other allegation. Smart Contracts of blockchain technology cannot let terms and condition of contractual agreement be diverted or amended or manipulated once entry is finalised. This can also increase the decision-making capacity of management and involving parties in that particular business in a speedy manner.
Blockchain experts consider this technology to be most suitable for recording ownership of real estate, stocks, bonds, debentures or any other assets belonging to a company. The entire history is traceable regarding any belonging of a company. Any type of collusion, window dressing, discrepancy in agreement about corporate governance is not possible by one person. Eliminating or modifying records of transaction cannot take place in governance without 51% of node consensus. Feasibility of source of financial transactions and ownership can facilitate the organisation to reduce or eliminate frauds. Additionally, all stakeholders can see to all transactions whereby authenticity and transparency can be incorporated in corporate governance under blockchain environment.
8. Current Issues and Challenges of Blockchain Technology
Of course, advantages and disadvantages are two faces of any technology. Technology is desirable to be used when there is excess of benefit over cost. Aforesaid challenges are to be addressed before using blockchain technology in accounting, auditing and corporate governance:
1. Inappropriate Audit Evidence & Off-Chain Risks
Recording a transaction in a blockchain may be lacking with appropriate audit evidence related to the nature of the transaction. It does not ensure that a transaction recorded in blockchain is not unauthorised, fraudulent or illegal. It could be executed between related parties or linked to a side agreement that is “off-chain”. After considering the complex nature of IND AS, it may incorrectly be classified in the financial statements. Blockchain technology is still not a complete solution, but technology can be transformed according to the need of accounting and auditing.
2. Absence of Statutory Regulatory Body
Absence of monitoring and controlling body under blockchain technology is a perturbing matter. Regulation is a serious issue under blockchain technology. When it is related to accounting, auditing and corporate governance statutory compliances are required to authenticate the financial transactions but there is no statutory regulation for this unique technology. There must be some regulations for ‘Node’ and ‘Miners’ to regulate this system.
3. Environmental Degradation & Energy Intensity
Very high-power consumption under this technology may have adverse effects on environment. Excessive usage of technology may lead to depletion of natural resources. ‘Proof of Work’ automated system is used to attest a transaction and it also requires huge, tremendous computational energy. Hence, sustainability development will be questionable under blockchain environment.
4. Technology, Latency & Cryptographic Risks
It is related to technology integration, associated IP protection, data privacy and speed and performance. A huge calculation takes on an average 10 minutes to complete the recording of transaction. It may be a delaying factor if the volume of transaction is high per day in business concern. Consensus protocol risk may also be a tough challenge in blockchain. No doubt consensus protocol seals the transaction ledger, though there is chance of private key robbery and ultimatum to assets associated with public.
5. Reporting and Controlling Risk
As this technology is not controlled by one person, it may be a threat to the chain of funding, controlling of financial transaction in place and financial reporting risks. It may be an open ended path for illicit activities.
6. Risk of Liquidity
Excessive use of blockchain technology may lead to liquidity risk. Bank for International Settlement has also warned that excessive usage of blockchain may boost the risk of liquidity. Maintaining cash balance in business concerns is very important to meet day to day business expenses.
9. Conclusion: Synthesizing Blockchain with Future Governance
“Blockchain technology is prominent in cryptocurrency. This technology could be implemented in accounting, auditing and corporate governance successfully in future after addressing challenges and threats.”
Presently, blockchain technology is prominent in cryptocurrency. This technology could be implemented in accounting, auditing and corporate governance successfully in future after addressing challenges and threats. Automation of system with smart contracts may lead to flawless and ideal confirmation of debt between organisations as well as account receivable/payable and balance check. Moreover, customised blockchain enables restricting access to data to different parties as per their role.
Accounting and auditing standards can be automatically programmed to set uniformity in triple-entry accounting system of blockchain. Tax return filing can also be automated through continuous updates as per CBDT and CBIC announcements.
Furthermore, prompt examination of expected fraud and errors in accounting entries and timely transaction verification under automated system of blockchain may result into highly satisfactory audit opinion and the finest corporate governance.
10. Academic References
- Alessio & Narcisa, 2019. Accounting and blockchain technology: from double-entry to triple-entry, The Business and Management Review, Volume 10, No. 2, pp. 108-116.
- Dai, J, & Vasarhelyi, M., 2017. Toward Blockchain-Based Accounting and Assurance, Journal Of Information Systems, 31, 3, pp. 5-21, Business Source Complete, EBSCOhost.
- Brender, N., Gauthier, M., Morin, J.-H., & Salihi, A. (2019). The potential impact of blockchain technology on audit practice. Journal of Strategic Innovation and Sustainability, 14(2), 35–59. Retrieved from https://doi.org/10.33423/jsis.v14i2.1370
- Chan, D. Y., & Kogan, A. (2016). Data analytics: Introduction to using analytics in auditing. Journal of Emerging Technologies in Accounting, 13(1), 121–140. DOI:10.2308/jeta-51463