What is a Distributed Ledger in the World of Blockchain?
by Albert Traverso, CPA, Sax LLP –
March 4, 2019
It is quite clear that blockchain will greatly impact the accounting profession. The financial services industry will be significantly altered by this new technology as current business models for processing transactions will change with the use of blockchain. Just how significant and how soon CPAs will begin feeling the impact remains to be seen.
Blockchain is a network that provides for the recording of transactions using complex algorithms and encryption that results in transactions being secure, irrevocable and available to everyone who would want or need to know about the transaction. Blockchain has the potential to impact audit engagements by rendering traditional audit tests redundant and unnecessary. Inherent self-checking safeguards that are built into blockchain address several assertions at the account balance and transaction level that traditional audit techniques would otherwise address in an audit engagement (existence, occurrence, and rights and obligation to name a few). However, it will also open new opportunities where accountants and firms can find value.
Blockchain v. Bitcoin
In 2009, the digital cryptocurrency Bitcoin was launched. While Bitcoin and blockchain are often mentioned together, it is important to make a key distinction between the two. Bitcoin is not synonymous with blockchain. Bitcoin is a currency, and blockchain is the technology that supports the bitcoin network. It may help to think of blockchain as an operating system like Microsoft Windows and Bitcoin as an application that runs within the operating system environment. Bitcoin is just one of the first applications that uses the blockchain technology. Since blockchain facilitates the process of recording financial transactions and tracking financial assets, virtually anything of value that is tangible (real estate, a car or cash) or intangible (intellectual property, patents or copyrights) can be tracked and traded on a blockchain network. Bitcoin is just one example of how assets with value are exchanged.
Blockchain enables companies to create an environment (a blockchain network), where transactions are recorded, stored and can be viewed by everyone with access to the network. On a blockchain network, transactional information is shared and/or distributed across the entire network to all users. Instead of each party to a transaction maintaining their own database of transactions, blockchain network users share the same data. Each network user has an identical copy of the transaction, which eliminates the need for reconciliation between parties that transact with each other.
Since blockchain deals primarily with the transfer of ownership of assets and maintains a ledger of accurate financial information, it will indeed be leveraged by the accounting profession when it comes to the measurement, communication and analysis of financial information. With that, blockchain will lead to more and more transactional-level accounting being done by technology and not physical accountants, but there is still much for accountants to do. For instance, an asset’s ownership might be verifiable by blockchain records, but its condition, location and true worth will still need to be assured.
What is a Distributed Ledger?
This sharing of data is where the term “distributed ledger” comes from. A distributed ledger is a blockchain-enabled network. For each transaction posted to a blockchain network, all participants’ records are updated and shared through peer-to-peer replication. Each transaction is the start of a “block” of data. Blocks include a record that confirms the time and sequence of transactions which are encoded within the blockchain using a “hash” or unique identifier. That data is copied and shared with all users. As updates to transactions are made, each addition adds a block of data with its own hash identifier which forms a chain of data linked by those hash codes. Hence the term “blockchain.”
Each participant of a blockchain network is referred to as a “node.” Nodes support the network by maintaining a copy of a transaction. Nodes are the individual parts of the larger structure that is the blockchain network. Each node in the blockchain network can publish or send transactions to other nodes, and the data is replicated and synchronized across the network as it is transferred.
To better illustrate how blockchain works, let’s take a look at this example:
Imagine you and your friend, Joe, are on stage at an auditorium and there are 1,000 people in the audience. While on stage, for all to see and hear, you give Joe the key to your motorcycle and Joe gives you a key to his jet ski. You declare, “Joe, you now own my motorcycle.” Joe declares back to you, “You now own my jet ski.”
There are 1,000 witnesses who can confirm that your motorcycle now belongs to Joe, and Joe’s jet ski now belongs to you. If anyone at a later date tells a conflicting account of what happened, there are 999 other people who will counter that one claim. Additionally, if you take a spare key to your motorcycle and try to give it to someone else, there are 1,000 audience members who can confirm that Joe now owns the motorcycle since each of them “witnessed” the transaction. This is essentially how the blockchain technology works, and it is built on transparency.
Now, take the above example and add on network access permissions, cryptography technology and a larger population of peers or nodes on a given network, and you can see how blockchain technology is more secure than traditional networks. It is this increased level of trust and security over transactions that makes blockchain a technology that will greatly change how companies and individuals transact with one another moving forward.
The Positive Side to Change
Some fear that blockchain could replace accountants in the future. More realistically, blockchain has the potential to enhance the accounting profession by reducing the costs of maintaining and reconciling ledgers and freeing up resources to concentrate on planning and other high-value services. Blockchain can also provide accountants with clarity over ownership of assets and existence of obligations and could dramatically improve efficiency.
There is no doubt that the accounting industry will be reshaped by the introduction of blockchain technology, and there does not seem to be a way we can slow down the train of change coming our way. As accountants, we must embrace and keep on top of this change. We must adapt and evolve as the times continue to shift to more technology-based solutions so that we can continue to identify the best ways to serve our clients and provide them with the most value possible.
Albert Traverso, CPA, is a partner at Sax LLP and is a firm leader in the area of computerized audit techniques, working to streamline the entire audit process. He can be reached at firstname.lastname@example.org.
This article appeared in the March/April 2019 issue of New Jersey CPA magazine. Read the full issue.