Blockchain - are you engaged?
Published 19 March 2019
Distributed ledger technology (“DLT”) is perhaps best known to date for its role in enabling the exchange of cryptocurrencies. However, its potential extends well beyond this.
We aim to explore this new technology from a legal perspective in a series of articles. This is our first. We consider what it might mean for auditors and accountants.
What is it?
There is no single type of DLT, but the most well-known is blockchain which has gained some fame, and arguably some notoriety, from its role in supporting the growth of cryptocurrencies.
The common feature of all DLT is the creation of a distributed digital ledger which may contain many and varied types of information. Rather than each party to a transaction creating their own record of the transaction and a central party controlling the process, transactions are entered into a shared ledger and validated by the consensus of each participant, according to a pre-defined algorithm. Once validated, the record is automatically added to each participant’s instance of the ledger which means that every participant can trace all previous transactions.
Each transaction entered into the ledger is identified by a unique digital fingerprint (or “hash”). This hash is made up of the data of the transaction, a timestamp and the hash of the preceding entry. Once a transaction has been entered onto the ledger, the record becomes resilient to change as any attempt to change the data will also change the associated hash. As the hash of each transaction is incorporated into the hash of subsequent transactions, a change to the data of one transaction will also invalidate the hash of all subsequent transactions. As the records are distributed, any change to hashed data will be flagged to all participants so any alterations are obvious to other members.
DLTs can be public (or “permissionless”), that means anyone can become members, or they can be private (or “permissioned”), which means an administrator or owner sets the rules of the ledger, controls access and verifies the identity of its members.
Not all DLT achieves this result in the same way. Blockchain, as one example, in simple terms, does it by:
- hash cryptography;
- block of information;
- a chain of consecutive blocks; and
- a distributed ledger.
Breaking it down into its parts:
Why is it relevant to you?
DLT has the potential to support the creation of permanent and trustworthy records, to supplement or perhaps replace existing bookkeeping or reconciliation of accounts.
While many point to its revolutionary potential, industry wide transformation is not likely immediately. One reason is the lack of standardisation of DLT, which limits its ability to connect with the current accounting design, and concerns in relation to accountability and jurisdiction: who is accountable when things go wrong in a distributed ledger, and if participants are located in a number of different jurisdictions, which country’s regulatory authority has responsibility?
That said, it is becoming a reality and regulators are engaged in making it a success: the FCA has accepted a number of DLT projects into its regulatory sandbox and the Financial Reporting Committee’s Lab (a hub which aims to support innovation in corporate reporting) advocated its potential in its report published in June last year “Blockchain and the future of corporate reporting”.
At the very least, soon we are likely to see the integration of DLT records into traditional accounting systems, where DLT is used as a means to facilitate and record transactions with both internal and external parties. Companies should be able to write transactions directly onto a shared ledger within small industry groups or consortia, for example. Alternatively, using DLT to record inter-company transactions could lead to efficiencies in the process of consolidating company accounts as updates could be recorded in real time on a central ledger.
Longer term, DLT may alter the way companies report to internal and external stakeholders by utilising the potential for enabling companies to deliver real time reporting to management, regulators and / or auditors. This potential lies, in particular, with permissioned DLTs and hybrid (combination of public and private) systems, where the administrator of the ledger can assign various participants different roles and levels of access to the ledger. The administrator will control access to the ledger, verify the identity of participants and set the rules, and could, for example, give an auditor a “view only” access to the ledger to allow it to monitor transactions in real time and perform audits.
What are the opportunities?
DLT has the potential to reduce dramatically the amount of time accountants spend on maintaining and reconciling company accounts, and the time auditors spend checking and validating transactions. This will free up accounting talent to concentrate on activities further up the value chain and allow them to focus on higher level questions.
That said, while it is true that DLT records should provide accurate evidence on the ownership of assets or the existence of a transaction, auditors are likely to have a vital role in giving assurances that the DLT records do match up with economic reality, that the parties and assets recorded in the DLT records do exist, and in determining the true value of the assets listed in the records. It may also fall to auditors to provide assurances on the completeness and accuracy of the distributed ledgers as a whole: while the resilience of DLT is one of its greatest strengths, and this is partly achieved via decentralisation, no system is without its faults.
The unique knowledge of accountants makes them well placed to advise on the integration and adoption of these new technologies and offer DLT led solutions: some of our clients are already working in the forefront of this space. The demand for these services can only increase as legal frameworks, assurance procedures and standards are developed to enable DLT to become part of main stream accounting and established audit evidence.
Whatever your view, DLT is likely to remain in the limelight. Any change will, we suggest, be gradual. There are regulatory, technological (and other barriers) to overcome, but if you haven’t yet seen it, DLT platforms will soon appear alongside existing systems and will be integrated where possible.
While the technology remains in relative infancy, the law does too. We will be watching how it evolves and integrates itself into the industry, and how the legislation develops around it. Will you?