This article corresponds with David Mondrus’ January 29th post entitled “In Mining, We Trust” to the extent that this piece explains from an accounting perspective why a distributed public ledger might be needed, but does not provide a detailed technical description of how it would work.
Anyone who spends more than a few minutes around Bitcoin people will eventually be engaged in a discussion about what Bitcoin REALLY is. You know the one that I mean: the conversation usually begins with an argument about capitalization. “Bitcoin” is an encrypted, decentralized system of exchange (payment infrastructure, if you will), whereas “bitcoin” is a unit of account (like the Dollar or Euro). What really gets hard core Bitcoin evangelists excited is not the bitcoin as a unit of account, but the distributed public ledger and all of its potential uses and functions. Bitcoin enthusiasts know this ledger as the “blockchain.”
What the blockchain is and how it works has already been the subject of dozens of pieces in Bitcoin Magazine, so I won’t provide a rehash in this article. Instead, I will point out for those who don’t already know that other uses have been proposed for this technology besides exchanging bitcoins. For example, one of the most intriguing ideas is the Colored Coins Project, or its more advanced outgrowth, Ethereum. Colored Coins uses the blockchain (or something similar) as a public ledger for all kinds of property other than bitcoins. The project gets its name from the idea that bitcoins could be “colored” to denote assets other than themselves, such as stocks, bonds or other types of property, and then used as both a recording and exchange mechanism. Want to sell me your house? No problem. Just send me the coin that is tagged with the deed and the deal is done. Ethereum takes this concept a step further by providing a way to use Bitcoin to encode any contract that can be expressed mathematically. It isn’t a stretch to see how these innovations could revolutionize the exchange and ownership of all types of property, especially in parts of the world where the sanctity of ownership is hamstrung by the uncertainty of local record keeping (if you’d like to read more about this, check out Hernando de Soto’s “The Mystery of Capital”).
Colored Coins and Ethereum are examples of how cryptography can be used to create trust between parties to a transaction that may be neither known to nor trusted by one another (the so-called “two generals” problem). The world economy is filled with trust problems and systems that have been developed to deal with them. If you are a lender, how do you know whether your borrower will repay you? (FICO scoring) If you are a manufacturer, how do you know that the raw materials you receive from your foreign suppliers will meet your specifications? (quality control) If you are an investor or regulator, how do you know whether the financial statements presented by a company are accurate or to what extent they are unreliable?
Modern financial accounting is based on a double entry system. Described simply, double entry bookkeeping allows firms to maintain records that reflect what the firm owns and owes and also what the firm has earned and spent over any given period of time. Double entry bookkeeping revolutionized the field of financial accounting during the Renaissance period. Whereas simple ledgers had long been the standard for record keeping for merchants, the church and state treasuries, the growth of long distance trade and creation of the first joint stock companies resulted in firms whose records were too voluminous and complicated to provide any assurance of accuracy to their users.
The double entry system solved the problem of managers knowing whether they could trust their own books. However, these same companies were now expected to share their records with outside stakeholders, such as investors, lenders and the state. This created the problem of how outsiders could trust the company’s books. Thus came the independent public auditor, whose role was (and is) to serve as an independent guarantor of financial information. Stakeholders placed their trust not in a firm’s management, who had a vested interest in presenting the rosiest of pictures to all who cared to ask, but in the auditors retained by management to vouch for them. It doesn’t take an attorney to see how a problem of agency is created by this arrangement. Do auditors work for the managers who hire and pay them or for the public that relies on their integrity in order to make decisions?
Financial statements are inherently representative of certain assertions by a firm’s management to the users of those financial statements. Among these are:
· Existence. That the assets and liabilities reflected on the balance sheet are true and accurate as of the balance sheet date.
· Completeness. That the financial statements represent all of the firm’s activities during the time period in question.
· Valuation. That the amounts on which the financial statements are based are correct or reasonable under the circumstances.
· Rights and Obligations. That what is owned and owed as reflected by the balance sheet is true and correct.
· Presentation and Disclosure. That the items in the financial statements are valued and described in the proper way.
Each of the preceding assertions is basically a problem of trust, which audits are designed to resolve. As an accountant, I am disappointed to admit that, all too often of late, my colleagues have failed in this respect. Not only have auditors failed to manage public expectations by honestly and openly communicating the limitations of assurance work, but in many cases they have also, through collusion, corruption, incompetence, or simple laziness, failed to properly do their jobs. This problem is even worse outside the US and EU member states, where lax enforcement of existing regulations creates opportunities for easy manipulation of financial statements. If a firm’s management is willing to issue inaccurate financial statements and capable of organizing a conspiracy to support them, then it is very likely that auditors will fail to detect the associated misstatements (assuming that the firm’s auditors were not colluding with the firm outright).
Production of bogus financial statements is a delicate affair. Merely falsifying revenue or recording it early doesn’t work on its own, because it throws the books out of balance. For example, a credit to the sales revenue account must be matched with a debit to an asset account (usually cash or accounts receivable). For fraudulent accounting records to stand up to any kind of scrutiny, they usually must be backed by a “legend” consisting of altered or falsified documentation. Bearing this in mind, Generally Accepted Auditing Standards require testing of all aspects of the financial statements and also that auditors obtain “sufficient, appropriate” evidence to support them. As one can imagine, the cost of completing the work ranges from obscene to astronomical. It is not uncommon for the cost an annual audit of a moderately sized company to run into the tens of thousands of dollars. However, the cost to the public of relying on faulty financials can be many times more.
Triple entry accounting is an enhancement to the traditional double entry system in which all accounting entries involving outside parties are cryptographically sealed by a third entry. These include purchases of inventory and supplies, sales, tax and utility payments and other expenses. Placed side by side, the bookkeeping entries of both parties to a given transaction are congruent. A seller books a debit to account for cash received, while a 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.
The companies using triple entry bookkeeping would derive two immediate benefits from adoption: First, since auditors could quickly and easily verify a large portion of the most important data behind the financial statements, the cost and time necessary to conduct an audit would decline considerably. Audits would still be necessary, but auditors could spend more time on higher risk areas such as internal control. Second, the integrity of a company’s financial statements would be essentially unassailable. Revenue and expense transactions could not be falsified if they required the encrypted signature of the counterparty in order to be accepted as valid. In the case of Bitcoin, transactions only occur when wealth is transferred, so there is no incentive and considerable cost associated with spurious activity. Taken together, both of these effects would have a strong positive effect on stock prices, borrowing rates, and a variety of other fundamentals.
It isn’t difficult think of ways to manipulate even a highly reliable system like the one described. Schemes like off balance sheet arrangements, improper valuations, disguised self-dealing, etc. would still be possible under a triple entry model, so new regulations would be necessary to mitigate some of the new sources of risk. These could be totally voluntary or only required for publicly listed companies, though companies of all sizes stand to benefit from better financials. For example, US Generally Accepted Accounting Principles could adopt the stance that, if it isn’t on the blockchain then it does not exist / didn’t happen and cannot be included in the financial statements. Rather than being created at random, financial wallet addresses could be assigned by a trusted third party such as the SEC or some yet to be created private organization in order to guard against abuse. It is true that new regulations would require firms to share some amount of proprietary information, but probably not more than they are currently required to disclose, just in a different form. The standard of privacy enjoyed by public firms in the United States is already quite low.
Triple entry is possible using existing Bitcoin infrastructure (with minor modifications) and highly desirable for both companies and outsiders. Its adoption would enhance the credibility of the financial statements of participants. Further, triple entry would empower smaller enterprises and create opportunities for growth by offering a very low cost way to prove economic activity to outside stakeholders, such as banks or angel investors. Triple entry accounting doesn’t address every financial statement assertion or totally take risk off the table, but its adoption would contribute greatly to the safety and stability of securities markets.