Wednesday 08 February 2023
Introduction
Organizations, both business and non-profits, are driven by data. The purpose of financial and business data, at least since the “invention” of accounting in 1494, has been to utilize recorded data for decision-making as prepared by accountants for managerial decisions that benefit the firm. Use of data for decision-making needs to be tailored so that it is “fit for purpose”.
Data that is fit for purpose has two primary characteristics: 1) Relevance to the task at hand and 2) Reliability or verifiability. It is the presence of these two characteristics that imbed trust in the data. Users of financial information need to be able to explicitly trust that the data is fit for purpose. The Blockchain assures trust that the data is usable for its intended purpose. Accounting data is the source of all financial data as displayed on the firm’s financial statements. These statements consist of the income (business operations) statement, the balance sheet (statement of financial position) and the cash flow statement which represents the cash inflows and outflows during the period under measurement that is derived from both the income statement and the balance sheet.
While relevance is dependent upon the purported use of the accounting data to make operating and financial decisions for the firm, reliability of data can and should be known with certainty. For instance, decisions regarding the company’s net working capital (current assets minus current obligations) needs is necessarily short-term in focus, while decisions regarding the company’s investments in increased capacity for growth are necessarily longer term in nature. Reliability of the data, however, is the purview of the accounting system that is used to populate the company’s financial statements. The question that needs to be asked is this; Can I as the decision-maker trust that the data I will use in the decision process is pertinent to that decision and is the information reliable?
The answer to the reliability concern can and will be met by The Blockchain. Blockchain is a secure, shared record keeping (accounting) system in which participants to the accounting transactions, generally at least two parties in a double entry accounting system, possess a copy of the accounting transaction, which can only be entered into the company’s financial records if the parties to the transaction agree beforehand that the transaction can be entered into the company’s accounting system. From an information technology and systems approach the Blockchain is a peer-to-peer, distributed ledger, that is cryptographically secure, append-only, immutable, and updated only by consensus of the participants.
Accounting information that is useful for decision-making at the present time normally needs to be adjusted and corrected be to fit for purpose. This process in the language of data analysis is referred to as extract, transform and load or ETL. The process extracts accounting and business data from a database, then that data if transformed into usable information by performing data cleansing activities that permit the data then to be loaded onto either another database or as a standalone spreadsheet for analysis. Cleansing of the data has been found to be the most difficult and therefore time-consuming activity in the ETL process. For example, assume the company needs to prepare an analysis of their customer accounts receivable to determine the appropriate amount to reserve or provision for the possibility of noncash collection of the outstanding customer accounts receivable. The database customer accounts receivable requires that the accounts be cleaned so that only outstanding customer balances are reflected in the customer respective accounts. Cleaning involves determining whether payments received have been updated into their accounts, whether any adjustments for sales and returns as well as discounts have been entered into their accounts and whether or not the payment and sales and return adjustments relate to the period under measurement. Only then is the information useful for the computation of the amount to expected credit losses in the period under measurement.
Or we could implement and use Blockchain to assure us that all the customer accounts receivable are updated as the transactions occur. In that way, the customer accounts are current, and the accounting data doesn’t need transforming as amounts on the blockchain cannot be entered without approval of both the customer and the company and once entered into accounting records is immutable from tampering. The accounting and financial data on the Blockchain is therefore ready for use as information that can be then transformed into business knowledge.
As a thought exercise for your company, contemplate the time and effort spent on transforming data to information for use in decision making. In almost all cases a majority of that time and money and is spent on “cleansing” accounting and financial data. The Blockchain removes that data reliability constraint from the decision process allowing users of the information to explore avenues of value add for the company. I would say confidently that the conversion of data to information prior to being used in the decision-making process is a revolutionary change to the role of accounting in firms. Accountants and finance professionals are now, with the Blockchain, will be in an enhanced position, within the company, to value add knowledge to strategic business decisions.
Foundational Concepts of Blockchain Technology
Blockchain Technology is a peer-to-peer system. This infers that there is no central technology controller and that participants (nodes) on the blockchain communicate directly with each other. This assures participants that the information on the Blockchain is trustworthy as the communications are between nodes. The distributed ledger means that the transactions on the Blockchain are communicated to all the nodes on the blockchain, again assuring trust that the transactions are correct and validated.
The immutability aspect of Blockchain is facilitated by the use of cryptographic encryption to secure all transactions, that take the form of blocks and are then arranged as chains on the Blockchain in the peer-to-peer network. This sequential ordering of the blockchain is referred to as append-only in time sequential order. So, blocks added to the blockchain cannot be changed and therefore become an immutable distributed ledger of accounting and financial transactions.
The critical feature of the Blockchain is that any transaction proposed for entry is subject to consensus of the participants (nodes) on the Blockchain. The blockchain protocols (written as software code) for entry on the blockchain are approved as rules by the participants on the Blockchain. Any proposed transaction that adds a block to the chain is subject to the protocols in place for doing business on the Blockchain and are subject to those protocols being approved for each transaction by consensus. This is what assures users that data on the blockchain is a repository of trustworthy information.
How it Works
Building Blocks
Source: Mastering Blockchain: A Technical Reference Guide, Bashir Amran, Packt Publishing ebook, 4th Edition
As illustrated above and using the following transaction, a company orders supplies or services from an approved vendor(s), you can visualize the blockchain sequence of events. The first block is the proposed accounting transaction which appears as the Genesis block and lists the terms of the contract between the ordering company and its approved vendors, which have agreed to the protocols (software code) to be able to transact business on the blockchain. The diagram then represents the N number of transactions (blocks) with the company. This will then provide an historical ledger for both the company and the vendor for each and every transaction that is entered between the company and the vendor and will provide an historical ledger of their transactions on the blockchain.
The diagram below indicates how the transaction between the company and its vendors appears as a Block on the Blockchain.
Anatomy of a Block
Source: Mastering Blockchain: A Technical Reference Guide, Bashir Amran, Packt Publishing ebook, 4th Edition
The cryptographic chronology of a block starts with assigning an encrypted hash number to a proposed transaction. The proposed transaction is then attached to the previously encrypted hash # so that it safely and securely enters the chain. The cryptographic hash # is the block proposer’s unique identity, signature above, that is accepted by the software code (embedded as a smart contract on the Blockchain) for acceptance of the blockchain. The database hash # then signifies that the transaction will be updated in the blockchain’s accounting ledger. And the transactions above indicate that all previous transactions between, in this case, the vendor and company have been securely stored and cannot by appended without consensus between the company and the vendor.
From an accounting and financial reporting perspective the company and vendor purchase process is illustrated below.
Source: Mastering Blockchain: A Technical Reference Guide, Bashir Amran, Packt Publishing ebook, 4th Edition
The accounting transaction sequence above is then reported to the company and the vendor.
Author of this article, Frank Beil, will be expanding on these concepts in our new course, Designing and Implementing Blockchain in Accounting Systems, available both virtually and face-to-face. Follow the respective links for more details.