Blockchain and Its Potential Use in Accounting

Blockchain, meet accounting.  I think you two will have a great relationship. You were practically made for each other.

For every debit, there must be a credit. The foundation of accounting works so well that there haven’t been significant changes since Luca Pacioli’s “double-entry” system was documented in the 1400’s.

Getting to its basic definition, “blockchain” is a secure, digital, distributed ledger.  At the heart of what makes blockchain technology work is the distributed (or decentralized) principle. A distributed ledger means that not one single person maintains the ledger, but instead, it is maintained by hundreds or thousands of individuals. When thousands of parties have a copy of the same ledger, it ensures that nobody can change the data once it has been recorded.

Blockchain technology could serve as the “third entry” that drastically changes the accounting landscape. I’m not implying that accountants want to change data, but, unfortunately, it happened.

Let’s illustrate the potential with two companies, Block and Chain.

Block’s inventory manager checks the accounting system and is notified she’s running low on their best-selling mining equipment.  Once she identifies their preferred supplier, Chain, she completes a purchase order (PO) to order 100 new pieces. The purchase order is received by Chain’s inventory manager and after checking her inventory system to ensure they have enough equipment on hand, she processes the order and ships the items.  Once the equipment is shipped, Chain’s inventory manager sends an email to Chain’s accounts receivable (AR) manager, instructing her to mail an invoice to Block for 100 pieces.

A few days later, the equipment arrives at Block’s warehouse and the invoice arrives at Block’s accounting department (Block’s on top of it with their segregation of duties!). Block’s accounts payable (AP) manager inputs the invoice into the AP module and sends it to the inventory manager for payment approval. The inventory manager verifies the quantity and price of the items she ordered, approves the invoice for payment, and sends the invoice back to the accounting department for payment. Once approved and processed by Block’s AP manager, the check is printed and ready for the Controller’s signature. Before signing the check, the Controller ensures her company has enough funds in their bank account to cover all the checks that are lined up to go out that week. Determining the answer is “yes,” she signs the check and returns it to the AP manager to mail.

A few days after mailing, the check from Block arrives at Chain’s office.  Chain’s AR manager deposits the payment and applies the receipt within their AR module to the outstanding receivable balance.  Chain’s staff accountant reconciles the cash receipt during her bank reconciliation procedures.  The next day, Block’s staff accountant sees that the check cleared their account and reconciles the cash payment within her bank reconciliation.

Throughout this process, there are numerous opportunities for mistakes, whether intentional or unintentional.  Chain’s inventory manager could have sent the wrong quantity.  Or, if she sent the correct amount, Block’s inventory manager could have added the incorrect quantity into the accounting system. Chain’s AR manager could have recorded the incorrect quantity or the incorrect price per unit. Block could have short paid the invoice. While both companies have established internal controls, there’s always a possibility for errors. This scenario also assumes both companies have internal controls. In reality, small businesses, and even some large business, don’t have adequate internal controls.

Enter blockchain.

Let’s assume that both companies use the same full-service enterprise software.

Block’s software detects that the company is running low on their best-selling mining equipment. Based on historical sales trends, shipping lead times, and warehouse capacity, the software estimates that Block will need 90 units for the upcoming sales season. The system puts together a PO for their best supplier, Chain. But this isn’t just any PO.  This is a smart contract.  A smart contract takes business logic rules, codifies them, digitally verifies, then enforces the performance and execution of the contract without the use of a middleman or “trusted” third party.

The smart contract is sent and put onto the blockchain. (I know I am skipping a lot of the technical steps behind what this means, but there are some great resources online that explain the logistics if you are interested. Here is one resource that I’d recommend: https://www.cbinsights.com/research/what-is-blockchain-technology/).

Chain’s system receives this smart contract and it is added to Chain’s ledger, which notifies Chain’s inventory manager of the order. She packs the items, scanning them as they are added to the shipment.

Once the items are packed and shipped, the system verifies that the shipment meets the requirements of the smart contract and adds this all onto the blockchain. Block is notified that the shipment is on its way.

A few days later, the equipment arrives at Block’s warehouse. Once it is scanned by Block’s inventory manager, the system matches the information to the smart contract. This triggers the payment requirement of the smart contract.

Block’s accounting system knows the balance of cash on hand and the upcoming working capital requirements of the company. It determines that Block can afford to pay Chain for the equipment and sends payment, satisfying the smart contract.

The scenario above assumes the system has been tested and is trusted. It would be possible to build in touch points along the process where people need to approve certain actions prior to their execution (e.g. the Controller might need to approve payment prior to it being sent).  But at its full functionality, many of the touch points can be eliminated.

The use of the blockchain in this scenario eliminates Chain’s AR manager and Block’s AP manager (invoices are eliminated and replaced by smart contracts).  Also, Chain and Block’s staff accountants are eliminated (the essence of the blockchain serves to reconcile each account, including the bank). The responsibilities of each company’s Controller are significantly altered based on how many touch points each company designates.  Another sizeable benefit is drastically improving the lag time between many of the steps in the first scenario.

This self-monitoring system makes the auditability of the accounting records much easier.  When an entity requires an audit, the auditors will be able to run software that verifies the blockchain’s data, which will be built upon the entire year’s operations. Doing so will free up time by the auditors to perform expanded analytical testing.

By |2018-10-15T18:01:21+00:00September 17th, 2018|Blockchain, Financial, Select Articles, Taxes|Comments Off on Blockchain and Its Potential Use in Accounting