In Module 5, we’ve learned about blockchain and Auditing. Please review all materials posted in this module, and submit a thoughtful discussion post in response to the readings. Spe

Blockchain Technology A game-changer in accounting?

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Introduction Blockchain technology has the potential to upend entire industries. Especially the financial sector may undergo disruptive change. Although this technology caught the attention of many of the largest financial institu- tions, use cases still remain in the experimental phase. This whitepaper lays out the benefits of the blockchain technology for specific use-cases in accounting across industries.

Current state of accounting technology Digitalisation of the accounting system is still in its infancy compared to other industries, some of which have been massively disrupted by the advances of technology. Some of the reasons may be found in the exceptionally high regulatory requirements in respect to validity and integrity. The entire accounting system is built, such that forgery is impossible or at least very costly. To achieve this it relies on mutual control mechanisms, checks and balances. This inevitably affects every day’s operations. Among other things there are systematic duplication of efforts, extensive documentations and periodical controls. Most of them are manual, labour intensive tasks and far from being automated. To date, that seemed to be the sacrifice of revealing the truth.

The recently emerged Blockchain is a trustless, distributed ledger that is openly available and has negligible costs of use. The use of the Blockchain for accounting use-cases is hugely promising. From simpli- fying the compliance with regulatory requirements to enhancing the prevalent double entry bookkeeping, anything is imaginable.

The giant leap: How the Blockchain may enhance today’s accounting practice Modern financial accounting is based on a double entry system. Double entry bookkeeping revolutionized the field of financial accounting during the Renaissance period; it solved the problem of managers knowing whether they could trust their own books. However, to gain the trust of outsiders, independent public auditors also verify the company’s financial information.1 Each audit is a costly exercise, binding the company’s accoun- tants for long time periods.

1 Stakeholders place their trust in the auditors retained by management to vouch for them. An obvious 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?

$

Complete, automated audit of all transactions

Blockchain entry serves in both companies' accounting

Every transaction becomes "notarized"

Courts

Banks

Tax authorities Auditors

Blockchain

B Company BCompany A

Fig. 1 – Blockchain technology enables complete, conclusive verification without a trusted party

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Blockchain technology may represent the next step for accounting:2 Instead of keeping separate records based on transaction receipts, companies can write their trans- actions directly into a joint register, creating an inter- locking system of enduring accounting records. Since all entries are distributed and cryptographically sealed, falsifying or destroying them to conceal activity is practi- cally impossible. It is similar to the transaction being verified by a notary – only in an electronic way.

The companies would benefit in many ways: Standardi- sation would allow auditors to verify a large portion of the most important data behind the financial statements automatically. The cost and time necessary to conduct an audit would decline considerably. Auditors could spend freed up time on areas they can add more value, e.g. on very complex transactions or on internal control mechanisms.

First steps towards Blockchain based accounting It is not necessary to start with a joint register for all accounting-entries. The Blockchain as a source of trust can also be extremely helpful in today’s accounting structures. It can be gradually integrated with typical accounting procedures: starting from securing the integrity of records, to completely traceable audit trails. At the end of the road, fully automated audits may be reality.

At first, let us have a look at the case of keeping immutable records. The regulatory requirements for record keeping in Germany for example urge the proof of immutability over the entire retention period.

For paper receipts, the risk of unnoticed modification is seen as comparably low, because of their physical nature. In contrast, electronic files cannot be perceived physically and hence are especially vulnerable. As a consequence, digitalizing paper records introduces the necessity for further preventive measures.

2 For a more detailed explanation of the concepts also known as “triple entry accounting”, also refer to Ian Grigg’s paper “Triple Entry Accounting” or Bitcoin Magazine’s article authored by Jason M. Tyra.

The result is a wide range of organizatory, technological and processual provisions. All preventive measures have to be documented in a conclusive manner for third parties. Unsurprisingly, many companies shy away from introducing a holistic electronic archiving system, although they are aware of the benefits.

Using the Blockchain makes it possible to prove integrity of electronic files easily. One approach is to generate a hash string of the file. That hash string represents the digital fingerprint of that file. Next, that fingerprint is immutably timestamped by writing it into the Blockchain via a transaction.

At any subsequent point in time, one can prove the integrity of that file by again generating the fingerprint and comparing it with the fingerprint stored in the Blockchain. In case the fingerprints are identical, the document remained unaltered since first writing the hash to the Blockchain.

Hashing ensures that original information cannot be seen by third party

Original record Audited record

Hash string is written into the blockchain

Search for the identical hash string

A

Hash string is embedded in

the Blockchain:

• Search for the hash string in the blockchain

• If search is successful, record must have remained unmodified

B

? =

Fig. 2 – One approach to verify the integrity of records using the Blockchain

AuditingRecord keeping

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Timestamping can be conducted at any point of the documents life cycle and render any subsequent organizatory, technological and processual integrity provision obsolete. Preferably, the fingerprint should be timestamped right after the creation of the electronic document, even before the document is sent from the issuer to the recipient. That way one can rule out the risk of the document being modified over the entire document life-cycle. For archiving the document, usual data storages may be used, because the integrity can be proven easily.

To extend this concept, one may represent the life-cycle of each accounting incident on the Blockchain, including all relevant documents. Entire business processes, spanning over multiple departments or companies become easily traceable.

Finally, blockchain technology allows for smart contracts, i.e. computer programs that may execute under certain conditions. Think of an invoice paying for itself after checking that delivered goods have been received according to specifications and sufficient funds are available on the company’s bank account.

Conclusion The blockchain technology has the potential to shapeshift the nature of today’s accounting. It may constitute a way to vastly automate accounting processes in compliance with the regulatory requirements. As described above, there are numerous starting points to leverage blockchain technology. A cascade of new applications will likely follow that are built on top of each other, leading way for new, unprecedented services.

Your contact

Nicolai Andersen Partner, Leader Innovation Deloitte Deutschland Tel: +49 (0)40 32080 4837 [email protected]

For more information please visit our website www.deloitte.com/de/blockchain

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Issued 3/2016

Blockchain Technology and Its Potential Impact on the Audit and Assurance Profession

Blockchain Technology and Its Potential Impact on the Audit and Assurance Profession

Blockchain Technology and Its Potential Impact on the Audit and Assurance Profession

DISCLAIMER This paper was prepared by the Chartered Professional Accountants of Canada (CPA Canada) and the American Institute of CPAs (AICPA), as non-authoritative guidance.

CPA Canada and AICPA do not accept any responsibility or liability that might occur directly or indirectly as a consequence of the use, application or reliance on this material.

Copyright © 2017 Deloitte Development LLC.

All rights reserved. This publication is protected by copyright and written permission is required to reproduce, store in a retrieval system or transmit in any form or by any means (electronic, mechanical, photocopying, recording, or otherwise).

For information regarding permission, please contact [email protected]

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Table of Contents

Executive Summary 1

The ABCs of Blockchain 3

What Is Blockchain Technology? 3

Characteristics of a Blockchain 4

What Are the Benefits? 4

Blockchains Are Not Made Equal 5 Permissionless Blockchain 5 Permissioned Blockchain 6

Evolution of Blockchain: Smart Contracts 6

Where Can Blockchain Be Applied? 8

The Potential Impact of Blockchain on the Financial Statement Audit and the Assurance Profession 9

Financial Statement Auditing 9

How Audit and Assurance Might Evolve with Blockchain 10

Opportunities for Future Roles of the CPA in the Blockchain Ecosystem 11 Auditor of Smart Contracts and Oracles 11 Service Auditor of Consortium Blockchains 12 Administrator Function 12 Arbitration Function 13

Blockchain Technology and Its Potential Impact on the Audit and Assurance Professionvi

Conclusion 15

Call to Action 16

Other Resources 17

About the Authors 17

About Deloitte 17

1

Executive Summary

Blockchain was first introduced as the core technology behind Bitcoin,1 the headline-grabbing decentralized digital currency2 ecosystem proposed in 2008. The appeal of blockchain tech- nology lies in its use of peer-to-peer network technology3 combined with cryptography.4 This combination enables parties who do not know each other to conduct transactions without requiring a traditional trusted intermediary such as a bank or payment processing network. By eliminating the intermediary and harnessing the power of peer-to-peer networks, block- chain technology may provide new opportunities to reduce transaction costs dramatically and decrease transaction settlement time. Blockchain has the potential to transform and disrupt a multitude of industries, from financial services to the public sector to healthcare. As a result, a number of venture capital firms and large enterprises are investing in blockchain technology research and trials to re-imagine traditional practices and business models.

In recent years, blockchain technology has evolved far beyond bitcoin and is now being tested in a broad range of business and financial applications. However, blockchain technol- ogy is still emerging and has not yet been proven at enterprise scale, which is a fundamental challenge to blockchain’s transformative potential. In addition, many accounting firms have undertaken blockchain initiatives to further understand the implications of this technology. It is important for the audit and assurance profession to stay abreast of developments in this space, and we encourage Chartered Professional Accountants and Certified Public Accoun- tants (collectively, CPA auditors) to learn more about this technology. The focus of this paper is to explain blockchain technology and how it could potentially impact the financial state- ment audit, introduce possible new assurance services and new roles for the CPA auditor in the blockchain ecosystem.

1 The term “bitcoin” is used when describing a bitcoin as a unit of account, whereas “Bitcoin” is used when describing the con- cept or the entire network designed by Satoshi Nakamoto.

2 Digital currency can be defined as an Internet-based form of currency or medium of exchange (as distinct from physical currency such as banknotes and coins) that exhibits properties similar to physical currencies but allows for instantaneous transactions and borderless transfers of ownership.

3 Peer-to-peer computing or networking is based on a distributed application architecture that shares tasks among peers. All participants engage equally in the application to form a peer-to-peer network of nodes.

4 Modern cryptography uses mathematics, computer science and electrical engineering to enable secure communication between two parties in the presence of a third party.

Blockchain Technology and Its Potential Impact on the Audit and Assurance Profession2

Blockchain technology has the potential to impact all recordkeeping processes, including the way transactions are initiated, processed, authorized, recorded and reported. Changes in business models and business processes may impact back-office activities such as finan- cial reporting and tax preparation. Independent auditors likewise will need to understand this technology as it is implemented at their clients. Both the role and skill sets of CPA auditors may change as new blockchain-based techniques and procedures emerge. For example, methods for obtaining sufficient appropriate audit evidence will need to consider both traditional stand-alone general ledgers as well as blockchain ledgers. Additionally, there is potential for greater standardization and transparency in reporting and accounting, which could enable more efficient data extraction and analysis.

Blockchain technology could bring new challenges and opportunities to the audit and assur- ance profession. While traditional audit and assurance services will remain important, a CPA auditor’s approach may change. Just as the audit and assurance profession is evolving today, with audit innovations in automation and data analytics, blockchain technology may also have a significant impact on the way auditors execute their engagements. Moreover, CPAs may need to broaden their skill sets and knowledge to meet the anticipated demands of the business world as blockchain technology is more widely adopted.

The Chartered Professional Accountants of Canada (CPA Canada), the American Institute of CPAs (AICPA), and the University of Waterloo Centre for Information Integrity and Infor- mation System Assurance (UW CISA) all encourage the audit and assurance profession to continue the discussions already begun in regard to the impact of blockchain technology on the profession and auditing standards.

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The ABCs of Blockchain

What Is Blockchain Technology? A blockchain is a digital ledger created to capture transactions conducted among various parties in a network. It is a peer-to-peer, Internet-based distributed ledger which includes all transactions since its creation. All participants (i.e., individuals or businesses) using the shared database are “nodes” connected to the blockchain,5 each maintaining an identical copy of the ledger. Every entry into a blockchain is a transaction that represents an exchange of value between participants (i.e., a digital asset that represents rights, obligations or ownership). In practice, many different types of blockchains are being developed and tested. However, most blockchains follow this general framework and approach.

When one participant wants to send value to another, all the other nodes in the network communicate with each other using a pre-determined mechanism to check that the new transaction is valid. This mechanism is referred to as a consensus algorithm.6 Once a trans- action has been accepted by the network, all copies of the ledger are updated with the new information. Multiple transactions are usually combined into a “block” that is added to the ledger. Each block contains information that refers back to previous blocks and thus all blocks in the chain link together in the distributed identical copies. Participating nodes can add new, time-stamped transactions, but participants cannot delete or alter the entries once they have been validated and accepted by the network. If a node modified a previous block, it would not sync with the rest of the network and would be excluded from the blockchain. A properly functioning blockchain is thus immutable despite lacking a central administrator.

5 The blockchain is managed by a network of nodes. When a node first accesses the database (i.e., the blockchain), it downloads its own instance of the entire ledger.

6 An algorithm is a process or set of rules to be followed in calculations or other problem-solving operations, especially by a computer. Consensus involves multiple nodes agreeing on values. A consensus algorithm is used to agree among the nodes. In practice, there are different types of consensus algorithms and mechanisms.

Blockchain Technology and Its Potential Impact on the Audit and Assurance Profession4

Characteristics of a Blockchain As a near real-time and distributed digital ledger, a blockchain has several unique and valu- able characteristics that, over time, could transform a wide range of industries:

Near real-time settlement A blockchain enables the near real-time settlement of transactions, thus reducing risk of non-payment by one party to the transaction.

Distributed ledger The peer-to-peer distributed network contains a public history of transactions. A blockchain is distributed, highly available and retains a secure record of proof that the transaction occurred.

Irreversibility A blockchain contains a verifiable record of every single transaction ever made on that blockchain. This prevents double spending of the item tracked by the blockchain.

Censorship resistant The economic rules built into a blockchain model provide monetary incentives for the independent participants to continue validating new blocks. This means a blockchain continues to grow without an “owner”. It is also costly to censor.

What Are the Benefits? A major advantage of blockchain technology is its distributed nature. In today’s capital markets, the transfer of value between two parties generally requires centralized transaction processors such as banks or credit card networks. These processors reduce counterparty risk for each party by serving as an intermediary but centralize credit risks with themselves. Each of these centralized processors maintains its own separate ledger; the transacting par- ties rely on these processors to execute transactions accurately and securely. For providing this service, the transaction processors receive a fee. In contrast, a blockchain allows parties to transact directly with each other through a single distributed ledger, thus eliminating one of the needs for centralized transaction processors.

In addition to being efficient, the blockchain has other unique characteristics that make it a breakthrough innovation. Blockchain is considered reliable because full copies of the block- chain ledger are maintained by all active nodes. Thus, if one node goes offline, the ledger is still readily available to all other participants in the network. A blockchain lacks a single point of failure. In addition, each block in the chain refers to the previous blocks, which prevents deletion or reversing transactions once they are appended to the blockchain. Nodes on a blockchain network can come and go but the network integrity and reliability will remain intact as long as it is being used. In this way, no single party controls a blockchain and no single party can modify it or turn it off.

The ABCs of Blockchain 5

Blockchains Are Not Made Equal CPA auditors should be aware that blockchain technology is a new form of database and each blockchain implementation may have different characteristics that make it unique. While the technology is emerging, there is a risk that a specific blockchain implementation does not live up to the promise of the technology. In the current ecosystem, there are two major classifica- tions of blockchain networks: permissionless and permissioned. The biggest difference is the determination of which parties are allowed access to the network. A blockchain may be shared publicly with anyone who has access to the Internet (i.e., permissionless or “public” blockchain), or shared with only certain participants (i.e., permissioned or “private” blockchain).

Permissionless Blockchain A permissionless blockchain is open to any potential user. For example, the Bitcoin blockchain is a public or permissionless blockchain; anyone can participate as a node in the chain by agreeing to relay and validate transactions on the network thereby offering their computer processor as a node. Joining the blockchain is as simple as downloading the software and bitcoin ledger from the Internet. Because the blockchain maintains a list of every transaction ever performed, it reflects the full transaction history and account balances of all parties.

Figure 1 is an example of a transfer of bitcoin (BTC) from one individual to another. When one party sends bitcoin (i.e., buyer sending value) to another party (i.e., seller receiving value), the Bitcoin blockchain is updated by the following process, including a process referred to as “mining”:7

FIGURE 1

An example of a bitcoin transaction which is a public/permissionless blockchain: peer-to-peer payment over the Bitcoin network. Note: Permissioned blockchains may have consensus protocols that may be similar to or different from Figure 1 because they are dependent on the agreement of the participants.

7 Mining is the act of adding new transactions to the blockchain by solving algorithmic problems with computing resources. Miners or participants in this process are awarded bitcoin for the computational effort they expend in order to support the network.

Blockchain Technology and Its Potential Impact on the Audit and Assurance Profession6

While a permissionless blockchain lives up to the potential of the technology by allowing anyone access, it can have limitations that are difficult to remedy. For example, when the blockchain is created, transaction volume or size may be set to the best available technology at the time. As technology advances, initial settings may become limitations that may make the blockchain out of date, potentially slowing transaction speeds. Users of permissionless blockchains should also be aware that their transaction history is exposed to anyone who downloads the database for as long as the database is active. While it may be difficult for an outside party to identify a participant on the blockchain, if a participant is identified, their entire transaction history would be public.

Permissioned Blockchain The limitations of permissionless blockchains have led some organizations to explore the use of private or permissioned/consortium blockchains, which restrict participation in the blockchain network to participants who have already been given permission by agreed-upon administrators.8 These blockchains address some of the drawbacks of public blockchains, but also sacrifice some of the potential benefits (e.g., decentralized transactions, wide distribution of the ledger, and a truly decentralized environment without any intermediaries). Permissioned blockchains are likely to be set up by a consortium of parties that can collectively benefit from a shared ledger system. For example, a supply chain network may want to use a blockchain to track the movement of goods.

Given the widely acknowledged limitations inherent in public blockchains, private or per- missioned/consortium blockchains are expected to have a higher adoption rate in the near term, especially in enterprise environments. However, adoption of public blockchains is also expected to increase in the longer term once the key infrastructure and technical challenges of the new technology have been addressed. The paradigm shift introduced by blockchain (and the level of interest in blockchain-based initiatives) in many ways parallels the develop- ment of the Internet in the 1990s. With Internet technology, there was a strong initial emphasis on corporate intranets until a critical mass was reached and the broader public Internet began to offer more benefits to offset the perceived risks of participating in an open network.

Evolution of Blockchain: Smart Contracts A key development in blockchain technology was the introduction of smart contracts. Smart contracts are computer code stored on a blockchain that executes actions under specified circumstances. They enable counterparties to automate tasks usually performed manually through a third-party intermediary. Smart-contract technology can speed up business pro- cesses, reduce operational error, and improve cost efficiency.

8 A consortium is a group of organizations that aims to achieve a common objective.

The ABCs of Blockchain 7

For example, two parties could use a smart contract to enter into a common derivative con- tract to hedge the price of oil at the end of the year. Once the terms of the contract have been agreed to, it is appended to the blockchain and the wagered funds are held in escrow and registered on a blockchain. At year end, the smart contract would read the price of oil by referencing a trusted source defined in the smart contract (known as an “oracle”), calculate the settlement amount, and then transfer funds to the winning party on the blockchain.

Ethereum9, at the time of publication the second largest blockchain network after Bitcoin (based on market capitalization), was the first platform to introduce the concept of a smart contract that could be deployed and executed on a distributed blockchain network. Ethereum is a public protocol that allows anyone accessing the Ethereum blockchain network to view the terms of each contract unless they are protected by encryption. This may prove problem- atic for contracts involving sensitive information (e.g., a hedge fund using smart contracts to execute a proprietary investment strategy or to quietly build a position in a particular stock). However, developers are actively building solutions to preserve confidentiality while taking advantage of public blockchains. Even with such perceived limitations, there is significant market interest across industries in smart contract applications because they could transform the processing and settlement of a wide range of contracts, from hedging and futures deriva- tives to automated payments under lease contracts.

Smart contracts are a method to automate the contracting process and enable monitoring and enforcement of contractual promises with minimal human intervention. Automation can improve efficiency, reduce settlement times and operational errors. Because using smart contract technology requires the translation of all contractual terms into logic, it may also improve contract compliance by reducing ambiguity in certain situations.

As smart contracts continue to evolve, inherent risks may emerge that need to be mitigated. For example, when setting up a smart contract, the parties may decide not to address every possible outcome, or they may include some level of flexibility so they do not limit themselves. This could lead to smart contracts with vulnerabilities or errors that could lead to unexpected business outcomes. Parties may find it difficult to renegotiate the terms of a deal or modify terms due to an unforeseen error. Also, incomplete or flexible contracts can lead to settlement problems and disputes. Perhaps most importantly, however, at the date of this publication, smart contracts have not been tested thoroughly in the court system. Nevertheless, smart contracts offer a compelling use case for blockchain adoption.

9 www.ethereum.org

Blockchain Technology and Its Potentia

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