Blockchain 101

Thousands of years ago, ancient Mesopotamians first developed accounting practices for the purpose of keeping a written record of money and barter transactions. In the intervening millennia, advances in technology and theory has allowed accounting to evolve into an art and a science. The most recent “upgrade” has enabled a revolutionary overhaul of accounting as we know it.

In 2008, an unknown person (or persons) using the pseudonym Satoshi Nakamoto created the first digital currency, Bitcoin. Nakamoto’s groundbreaking whitepaper Bitcoin: A Peer-to-Peer Electronic Cash System paved the way for the establishment of a multi-billion dollar[i] global industry via a distributed database known as a blockchain.

A blockchain is a decentralized public ledger system that stores digital information chronologically in the form of “blocks.” These blocks are inherently linked (“chained”) to one another, and each block plays a role in facilitating anonymous and secure transactions between users, while providing monetary rewards to those who help maintain the public ledger. This chain of blocks contains a record of every single transaction ever in the history of a given cryptocurrency (“coin”). Cryptocurrency coins are virtual assets created by the process of “mining,” which is essentially the process of a computer algorithm solving a complex mathematical equation to validate a single block of the blockchain (think of a batch of transactions), and subsequently broadcasting this record to all other computers connected to this global network (each computer being a “node”). This process creates a single distributed public ledger across thousands of nodes around the globe. If a computer is able to solve the complex equation (via “cryptography”) and prove to the network that its equation validates a block (“proof of work”), the computer’s operator is compensated with a combination of a per-block reward of newly minted coins--“block reward”--and a small percentage of the transactions contained within the block--the “mining fee.” The newly-minted miner rewards tend to decrease over time on a schedule as the monetary value of the coin tends to increase, giving cryptocurrencies an economically deflationary appeal. The monetary value of a coin stems from the active trading between users on public coin exchanges. Technically, cryptocurrency mining creates inflation; however, using Bitcoin as an example, the inflation is controlled. For example, the mining reward for successfully “solving” the first ever block started at 50 Bitcoins, and at every 210,000 blocks (approximately every four years) the mining reward is cut by 50%, up to a total maximum supply around 21,000,000 Bitcoin. As of July 31, 2017, we are currently in block #478446, and the mining reward today is 12.5 Bitcoin (equivalent to approximately $35,000).

The revolutionary aspect of blockchain technology rests in the triple entry accounting concept. Triple entry accounting tweaks the double entry by including a cryptographic seal by a third entry. Today, a seller and a buyer maintain two separate sets of accounting records. A seller books a debit to account for cash received, while a buyer books a credit for cash spent in the same transaction. 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 within the same distributed public ledger. This process creates an interlocking system of enduring accounting records. Because the entries are distributed and cryptographically sealed, falsifying them in a credible way or destroying them to conceal activity is practically impossible. How it is impossible, well… keep reading!

 
 

Transactions (i.e., transfers of coins from one party to the next) are recorded in blocks on the blockchain. Depending on the coin in question, the size of a block is usually fixed to either the total number of kilobytes or megabytes of transaction data contained within (which is merely a bunch of alpha-numeric characters), or simply a predetermined length of time containing all transactions falling within that time span. Today, there are hundreds of cryptocurrency coins, each with their own unique blockchain and their own unique characteristics as defined within the open-sourced codes of their respective mutually agreed upon distributed algorithms. The total number of cryptocurrencies increases daily.

To visualize a blockchain, imagine a hierarchal grouping of folders on a hard drive. Each block, or sub-folder, within the root “Blockchain data” folder essentially contains a batch of time-stamped transactions representing every transaction of a given cryptocoin over a small span of time, from numerous anonymous parties to the next anonymous parties. All of this data is publicly available and searchable either by block number, transaction ID, or wallet address. Using the example above, the Block002 sub-folder contains a reference to Block001’s encrypted validation code. The encrypted code for Block001 must be incorporated into the encryption of the Block002 validation code by the miner validating the block, along with the encryption of every transaction within Block002, for the block to be considered validated (thus creating a running chain of encryption and validation). This chronological validation process computed by the miners proves not only the validity of the Block002 and all its contents, but also every single block preceding it. Throughout the validation process, miners stamp on their digital signatures documenting their witness and confirmation of the activity on Blockchain. It’s important to note that the miner validation for each block is competitive around the globe. This is due to the high monetary reward for successfully solving the equation. This intense competition renders it highly unlikely for the same individual to validate the two or more times in a row.

This is how the blocks become a chain. Because the system is managed by a peer-to-peer network collectively adhering to a validation protocol, the system is inherently resistant to modification of the data. Once recorded, the data in any given block cannot be altered retroactively without the alteration of all subsequent blocks and a collusion of the network majority. Blockchains can be used to facilitate any financial transaction between multiple parties—not just cryptocurrencies, but transactions in real estate, ordinary property, and financial securities.

What makes a blockchain truly valuable, especially from an accounting perspective, is that each block has a unique identifier. In any given transaction, the unique identification of each party involved is auditable. This unique identification system creates a transparent and verifiable path documenting the historical transfer of value from one individual wallet to the next. Similar to the process of an auditor confirming a cash balance with the bank directly, an accountant could verify a transaction or the balance of a wallet across hundreds of independent, yet identical ledgers.

 

Curious to know more? Click here for a quick primer on blockchain terminology.

 

Due to the blockchain concept’s relative novelty, authoritative regulatory bodies have yet to create blockchain policies specific to the industries they operate in. The IRS’s position on virtual currency (cryptocurrency) in their IRB 2014-16 in April 2014 maintains that for federal tax purposes, virtual currency is treated as property. In June 2017, the Chamber of Digital Commerce petitioned FASB to determine the appropriate recognition, measurement, presentation, and disclosure for digital currencies. This petition considered four different accounting topic methods under which digital currencies could fall (ASC section’s 305, 330, 350 and 825), but no guidance to define exactly what a digital currency is. In July of this year, Accounting Today discussed key foundations that need to be in place before fully adopting blockchain to meet business needs. Among them are standards to be set by the auditors who must rely on the system as audit evidence.

Ethereum is the second largest cryptocoin by market capitalization, but it’s much more than a digital currency. Ethereum helped organize the world’s largest open-source blockchain initiative, the Enterprise Ethereum Alliance. Its purpose is to build a clear roadmap for businesses to learn and leverage the technology and to provide governance for enterprise accountability, features, and licensing models. One of the systems they have helped implement is the smart contract.

A smart contract follows the same principles as a cryptocurrency transaction, but you can layer condition-based code to facilitate, verify, or enforce the negotiation or performance of a variety of financial and non-financial transactions. This effectively and efficiently eliminates a lot of the paperwork and middle-man responsibilities in the world today. Many Fortune 500 companies have already invested billions of dollars in this technology and are members of this organization (e.g., J.P. Morgan, Intel, UBS, Microsoft, ING) who recognize the impact this technology will have on their specific industries and the marketplace. Deloitte and PwC (and now Raich Ende Malter) have started ThinkLab groups in their practices and are working diligently in developing strategies to employ using blockchain.

What does all this mean for us as auditors and tax preparers? Stay tuned—we’ll explain in a future post.

Are you involved in cryptocurrencies? Thinking of getting involved? Contact your trusted advisor, or talk to us at REM.

Special thanks to The Geek Group of Grand Rapids, Michigan, for vetting.