How the Blockchain Could Stop Firms Cooking the Books

Enron, WorldCom, Lehman Brothers and Saytam are all dark moments in corporate history. One way or another, they all cooked the books to hide their true financial position, at the expense of investors, customers, and sometimes, the tax payer. Could the blockchain be used to stop corporate fraud?

It’s unlikely that large organizations would begin trading entirely in bitcoin, but some believe that distributed ledgers could be used to 'bake' verified transactions directly into a company’s accounts, even if those transactions are conducted in fiat currency.

Charles Hoskinson, former CEO of Ethereum, believes that accounting is one of the next big opportunities for the blockchain.

Hoskinson said:

“With blockchains, you have transaction histories back to the beginning. If you can internalise it and merge with GAAP [generally accepted accounting principles] then every single penny could be accounted for by this incorruptible entity.”

Transactions and records united

One of the biggest advantages that the blockchain brings to cryptocurrency transactions is that the transaction and the record of the transaction are the same thing. When you send someone bitcoin, the blockchain not only makes that transfer, but provides an eternal, immutable record of it.

Marrying the transaction and the record would be invaluable when a company came to audit its transactions. So explained Roger Willis, a UK-based tech entrepreneur with an accounting background who has written about the value of merging the two together.

“You can embed the accounting for the transaction within the transaction, and you can get participants for these networks to approve these transactions as they happen,” he said.

This has several benefits for companies needing to audit their books.

The first is broad integrity across all transactions. Today, auditors will typically only be able to verify a small sample of transactions in a large company, Willis said. They approve the rest based on statistical probabilities. Merging transaction and record together creates a more comprehensive and explorable view of an organisation’s transaction history.

The other benefit is continual auditability. Auditors could come in and do a complete spot-check audit at any time, because the record would always be complete up to the current point. It would be a ‘clean as you go’ approach to auditing.

Bringing auditing up to date

“Audit hasn’t changed for a long time, and it needs to. The tech revolution went past audit and accounting and never looked back,” said Willis, suggesting that the big four auditors have little incentive to change the status quo.

Willis doesn’t think the public blockchain is a good fit for this task, though, citing the privacy of transactions as a concern.

Instead, TriplEntry, the system he is currently building, uses a central server as an intermediary between senders and recipients of invoices. They both digitally sign an invoice, and TriplEntry's server provides the third signature, acting as a trusted third party.

Others are more positive about the use of public blockchain technology as a distributed ledger for accounting. Blockstream founder Austin Hill is already experimenting with it.

“Blockchain technology by its nature is public. If you’re running a private alt chain, there’s no guarantee that you can’t play all sorts of games,” he said. The greater and more distributed the blockchain’s hash rate, the more trustworthy it will be, he suggested.

Hill acknowledges that privacy would be a problem, however, and suggests that one-way homomorphic encryption would be a useful way to protect the privacy of transactions in a public blockchain ledger.

“You can hide the value of a transaction so that only authorised people can see its value, but it would still be recorded in a public ledger” he said. “This would allow the accounting systems, or potentially risk managers looking at a company’s stock, to say ‘the books add up, but we're not allowed to know the values’.”

Insurance companies could prove that they hadn’t violated reinsurance rates, without having to reveal the full value of their portfolios, for example.

Getting all those transactions onto a large blockchain like bitcoin is where Blockstream hopes its system will come in. The firm uses sidechains technology to offload transactions from the bitcoin blockchain. Another alternative could be the use of a 'notary chain', as offered by Factom.

Integrating non-crypto transactions

The problem here is the merging of an accounting transaction and a record in a journal, as Willis describes, so that one becomes the other. If companies are making transactions in cryptocurrency, that’s easily done. But what about those that aren’t? Most companies trade in fiat currency, or stocks, or property, or other assets.

Simply merging accounting systems with a distributed blockchain ledger wouldn’t be enough to validate transactions. To be truly verified, those transactions, rather than just the records of them, have to be recorded in the blockchain too.

Let’s say two companies make a transaction, with one selling something to the other in US dollars. Who’s to say that they couldn’t collude, to make that record in their accounting system far smaller or larger than they actually were?

Unless the payment system that was used to send the fiat currency from one to the other was also writing to the blockchain, then you’re just relying on the two companies’ word for it. Lies encoded into the blockchain are still lies. They’re just immutable lies.

This is the larger challenge, says Hill. “Companies receive payment via SWIFT, via business-to-business checks, or card data. [However,] I’m aware of a business-to-business checking company that’s trying to replace paper-based cheques in parts of the developing world. They want to replace cheques with blockchain transactions,” he said.

“If those kinds of services evolve, where we see more of the payment networks moving to technology, then we could have a far larger majority of a company’s business affairs being conducted on the blockchain, and auditable a priori,” he continued.

This isn’t something that payment networks will necessarily do on their own without help. Blockstream is already building a software stack that, Hill says, will allow developers to build out solutions.

We’re a long way from a point where non-cryptocurrency payment networks all write to the blockchain, but Hill maintains that allowing developers to build out sidechain solutions will begin to draw payment networks towards this approach. He would like to see global remittance networks, forex exchanges and asset-to-asset exchanges hopping on board too.

A solution for exchanges first?

One of the first places this could start is bitcoin exchanges, which still face a challenging audit problem, especially given the historical issues over cybersecurity and the integrity of their reserves.

The broader opportunities are far greater, Hoskinson said, suggesting that if we can pull this off, it could create a useful means for investors to analyse accounts across different organisations more effectively.

He said:

“Once you have it in blockchain format, you could have interoperability on accounting. I could take Microsoft’s accounting in their books and make sense in terms of Google’s, or BP’s accounts. That’s powerful, especially for developing nations.”

While bitcoin continues the uphill journey from speculative asset to everyday means of exchange, the real opportunity for businesses may lie with the technology underneath it. Although human ingenuity being what it is, crooks may always find a way.

Audit image via Shutterstock