Jan 28, 2022

Blockchain Basics and Accounting

Kathy BrunnerBy Kathleen Brunner

Although blockchain is perceived by many to be just the foundation technology of cryptocurrencies it actually can serve large systems across a wide variety of industries. Blockchain is an accounting technology. CPAs need to have a basic understanding of blockchain’s role in maintaining a ledger of financial information and transferring the ownership of assets in a safe and verifiable manner.

Essentially, a blockchain is a growing list of records linked together using cryptography. Each of these “blocks” contains a cryptographic hash or “time stamp” of the previous block as well as the transaction data. The time stamp proves the transaction data existed when the block was published to be able to get into its hash. As each block contains information about the block prior to it, they form a chain with each additional block, reinforcing the ones before it. This makes blockchains resistant to data modification because, once recorded, the data in any given block cannot be altered retroactively without altering all subsequent blocks.

Stylized chain link with digital 0s and 1s on the links.Blockchain creates a digital ledger of “blocks” that record transactions across many computers. The ledger is decentralized, distributed, and frequently public. Participants in the chain can verify and audit transactions independently, and relatively inexpensively, since any block in the chain cannot be altered. The economic benefit can be calculated through efficiency gains, innovation opportunities, new markets, etc.

Blockchains, or distributed ledgers, use consensus mechanisms to authenticate and validate values and transactions. Consensus mechanisms eliminate the need to rely on a central authority and are central to the functioning of any blockchain or distributed ledger. A consensus mechanism is a fault-tolerant mechanism that is used to achieve the necessary agreement on a single data value or a single state of the network among distributed processes or multiagent systems, such as with cryptocurrencies.

There are at least four types of blockchain networks: public, private, hybrid, and consortium blockchains.

Public blockchains – A public blockchain has no access restrictions: anyone with an internet connection can send transactions. These networks usually offer economic incentives for those who secure them using algorithms. The three main algorithms are Proof of Stake, Proof of Work, and Practical Byzantine Fault Tolerance. Some of the best known public blockchains are Bitcoin and Ethereum.

Private blockchains – Private blockchains are just that – private. One cannot join a private blockchain unless invited by a network administrator. Participant and validator access is restricted. In a private blockchain, consensus is usually achieved through a process called selective endorsement.

Hybrid blockchains – A hybrid blockchain combines both centralized and decentralized features. The exact workings of each chain varies based on which portions of centralization and decentralization are used.

Consortium blockchains – A consortium blockchain is a hybrid between public blockchains that are low-trust and a private blockchain that is a single, highly trusted entity model of private blockchains. These chains have multiparty consensus, where all operations are verified by special preapproved nodes, different from those like bitcoin achieving consensus by the world community.

With all this are sidechains, a blockchain ledger that runs in parallel to a primary blockchain. Think of them as subledgers. Entries from the primary blockchain can be linked to and from the sidechain, allowing the sidechain to operate independently of the primary blockchain. Sidechains are frequently used in the context of private consortium blockchains.

Blockchain in Use

With an increasing number of blockchain systems appearing, interoperability is becoming a topic of importance. The objective is to support cooperation among systems to permit a transfer of assets from one blockchain system to another despite differences in system interfaces, language, and execution platform.

Blockchain, is not always considered  “green.” According to Bill Gates, "Bitcoin uses more electricity per transaction than any other method known to mankind.” U.S. Treasury Secretary Janet Yellen called Bitcoin, "An extremely inefficient way to conduct transactions," explaining that "the amount of energy consumed in processing those transactions is staggering."

The peer-to-peer computer computations by which transactions are validated require a significant amount of energy. The Bank for International Settlements has criticized the public proof-of-work blockchains for high energy consumption. In a 2021 study conducted at Cambridge University, researchers determined that Bitcoin (at 121.36 terawatt-hours per year) uses more electricity annually than Argentina (at 121 terawatt-hours) and the Netherlands (at 108.8 terawatt-hours). According to Digiconomist, one Bitcoin transaction requires about 707.6 kilowatt-hours of electrical energy – the amount of energy the average U.S. household consumes in 24 days.

There are others who argue that all industries use a lot of energy, and that it’s unfair to single out bitcoin. It has been pointed out that ATMs and data centers of traditional banks consumes a lot more energy than bitcoin.  

Blockchain Applications

Blockchain technology can be integrated into multiple areas. The primary use of blockchains is as a distributed ledger for cryptocurrencies, the most famous being Bitcoin. It can, however, also be used in blockchain-based smart contracts, which can be partially or fully executed or enforced without human interaction. One of the main objectives of a smart contract is automated escrow. A key feature of these contracts is that they do not need a trusted third party (such as a trustee) to act as an intermediary between contracting entities: the blockchain network executes the contract on its own. Home Depot uses smart contracts on blockchain to quickly resolve disputes with vendors.

Blockchain and CPAs

CPAs should not assume blockchain is a technology that erases opportunities. Instead, it is one where many opportunities exist. Potential new roles for accountants and auditors include the following:

  • Auditing smart contracts and oracles (data feeds from external systems that feed vital information into blockchains )
  • Being a service auditor for a blockchain used by a consortium of companies to ensure the controls on a blockchain.
  • Serving as administrator of a blockchain to permit access.
  • Performing an arbitration function to settle disputes.
  • The automation of auditing would allow for an increase in advisory services for clients and the interpreting of results.

Kathleen Brunner is founder, CEO, and president of Acumen Analytics. Acumen Analytics, based outside Philadelphia, helps organizations combine innovation with technology to improve and accelerate outcomes. She can be reached at getinsights@acumenanalytics.com.

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Statements of fact and opinion are the authors’ responsibility alone and do not imply an opinion on the part of PICPA officers or members. The information contained in herein does not constitute accounting, legal, or professional advice. For professional advice, please engage or consult a qualified professional.