In 1494, an Italian monk called Luca Pacioli created the double entry accounting system. The accounting system we use even today is based on his work. The single biggest advantage of the double entry accounting system was that, for the first time, I could trust my own accounts.
Earlier, when using the single entry system, if an entry was made and forgotten about, there was no way to verify whether the entry I’d made was correct or not. The double entry system allowed me to trust my own accounts. This way, if I made a payment to my vendor, I debited his account but I also credited my cash account.
Therefore, six months later, if I was to recheck my accounts, I could say, with certainty, that I made a payment to my vendor because there was a corresponding entry in my cash ledger.
Now, I can trust my account and my vendor can trust their account. But, can I trust my vendor’s account?
A test case
Let’s say I made a payment of INR1000 to my vendor, and I made an entry in my books. My vendor made an entry in his or her book, but due to a small typing error, a zero was missed. In their accounts, it reflects that I paid him INR100 and that I still owe them INR900. In my accounts, however, I don’t owe anything because I’d already paid the amount in full.
Here, I trust my accounts, and the vendor trusts his or her accounts. But who is correct? This is now a matter of trust. This trust is bridged by something called the triple entry accounting system which can be implemented using blockchain technology.
In triple entry accounting, every transaction will have a third entry in the blockchain. This will create a situation where it will be impossible for both parties to have any disagreements with regard to their accounts. So, in our example, when I make a payment to my vendor for INR1000, apart from adding the entry to my books, I will also add this entry to the blockchain. My vendor can see this entry and can be sure that they received the money even if their accounts do not match. This blockchain entry will be added into a new block and a unique hash will be generated for it by miners. This makes it impossible to edit or change the entry in future.
In double entry accounting, since there is a trust deficit with regards to the two accounts, an audit is required to reconcile the figures. In a nutshell, this is what an audit is, isn’t it? Now, in the triple entry accounting system, can you see how the need for such an audit is eliminated, or is at least minimised?
An audit is an expensive affair, both in terms of time and money. Here, blockchain accounting can help in reducing costs significantly. Since transactions are already confirmed as true and accurate, and both parties are in agreement, a third party reconfirmation is not required. This solves the trust problem and prevents financial mismanagement like ‘cooking’ the books.
Another great advantage of the triple entry system is there is no need for sampling. All chartered accountants have to use one sampling technique or the other. This is because the data volumes are so large that it becomes infeasible to audit each entry individually. In the triple entry system, sampling is not required since each entry can be tracked and audited. It is all recorded on one blockchain and computers will perform the hard labour.
There are a few companies already offering triple entry accounting services. Balanc3 was a very promising startup that introduced triple entry accounting in 2015-16, but the company has since ceased operations. There is a Norwegian company called Abendum that is now leading the market in this field. Aragon is another such company, and it has even raised funds for business expansion.
Apart from triple entry accounting, Abendum also uses what are called ‘smart contracts’. These were first proposed in the 1990s. Let us understand smart contracts with a simple example.
Let’s say I wish to purchase a plot of land. To complete this transaction I will have to pay an advance to the seller and create an agreement. Thereafter, when I make the full payment, the registration is transferred. Here, the element of trust is in the agreement and the legal system. By using smart contracts, this trust can now be transferred to the blockchain.
In smart contracts, when certain conditions that are pre defined, are fulfilled, the money is automatically released. In our example, I will transfer the money, for the land, to the smart contract account on the blockchain. The contract specifies that when the registration is transferred, the money will be transferred to the seller automatically, without needing any human intervention. It essentially acts as a bank escrow account without the fees that a bank or a third party may charge.
This same system can be replicated for an endless number of scenarios. Imagine you wish to buy machinery for your factory. Before you place your order and transfer the money, you can set up a smart contract which specifies that only when the machinery is delivered in working condition will the funds be released. This ensures trust between both parties.
Hiveterminal is one company offering smart contract based invoice financing for small businesses.
There are numerous examples of blockchain technology being used in the real world today, apart from just cryptocurrencies. Big 4 accounting firms like Deloitte have put in huge sums of money in incorporating such frameworks into their organisations.
Walmart is using blockchain in their supply chain to track their fresh foods — from farm to the consumer. NFTs are the latest buzzword in the market today and they help authenticate ownership of digital assets, and their trade. The potential, in this segment, is enormous.
The future is technology powered
Imagine thinking, 10 years ago, that tweets (on Twitter) will be sold someday. It sure would have sounded outlandish. But this is exactly what is happening now through non-fungible tokens or NFTs. Burst IQ in the health care industry, HYPR in IoT and cyber security, Civil in digimedia and journalism, and Open IDL in insurance are but a few examples.
The future is going to be technology driven. There is no doubt. People in the accounting profession will have to adapt and learn these new technologies that are on the horizon and upskill themselves. To not be left behind, you must adapt to the changing landscape.
(This is Roheen’s second piece on blockchain and accounting. The first can be read here.)