Can Blockchain Technology Help with The Production of Financial Reporting Information?

A recent CFA Institute report discusses what a blockchain is and answers the question posed in the article title, Can Blockchain Technology Help with The Production of Financial Reporting Information?

As the paper, Blockchain Technology for Corporate Reporting: An Investor Perspective, describes: A blockchain (also called a distributed ledger) is a type of shared database that creates a permanent record of transactions. The “blocks” in blockchain contain records of information:

• transactions (e.g., the date, time, and amount of a purchase),
• the digital signature of the buyer and seller of the transaction, and
• a unique identifier (called a “hash”) that allows us to tell it apart from every other block.

Each block is linked to the previous block by the hash or piece of cryptographic code that verifies it has not been changed since it was created and sets its position in the chain. The “chain” in blockchain includes the links between all the blocks. Each time a new transaction occurs, it is added as a permanent block to the chain.

The purpose of the blockchain is to establish trust (that a transaction has occurred and the amount has been paid) among untrusted parties (when you don’t know the identity of the parties to a transaction). In the absence of blockchain, trusted third parties like banks, brokers, or big retail distributors, like Amazon, facilitate transactions between two parties who don’t know each other. The intermediary serves an important role because it can verify and check identities, confirm that the transaction actually occurred, and ensure that it was conducted for the amount that both parties agreed upon. The blockchain eliminates the need for such centralized authorities because it contains all the data about the transaction and is viewable by, but masks the identities of, all parties.

To sum up, the blockchain is distributed across a number of participants in a network and not under the control of a single participant. Any changes made to the data are clear to all participants. It is different from a traditional database because of the way it creates trust among the parties. Provided it has been designed and implemented correctly, the blockchain also ensures that both the data and the network are resilient as it cannot be tampered with. This is because any attempt to manipulate a prior transaction requires a reprocessing of all the following blocks in the chain. This reprocessing would need to outpace the rate at which new blocks are added to the chain. As a result, many view the blockchain as immutable or immune to manipulation.

Production

According to the UK Financial Reporting Council (FRC) report, the production of financial information includes the cost and complexity of recording and aggregating transactions across multiple entities across jurisdictions as well as consolidating the information. Blockchain could be used to help solve these problems in the production of accounting records because having a single structured location enhances accessibility.

In addition, the role of blockchain could enhance the consolidation process. The complexity of combining financial information from multiple entities spanning multiple territories, can be problematic. Blockchains could bring efficiency and reliability to consolidation processes.

When setting up a blockchain as an accounting ledger, the first question a company must ask is who should be able to access the blockchain.

Private Versus Public Blockchains

A blockchain may be public or private. A public blockchain allows anyone to join. Hence, if a company had a single ledger that contained all its transaction and accounting data, it could be shared instantaneously with regulators, investors, and creditors. Of course, this is unlikely because of the desire for confidentiality. Companies keep their records private for perfectly good commercial reasons.

Private blockchains may be more desirable to companies as accounting ledgers given their need for privacy. Because private blockchains are not distributed, companies don’t have to publicize their transaction ledgers. Private blockchains, however, do pose other challenges. First, private blockchains are permissioned, and only authorized participants are allowed to add transaction blocks to the chain. The problem with this authorization is that although it affords privacy, it also makes private blockchains more of a sophisticated transactional database rather than the blockchains used for cryptocurrencies.

Second, private blockchains allow for companies to retroactively manipulate the blockchain. A blockchain needs to result in a large distributed network so that it is not susceptible to the 51 percent attack or to the manipulation of additional new blocks to the blockchain by a majority of agents participating in the distributed network. The article Blockchain: Emergent Industry Adoption and Implications for Accounting explains that a 51 percent attack on a blockchain refers to participants in the network trying to control more than 50 percent of a network’s computing power or hash rate. People in control of such computing power can block new transactions from taking place or being confirmed. They also can use 51 percent attacks to reverse transactions that already have taken place. A private blockchain, by definition, is not a large distributed network.

The need for privacy by companies stands in the way of widespread adoption of blockchain for financial reporting.  Of course, the use of blockchain in accounting is in its infancy. It is important to monitor the progress of blockchain implementation in companies to see how companies determine whether to place data in a distributed ledger or choose to encrypt some data to balance the needs for both transparency and privacy.