By FLG Partners
First in a series of 3 articles on this topic. In this series, we’ll discuss Blockchain, its benefits and challenges, and its impact on your Finance function.
What is Blockchain?
Blockchain is a distributed ledger technology that enables any digital asset (e.g., land, house, currency, vote, goods, certificates, identity, rewards) to be transacted and traded in near real time while also creating a permanent, irreversible record of these transactions.
Defined in these simple terms, blockchain might perhaps not seem so groundbreaking as a technology. Nothing could be farther from the truth. The invention of blockchain-based computing and transactions, combined with near real-time data sharing of cryptographic assets, have ushered in the next major era of the open internet. In fact, blockchain technology could be the best invention since the internet itself.
Why? Because blockchain allows a value exchange between entities without the need for a trustworthy, central authority. Blockchain technology thrives through the backbone of the open internet – a global, distributed network of computers that share common open source software protocols. Just as HTTPS and SMTP allowed for free information sharing and communications, crypto assets and blockchain technology allows humans to exchange value and transact with one another in the same way: instantly, globally, securely, and at low cost.
The implications of this technology are profound and are still unfolding. An open internet of value exchange has the potential to eventually connect, integrate, and transform the world significantly, eventually eliminating artificial economic borders and enabling a more efficient and inclusive global marketplace. And the future global economy enabled by blockchain is open, shared, far more evenly distributed, and powerful, not just for a few chosen gatekeepers, but for all who choose to connect through it.
Myths About Blockchain
Unfortunately, there are a number of myths about blockchain and challenges associated with its implementation that have contributed to a bias against this new technology.
MYTH: Blockchain = cryptocurrencies such as bitcoin.
Many people confuse crypto currencies with blockchain. Although the first prominent application of blockchain was in the trading of bitcoin and bitcoin transactions, the two are not synonymous. As the interim CFO at Coinbase for almost a year, I saw some make this mistake, narrowing the opportunity posed by blockchain to those advantages gained from using cryptocurrency and bitcoin. But from my vantage point, it was easy to see how the benefits of blockchain apply well outside of the cryptocurrency sector.
MYTH: Blockchain is a panacea.
Blockchain will not solve all your business problems. As a technology, it still relies on data supplied by multiple subsystems to execute transactions. Data integrity is still key and data integration is still necessary. Also, these transaction requirements mean that blockchain is not truly real-time (but close).
Current Challenges to the Adoption of Blockchain
Blockchain technology is still evolving and there are currently many challenges to adoption of blockchain across industry sectors.
For blockchain technology to gain real traction, an industry such as financial services or healthcare (and early adopters within them) must successfully overcome several challenges.
Successful implementation of blockchain requires:
- Recruiting enough technical specialists experienced with blockchain
- Ensuring data security and privacy for all transaction parties
- Proving the benefits of blockchain across production environments
- Extensive collaboration between transaction players to test and confirm that a blockchain-based system is working as intended
- Navigating the regulatory and compliance requirements for a new technology which, today, are still in flux. Not all regulators are on-board with blockchain, including FASB, IRS, SEC, CFTC and FINRA, among others
- Solving auditing challenges caused by the variety and complexity of different types of blockchain applications and current lack of accounting standards
At Coinbase, I experienced the auditing challenges posed by blockchain first hand. The proliferation of cryptocurrencies and the lack of US GAAP guidance that specifically addresses cryptocurrencies have raised questions about how holders of these assets should account for them.
Financial Statement Classification of Digital Assets
While the Financial Accounting Standards Board (FASB) does not have a standard-setting project for auditing cryptocurrencies on its agenda, an industry trade group has requested that the FASB address accounting standards for cryptocurrencies and FASB staff has begun research aimed at addressing this challenge. Some Big 4 auditors currently believe that cryptocurrencies meet the definition of indefinite-lived intangible assets, and holders should account for them at historical cost less impairment, thus applying the guidance in Accounting Standards Codification (ASC) 350, Intangibles — Goodwill and Other. A second way of accounting for cryptocurrencies, as investment companies which fall under the scope of ASC 946, Financial Services — Investment Companies, would account for investments in cryptocurrencies as “other investments” and measure these assets at fair market value through earnings generated by them.
Auditing Digital Assets on the Blockchain
The challenges associated with developing blockchain technology should ultimately be solved as the technology matures, but one major issue still looms – auditing blockchain assets. Audit is the process that produces confidence for all parties involved in any operational process. These parties include an organization’s board of directors, management team, accounting organization, risk committees, regulators, and more. Many of these parties lack the technical sophistication to simply trust innovations in technology such as blockchain, and the current legal climate and enterprise risk framework makes blind trust an unacceptable risk for them. Thus, there will always be a need for an independent audit function to provide assurance and confidence for key stakeholders in any blockchain operation.
Audit teams may not currently have the expertise or guidance to know how to fully gain comfort with a system that puts trust in advanced cryptographic algorithms. Because the technology is new, blockchain requires a new way of thinking about controls. Auditors need to welcome this new development and it’s their job to ask difficult questions: Who controls the blockchain? Who gets access? Where are the blockchain servers, and what physical and digital controls exist? Who monitors activity? Is the technology in fact doing what it claims to do? More importantly, how can you assess existence, control, and value when traditional approaches to auditing have never considered technology of this kind?
One approach being considered involves real-time, transaction-level assurance that is also blockchain, and industry, agnostic. This audit method encompasses an assessment of the blockchain’s infrastructure and the transaction-level processing associated with the business use case. This approach provides the necessary transparency to meet the assurance needs of key stakeholders and may become more prominent as artificial intelligence and other automation technologies continue to push auditing into a true real-time process.
In conclusion, it should be noted that these challenges to the adoption of blockchain are temporary ones and are small in the scope of the promise held out by this new, evolving technology.
In the second of our three articles on this subject, we examine the benefits and opportunities of blockchain across industry sectors and the supply chain.