Bitcoin, Accounting and the Blockchain

I usually find that the easiest way to explain Bitcoin is to focus on the blockchain. By sidestepping questions about the nature of money until later on the conversation, people usually get the value immediately of a permanent global record that’s accessible to all and incapable of being forged. Most within the business community understand why a ledger is so valuable.

Single-entry bookkeeping

It’s easy for people to understand the limitations of single-entry accounting where you keep track of your affairs by simply compiling a long list of numbers that you then add up. For all but the simplest personal undertaking, the risks of using this system are unacceptable. Mistakes can be made in adding up the figures or false figures inserted by others stealing money whilst covering their tracks. There are few safety nets. With little evidence available, it can be extremely hard to identify where any issue lies until it is far too late.

Double-entry bookkeeping

This problem was significantly reduced some 500 or so years ago when the vastly more robust method of double-entry bookkeeping came into widespread usage. Popularised by the pioneering Medici Bank in Italy, every transaction that is carried out by a business using this system requires a change to (at least) two accounts within its records. You debit one account and credit the other. In short, money can’t just appear (or disappear). It always has both an origin and destination. Anyone auditing the books now can quickly identify areas where the story doesn’t add up.

So what’s this got to do with Bitcoin?

Whilst double-entry bookkeeping has been the foundation of corporate accounting for centuries, Bitcoin – or more accurately the blockchain itself – now provides a way to introduce an even more powerful method that has been discussed for a number of years – triple-entry bookkeeping. The simplest explanation here is (inevitably!) found on another of Richard Gendall Brown’s excellent recent posts. However, for those of you who want my summary rather than his (far clearer) explanation, here goes:-

• Let’s imagine Company A buys goods from Company B. In today’s world, that means:-
  • Company A will change its accounts accordingly – by recording the cash going out/goods going in.
  • Company B will change its accounts accordingly – by recording the goods going out/cash going in.
• But what if the record of that transaction also gets recorded by a third party?
• Third party = the blockchain, which verifies (cryptographically seals) each transaction and issues a receipt.

Result: every transaction would have a corresponding entry on the books of the other that would have to be verified by the blockchain. Now every transaction is effectively recorded in three places.

Now things can get really interesting. As a public, secure, global platform, the blockchain can then be interrogated by auditors investigating whether transactions truly took place. With such details living on a digital, permanent and trustworthy platform, the potential for cost-saving (and automation) in this area becomes fascinating.

Place questions of transparency to one side for a moment. We could have a system which contains a permanent record of all corporate transactions that have, as a matter of fact, taken place. Systems could then be developed to analyse data on a massive scale – and perhaps even provide an early warning when areas of significant risk start to develop within large businesses or even economies.

Could we do this tomorrow?

Not quite. The basics of the technology are there but, as Richard points out, there are current limitations that need to be overcome. For one, there is a radical transparency here that may not be suitable for all businesses (although it’s not hard to imagine charities viewing this as a feature). We also have a few questions around the scalability of the technology which need to be addressed. Finally, to be clear, whilst this system provides conclusive proof that a transaction itself actually took place, the valuation of such transactions on the books of each individual business would remain for the determination of the auditor. Nonetheless, the timesaving (and cost) in auditors’ fees would surely be significant.

It seems more likely to me that blockchain technology itself (as opposed to Bitcoin’s blockchain) will be used here. You could certainly imagine there being value in different types of transactions being recorded on hundreds of standalone blockchains. 2015 will inevitably see far more debate around the value of fully decentralised versus ‘semi-decentralised’ (!) systems, given the release of technologies such as those created by Eris Industries and the increased involvement of both financial services companies and regulators in the scene. I can imagine that the creation of a blockchain that seeks to record every single transfer of every company share listed in the UK might provoke some heated discussion from those who are currently invested in the current process, for example.

Ultimately, we identified centuries ago that relying on internal ledgers were significantly flawed. Building a system that required double entries provided us with much greater comfort. Now with the advent of the blockchain, once we start to apply ourselves to addressing some of these questions, we have the potential to take that efficiency to another level still.