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Narayanan Vaidyanathan

Narayanan Vaidyanathan, Senior Professional Insights Manager, ACCA.

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Blockchain, the Future of Audit, and What It Means for Businesses

Blockchain is a method of recording data, a digital ledger of transactions, agreements, contracts and bills distributed across several hundred or even thousands of computers around the world.

Photo Credit : GECKO Governance,

Blockchain

The ability to track and transfer value, in the form of money or assets, in a secure, real-time way, similar to how we transfer information today, could fundamentally alter the way businesses transact with one another. Distributed ledgers, or blockchain – the underlying technology to enable this – is at the heart of these developments. It could change not just individual organisations, but entire industries and their supply chain. The financial services industry is not exempt from this phenomenon. Banking, insurance, and even the implementation of the Goods and Services Tax, can benefit from utilising the blockchain technology.

Blockchain is a method of recording data, a digital ledger of transactions, agreements, contracts and bills distributed across several hundred or even thousands of computers around the world. Digital records are lumped together into ‘blocks’, then bound together cryptographically and chronologically into a ‘chain’ using complex algorithms. It is used as a ledger which can be shared, but can only be updated or altered by consensus of the majority. Thus, there is trust, but it is ‘distributed trust’. This peer-to-peer network makes participants responsible for the validation of records, without the use of a central authority for this purpose. So if the majority of participants agree that an update has been correctly validated, that becomes the basis for the updated entry to be added to the ledger.

New technologies are allowing us to reimagine the way we live and interact with one another, and blockchain can be a defining moment in this new wave of information sharing. Some of the major benefits of this technology are:

  • Data privacy: The permissioned distributed ledger has mechanisms in place to ensure that users can only see data that they are authorised to see, or that transactions can be viewed without the identities of the participants being shown, providing extra assurance. A common ledger doesn’t necessarily mean that everyone can see every detail; controls can be put in place if necessary
  • Eliminating human error and fraud: Distributed ledgers can significantly reduce, but not completely remove, human error or fraud; the technological architecture makes fraud and error difficult. The in-built consensus mechanism has safeguards to prevent either collusion between participants or the acquisition of too much influence over a single participant within the network. It also makes it difficult for a rogue actor to singlehandedly disrupt the network.
  •  Accountability: Records are shared among network participants and co-owned by them, similar to a model of mutual ownership. There is a certain level of accountability inherent to the concept of a distributed ledger. Consensus is a pillar that supports governance, assurance, privacy, security and performance; any change that needs to be made needs to be voted upon and all participants are made accountable for said change.
  • Immutability: ‘Immutability’ refers to the inability to remove or amend transactions once they’ve gone through the process of validation, achieved majority consensus, and been added to the ledger. Once the entry has been created, it cannot be removed or changed in any way. This means that an uncorrupted view of all entries recorded by participants is created – a perfect audit trail. As a corollary, if a transaction is incorrect, it cannot be amended; instead a new reversing transaction in the opposite direction must be entered to cancel it out.
  • Greater efficiency: In industries that involve a large amount of manual processing, ‘legacy’ systems, or have heavy reliance on outdated and/or offline modes or working could immensely benefit from the blockchain technology.

Commercial applications of blockchain

Many notable entities have examined blockchain and are now moving to adopt it. In India, several banks are looking into the technology to better understand how best it can revolutionise their banking services. Last year, RBI, SEBI and IRDAI decided to launch a new system of online KYC (Know Your Customer) that helps reduce redundancy in collating documentation from customers. In order to comply with the process of KYC, banks and other entities must dedicate a huge amount of resources. The new system aims to have a common KYC process for all financial sector intermediaries, which include mutual funds, banks, insurance companies and brokers. The distributed ledger technology reduces reconciliation across different databases and drive significant efficiencies. A blockchain-based registry would not only remove the duplication of effort in carrying out KYC checks, but also enable encrypted updates in real-time. The record would also provide evidence of the institutions’ compliance in carrying out the KYC process.

The Goods and Service Tax (GST) now looks to be all set to roll out on July 1, 2017. For a smooth transition, states have come to a consensus on a common portal providing three core services: registration, returns and payments. The present system of data management by tax departments typically involves large legacy centralised IT systems based on a ledger with some recovery sites. These are supplemented by an array of networking and messaging systems to communicate with external stakeholders. Highly centralised systems present a high-cost, single point of failure, apart from the cost and complexity. In contrast, distributed ledgers are inherently harder to attack. They are multiple shared copies of the same database, so a cyber attack would have to attack all the copies simultaneously to be successful. The distributed ledger can record proof of events, which is public, irrefutable and impervious to tampering, as it establishes a distributed consensus about every transaction. With something as complex as the implementation of GST, some leading advocates argue that the use of blockchain could potentially make central uploading and invoice-matching by tax departments redundant.

Auditing businesses in the era of blockchain

Digitisation of accounting systems in the country is still at its infancy compared to other industries. Some of the reasons may be found in the exceptionally high regulatory requirements with respect to validity and integrity. As blockchain moves to transform existing business models and the skills relevant to delivering them, their books and records are also likely to evolve. The value of assets companies hold, details of ownership, information about transactions between participants or other information can be represented within a digital registry, and those who audit these industries need to change the very system and tools they use to accommodate this fact. Here are a few ways how blockchain could impact the role of professional accountants:

  • Audit - Completeness: The distributed ledger removes multiple, disjointed internal and external databases of records that need reconciling – and should reduce the risk of inadvertently missing transactions through timing mismatches or booking errors
  • Audit -Accuracy: Transactions booked in a transparent manner and without involving intermediaries could help maintain accuracy, although human error remains a factor. But the transparency safeguards should ensure that everyone can see when there has been an inaccuracy, and if immutability is respected the audit trail will be preserved; a correcting entry is added rather than removing or making historical entries
  • Finance business partnering: With the new system, the auditor is no longer a third person in the auditing process, looking at the business from outside. The auditor can now act as a strategic advisor who can view the business not only from a risk perspective, but also as a part of the business who can contribute significant insights to help increase divisional revenues
  • Regulatory compliance: Combining regulation and technology may change the current operating environment, since proof of compliance requires data from transactions to be readily available and trustworthy. Distributed ledgers may give the regulator a more transparent view of an organisation’s ability to meet requirements, and may impact the way accountants need to manage regulatory reporting
  • Audit - Timing: The current audit process is typically an annual exercise, mostly because of the time and effort invested in it. Distributed ledgers may make it possible to conduct more frequent audits on a quarterly or even a monthly basis. Taken to the extreme, one might even imagine a scenario where real-time audits would be possible. This improves the auditor’s understanding of the business, as the engagement is no longer a year-end snapshot. This in turn, can facilitate the ability to spot trends or future risks more proactively.
  • Audit - True and fair view: Auditors will now be able to get a true and fair picture, and have the time to gauge a deeper understanding of the overall business model, rather than reducing the audit to a tick-box compliance exercise. 

Whatever one’s opinion about distributed ledgers, they look likely to be the focus of sustained attention over the coming years. Innovation, where it concerns new technologies in particular, tends to be a constant iterative process of improvement by trial and error. And distributed ledger technology is very much in the early to middle stages of that development. Its attractiveness is as an idea that creates more than a technology process improvement. It aspires to create a business model and ecosystem-level transformation. Just as online learning did not eliminate the classroom teaching model, distributed ledgers may prove to be at their best when combined alongside human experience and judgement.

Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house


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