Blockchain Inspired Future Accounting
Exploring Triple Entry Bookkeeping
Confidence in blockchain and Bitcoin are at an all-time low. In addition to recent bad press, blockchain has problems with scale and energy consumption. Despite this, the concepts blockchain leverages hold real promise in unlocking value and better outcomes for consumers and business. We’ll explore one overlooked and potentially breakthrough aspect that blockchain has made newly relevant: Triple Entry Bookkeeping.
This article is coauthored by Corinne Finegan and Roger Meike
Headlines over the last year have decried the fall of blockchain, and in recent months have reached a fever pitch. A sampling includes “Cryptocurrencies Have Failed, And Blockchain Still Has Yet to Be Proven Useful” (Forbes), “Blockchain companies go silent when their promises fall short.” (MarketWatch). Or the particularly rosy, “Don’t believe the hype: There are no good uses for blockchain” (American Banker).
The news about Bitcoin, the most high-profile cryptocurrency based upon blockchain technology, is equally bad or worse. Hacks, news such as the $137 million in cryptocurrency apparently lost forever due to the untimely death of a cryptocurrency CEO who had the only key (the wallets were later found to be empty), and rampant speculation have plagued Bitcoin of late.
Confidence in blockchain and Bitcoin are at an all-time low after reaching soaring heights. Like Icarus, blockchain flew too close to the sun and its proverbial wings have melted.
Given all the bad press, it would be easy to focus on the shortcomings of blockchain, such as its challenges with scaling or the huge energy consumption of Bitcoin mining, known as proof of work (POW). Bitcoin POW is estimated to consume the same amount of electricity that Switzerland does in one year. Focusing on this would miss an important opportunity, however.
Beyond the hype and bad news cycle, concepts underlying blockchain hold real promise in unlocking value and better outcomes for consumers and businesses. Warren Buffet may have put it best recently when he said that Bitcoin is a “delusion” but Blockchain is “ingenious.” It’s worth exploring how the reduced costs of verification and greater levels of trust engendered through blockchain-adjacent tech could benefit businesses and consumers.
Blockchain’s original purpose was that of a shared and decentralized public ledger. This public ledger is verified by multiple parties. This establishes some trust in the veracity and provenance of the information. Because multiple parties verify the information on the blockchain, through a process called mining, the data is immutable. This means data can’t be changed.
Example: Triple Entry Bookkeeping
Bookkeeping, the process of tracking financial transactions and assets for a business, can be traced back thousands of years to the ancient civilization of Mesopotamia. The “books” consisted of a “ledger” or list that was used to record transactions or changes of state in an organization’s financial situation. Over time this ledger represented the accumulated financial history of the organization. Back then, anyone who touched the books had to be completely trustworthy as it would be easy to fudge the numbers. Mistakes were easily missed as there was no cross check. These single ledgers limited the growth of organizations.
Fast forward a few millennia to the 1300s and the invention of double entry bookkeeping. This was a major innovation. Luca Pacioli, an Italian mathematician and colleague of Leonardo da Vinci, described the system of double-entry bookkeeping used by Venetian merchants in his “Summa de Arithmetica, Geometria, Proportioni et Proportionalita” in 1494. With double entry bookkeeping, businesses could now grow beyond trusted insiders via the introduction of a symmetry that was more difficult to fake and easier to keep accurate. It employed checks and balances across the different parts of the organization. This meant that collusion was required across an organization to commit fraud, not just changing one entry in a ledger, thus making it much more difficult.
This advance has become central to modern business and has been the standard for 700 years. Double entry accounting has allowed the growth of businesses as we see them today. However, while much better than its predecessor, double entry accounting is also vulnerable to fraud. Enron is a well known example — in the 1990s, the company used creative accounting to obfuscate massive trading related debts and losses through manipulating revenue recognition. Part of the issue stems from the fact that transactions are still represented individually by each party involved. Each organization represents their version of a transaction independently of the other. There is no synchronization across organizations. In this case Enron was able to represent transactions in a way best suiting itself. As a result of the Enron scandal, regulations were tightened with the Sarbanes-Oxley Act of 2002. This Act requires more intense oversight and audit of the books of large public corporations. By shining a light onto the books of public companies it is hoped that fraud will be easier to spot.
Whether intentionally fraudulent or accidental, the two participants in a transaction can get out of sync because there are no checks and balances other than outside audit. Looking at the transactions that make up an economy, it can be difficult to arrive at a single source of truth.
Can Triple Entry Bookkeeping help?
One concept central to blockchain is that it acts as a central ledger across parties to be the single source of truth of a transaction. The transaction itself resides on a ledger outside and independent of any particular organization’s books. This is a clear use of triple entry bookkeeping which was developed by Yuji Ijiri in 1986 and resurfaced by Ian Grigg’s 2005 paper, just before Satoshi Nakamoto’s bitcoin-defining paper was published in 2008.
A third ledger shared between multiple organizations is a potential solution to some of the limitations of double entry accounting. Just as double entry accounting allows individual businesses to grow, triple entry bookkeeping may allow whole economies to scale with trust and transparency. An entry in this third public ledger now carries more weight because it is vouched for by both parties involved in the transaction.
The India Goods and Services Tax (GST) is an early move toward triple entry bookkeeping. In this system, businesses are required to submit invoices each quarter. This is required so that they can pay taxes on the transactions. However, there is an interesting exception to this. If you sold widget X to your customer, but you can show that widget X is made up of parts (or services) that you acquired from someone else who has already paid their taxes when you acquired them, you don’t have to pay that portion of the taxes. This encourages businesses to deal with legitimate, tax paying businesses, and allows the government to see a chain of transactions across the various players that ends in a product. In this case the government records become the third ledger and essentially the single source of truth about transactions in that economy. GST aims to simplify sales tax, increase transparency and limit fraud by ensuring only the incremental value created at each stage of a supply chain is taxed. The GST relies entirely on digital reporting. The jury is still out on how successful this will be given implementation issues and the fact that many small businesses in India do not have digital records, but it’s a use case to watch.
Blockchain takes this a step further by only recognizing transactions that exist in the public ledger. It is, by definition, the single source of truth for all transactions. There is no way to carry out an official bitcoin transaction without putting it on the blockchain. As an auditor of a bitcoin account I need to look no further than blockchain. Any and all transactions are on the blockchain and if they are not there, they don’t exist.
Let’s consider how this changes common financial activities such as approving loans. Imagine you are a consumer or small business looking for a loan. In today’s double entry accounting world, a loan officer requires proof of your financial status through income statements (like paychecks), tax filings and other records. Bad actors invent transactions and fake these documents to seem much lower financial risk than they actually are. When the loan officer looks at your books, in a double entry system, they only know that your books are self-consistent. They would have to do a lot of digging to make sure each transaction is legitimate.
Now let’s consider the loan officer above in the world where all transaction are on bitcoin blockchain or some other single source of truth that is outside of the individual players in the transaction. There is high confidence that any transaction listed is recorded by both parties involved and therefore highly likely to have actually occurred. In a triple entry system, this loan officer has much higher confidence that everything on the third ledger is likely to be legitimate as it would require complex collusion across organizations to be faked. This reduces friction for consumers and businesses and reduces verification costs for lenders.
The loan officer or auditor who has access to the transactions on such a third ledger would have access to a complete financial history of that account. While this may appear to add security issues, it is also an opportunity to increase privacy. Unlike blockchain, not all third ledgers need to be publicly readable. They can be permissioned. Imagine that the loan officer above has a set of criteria that they use to determine eligibility for a loan. They can encode this decision criteria into an algorithm, that returns a boolean value of true (you are eligible) or false (you are not eligible). Then, rather than giving access privileges to the loan officer, the loan applicant grants permission to run the algorithm against their account. The loan officer doesn’t get to see your income or your taxes paid, but the algorithm can, in a trustworthy way, access this information and return true or false to the loan officer.
In the increasingly distributed and impersonal world of digital commerce, the trust and confidence once built from in person dealings no longer exists. By and large, business is no longer done by a handshake or dealing with the bank teller that you’ve seen for years. Triple Entry Bookkeeping has the ability to bridge this gap and foster trust and transparency.
