How blockchain could introduce real-time auditing

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6 minute read 27 Sep 2016
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EY Reporting

Insights from external journalists, academics, practitioners and EY professionals

Reporting, EY Global Assurance’s insights hub, provides high-quality content tailored for board members, finance directors and audit committee chairs.

6 minute read 27 Sep 2016

Blockchain is set to transform financial transactions, and thus the world of corporate reporting as well. We examine the implications for the financial services industry, for the finance function and for audit.

Imagine a world where transactions are executed automatically and verified in real time, and where a computer settles derivative contracts on your behalf. Could the world you’re imagining soon exist, thanks to blockchain?

Blockchain may be best known as the distributed ledger technology that underpins the digital currency Bitcoin, but it could also be used for a host of other purposes that involve transmitting data securely. These include payment processing, online voting, executing contracts, signing documents digitally, creating verifiable audit trails and registering digital assets such as stocks, bonds and land titles. Its potential for application within the transaction-based financial services industry is particularly vast, but it is relevant to organizations in every sector.

Going a stage further, blockchain could even overturn entire business models in certain sectors by empowering the growth of “virtual organizations,” also known as decentralized autonomous organizations (DAOs). DAOs operate through computer programs known as “smart contracts” that carry out the wishes of human shareholders by automatically executing the terms of a contract – for example, transferring money or assets.

By the first quarter of 2016, US$1.1b of venture capital had been invested in Bitcoin and blockchain start-ups, according to the Q1 2016 State of Blockchain report by CoinDesk, a news website specializing in digital currencies.

“Blockchain technology represents nothing less than the second generation of the internet,” claims Alex Tapscott, CEO of consultancy Northwest Passage Ventures and co-author of the book Blockchain Revolution. “It is going to have a profound impact not just on financial services, but on the world of business and society as a whole. For the first time in history, two or more parties need not know or trust each other to transact or do business online.”

Automated processes

In the future, finance teams could make use of distributed ledgers – together with artificial intelligence – to automate a range of processes, from payments through to foreign exchange trades and the filing of tax returns. For greater efficiency, finance functions could even outsource parts – if not all – of their routine work to DAOs.

In the future, every company is going to need a blockchain strategy
Alex Tapscott,
Author

Since the data stored in distributed ledgers is authenticated by multiple parties and continually updated, it offers finance teams the possibility of both real-time reporting to management and external auditors, and being able to work more effectively with their external audit and tax providers.

Implications for audit

Blockchain could have considerable implications for audit as well. Tapscott says: “If, each time a company entered into a transaction, an unchangeable record was automatically reported to a distributed ledger, …you could actually have a real-time audit, because all transaction data is recorded to the distributed ledger.”

“I can see the world moving to real-time auditing,” concurs futurist Rohit Talwar, Editor of The Future of Business. “Audit firms will provide plug-ins for blockchain, do the audit in real time, spot anomalies and then send in humans to dig deeper if necessary – unless software can do it for them, of course.” Blockchain could also spell the end of random sampling by auditors, since code could perform a check on every single transaction in future.

Talwar also suggests that blockchain, together with artificial intelligence, could transform the way in which fraud investigations and forensic accounting are undertaken. “The real-time systems would highlight and investigate anomalies and unusual transaction patterns as they emerge,” he explains.

Nevertheless, many commentators suggest that auditors will always be needed to design the appropriate audit strategies in complex systems – making decisions about what level of audit is required, how data should be captured, and the type of audit analytics that should be applied. An even more crucial role will be to provide assurance in an increasingly complex control environment and, for instance, to ensure the party or entity that is entering the records on the distributed ledger does actually exist and the transaction has economic substance.

“Auditors do far more than just add up the numbers and make sure they come to the right value,” Smart adds. “They also audit control mechanisms, disaster recovery mechanisms, processes, resilience and systems. So the auditors will also need to audit whether the distributed ledger systems are working correctly.”

Too good to be true

In principle, blockchain is extremely secure. That’s because every transaction on blockchain is digitally signed, providing assurance that only a certain party could have recorded it. In addition, the data is validated by a majority of other users on the system. Having said that, if the majority of the users on the distributed ledger become corrupt, it is possible to break the chain. Blockchain can also be vulnerable to programming mistakes, as a Swiss-based DAO – actually called The DAO – discovered when it lost US$50m in virtual currency in June 2016 after someone exploited a programming mistake. The reality is that no system is flawless – not even blockchain.

The auditors will need to audit whether the distributed ledger systems are working correctly
Professor Nigel Smart,
University of Bristol

Blockchain has other shortcomings that need addressing. These include its comparative slowness, heavy consumption of power (which makes it expensive to run and environmentally unfriendly), privacy issues (other users on the ledger need to be able to see data if they are to validate it), a lack of standards governing the industry and its limited scalability to date.

Given the opportunities and risks associated with blockchain, it is not surprising that the technology has attracted the attention of governments, central banks and regulators. In June 2016, the European Securities and Markets Authority announced that it was consulting on whether distributed ledger technologies should be used in the securities markets.

Paul Brody, Global Innovation – Blockchain Leader at EY, says: “Regulatory approval is going to be required for any major implementation of blockchain in company accounts and reporting, which means that we won’t see a rapid adoption of the technology.

“Blockchain is spreading quickly in non-regulated areas,” he continues, “both as a general-purpose information technology and as a tool for integrating financial services with operating technologies. Companies will use these unregulated use cases to build confidence as they gradually implement blockchain in their core financial operations.”

We are still in the early days of understanding what blockchain can do, but the long-term potential of the technology is undoubtedly huge. “In future, every single company is going to need a blockchain strategy,” Tapscott predicts. “It will need to rethink its whole organization and what it does.

Summary

Blockchain is set to transform financial transactions, and thus the world of corporate reporting as well. We examine the implications for the financial services industry, for the finance function and for audit.

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By

EY Reporting

Insights from external journalists, academics, practitioners and EY professionals

Reporting, EY Global Assurance’s insights hub, provides high-quality content tailored for board members, finance directors and audit committee chairs.