How blockchain is shaking up your financial statement

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Organizations are already taking advantage of distributed ledger technology where it can improve processes, transparency, and data management. We know our businesses well enough to understand how this frontier technology can deliver value and efficiency. But new technology can also throw up entirely new ways of operating. What kinds of innovations are emerging that may have an impact on the finance function and strategic decision-making?

One project that has caught the attention of the profession is Auditchain . This is described as “a decentralized accounting, reporting, audit, and analysis virtual machine that automates and provides proof of assurance on the world’s financial and business information.” The brainchild of former investment banker Jason Meyers , Auditchain enables anyone to review published financial statements, checking that the reporting reflects accurate application of accounting controls and transactions rules within the business.

An independent audit mechanism

Jason set up Auditchain after crossing swords with a regulator. “Audited financial statements didn’t answer their questions,” he says. “I did a forensic audit where we counted every penny. When that didn't work, I realized it was something else.” He wanted a way to provide unequivocal insight into published financial reports. The arrival of blockchain and the introduction of a software application layer on the Ethereum chain gave him the mechanism he was seeking.

The choice of a decentralized, democratized platform to increase transparency, and the use of XBRL, the international audit standards, created a? tool that anyone can access to check their accounts or those of others. Jason’s aim is for Auditchain to remove institutional bias and offer verifiable evidence that the financial statements have been prepared in line with international standards.

For Jason, the thing that is lacking is effective communication. “Companies have to talk to their stakeholders and the market,” he says. “They do this through financial reporting. However, we don’t always hear what they are saying clearly because there are flaws in various aspects of the taxonomies and how they're used. The word audit comes from the Latin adia, to hear. We must be able to hear them.” Auditchain provides a way to check and amplify the story that is being told.

A 21st Century Pacioli

Auditchain currently allows users to check their financial statements against regulatory standards and accounting taxonomies. At the heart of the system sits Pacioli, named for Luca Pacioli, the ‘Father of Accounting’ who first wrote about double-entry bookkeeping in the fifteenth century. Pacioli holds all the transaction controls against which submitted financial statements are reviewed. The most basic rule, of course, is ‘Assets = Liabilities + Equity,’ but there are many thousands of controls in use.

“Pacioli is a complex software package that acts as the network client on the auditchain protocol,” says Jason. “It's built using Prolog, which is a logic-based programming language. You need that for the logic of accounting, audit, and financial reporting. Then it uses iXBRL 2 as a mirror to verify whether a report is actually correct. It computes the output of the proper rules based upon the reporting style of the company and its reporting scheme, principally IFRS, UK GAAP, and US GAAP.”

In simple terms, the system checks the relationship between the opening and closing balances on the published accounts and matches the movements to the rules that should have been followed and the XBRL tags that have been submitted with the filed reports.

Pacioli calculates what the closing positions should be if the declared rules have been followed throughout the year. If the balances are not what would have been expected, this triggers a report on the specific inconsistencies that have been found.

Economic entities can submit their own reports for checking so that they can make any adjustments needed before the company’s statements are published, and data subscribers will soon be able to submit as-filed reports of other economic entities to examine the consistency of logic, data, and taxonomies that have been applied.

The art of transaction controls

Auditchain features extensible business reporting language “XBRL”, the open international standard for digital business reporting. Pacioli incorporates all the transaction controls of the XBRL standard. “It exceeds regulatory specifications,” says Jason. “It's able to detect things that currently specified taxonomy sets and control sets in commonly-used reporting schemes may not.”?

Taxonomy sets and enterprises themselves are highly complex. As well as the thousands of XBRL rules there are common transaction controls that do not fall under the standard. Many companies also develop their own rules or “extensions” to manage highly specific trading circumstances. This opens up some interesting possibilities for finance professionals to contribute to Pacioli’s library of process controls.

“We’ve developed an incentive system for contributing additional process controls based upon the XBRL standard,” Jason explains. “When added to a control set, they will refine its ability to articulate financial state and automate certain processes. Every time those controls are used, you get paid a royalty in AUDT tokens, the native Auditchain Protocol token.”

Each control becomes a unique token, an NFT that gives the owner income from its use and the potential to sell it to another buyer. This can be similar to a sale-leaseback where the owner wants a liquidity event and is willing to rent the controls for a fee.

Could Auditchain’s structure offer a new income stream for finance in the gig economy of the metaverse? Jason certainly thinks so. “If you decide to put down the calculator and build controls, that’s the finance equivalent of play-to-earn,” he says. “Build a portfolio of Process Control NFTs and earn money from them, or sell them on.”

When an accountant submits their own controls, a strict validation process ensures that there is no conflict with other controls and that they work correctly. This is an audit-to-earn mechanism for auditors who are qualified to conduct audits of controls under the ISAE 3402 standard that governs engagement agreements for controls that affect financial reporting.

“To write a control, you just need to know Excel,” says Jason. “Then you select a cohort of licensed validators from the Auditchain Protocol. They check that control and prove that it works, that it doesn't conflict with others in a control set, and that the main control set doesn’t break the new control.”

The Polygon blockchain upon which Auditchain sits distributes royalties to validators and to the owners of any custom controls that are used during a validation. It also manages submission requests and records the certification key for each validation and its findings.

Adding value for CFOs one block at a time

While transparent and decentralized real-time auditing is something that lies in the future, the first commercial Auditchain service to launch will allow anyone, not just accounting users, to submit as-filed reports of any organization for validation.

“Anyone will be able to take a set of reports filed already with regulators,” says Jason, “and submit it to determine where any inconsistencies might be. It's not up to us to say whether these are just anomalies or something much worse, of course. It's obviously up to the analyst that uses the service to take a view on whether or not the financial statements are reliable. But any CFA will tell you that large institutional investors can't rely solely on the data coming out of regulators, the SEC, Companies House, HMRC, or ESMA. They need all the extra context they can get.”

Submitting financial statements for a thorough, logical, and impartial analysis based on defined transaction standards complements the professional skill of internal finance and external auditors. A Pacioli validation will flag up any inconsistent aspects of a financial report for analysts to investigate.

This offers to reduce the burden of complex analysis in investment and M&A decision-making. It pinpoints areas in the financial reports where there are inconsistencies in the story being told, saving considerable effort and cost in number crunching. The target company may simply need help with internal controls and transactions, but there is always the possibility that something more fundamental may be exposed. Auditors are not tasked with fraud detection, and determined efforts to hide problems can be hard to spot, as some high-profile business collapses have demonstrated.?

Auditchain also shows us a compelling vision of a future where finance professionals can improve the story they tell to stakeholders, identify any areas for improvement in their own operations, and satisfy regulators that they have adhered to international standards. It offers a chance to check on the financial reports before filing, a sweep to identify anything that may raise concerns, or to review past filings for any internal treatments that need to be updated.

Frontier technologies help CFOs to deliver greater value through improvements in their processes. Auditchain is one example of a new way of approaching this value creation, enabled by blockchain.

This was the fifth article in my latest series "Frontier Technologies for Finance". You can read the previous ones below. Remember to click subscribe to be notified about future articles.

How are frontier technologies impacting the world of Finance?

Why CFOs are well-placed to understand Blockchain and Distributed Ledgers

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Anders Liu-Lindberg ?is the co-founder and a partner at the?Business Partnering Institute ?and owner of the largest?group dedicated to Finance Business Partnering ?on LinkedIn with more than 10,000 members. I have ten years of experience as a business partner at the global transport and logistics company?Maersk . I am the co-author of the book “Create Value as a Finance Business Partner ” and a?long-time Finance Blogger ?on LinkedIn with 67.500+ followers and 150.000+ subscribers to my blog. I am also an advisory board member at?Born Capital ?where I help identify and grow the next big thing in #CFOTech.