Following several auditing scandals, the most notable the Enron Scandal in October of 2001,for the first time in its modern history the global audit industry lost its most precious asset: public trust. Although the industry has since recovered, and the rules have changed to limit the risk of another scandal of similar proportions, the potential for auditor fraud, as uncovered in 2001, still remains.
Over the course of the evolution of financial markets, there was an obvious and increasing need for a system of public accountability. Traditional methods of accounting and bookkeeping allowed companies to record and report their financial information in a standardised format that could be more easily digested by fund members and public investors; but without adequate trust, the public was often left at the mercy of self-interested businesses.
The Auditor
An audit is quite simply an opinion provided on the financial statements of a Fund or Company based on pre-determined accounting guidelines (most commonly International Accounting Standards). The role of the auditor is to provide the trusted voice that states that opinion. On this, an enormous and lucrative industry has been built, with the majority of large players in global financial markets being audited by the “Big Four”. Our Australian Superannuation sector has mandated yearly audits as part of the public confidence in the Superannuation system.
The evolution of bitcoin, and more recently specialist standard double entry accounting systems with integrated Block Chains, has been discussed as being potentially disruptive in the context of many major industries. In different scenarios, significant variations of block chain architectures have been suggested. Bitcoin, the most common use of a block chain, has proven to be tremendously valuable as a perceived network for broad transparency and security, where public participation and visibility is is essential element of this trust. This contrasts with the secretive nature of almost all Superannuation Funds worldwide, a similar situation applied to most investment managers,
Recently we have seen the emergence of both Public (bitcoin like) and Private Block Chain Ledgers, the latter have greater flexibility for data privacy and authorised access. In many implementations these are based on standard double entry ledgers with block chain security applied to them, nothing radical like bitcoin, just a natural evolution of accounting systems.
Across this spectrum (from fully public to private) lies the solutions to many of the world’s centralised data problems, including financial reporting and auditing. The first commercial Private Block Chain Ledgers for the superannuation industry was released in 2015, we expect to see the first truly decentralised (bitcoin has a single distributed block chain) Public Block Chain Ledger within the same year.
Problems and Opportunities
Those familiar with accounting will understand the concept of double-entry bookkeeping, as being an evolution “from single-entry, which just recorded what happened, to double-entry, where what happened has to be explained by reasoning with another account. So if you don’t have an explanation, you can’t have an entry”.
This is the basis of debits and credits in accounting, where one account tracks a balance and the other an event or activity. Over the course of an operating period, balances above accumulate with each additional entry. By the end of the year, Fund X may be accumulated balances for each of its members after all contributions, investment activities and payments are netted together.
This is the point in time where the auditor comes in. Because Fund X is accountable to its members, they require accurate financial statements to characterise the Fund activities and their resulting member benefits.
In essence, the auditor will test a reasonable sample of these balances, and the transactions they are comprised of, to make sure that the reporting is “close enough” to the truth (based on the materiality of the Fund). Often, the auditor’s test will include communicating with the respective parties to have them confirm the balance reported on Fund X’s financial statements.
In addition to this entire process, consider that for each customer and supplier, there could be another auditor testing the very same transactions on the other end. In terms of instances of redundancy and inefficiency, this is one of global proportions.
The Audit Premise
The audit processes involved in the scenario described above have remained relatively unchanged for decades, with slight improvements to change the nature of the information from paper to digital, but without questioning the underlying premise and the role of the auditor. The technology of a Block Chain Ledger is very well suited to address this scenario.
With the ability to compare accounting entries between two parties, while maintaining data privacy, this solution could significantly reduce the reliance on auditors for testing financial transactions. Once a match is posted to the block chain ledger, the transaction is time stamped and irreversibly recorded. each and every transaction and flows between systems can be verified from the source. You have the debit, the credit, and the confirmation by the network.
A block chain ledger solution could essentially allow for an automated third party verification by a distributed network to ensure that transactions are complete and accurate and unalterable.
As described, it is difficult to properly convey the size of this opportunity. The use of a block chain for the purpose of audit is unique from other uses as audits impact all industries and are the fundamental basis by which global financial markets are trusted by superannuation members.
The use of private and Public Block Chain Ledgers, will revolutionise the audit process and significantly enhance the confidence in the Superannuation Industry. The rate of change in this area is truly amazing, and like all disruptive technologies there will be the inevitable winners and looses.
The future of secure Block Chain Ledgers and the next generation of digital audits is here today..
Further Reading
Public Block Chain Ledger for Accounting, SMSF, and Portfolio processing.
Disclaimer
The contents of this site should not be understood to be accounting, taxation or investment advice but rather as general product related educational information that may or may not meet your specific requirements.
