The Guide and Workbook for Understanding Blockchain in Accounting

Chapter 1: Introduction

The objective of The Guide and Workbook for Understanding Blockchain in Accounting is to help you understand blockchains in business and accounting, broadly defined. A blockchain is a specific type of information system without reference to a functional purpose. As an information system, it is natural to compare it to accounting information systems (AISs). At a high level, we think of AISs as computerized systems that process business transactions, collect and store them as data, typically in proprietary databases, and report on demand the results of operations. At a higher level, we think of AISs interacting with other systems as part of an enterprise information system that supports short and long-range decision making to run a business entity. And, since business entities interact with other business and regulatory entities, their internal information systems need to be able to interact with those outside of their corporate boundaries, forming an ecosystem of information systems. Blockchains are a relatively new form of information system that do all of this and more; including, process transactions based on agreed upon rules in digital contracts, validate and combine transactions to form blocks, which are then linked together in an immutable chain, and share transactions in an open ledger.

Blockchain is a concept as well as an information technology (IT). Because of cryptocurrencies, like bitcoin, most people are somewhat familiar with how the technology works, but not with its underlying IT or the concepts on which it is built. Making matters more confusing, is the hype surrounding blockchain applications. This book is designed to introduce blockchain from a business and accounting perspective, with a focus on applications. It is based on how the author teaches blockchain to accounting and MIS students at the University of Delaware and to educators and other professionals in workshops and seminars.

From an IT perspective, blockchain is a peer-to-peer transaction computer network technology where each peer can submit transactions, that are validated, assigned a digital identity, collected into blocks, linked to previous blocks, and stored on a shared blockchain ledger. On a cryptocurrency blockchain, anyone can become a peer by downloading an application, purchasing some of the cryptocurrency, and submitting transactions to spend it by sending an amount to a peer. Every peer on the blockchain can see the transaction but not the identity of the parties involved in the transaction. In contrast, on a business blockchain, peers are invited to join and each has a known identity and permission to perform specific transactions; which may or may not be visible to all.

The Guide and Workbook for Understanding Blockchain in Accounting (The Workbook) is intended to be used by accounting and MIS students, professionals, and others interested in learning about blockchain as a concept and as an IT in business and accounting. From an accounting and management information systems perspective, blockchains should be considered to be a part of new, redesigned business information ecosystems that exhibit characteristics different from more traditional information systems. The author refers to business ecosystems as “… the network of organizations, including suppliers, distributors, customers, competitors, and government agencies, involved in the delivery of a specific product or service through both competition and cooperation” (Investopedia.com, 2019).

The Workbook is written from the perspective that accounting and MIS students and professionals need to understand the technology behind blockchains in order to know how they work and make informed decisions about their data, processes, and their potential for improving business information system ecosystems. To do so, one must understand the concepts and the enabling technology. It is intended to be used as part of an accounting or MIS class or as an independent study guide and workbook. To get the most out of it, keep in mind the following:

• The Workbook is designed to be used while you are in front of a computer connected to the Internet. You should also have a current Web browser and a text editor. In examples and exercises, the author uses Mozilla Firefox, the Internet Explorer, Chrome, and Notepad ++. For a text editor, the author recommends Notepad ++ (Notepad-plus-plus.org) or Visual Studio Code (code.visual.studio.com) for Windows and Macs. As you read the material and work through the examples, point your Web browser to the indicated URLs, download the example files, and use the recommended tools to write code;
• In Chapters 2 and 3, you will be introduced to other blockchain technology, including hashing and JSON, and you will find “Interactive exercises” designed to reinforce your learning, as well as, end-of-chapter exercises designed to be completed as assignments or self-directed exercises;
• In Chapter 4, you will find examples of blockchains in business, with an emphasis on finance, accounting, and auditing applications.

Blockchain – what and why

Though you will see a lot of different definitions of blockchain, at its heart, a blockchain is a peer-to-peer network in which peers create transactions that are written to a shared ledger and affect the status of an asset. These transactions are collected into blocks, validated by a consensus algorithm, connected to pervious blocks to create a chain of blocks of transactions that cannot be changed, and shared among the peers. On a cryptocurrency blockchain like Bitcoin (BTC), the asset is bitcoin, the transaction is a decrement in the number of bitcoins held by a peer in a wallet (i.e., a peer spends bitcoins in his or her wallet by sending them to another peer), the validation algorithm is known as “Proof of Work,” and the sharing is known as a “distributed ledger.” On a business blockchain, the asset is anything of value, the transaction is something that changes the status of the asset, like transferring ownership from one peer to another, the validation algorithm varies but is often a “Proof of Authority,” meaning the current owner has the authority to transfer ownership, and the sharing is a ledger available to authorized peers. In any case, blockchain is a peer-to-peer network technology that validates and records transactions in blocks, chains them together, and shares the results.

Two of the most important business reasons for implementing blockchains, alluded to in this definition, are collaboration and sharing. Most, if not all, businesses today collaborate with other businesses, customers, and agencies in some type of relationship. They share data and reports and they connect to each other in various ways forming business ecosystems. The most basic example is a supply chain; which, when it involves multiple participants, is better labeled a business ecosystem. As you will see, the De Beers Group blockchain is much more than a supply chain – it is part of a business ecosystem.

Tracr – www.tracr.com

The stated objective of the Tracr blockchain is to “assure the provenance, traceability, and authenticity of natural diamonds.” All entities in the natural diamonds industry are faced with the problem that their diamonds may have been mined in a country with a history of warlords using child and slave labor and ill-gotten gains to support war and genocide. Being able to prove to a potential customer that a diamond in a jewelry store is authentic, and not a “blood diamond,” is inherently difficult and requires the collaboration of business entities from mine-to-retailer.

The Tracr blockchain is a collaborative platform on which business entities submit documents and interact to accomplish the objectives of provenance, traceability and authenticity. As with many information systems in business, the Tracr blockchain is a digital representation of the operation of a physical system. It operates as follows:

• A trusted ethical mining operation is invited to join Tracr. The entity mines raw material, extracts a diamond and creates a diamond registration document; including, the date, time, location, and country of origin. It then creates a digital asset on the blockchain by posting the registration document to the Tracr blockchain;
• Next, the diamond is purchased by a manufacturer where it is cut, polished and graded for carat, color, clarity, and cut, and is then “certified” – in the U.S. by the standards established by the GIA (Gemological Institute of America). The certification documents, including 3D scans and images, are added to the Tracr blockchain;
• Next, the diamond is purchased by a retailer where it is made into a piece of jewelry, documented, market-valued, and purchased by a consumer. The retailer is able to prove the authenticity of the diamond based on its provenance as documented on the blockchain. And, if the consumer so desires, the retailer can assist him/her with an ownership registration document.

This written explanation of the De Beers Group blockchain serves to illustrate several key characteristics of business blockchains that make them different from traditional accounting information systems. First, on a traditional AIS, we think of an asset as a resource with economic value owned by an entity. On a blockchain, an asset is something of mutual value to the participants. On the De Beers Group Tracr blockchain, the diamond registration document submitted by a “trusted” mining entity meets this definition; as do, the diamond certification document and the 3D images submitted by a “trusted” manufacturer. Second, on a traditional AIS, we think of a transaction as representing an economic event measured in a fiat currency. On a blockchain, a transaction is any event that affects the value of an asset. To the blockchain participants, the value of a transaction depends on where they are on the blockchain. Each diamond registered by a mining entity is an ethically-sourced diamond from a trusted mining operation. As such, it is more valuable to the mining entity itself and all participants further down the chain. The manufacturer who purchases the diamond and then cuts and certifies it is sure of its source; it can be graded and priced accordingly. The jewelry retailer who purchases it benefits from being able to document and prove its provenance and therefore its retail value. Third, with a traditional AIS, the network is typically internal, proprietary, and based on a client-server configuration - with individual clients posting transactions to a database on a central server. In contrast, a blockchain is open, collaborative, and based on a peer-to-peer configuration - with each node able to interact with each other node and each having access to the data.

The Tracr blockchain is a great example of a system that answers the question of “why” are businesses implementing blockchains – to meet business objectives that can only be accomplished by trusted partners collaborating and sharing things of value with each other. It also illustrates why blockchain is so revolutionary. In the late 1990’s and early 2000’s, the business information systems landscape was revolutionized by the implementation of enterprise resource planning systems (ERPs), like SAP and Oracle. ERP’s were so revolutionary because with them a business could network their entire organization by integrating all of their separate internal functional information systems, like production planning, asset management, and accounting, into a single ERP package. Today, blockchain is revolutionizing business information systems by providing a platform on which businesses can collaborate and share data with partners in a business ecosystem. EY states that “Blockchains will do for networks of enterprises and business ecosystems what enterprise resource planning (ERP) did for the single company” (EY, 2018). Its effect on accounting and accounting professionals will also be dramatic. In a joint paper, the Chartered Professional Accounts of Canada and the American Institute of CPAs, state that “ … blockchain technology has the potential to impact all recordkeeping processes, including the way transactions are initiated, processed, authorized, recorded and reported” and “CPAs may need to broaden their skill sets and knowledge to meet the anticipated demands of the business world as blockchain technology is more widely adopted” (CPAC, et. al., 2017). Both of these statements are being borne out today.

In the upcoming Chapters we will uncover the “what” and the “how” of blockchains. As you will discover, implementing blockchain in business is only limited by your imagination. Starting with this foundation, The Workbook is designed to help you understand blockchain as a new information systems technology with revolutionary potential. InThe Workbook, we will take an object-oriented approach to understanding blockchain. By working through the interactive exercises and completing the end-of-chapter exercises, you will gain hands-on experience with the blockchain technology.

Preview of The Guide and Workbook for Understanding Blockchain in Accounting

To understand the blockchain concepts and the technology on which it is based, it is beneficial to start with cryptocurrency and then move to business applications. In Chapter 2, you will find a discussion of permissionless blockchains, as exemplified by Bitcoin, and a retail business, Starbucks, accepting it for purchases. The chapter is designed to explain the technology and flesh out the underlying concepts behind all blockchains. With hands-on exercises, it provides a foundation for understanding blockchains and the mechanics of how they work. In Chapter 3, you will find a discussion of permissioned blockchains, as exemplified by Tracr, the IBM Food Trust platform, and Home Depot. With hands-on exercises, it extends the foundation to include how permissioned and hybrid blockchains work. In Chapter 4, you will find a discussion of smart contracts and blockchains applications in finance, accounting, and auditing.

From a teaching perspective, The Guide & Workbook for Understanding Blockchain in Accounting is designed to be self-contained. Each chapter will introduce a student to concepts with hands-on examples of how they are implemented. Each chapter has end-of-chapter exercises through which to broaden your understanding of blockchains in business.

I hope you enjoy The Workbook and find it to be a useful tool for learning about this emerging technology that is changing the face of business and accounting. It will be an important part of your future as a business professional.