Blockchain Technology: A necessary part of Audit

Audit Blockchain Technology

High-level insights

  • More and more audit engagement teams must consider Blockchain technology as part of their audit planning.
  • Projections are that the Blockchain market will reach close to US$40 billion by 2025.
  • The greatest beneficiaries will most likely be the banking and financial services sectors.
  • Blockchain is a certain type of database
  • Blockchain stores the information in structured blocks
  • When value needs to be exchanged in the Blockchain, all nodes on the Blockchain network gets involved by checking the validity of the transactions
  • There are two main types of Blockchains: permissioned and permissionless Blockchains
  • Admittedly Blockchain is not the perfect system and has its disadvantages.
  • The auditor needs to be able to obtain sufficient appropriate evidence, so the Auditor is able to express an opinion.
  • Can The Blockchain fundamentally support all the statements made by management?
  • The manner in which the transactions on the blockchain initiated, processed, authorized, and recorded are fundamental to control risk
  • Blockchain may not report on estimates that management is making about certain elements in the financial statements
  • Blockchain risks to be addressed:
    • Money Laundering
    • Related party transactions
    • Internal Controls
    • Tax treatment
    • Measurement


Introduction

The rise of the Blockchain over the last few years has created a space where many industries will most likely be completely or partially disrupted by the Blockchain. The future of audit is also fundamentally impacted by the Blockchain. This is evident from the growing popularity and use cases of the Blockchain. More and more audit engagement teams must consider this technology as part of their audit planning.

We have seen a growing number of use cases in the Financial Services industry, The Healthcare Industry, the Public Sector, and Manufacturing. Some are of the opinion that the Blockchain can ultimately erode the need for an Auditor completely. It is therefore worth having a look at the functioning of the Blockchain and the purpose of an Auditor.

What is the Blockchain?

It is useful to understand what Blockchain is before diving into the audit specifics. Simply put, Blockchain is a certain type of database. It is different in the sense that it stores the information differently than traditional databases do. A traditional database stores information in a table format whereas Blockchain stores the information in structured blocks. Each time the block is filled with information by the users, a new block is created.

The data stored on the blockchain is encrypted by using a cryptographic hash function. A cryptographic hash function is a security feature that authenticates the information on the Blockchain. Each new block created on the Blockchain contains the hash of the block header of the previous block in addition to creating its own hash. This attribute makes it therefore very difficult to hack the Blockchain.

Databases are stored on powerful computers so that it makes it easier to house a large collection of information. It can therefore be seen as a digital ledger that captures different transactions by various different parties that is on the blockchain network.

The key attribute of Blockchain is its decentralized nature. This means it needs more than one computer to store the Blockchain. These computers are spread all across the world and not owned by one single individual.

How does Blockchain work?

There are different participants on the Blockchain called “nodes” and each node maintains a digital copy of the information or ledger. Every entry into the Blockchain is a transaction. A transaction is a representation of value e.g. smart contracts, cryptocurrencies, or physical goods.

When value needs to be exchanged in the Blockchain, all nodes on the Blockchain network get involved by checking the validity of the transactions. The validity check by the nodes is called a consensus algorithm. Once all the nodes are happy, all the digital ledger copies are updated with the transaction.

In this way, the Blockchain is used in a decentralized way. It is important to note that the Blockchain keeps and entire history record off all transactions.

Types of Blockchains

There are two main types of Blockchains. They can be referred to as permissioned and permissionless Blockchains.

Permissioned Blockchains are “closed” or “private” Blockchains whereby access can only be granted upon permission. These are usually applied within a certain value chain of business like a supply chain. It has some drawbacks in that it is not completely decentralized as other “open” Blockchain” would be.

Permissionless Blockchains are “open” to the public. Therefore any potential user can access the Blockchain. An example of this is typical cryptocurrency Blockchains such as Bitcoin, Ethereum, or Dogecoin.

Growth of Blockchain

The growth of Blockchain is imminent and recent research suggests considerable growth in the Blockchain market over the next few years.

It is projected that the Blockchain market will reach close to US$40 billion by 2025. The compound annual growth rate from a 2020 base (CaGR) is projected to be close to 68% (Source: MarketsandMarkets). The greatest beneficiaries will most likely be the banking and financial services sectors. The biggest contributors can be seen below and are projected to be the United States, Europe, and the Asia Pacific. Much of the research suggests that the majority of spending on new Blockchains will take place in Permissioned Blockchains.

Use cases for Blockchain in banking and Finance.

The most recent use case in banking and finance that the Blockchain has been utilized for, is as a money transfer tool. The Blockchain uses its decentralized ledger system for peer-to-peer money transfers. This reduces the cost considerably and has no cross-border limitations, which means that the sender and receiver can be in different countries.

Financial institutions are also subject to KYC (Know Your Customer) requirements in the United States, or FICA requirements in South Africa. The Blockchain also presents an opportunity for financial institutions in this area, as identity verification can be reused for other services in a secure manner.

Another recent use case has been to use blockchain as a trading platform. Current trading platforms are time-consuming with high costs associated with this. Blockchain enables the real-time transfer of ownership of a share accompanied by much lower transaction fees.

Advantages and disadvantages of Blockchain

Admittedly Blockchain is not the perfect system and has its disadvantages. Advantages and disadvantages should be weighed up against each use case.

Disadvantages:

  • Cost. The cost of operating and implementing the blockchain can become expensive. Power usage has been the main driver in operating costs. Specialized development is required for custom permissioned Blockchain which can increase the cost of implementation.
  • Regulation. Regulation around Blockchain is still very uncertain. Central governments may oppose certain aspects of the use of blockchain technology if found that it provides a risk to a country. This is still very underdeveloped are with still many future changes expected.
  • Security. In particular security around private keys. Users have to secure their own private keys to ensure safe custody of their digital assets.

Advantages:

  • Traceability. The blockchain creates a trail that documents the journey of assets.
  • Efficiency. Speed can be increased through the automation of transactions, for example, by using smart contracts. Organizational processes can be enhanced through the use of Blockchains which traditionally required a high level of human input.
  • Transparency. Organizations with access to the Blockchain have a full view of the transactions on the Blockchain. This is due to the distributed ledger that the Blockchain uses

The Role of the Audit in the Blockchain

The role of the auditor is to express an opinion on the Financial Statements. Our role as Auditors is to establish if the financial statements are materially misstated, whether due to fraud or error. On the other hand, the management of a company makes certain statements about these financial statements e.g., that the transactions in the financial statements occurred and are accurate, or that certain balances are valued correctly. The auditor needs to be able to obtain sufficient appropriate evidence about these statements, so the Auditor is able to express an opinion.

Does the Blockchain eliminate the need of the Auditor then?

The first question is then, can The Blockchain fundamentally support all these statements made by management, at any particular time? In some cases, it may and in other cases, it may not. Take for example where a buyer sends a seller Bitcoin for a product purchased. We can certainly establish that the transaction occurred on the Blockchain. But do the goods pass hands? When should the company recognize the transaction? i.e., when the goods were delivered by the seller and are the value of the goods correct?

Secondly, another fundamental concept that the Auditor makes management aware of, is any weakness in their control environment. Therefore, how were the transactions on the blockchain initiated, processed, authorized, and recorded? Fraud can still very easily be perpetrated by a company. If the necessary company internal controls have not been in place or have been overridden. This has a direct impact on the financial statements.

Thirdly, much of what management reports in the financial statements are based on estimates. Once again, the Blockchain may not report on estimates that management is making about certain elements in the financial statements. Estimates are of particular importance to investors. Especially. in making their investment decision or being able to get a sense of the outlook of the business.

Potential risks of the Blockchain in the audit scope

As with any technology there a risk that has to be appropriately be addressed as part of the audit. Appropriate risk responses should therefore be developed to address these risks is seen as significant as part of the audit plan. 

Illicit trade and money laundering. This has been highlighted as one of the main areas where Blockchain has been utilized in the black market. While confidentiality is important for users on the Blockchain, this also the key attribute that allows for this type of illegal activity to take place. 

Related party transactions. In the Blockchain Audit environment, the counterparty is not necessarily known. You just have digits of who the counterparty is. This makes it extremely difficult to understand with whom a transaction took place. 

Internal control weaknesses. In the Blockchain, the control environment is spread across the entire network. All nodes there need to have the necessary controls in place to be able to rely on these controls. Controls around private keys will also be important. This presents a security threat. The private key represents ownership of the digital asset. 

Tax treatment of transactions. There is still much uncertainty around the tax treatment of many of the transactions that pass the value on the Blockchain. Are all digital assets treated similarly such as stable coins, tokens, etc. when they inherently are different? 

Measurement of digital assets. Complexities start to arise where it is difficult to determine the value of a digital asset that has to be reported in the financial statements. Not all digital assets are traded as frequently, and valuation becomes quite complex with new digital assets.  

Conclusion

There is no doubt that the use of Blockchain will increase in the future due to the many advantages it has. Blockchain will enhance efficiency and enable real-time information to be available for decision-makers. It may even eradicate much of the current reporting requirements out there due to greater transparency in the Blockchain.

The role of the Auditor will revolve around Blockchain technology, and the Auditor will have to adapt and learn new skills to meet the new demands of a Blockchain Audit. Much of the work that the Blockchain Auditor will have to do in an audit is to understand and respond to the risk associated with a particular blockchain. The advantage to the Auditor is that it may be possible for the Auditor to continuously audit a company. It also eliminates many of the manual processes and activities around performing audit procedures. These procedures can be labor-intensive and time-consuming. If anything, the Blockchain has the potential to enhance the robustness of the capital markets, a place where the Auditor plays an integral role. 

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