LUTZ BUSINESS INSIGHTS
BLOCKCHAIN, DISTRIBUTED LEDGERS AND CRYPTOCURRENCIES EXPLAINED
WILL FREI, SENIOR ACCOUNTANT
When attempting to learn about ‘blockchain’ or ‘cryptocurrency,’ a simple Google search can become overwhelming. There is a lot of noise and a smattering of buzzwords that require their own custom dictionary. A volume of promises are made; some true, some not, about the potential of the technology. For businesses and individuals interacting with or looking to interact with the blockchain, distributed ledgers, or cryptocurrency, it is important to understand what they are and what they are not.
BLOCKCHAIN, DISTRIBUTED LEDGERS AND CRYPTOCURRENCIES ARE:
Blockchain, distributed ledgers, and cryptocurrencies are all terms that describe a set of technologies. While they are often used as synonyms, they are not entirely the same. A blockchain is a format for storing and updating transaction data and can be thought of like an accounting ledger. Data about objects are used to track their transfer in an ‘append only’ way. Think about a checkbook. If you void a check, you add a new line to show the reversal of the check’s amount (rather than deleting the original line showing the check was written).
A blockchain can be centralized, managed by a single entity (i.e., checkbook), or decentralized, managed by a protocol that allows a variety of entities to participate in management. A blockchain that is managed in a decentralized manner is known as a distributed ledger. The key to a distributed ledger is that it has rules in place to ensure managing entities do not act dishonestly.
To illustrate how blockchain and decentralized ledgers relate to cryptocurrencies, we can use bitcoin as an example. The bitcoin whitepaper describes bitcoin as “A purely peer-to-peer version of electronic cash.” The creator(s) set out to invent a way for people to directly send money to one another over the internet, just like you would hand over cash in the real world. To do this, they used a blockchain as their ledger. They realized that if any single entity managed it, it would be no different than a bank’s ledger, so they used a ‘distributed ledger.’
The blockchain tracked bitcoin transactions, and the distributed ledger protocol defined the rules and methods for the way transactions were recorded and tokens were created. These protocols allow and attempt to incentivize anyone to participate in the shared responsibility of upkeeping that blockchain. Those that participate are known as ‘miners.’
To incentivize participation in those responsibilities, the protocols define a reward (denominated in bitcoins) to those that contribute resources. It also defines penalties against those that attempt to do harm (i.e., theft, fraud, etc.). Other cryptocurrencies use different blockchains, rules, and tokens as an incentive to reward people for maintaining that specific blockchain.
To summarize, blockchain is a technology for recording transactions electronically (financial and otherwise). A distributed ledger is a technology that allows for the shared responsibility of managing a blockchain. Lastly, a cryptocurrency allows for economic and other incentives to be included in a distributed ledger.
Part of the conversation surrounding blockchain and cryptocurrency revolves around security and privacy. Some blockchain-based projects can be transparent with information, while others provide anonymity. While it is possible to design a project either way, a basic distributed ledger project, such as Bitcoin, can be described as semi-transparent. If we compare the way the bitcoin blockchain works with the way a bank’s ledger works, we can see why.
Example of a Bank Ledger:
In this example, we can see that the user sends information about their desired transaction to the bank. The bank then checks its ledger, updates it accordingly, and notifies the payee that they have received the money. Essentially the entire transaction flows through and relies upon the bank. Only the bank, payee, and payor can see the transaction reflected in their own account.
Example of a Blockchain Transaction:
In this example, we can see that the user sends information about its desired transactions to a network of ‘miners.’ At that point, the information is public. The miners update the blockchain, and everyone can see that the cryptocurrency was moved. Some level of privacy is afforded because the blockchain identifies accounts with random strings of numbers and letters rather than names or usernames. However, all transaction information is public, but it only makes sense if you know who owns each account.
These qualities give distributed ledgers the ability to grant ownership over digital assets. That ownership can apply to a cryptocurrency, NFT, or other data. Rather than a centralized entity that attests to the ownership of an asset (i.e., a bank sending money on your behalf and updating its internal records), a
blockchain is a public registry where the general network agrees about who owns what and can verify directly (i.e., you sending crypto directly which is reflected in public records and can be seen by the counterparty).
BLOCKCHAIN, DISTRIBUTED LEDGERS AND CRYPTOCURRENCIES ARE NOT:
1. A SILVER BULLET
Many companies, projects, and industries are promoting blockchain-based projects. These projects are often not using a blockchain to its full extent, or their use of a blockchain or distributed ledger is inefficient
- A blockchain is best used when you are trying to track the exchange of data (or money) and need a record of all transactions that occur (an accounting system is a type of centralized blockchain).
- A distributed ledger is best used when different parties who don’t fully trust each other need to share data. They may agree on one goal but may have conflicting motivations in other areas concurrently.
- A cryptocurrency is best used to incentivize positive participation in a distributed ledger’s project. you don’t need a shared, common database for multiple parties with conflicting interests, you likely do not need a distributed ledger or cryptocurrency.
Note: Yes, there are distributed ledgers that do not use cryptocurrencies. Often, ‘private’ or ‘enterprise blockchains’ are set up between preapproved parties and transact information rather than ‘tokens.’ Because this information provides value to all parties involved, there is no need for a cryptocurrency to incentivize participation in the network.
2. Accounting Records
While the technologies can be explained by analogy with an accounting ledger, they are not the same. Whether you are trading cryptocurrencies, transacting with them for business, or using another form of distributed ledger in your enterprise, your accounting records are still necessary to tell the full story. There are accounting transactions to be recorded that would never show up on a distributed ledger, and there are events on a distributed ledger that should never show up in your accounting records.
With that said, if you are interacting with a distributed ledger or cryptocurrency, there is often an opportunity to simplify or even automate the associated accounting, especially if your transactions are uniform in nature. Records stored on a digital ledger can also provide properties that traditional transaction methods do not.
Transactions are settled to the blockchain directly, as opposed to banking transactions which typically go through multiple parties (bank, Fedwire, ACH, etc.). , and there may be less need for reconciliation due to canceled transactions or those that are in processing during a ‘cut-off’ period.
Transactions also have the properties of an ‘audit trail’ built in. Because transactions are transparent (as discussed above), anyone who knows your account number can look them up and glean information about the transaction. This includes your accountant or auditor.
In the case of Bitcoin, this information includes the counterparty’s account address, date, time, and amount. Certain other information can be inferred, especially if the counterparty is known.
These properties, while helpful to an accountant who understands how to use them, are not a replacement for accounting altogether.
UNDERSTAND THE TECHNOLOGY YOU ARE DEALING WITH
If you are interacting with cryptocurrencies or a distributed ledger, it is important to understand the technology you are dealing with. While these generalities are true of many cryptocurrencies and distributed ledger situations, each project is unique and has different nuances.
It is also important for your accountant to understand the technologies and applicable tax and accounting rules. These factors all have an impact on business and tax planning decisions. If you have any questions, please contact us.
ABOUT THE AUTHOR
WILL FREI + SENIOR ACCOUNTANT
Will Frei is a Senior Accountant at Lutz with over three years of experience in audit. He is responsible for providing credibility to clients through financial reporting. In addition, he works to maintain a high level of objectivity and confidentiality in all areas for clients in a variety of industries.
AREAS OF FOCUS
- Audit & Assurance
- Blockchain & Cryptocurrency Accounting
AFFILIATIONS AND CREDENTIALS
- American Institue of Certified Public Accountants, Member
- Certified Public Accountant
- BSBA in Accounting, Hastings College, Hastings, NE
- TeamMates, Mentor, Millard Chapter Board Member
- Lutz Gives Back, Committee Member
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