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Accounting, Auditing and Blockchain. The common thread that binds the 3 is Triple Entry Accounting

Introduction: A background of accounting and auditing mis-governance, that’s hard to ignore:

With sheer increase in the number of accounting scams that the industries have witnessed since early 2000, I have had this inner urge to bring this subject for more intensive debate. The last to hit a similar cord, is the recent issue of a whistle-blower, alleging accounting irregularities at Infosys, an entity that has long been viewed as a "poster boy" of corporate governance in India. There are complexities surrounding this body of knowledge and there are people who still think that besides hoodoo, there may be only a few other things more mystifying to human mind and puzzling to man, than the study of double entry accounting. Nonetheless, bookkeeping is still all about data and debiting or crediting the right accounts. So, the reason, as why should it be so complex to deal with its governance, is equally mystifying to many.

In this article we shall look at how, with the advent of blockchain and it's growing adoption across industries, it may not be any more necessary to centralize trust on auditors to play the key role as watchdogs but with a framework known as “Triple Entry Accounting” , this governance could be decentralized using distributed ledger framework as the underlying technology. However, before we delve deeper into the concepts underlying Triple Entry Accounting, let us first look at more cases in the public domain where accounting and auditing went wrong.

  • Till September 2001, Enron Corporation ranked as the seventh largest U. S. transnational firm in terms of total balance-sheet revenues, and a few years preceding 2001 Fortune magazine had ranked Enron as the most innovative firm. But a series of events during later part of the same year, resulted in the bankruptcy of this U.S. energy, commodities, and services major along with dissolution of Arthur Andersen LLP, which was one of the big 5 auditing firms at that time. We now know as how they had cooked Enron’s books as a result of which the company was able to hide billions in debt due to institutionalized, systematic and creatively planned accounting fraud. The purpose here is not to unscramble the Enron issue, but to take it as an example and explain as how accounting and auditing has been in the center of most financial scandals of our times. I was still doing my major in finance and accounting during those years and Enron’s debacle, was the first such case to trigger in me the curiosity to research on the principles of Triple Entry Accounting, as a prospective solution to these issues.
  • Many of us wouldn’t attribute 2008 financial crisis to wishful accounting by large banks that eventually fell. However, if we were to look deep, auditing did play a significant role in allowing banks to publish financial statements year on year, to best fit their intend of masking the realities of weaker balance sheets.
  • Closer home, in 2009, the promoters of Satyam Computers resigned, confessing that they had manipulated the books of accounts by approximately $2.1 billion in collusion with PwC as their auditor for which the accounting and auditing firm was banned in India to take up similar assignment for the subsequent 5 years.
  • And then as late as in 2018, we witnessed a disclosure of more than $ 1.8 billion being siphoned away by Nirav Modi (a diamond merchant) from large banks and their overseas counter-parties, over a span of 3 years under the eyes of auditors on both sides. Likewise, since quarter one this year, we started seeing the payment defaults of Development Financial Institutions like ILFS, DHFL etc. What will eventually come out as reasons are yet not know, however the government has already initiated efforts in nailing the auditors for right reasons, linked to willful errors and omissions in signing books of accounts over the years, that failed to uncover the weak financials of these institutions.

One can argue that bookkeeping is always post facto, and can't influence someone’s intend to hack the system, however it's also true that auditors are in a fiduciary role and are considered to be the watchdogs. Therefore right accounting followed by honest auditing can truly be the needed deterrent that can thwart any intend to fraud a system if done honestly. It's not the accounting best-practices or the rules of book-keeping which are in question here, that have matured over the last 600+ years since the double entry accounting principles were pioneered by Luca Pacioli, but the adoption of such rules, which have fallen below standards and lost the respect of consumers worldwide.

Hypothesizing a solution to this problem - A solution to this problem was envisaged by Yuji Ijeri during early 1980s in the form of adding a third dimension to an already existing double entry accounting system.  In theory, the third dimension would not change any of the existing or evolving accounting norms of book keeping, but help in adding a third check to the prevailing framework, and thereby ensure a self-regulated and shared environment amongst all participating entities, so that the larger purpose of book keeping and auditing doesn't suffer because of errors or omissions either caused intentionally or unintentionally.  His paper introduced to the world the subject of " Triple Entry Accounting ". However, before we dig deep on this subject, let's travel the journey that accounting took from being "single entry" to "double entry book keeping", understand the rationale, as what brought about this change, and then logically relate it to "Triple Entry Accounting " and what change it may bring, if adopted at scale. 

  • Single Entry - Since medieval times the practice of maintaining financial data has been adopted at mass, however during those times what got recorded was only one side of transactions, much like someone maintaining a diary of his personal expenses or income. As a result, looking at those historical data, it would be tough by any measure to find out as why a transaction would have happened. In other words, a transaction recorded in single entry form would not ever establish a "cause and effect" relationship of a business event between two entities. For example - "an amount spent on purchase of an asset" under the norms of single-entry, would be recorded in cash book as a single line - "Amount spent on Purchase of Asset" and thereby the entity’s cash balance depleting by an equal amount. The issue with this type of recording transactions, (as was realized later), is that it doesn't give enough insights on the other leg of the event which in this case is an equal amount of increase in Asset. 
  • Transition to double-entry accounting - During the renaissance period, when businesses became more organized, societies started embracing change and for every event people started questioning the causal relationship, it also led to gradual changes in the way how books of accounts were maintained. This led to the start of recording two side of every transaction that had business significance. Till early 15th century, when Luca Pacioli (an Italian monk and mathematician) formally laid down the basic tenets of double entry accounting surrounding "real", "nominal" and "personal" heads of accounts, which have not changed in the last 600 odd years. Business have become more complex, the types of income and expenses which are made or incurred have kept changing, new asset classes and thereby the nature of cash flows continue to keep evolving, however the basic rules following which real, nominal and personal accounts get debited or credited do not change irrespective of geographical, linguistic or currency differences. Wonder if Luca Pacioli would have received an equivalent of Nobel Prize during his time for having envisioned the rules of accounting that wouldn't change for centuries.
  • This brings us to the question as – Why now, the need to add a third dimension to accounting? - The answer to this question is in the issues we discussed earlier in this article. The problems which have plagued our systems is not in the double entry rules but because of adoption of such rules within the governance framework of today's accounting world, which have fallen so much below standards that they have lost the respect of consumers worldwide. And a possible solution to this secular problem (as mentioned earlier) was envisaged by Yuji Ijeri in the early 1980s in form of adding a third dimension to the already existing double entry accounting system, that would not change any of the existing or evolving accounting norms of book keeping, but add a third lever, and thereby establish a self-regulated and shared environment amongst all participating entities to ensure that the larger purpose of book keeping and auditing doesn't suffer because of errors or omissions either cased intentionally or unintentionally.  The need for “Triple Entry Accounting” was further advocated by Ian Grigg in 2005-06. This one statement by him that mentions - "It's tough to lie when everyone is watching" summarizes the principle and the need of Triple Entry Accounting to its core.

Explaining Triple Entry Accounting with the help of an Example - The best way to substantiate this theory would be by a simple example:

Suppose Philippe extends a loan of EUR 1000 to Jenny.

  • In Philippe’s book this transaction following double entry norms would reflect as “Jenny being debited with EUR 1000” and “Bank being Credited with EUR 1000”.
  • Similarly, in Jenny’s Book the same transaction will be accounted as “Bank being Debited with EUR 1000” and “Philippe being Credited with EUR 1000”.

However, since Philippe and Jenny are two separate entities there is no guarantee that both would have accounted exactly like the above. What if Jenny has an ill intend and accounts for only EUR 100, that passes through the audit too? What if Jenny keeps understating her liabilities book till hell breaks loose, and it’s too late to recover, leading to major shareholder losses. Well there is no answer to this question because the system, as it is today, expects auditors to be the watchdogs and ensure that such inconsistencies do not happen.

What Triple Entry Accounting does is that it takes the dependency out from the Auditors (as the only means) to ensure consistency and introduces as well a pubic ledger to be a mandatory place to host all accounting entries from all participating entities and thereby establish a self-regulated and shared environment amongst all to ensure that the larger purpose of book keeping and auditing doesn't suffer because of errors or omissions either cased intentionally or unintentionally.  Extending the above example to a “Triple Entry Accounting Framework”, following will be the output.

  • In Philippe’s book this transaction following double entry norms would reflect as “Jenny being debited with EUR 1000” and “Bank being Credited with EUR 1000”.
  • Similarly, in Jenny’s Book the same transaction will be accounted as “Bank being Debited with EUR 1000” and “Philippe being Credited with EUR 1000”.
  • Plus, in the public accounting book, both of the above entries will be recorded so that at any time if there is a reconciliation by either parties, auditors or regulators, any discrepancy can be spotted immediately.

How do we implement such a public book technically, and where does Blockchain fit in?

Wouldn't the world be different if there was a possibility of a public database that could be encrypted, would be trust-less, decentralized and immutable? These questions remained unanswered for a long time till in 2008 the whitepaper on blockchain became public and the world had answers to how trust can be decentralized. With the advent of blockchain and it's growing adoption across industries it is no longer necessary that to build trust between multiple trading entities there must essentially be a middleman. If the same principle can be extended to a (now) probable use case for distributed ledger implementation on Triple Entry Accounting, this is what it will translate to:

  1. Introducing a Public Ledger - As step 1, to solve this problem lets enhance the traditional double entry system by introducing a central public ledger which will host all accounting entries involving all entities which are cryptographically sealed by a respective third entry into the public ledger. And every journal entry that has a double entry reference to another node (entity) in the chain will be linked through a hash to ensure that every subsequent entry in the lifecycle of its cash flow, follows the previous entries hash as reference to ensure traceability across the lifecycle.                       
  2. Decentralizing The Public Ledger - However the issue with a centrally hosted public ledger is that, any entity centrally made responsible to host such a public ledger shall again lead to “trust” getting centralized which ideally means that we just move from a system of double entry where trust was on each entity’s ledger to now a system where we have a public ledger, in which records can be ensured to be consistent across entities (because of central reconciliation), however at the same time this system doesn’t solve problems related to hosting of data centrally. And therefore, as step 2, the need is to distribute the risk from central hosting, to a distributed model where each entity within the system can have an exact copy of the public ledger that is secured, distributed, reliable and Immutable. An eureka moment for blockchain, because these are also the exact characteristics of a blockchain framework.

In conclusion – It wouldn’t be far from truth, to say that “self-sustaining audit with the help of Triple Entry Accounting is most likely one of the most profound use case on blockchain after STOs”. While this may remain a scholarly concept till it finds interest in regulators, however it’s no doubt food for thought for the accounting community, which, if implemented at scale can lead to significant benefits to corporate finance. While on one side it doesn’t change the basic tenets of accounting, however on the other side, by an extension of the accounting chain, it mitigates most the risks related to accounting and auditing mis-governance.

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