Digital Financial Reporting

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Understanding Digital Distributed Ledgers

In a post a few days ago, I mentioned that someone was creating a “triple-entry accounting system”. They point out three key lumps to that system:

Those three things might be “technologies” or “implementations of technologies”. But I don’t think that those are the lumps of the puzzle. Or, there may be more than three lumps. For example, Ethereum is one of many blockchain and other supporting technology implementations.

One of the fundamental chunks however is the idea of a digital mutual distributed ledger. (I have heard “distributed ledger” and “mutual distributed ledger” and “digital ledger” used interchangeably. I will use the term digital distributed ledger.)

So what is a digital distributed ledger? A digital distributed ledger is an indestructible and uneditable decentralized computer record, or ledger. It provides a utter and finish history of transactions in that ledger. Ledgers can be as public and open or private and limited as the use case requests. Ledgers can be permissioned or permission-less in determining who can add fresh transactions. Different approaches can be used to determine how fresh transactions are authorized (proof-of-stake, proof-of-work, consensus, identity mechanisms) before they can update the ledger. Ledgers can be interlinked with one or more other ledgers.

The key innovation that enables computerized digital distributed ledgers is the blockchain technology. Blockchain technology is used to maintain what amounts to a continuously growing list of translational data records hardened against tampering and revision, even by operators, using advanced cryptography (basically, cryptographic mathematics). As Gabriel Tumlos of KPMG put it in his paper Blockchains, Distributed Ledgers in Finance and Accounting, “Blockchains introduced a trust-minimizing transactional platform that all but eliminates the need for a vulnerable third party and permits accounting systems to take their logical next step.”

What can digital distributed ledgers be used for? This movie mentions the following use cases:

  • Regulatory records
  • Delivery records
  • Chain of custody
  • Property titles
  • Know your customer
  • Digital rights management
  • Loyalty management
  • Motor insurance
  • Proof of authenticity
  • Account portability
  • Anti-money laundering
  • Peer-to-peer lending
  • Private insurance
  • Corporate credit
  • Trading records

Don’t limit yourself by thinking that a “transaction” is an accounting transaction such as an invoice. While transactions can be recorded, so can events, circumstances, and other phenomenon that affect, say, a business during a period. That sounds a lot like the sort of information from a financial report. A report is a transaction. The “payload” of the transaction is the information in the report itself. XBRL-based digital general purpose financial reports, say to a regulator like the Securities and Exchange Commission, are indeed transactions that hold elaborate information structures about the financial condition and financial position of an economic entity.

What XBRL brings to the table is an capability to agree on and document the relations inbetween the reported facts in the sophisticated transactions we refer to as financial reports. But XBRL can also be used to make sure that smaller transactions that go into these ledgers adhere to agreed upon business rules. This keeps information within those digital distributed ledgers correct.

If digital distributed ledgers are used to their total potential, it could enable a fundamental shift in the way economic entities transact business with one another. How will this influence the role of accountants and auditors? Time will tell.

Here are some extra resources useful in understanding computerized digital distributed ledgers:

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