To appreciate blockchain, do we need to appreciate accounting and auditing first?

As an accountant, we can often forget the importance of the craft of accounting and what it meant for not just business but society.

And was it an accountant who pointed this out to me?

No, it wasn't. It was actually blockchain enthusiasts who drew a straight line between the role accounting plays and the role blockchain could play. 

In preparation for a presentation on blockchain, I wanted to refresh my mind around all things blockchain and so I was going through the audiobook, The Truth Machine, by Paul Vigna and Michale Casey. These are the two same authors who wrote the Age of Cryptocurrency. (At that time, both were Wall Street Journal reports, but Michael Casey since that publication actually decided to leave his 23-year career in journalism to focus on blockchain full time at MIT.)

And it was during this book that I was reintroduced to how important accounting was in terms of societal governance as it relates to the administering resources. 

Michael Casey in this lightning talk speaks to how blockchain now offers the possibility to deliver the necessary accounting to deal with the "tragedy-of-commons-type problems" that emerge in Capitalist societies that promote self-interest above the common good and all else. 

But going back to accounting, this is how he and Paul stated the importance of accounting:

"Fibonacci’s new numbering system became a hit with the merchant class and for centuries was the preeminent source for mathematical knowledge in Europe. But something equally important also happened around this time: Europeans learned of double-entry bookkeeping, picking it up from the Arabians, who’d been using it since the seventh century. Merchants in Florence and other Italian cities began applying these new accounting measures to their daily businesses. Where Fibonacci gave them new measurement methods for business, double-entry accounting gave them a way to record it all. Then came a seminal moment: in 1494, two years after Christopher Columbus first set foot in the Americas, a Franciscan friar named Luca Pacioli wrote the first comprehensive manual for using this accounting system.

Pacioli’s Summa de arithmetica, geometria, proportioni et proportionalita, written in Italian rather than Latin so as to be more accessible to the public, would become the first popular work on math and accounting. Its section on accounting was so well received that the publisher eventually published it as its own volume. Pacioli offered access to the precision of mathematics. “Without double entry, businessmen would not sleep easily at night,” Pacioli wrote, mixing in the practical with the technical—Pacioli’s Summa would become a kind of self-help book for the merchant class.

...The Medici of Florence came first, turning themselves into vital middlemen in the matching of money flows around Europe. The Medici’s breakthrough was made possible because of their consistent use of double-entry ledgers. If a merchant in Rome wanted to sell something to a customer in Venice, these new ledgers solved the problem of trust between people who lived at great distances from each other. By debiting the payer’s bank account and crediting that of the payee—with double-entry practices—the bankers were able to, in effect, move money without having to ship physical coins. In so doing, they transformed the whole enterprise of payments, setting the stage for the Renaissance and for modern capitalism itself. Just as important, they also established the 500-year practice of bankers creating an essential role for themselves as society’s centralized trust bearers.

The value of double-entry bookkeeping, therefore, wasn’t merely in dry efficiency. The ledger came to be viewed as a kind of moral compass, whose use conferred moral rectitude on all involved with it. The merchant was pious, the banker had sanctity—three popes in the sixteenth and seventeenth centuries came from the Medici family—and the trader discharged his business with veneration. Businessmen, previously mistrusted, became moral, upstanding pillars of the community. Aho writes: “Methodist Church founder John Wesley, Daniel DeFoe, Samuel Pepys, Baptist evangelicals, the deist Benjamin Franklin, the Shakers, Harmony Society, and more recently, the Iona Community in Britain, all insist that the keeping of meticulous financial accounts is part and parcel of a more general program of honesty, orderliness, and industriousness.”

Thanks to mathematical concepts imported from the Middle East during the Crusades, accounting became the moral grounding for the rise of modern capitalism, and the bean counters of capitalism became the priests of a new religion. Most (though certainly not all) people today have a hard time seeing the Bible as literal truth; but they had no trouble seeing Lehman Brothers’ books as literal truth—until the gaping inconsistencies were exposed.

The great irony of 2008 was that our belief in a system of accounting, a belief woven so deeply inside our collective psyche that we’re not even aware of it, made us vulnerable to fraud. Even when done honestly, accounting is sometimes little more than an educated guess. Modern accounting, especially at the big, international banks, has become so convoluted that it is virtually useless. In a comprehensive dissection in 2014, the Bloomberg columnist Matt Levine explained how a bank’s balance sheet is almost impossibly opaque. The “value” of a large portion of the assets on that balance sheet, he noted, is simply based on guesses made by the bank about the collectability of the loans they make, or of the bonds they hold, and the prices that they might fetch on the market, all measured against the offsetting and equally fuzzy valuation of their liabilities and obligations. If a guess is off by even 1 percent, it can turn a quarterly profit into a loss. Guessing whether a bank is actually profitable is like a pop quiz. “I submit to you that there is no answer to the quiz,” he wrote. “It is not possible for a human to know whether Bank of America made money or lost money last quarter.” A bank’s balance sheet, he said, is essentially a series of “reasonable guesses about valuation.” Make the wrong guesses, as Lehman and other troubled banks did, and you end up out of business.

Our goal here is not to trash double-entry bookkeeping or the banks. Were we to, you know, add up all the debits and credits, double-entry bookkeeping has done more good than harm. The goal really is to show the deep historical and cultural roots behind why we trusted this kind of accounting. The question now, in the wake of our fall, is whether a particular technology that allows a different kind of bookkeeping will help us renew our trust in our economic system. Can a blockchain, which is continuously open to public inspection and guaranteed not by a single bank but by a series of mathematically secured entries into a ledger that’s shared and maintained by many different computers, help us rebuild our lost social capital?"

Source: Vigna, Paul and Casey, Michael The Truth Machine: The Blockchain and the Future of Everything (p. 26-29). St. Martin's Press. Kindle Edition. 

Reading this, a few things jumped out:

• Double-entry accounting actually was invented by "Arabs": As the authors noted above, "Europeans learned of double-entry bookkeeping, picking it up from the Arabians, who’d been using it since the seventh century". Going through accounting, this was the first that I heard of this, but it's not surprising given the Islamic world led the globe in terms of science and technology for a few centuries. 
• The link between ethics/integrity and accounting was established at the inception:  "The value of double-entry bookkeeping, therefore, wasn’t merely in dry efficiency. The ledger came to be viewed as a kind of moral compass, whose use conferred moral rectitude on all involved with it. The merchant was pious, the banker had sanctity—three popes in the sixteenth and seventeenth centuries came from the Medici family—and the trader discharged his business with veneration. Businessmen, previously mistrusted, became moral, upstanding pillars of the community. Aho writes: “Methodist Church founder John Wesley, Daniel DeFoe, Samuel Pepys, Baptist evangelicals, the deist Benjamin Franklin, the Shakers, Harmony Society, and more recently, the Iona Community in Britain, all insist that the keeping of meticulous financial accounts is part and parcel of a more general program of honesty, orderliness, and industriousness.”" Although it's quite far to say that accountants are any kind of priest, there is a level of "financial asceticism" in terms of abstaining from investments to be able to have the objectivity required to complete financial audits. Furthermore, the profession needs to assess to the degree we are investing in this cornerstone of the profession. More thought needs to be given as to how much of threat the "post-truth era" is on the profession. If society continues to feel there is no such thing as truth, then the ability to act as an anchor of integrity is limited.  
• Pervasive importance of accounting to the functioning of society: When expressing the value of financial accounting and auditing, people seem to take it for granted forgetting that if there was no way to inspect the confidential books of companies that "game theory" would take over. In a sense, the "tragedy of the commons" that is addressed by financial audits is ensuring managers don't lie when claiming that they made profits of this much and have assets of that much. That is, without audits there would be no way to trust management as the financial fraud that we see wouldn't be limited to a few players but be much more pervasive. 
• People will blame accountants even though we are just recordkeepers: The authors call out accounting stating that: "Modern accounting, especially at the big, international banks, has become so convoluted that it is virtually useless". Accounting is the art and science of communicating the economic reality of entities to allow people to make investment decisions. It is a complex function of navigating competing opinions on how to accurately report on things. I think it's ironic that the book notes a few pages later on how Bitcoin Classic had to separate (or fork) from Bitcoin Cash because the two factions couldn't agree on the memory size of the protocol. When it comes to accounting standards there is no forking: all must agree on a common set of accounting standards to be used for  financial reporting. Furthermore, the problems that lay with the banking system really can't be blamed on financial reporting but stem from the reality that capital runs the world - even if it means running over the truth once in a while. 

With respect to the last point, it is important for blockchainthusiasts to keep in mind that standards are really at the heart of blockchain. Traditionally, setting the standard has always been hard because Capitalism promotes freedom, and so people are incentivized to get away from standards! It's hard enough when you have people trying to simply codify something, let alone trying to create decentralized distributed ledger that will be intolerant of any unauthentic interpretations. But we will delve into this in future posts. 

Author: Malik Datardina, CPA, CA, CISA. Malik works at Auvenir as a GRC Strategist that is working to transform the engagement experience for accounting firms and their clients. The opinions expressed here do not necessarily represent UWCISA, UW, Auvenir (or its affiliates), CPA Canada or anyone else