The Future of Blockchain-based Auditing is Called “Multi-chain Reconciliation through Blockchain Interoperability”
by Jana Schmitz
Processes currently used by auditors for reconciling accounting data proved to be inordinately labour-intensive, time-consuming and complex. Blockchain technology allows for more efficient reconciliation of accounting data. However, blockchain technology is not free from flaws. Some of the problems blockchain technology faces today are related to interoperability. Blockchains simply do not speak the same languages. In fact, different kinds of blockchains use varying smart contract features, consensus models and transaction schemes.
Big 4 audit firms have already pointed out that they will have to deal with different clients deploying different kinds of blockchains. The issue of how accounting data of client businesses will be reconciled by auditors if those data are spread across multiple different blockchains, is yet to be addressed.
We propose that an ideal solution would be a network that brings independent blockchains operating in isolation together in interoperable harmony. More precisely, what is needed to effectively leverage blockchain technology to make reconciliation more efficient, is a blockchain interoperable network that allows for reconciliation of accounting information encoded onto multiple independent blockchains.
What are blockchain interoperable networks? Blockchain interoperability implies that in the event of a transaction one party pays with Ether on the Ethereum chain and the other party receives Bitcoin on the blockchain without a third party functioning as an “exchange”. In simple terms, blockchain interoperability makes different blockchain architectures such as Ethereum and Blockchain talk to each other. Why do we need blockchain interoperable networks? Interoperable blockchains open up a world in which assets can easily be moved from one blockchain network to the other. This fully unlocks the network benefits of blockchain technology. The tool that allows different blockchains to connect with each other is called multi-chain technology. Why is multi-chain reconciliation in blockchain interoperable networks important for auditors? We provide the answer after looking into the potential benefits blockchain technology holds for auditing, and more precisely, reconciliation purposes.
Reconciling Accounting Data in the Blockchain Environment
Blockchain technology is fundamentally an accounting technology. It has the potential to bring foundational change to audit practice. Contemporary audit practice requires extensive manual work often plagued by the duplication of efforts. Usually, the audit process begins with auditors receiving journal entries, trial balances, spreadsheet files and other documents in electronic and manual formats. The significant time auditors are required to invest into the preparation of such data comes at the sacrifice of efficiency and cost-effectiveness.
Whereas traditional auditing requires the confirmation of transactions and balances on firms’ accounting ledgers at the end of the reporting period, blockchains provide the immutable record of transactions almost immediately. This instantaneous availability of transaction information facilitates the development of continuous auditing. For auditors, this implies a transition from a periodical or annual exercise to a continuous matter. As blockchains allow the recording of the transaction to occur at the same time as the transaction itself, auditors can obtain data in real-time and in a consistent, recurring format. Monitoring what happens in real time rather than testing (selectively) and reconciling what happened in retrospect is a substantial departure from contemporary audit techniques.
Due to its distributed ledger technology, blockchain technology eliminates the need of entering accounting information into multiple databases and potentially removes the need for auditors to reconcile disparate ledgers, whereby substantial amounts of time could be saved and the risk of human error be considerably reduced. We do not believe that reconciliation of accounting data will be fully automated through blockchain technology as auditors’ professional expertise and experience is required to assess the accuracy of complex accounting transactions. However, we suppose that the real-time availability of accounting data offers immense benefits for accounting data reconciliation.
Clients with audit firms are involved in doing business with various parties that may use different blockchains to record transactions. The benefits of continuous audits, real-time monitoring and less time-intensive reconciliation of accounting data, can only be realised if different blockchains used by client businesses are connected. We suggest that multi-chain technology that allows different independent blockchains to plug into and become part of a bigger blockchain ecosystem may help auditors to make use of such benefits.
Blockchain Interoperability powered by Polkadot and Cosmos
Multi-chain technology connects independent blockchains to develop a truly decentralised network. By making each blockchain a component of a larger system, multi-chain technology allows for interoperability of blockchains. Two multi-chain technologies that increasingly receive attention are Cosmos and Polkadot. Essentially, Cosmos and Polkadot are networks that make it easy for blockchains to interact through chain relays. While we leave it to others to examine the technical aspects of network designs and security models of these two protocols (see Dave Kajpust’s Medium article), we briefly emphasise the main features relevant for auditing purposes with regards to multi-chain reconciliation.
Cosmos and Polkadot are building protocols that allow different kinds of blockchains to interact with each other. Both employ similar interoperability strategies: Polkadot refers to its central connector as Relay Chain. The Relay Chain coordinates consensus and transaction delivery between blockchains. Polkadot ensures that each of the blockchains connected to the Relay Chain remains secure and that transactions between blockchains are faithfully executed. Cosmos calls its connector Cosmos Hub. Cosmos Hub is the main blockchain that acts as a central connector for all blockchains in the Cosmos Network.
Multi-chain Reconciliation and Ecosystem Audits
For auditors, such multi-chain technologies provide a bridging tool that allows transacting parties to be part of different blockchain networks. Blockchains plugged into the Relay chain or the Cosmos Hub can spread out their transactions across other blockchains in the ecosystem. Notably, this would not only result in a more scalable network consisting of different blockchains, but would also allow auditors to conduct audits across the ecosystem in a continuous and more efficient manner.
Although the future of blockchain interoperability is challenging to predict, promising multi-chain solutions like Polkadot and Cosmos demonstrate with what the future might hold. For auditors, blockchain interoperable networks would undoubtedly help to expedite reconciliation of accounting data. While there are still several legal and technological challenges to be solved by multi-chain technologies before blockchain interoperability is ready to be embedded into record-keeping systems, audit firms should stay abreast of current developments in the blockchain space.
Jana Schmitz is from the RMIT Blockchain Innovation Hub, the world’s first social science research centre into the economics, politics, sociology, and law of blockchain technology.