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Blockchain Could Improve Corporate Auditing
While blockchain technology is disrupting and transforming many aspects of business, it remains unclear how it will change the auditing profession. But corporate audits could be more collaborative, efficient, reliable, and cheaper using blockchain, suggests research by Georgia State’s Sean Cao and Baozhong Yang and Chicago Booth’s Lin William Cong.
Audits, of course, are an important part of business. Among other things, auditors verify a company’s information and risk-control processes and assess its viability and health. The Big Four audit firms have started to use blockchain technology, in part by launching some blockchain offerings and research labs. To better understand the potential effects on competition and coordination, the researchers created a model.
A blockchain is a distributed ledger of transactions that resides on all of the computers in a network (see “Blockchain’s weakest links,” Fall 2018). In a public blockchain, such as the one that supports the trading of bitcoins, each new “block” of transactions is verified using cryptography and then appended immutably to the end of the “chain” of prior transactions, so it can’t be altered. All information about every transaction is made public. This understandably worries companies resistant to such public disclosure.
However, federated blockchains seek to address this. In federated blockchains, multiple authorities maintain the system and can keep some information from public view, allowing corporate transactions such as supply purchases and payroll distributions to be verified and stored on a blockchain while also preventing crucial information from circulating widely. Some groups have started to use this technology, or something similar. If rolled out more widely, it would not only help auditors; it would give their clients peace of mind about privacy concerns, the model suggests.
Federated blockchains’ encryption technology includes zero-knowledge protocols, which means that auditors can see definitive proof that a transaction happened, but others using the blockchain can’t see all the details. This function can be automated, which would keep costs down, the researchers note. Corporate auditors could share information about their clients’ finances during audits without compromising client confidentiality. And this, find Cao, Cong, and Yang, “can potentially enable collaborative auditing and make the auditing process more efficient and reliable when detecting fraud.”
The more companies and counterparties using the federated blockchain, the more complete a company’s information will appear to auditors on the same blockchain, or on blockchains that are connected to one another. Say, for instance, that Walmart and General Mills are using a blockchain for cereal transactions. Meanwhile, Walmart and Nestlé are doing the same for chocolate on a separate blockchain, and Nestlé and General Mills are transacting on a third blockchain. With the companies’ permission, an auditor might be able to access all these blockchains to verify transactions during an audit.
As a result of this network effect, companies will save money on audits if more firms and their clients start using blockchains. “The cost of auditing cross-auditor transactions goes down when both auditors adopt,” the researchers write. The technology also can help reduce regulators’ costs because immutable data are readily accessible.
By adopting blockchain technology, auditors could rely less on sampling, which involves taking transactions from a company’s ledger and verifying them using purchase orders, shipment receipts, and other documentation. Instead of charging by the client company’s number of transactions, then, auditors could charge by the number of counterparties, say the researchers. They qualify that such improvements concern transaction-based auditing—nevertheless, the technology frees auditors from routine tasks and allows them focus on areas where they add the most value, such as discretionary account auditing.
Companies that intend to file fraudulent or misleading financial statements won’t want to hire auditors that use blockchain technology, even if their audits would cost less, because their errors will be easier to detect, the researchers write.
“Although our model focuses on reducing intentional misstatements, it is straight-forward to see that collaborative auditing can also significantly reduce the costs of detecting unintentional errors, either made by clients or auditors, which further improves audit quality,” they write. As a result, it’s likely that either all major auditors will adopt blockchain, or none will.
Despite the benefits, clients may not want to adopt blockchain-based auditing “even when it is socially beneficial to do so” without a mandate from the Public Company Accounting Oversight Board, the researchers write. Some unscrupulous companies may want to instead pad their accounts, or otherwise defraud their counterparties or the tax authorities. However, the researchers find, “regulators can coordinate the technology adoption in order to reduce equilibrium misstatements and costs associated with auditing and its regulation.”
While blockchain technology is disrupting and transforming many aspects of business, it remains unclear how it will change the auditing profession. But corporate audits could be more collaborative, efficient, reliable, and cheaper using blockchain, suggests research by Georgia State’s Sean Cao and Baozhong Yang and Chicago Booth’s Lin William Cong.
Audits, of course, are an important part of business. Among other things, auditors verify a company’s information and risk-control processes and assess its viability and health. The Big Four audit firms have started to use blockchain technology, in part by launching some blockchain offerings and research labs. To better understand the potential effects on competition and coordination, the researchers created a model.
A blockchain is a distributed ledger of transactions that resides on all of the computers in a network (see “Blockchain’s weakest links,” Fall 2018). In a public blockchain, such as the one that supports the trading of bitcoins, each new “block” of transactions is verified using cryptography and then appended immutably to the end of the “chain” of prior transactions, so it can’t be altered. All information about every transaction is made public. This understandably worries companies resistant to such public disclosure.
However, federated blockchains seek to address this. In federated blockchains, multiple authorities maintain the system and can keep some information from public view, allowing corporate transactions such as supply purchases and payroll distributions to be verified and stored on a blockchain while also preventing crucial information from circulating widely. Some groups have started to use this technology, or something similar. If rolled out more widely, it would not only help auditors; it would give their clients peace of mind about privacy concerns, the model suggests.
Federated blockchains’ encryption technology includes zero-knowledge protocols, which means that auditors can see definitive proof that a transaction happened, but others using the blockchain can’t see all the details. This function can be automated, which would keep costs down, the researchers note. Corporate auditors could share information about their clients’ finances during audits without compromising client confidentiality. And this, find Cao, Cong, and Yang, “can potentially enable collaborative auditing and make the auditing process more efficient and reliable when detecting fraud.”
It’s likely that either all major auditors will adopt blockchain, or none will.
The more companies and counterparties using the federated blockchain, the more complete a company’s information will appear to auditors on the same blockchain, or on blockchains that are connected to one another. Say, for instance, that Walmart and General Mills are using a blockchain for cereal transactions. Meanwhile, Walmart and Nestlé are doing the same for chocolate on a separate blockchain, and Nestlé and General Mills are transacting on a third blockchain. With the companies’ permission, an auditor might be able to access all these blockchains to verify transactions during an audit.
As a result of this network effect, companies will save money on audits if more firms and their clients start using blockchains. “The cost of auditing cross-auditor transactions goes down when both auditors adopt,” the researchers write. The technology also can help reduce regulators’ costs because immutable data are readily accessible.
By adopting blockchain technology, auditors could rely less on sampling, which involves taking transactions from a company’s ledger and verifying them using purchase orders, shipment receipts, and other documentation. Instead of charging by the client company’s number of transactions, then, auditors could charge by the number of counterparties, say the researchers. They qualify that such improvements concern transaction-based auditing—nevertheless, the technology frees auditors from routine tasks and allows them focus on areas where they add the most value, such as discretionary account auditing.
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The Good and Bad of BlockchainCompanies that intend to file fraudulent or misleading financial statements won’t want to hire auditors that use blockchain technology, even if their audits would cost less, because their errors will be easier to detect, the researchers write.
“Although our model focuses on reducing intentional misstatements, it is straight-forward to see that collaborative auditing can also significantly reduce the costs of detecting unintentional errors, either made by clients or auditors, which further improves audit quality,” they write. As a result, it’s likely that either all major auditors will adopt blockchain, or none will.
Despite the benefits, clients may not want to adopt blockchain-based auditing “even when it is socially beneficial to do so” without a mandate from the Public Company Accounting Oversight Board, the researchers write. Some unscrupulous companies may want to instead pad their accounts, or otherwise defraud their counterparties or the tax authorities. However, the researchers find, “regulators can coordinate the technology adoption in order to reduce equilibrium misstatements and costs associated with auditing and its regulation.”
Sean Cao, Lin William Cong, and Baozhong Yang, “Auditing and Blockchains: Pricing, Misstatements, and Regulation,” Working paper, October 2018.
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