As blockchain technology reached its 10th birthday, many CPAs and accountants continue to ask how this disruptive technology will impact their practice and their clients.
I think the best place to start is with an understanding of a “smart contract,” a relatively older concept gaining steam because of blockchain. Smart contracts originated in the mid-‘90s during the emergence of buying and selling items on the internet. Nick Szabo, a computer scientist and cryptographer, conceived smart contracts to evolve contract law in the new era of e-commerce.
Szabo envisioned contracts converted into computer code that could be maintained, monitored and executed by the networks on which they resided. The missing piece to these automated contracts was, of course, blockchain.
How Smart Contracts Differ from Traditional Contracts
A standard contract outlines the terms and conditions of the contractual relationship, whereas a smart contract not only defines the rules and penalties of the agreement, but also enforces the terms and conditions. A common smart contract analogy involves comparing its technology to a vending machine.
Rather than going to an intermediary, giving them money and waiting for your product, you put money in the vending machine – or into the blockchain network – and ownership of the product is automatically associated with your account on that blockchain.
Here’s a broader example: Consider a global freight carrier we call Carrier A that picks up a shipment of red wine from a vineyard in Argentina. We’ll call this vineyard Supplier A. Carrier A guarantees Supplier A that its shipment headed to the Port of Houston, USA, will be temperature controlled the entire route.
In fact, these two have a smart contract in place that states temperature readings will be collected every three hours from sensors inside the container, and that if two consecutive readings fall outside the acceptable range of 45 to 70 degrees Fahrenheit, Carrier A will pay a $300 penalty to Supplier A, with an additional $300 penalty for each subsequent reading outside the agreed upon range.
As the shipping container moves along the nearly 7,800 nautical miles from Buenos Aires to Texas, temperature sensors inside the container automatically gather readings every three hours, as designed and reports the internal temperature to a tracking system that records the readings to its blockchain. Upon arrival in Houston, the tracking system triggers the smart contract, which reviews all temperature readings for the shipment.
If the wine remained within acceptable temperatures, the smart contract does nothing further. However, if the smart contract finds that the shipment falls outside the agreed upon parameters, it executes an automatic payment from Carrier A’s account to Supplier A’s account.
This process sounds similar to how a standard contract between a carrier and supplier would work without blockchain technology, so what’s the impact of blockchain with regard to smart contracts? Here are five of the biggest benefits:
Lawyers will still play a role in contract negotiations, perhaps less than in the past, but with smart contracts, there is no need for a broker, lawyer or other intermediaries during the execution of the contractual relationship. This also eliminates the possibility of third-party manipulation since execution is automated by the network.
In addition to removing intentional manipulation, the automated execution of smart contracts removes the impact of possible human error when manually filling out and processing loads of forms and other documentation.
The encrypted and immutable nature of blockchain technology ensures the contract and transaction details are encrypted and cannot be changed after the fact. All relevant parties have access to the data they need on the shared ledger with confidence it has not been manipulated. As a result, losing or misplacing documentation is impossible.
If you have ever lost your wallet, panic typically ensues. You must locate documents that prove your identity and residency to replace your government-issued ID. With your replacement ID, you can prove ownership of, or entitlement to, your assets. Smart contracts that associate asset ownership on a blockchain provide the resiliency inherent to distributed ledger systems.
The manual processing of traditional contracts requires large amounts of time, paperwork and back-and-forth communications to complete, not to mention the challenge of conducting business within business hours, although operations may span multiple time zones. Contractual tasks automated by the computer code of smart contracts reduce the time required to complete the contractual agreements.
Challenges of Smart Contracts
Beyond the obvious smart contract challenges, including errors in the code that could result in unintended consequences and vulnerabilities exploited by nefarious parties, coding every possible outcome of the business transaction could be an almost impossible undertaking because some results may be unknown.
Similarly, some traditional contracts are designed with intentional flexibility, allowing for human interaction or judgment during execution of the contractual agreement. Flexibility is difficult to automate, so these contracts may be poor candidates for smart contracts.
Off-chain events may be difficult to plan for and difficult to program into a smart contract. For instance, a rental agreement for a beachfront vacation condo may be set to self-execute based on the date and time of the rental agreement.
But what if a natural disaster severely damages the property? It is no longer inhabitable, but the smart contract executes transferring the rental fee from the renter to the property owner.
As with other blockchain applications, the lack of standards defining best practices for developing smart contracts is one of the biggest challenges facing the technology. Oversight does not exist on a global or more local focus, with much debate about how, or if, governments should be responsible for regulating such contracts. And, arbitration standards do not currently exist for handling smart contract disputes.
One more challenge: The lack of guidance regarding where smart contract transactions end up on the balance sheet. Are smart contracts invoices? Should smart contract transactions that automatically exchange crypto assets on blockchains be included in payables and receivables, or could they be escrow accounts?
Moving Forward – The Opportunity for Accounting Professionals
PwC’s Global Blockchain Survey 2018 shows that 84 percent of responding companies started their blockchain journey; 57 percent have projects in development or in production. While financial services is the front-running industry in blockchain use cases, advances are being made in manufacturing, supply chain and healthcare.
Walmart, Costco and Tyson Foods partnered with IBM, forming the largest global food supply chain collaboration project. The group anticipates that smart contracts will be a tool to automate governance of food supply chains, as well as a tool to facilitate the commercial relationship between the various participants in the system.
Companies of all sizes are paying close attention to the shared value of their blockchain solution, ensuring benefits for everyone along the supply chain, from farmers to retailers. These companies currently leverage their accounting firms for business advisory services beyond the traditional compliance offering.
As implementation upstream triggers ripples of disruption throughout the supply chain, firms that build specialization in blockchain technology and smart contracts will now have an opportunity to guide these clients. In addition, a discussion about blockchain in public accounting typically includes the technology’s impact on audit.
Specifically, blockchain’s inherent transparency provides insight into both sides of a transaction for all participants and, potentially, regulators. Verification of transactions happens before they are added to the immutable ledger, so blockchain sounds like it could automate pieces of an audit.
Smart contracts offer an opportunity for auditors. Today, a smart contract audit concentrates on the accuracy and security of the contract’s code. A technical expert examines the code to identify bugs or vulnerabilities, ultimately attesting the code performs as intended. This type of audit is essential to ensuring the proper functionality of the smart contract.
However, a technical audit of the code does not ensure the smart contract properly applies the business logic relevant to the participants’ industries. An independent attestation of the smart contract’s functionality provides your client the confidence needed that blockchain will become a part of our business landscape.
Blockchain technology has come a long way in just 10 years. Although challenges remain for the technology, interest and investment continue to increase.
The technology evolved from a distributed ledger designed to track Bitcoin transactions to a platform upon which new tools of transparency and automation are built. As clients rely on accountants to be their trusted business advisors, we have a responsibility to educate and prepare for these new instruments of blockchain disruption.