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Blockchain“Blockchain is a solution looking for a problem. Unless you want to buy drugs on the internet,” said the instructor in a technology training I recently attended.

While not the first time I had heard such a comment, it was disturbing that a hundred of my fellow practitioners were being misled. Ignoring or dismissing blockchain does the accounting profession no favors. Instead, let’s consider the problem that the technology solves. This will provide a basis for later understanding possible applications to our work.

 What is the problem blockchain is trying to solve?

Blockchain, or distributed ledger technology, set out to solve how we transfer a digital asset between two peers without an intermediary. While there are many applications of this transfer, let’s look at it in the context of money.

Imagine you are selling a bike online. You don’t actually know the person who is buying your bike, so you have no way of knowing if the buyer actually has the money to pay for it. You have to trust an intermediary like PayPal for this information. PayPal is crucial to the transaction because it verifies what you cannot – whether the buyer has enough money in their bank account to make the purchase.

The asymmetry of trust in this transaction is known as the Byzantine General’s Problem. Imagine we have four generals planning to attack a city. At least three of the generals must attack at the same time to overpower the army holding the city. However, the only way they can communicate with each other is via messenger, and they do not know if one of the generals is a traitor. If a general were traitorous, he could modify the attack message and cause the other generals to fail. The only way to overcome a traitorous general is to provide the history of all messages sent and evidence they have not been altered. If the generals see that one of their peers has sent a message different from the others, they would know the general is traitorous and disregard his message. If more generals are good actors than bad in this attack, the correct message will be obvious.

In our bicycle-selling scenario, we cannot see the buyer’s equivalent of “history of all messages sent” – that is, their entire transaction history. Therefore, similar to the Byzantine General example, we cannot see if the buyer is traitorous in telling us they have the funds to send. PayPal acts as a clearinghouse, but also adds cost and time to the transactions.

Blockchain removes the need for PayPal. With a distributed ledger, we can verify for ourselves that the buyer has the necessary currency – cutting out the middleman and saving time and fees.

 How does blockchain solve that problem?

Blockchain technology solves the Byzantine General’s Problem using a proof-of-work consensus algorithm. What is that, you ask? Simply put, instead of having a central bank determine the order of transactions, a majority of the users on the platform agree to the authenticity of the transactions. (And by “users” I really mean nodes. In the early years of cryptocurrencies, a node could be a simple laptop. Now it is more likely to be a server farm in a region with cheap electricity.)

First, transactions are grouped together in blocks. Then users (“nodes”) compete to solve a complicated, cryptographic puzzle to add a block of transactions to a chain of previous blocks. After a block has been added to the chain, a majority of users must agree to the authenticity of it by adding other blocks onto this existing chain. Because all future blocks are connected to, and dependent on, previous blocks, it is virtually impossible to alter or delete previous entries. This is why blockchain is considered to be immutable.

Further, every transaction in the blockchain is visible, so every user on the blockchain can see whether the sender has the digital assets they claim – without the use of a third-party.

Through the immutability and the visibility of all transactions, blockchain technology removes the intermediary required and allows participants to interact in a trustless exchange of digital assets. 

But asset exchanges are just one application. The technology could be applied to audit and assurance services, supply chains and the assessment and collection of taxes. As such, the accounting profession must educate itself about the technology so we can be prepared for its more widespread adoption.

Joshua Holley, CPA, is the Founder & Managing Director of The Tripoli Group, which provides services to early-stage, high-growth startups in multiple industries and an Adjunct Instructor at UNC’s Kenan-Flagler Business School. He was an enlisted Marine before earning a bachelors degree from the University of Tennessee and a Master of Accountancy degree from Vanderbilt University.

Blochchain courtesy of Shutterstock.

Originally published by AICPA.org