How Bitcoin and Blockchain Are Impacting The Accounting Industry
This article is Written by ProAdvisor CPA Rebecca A. Casarez, CPA along with Evan Francis and Dorian Kersch, Co-Founders of Lunafi (an online platform that makes investing in cryptocurrencies easier).
What is Blockchain?
Blockchain is an electronic ledger (list of entries) that contains virtual transactions between buyers and sellers that is maintained through a network of participating computers. “Blockchains use cryptography to process and verify transactions on the ledger, providing comfort to users and potential users of the blockchain that entries are secure” (SEC.gov: BitCoin Offerings)
Evan: The Blockchain was the innovation that allowed Bitcoin to be the first truly secure and functional digital currency. At its core, the blockchain is a digital ledger that is immutable (can never be modified) and is able to be kept in sync with every computer on a network without any single computer or database determining what is correct. This decentralized system of trust is what makes Bitcoin so special, you can verifiably trust that your financial transactions are legitimate without needing to rely on a central processor such as Visa or PayPal. Although Bitcoin uses the blockchain to keep track of account balances and transactions, that’s just one possible use case. Any system that requires a system of trust or verifiable data can use the blockchain to store data without requiring a central company or database to keep track. Possibilities include using the blockchain to track who owns what real estate and transfer ownership when appropriate, to track where your groceries were sourced from and have travelled before you purchased them, recording and verifying insurance claims, and many others.
What is Bitcoin?
Bitcoin is a virtual currency that is treated much like paper/coin currency and uses the Blockchain technology to record, process and verify each transaction.
Dorian: Bitcoin is a digital currency that uses encryption methods to create and validate transactions, independent of a bank. It was created by an “unknown identity” that goes by the name Satoshi Nakamoto. Bitcoin is not the only digital currency out there.
Evan: Bitcoin is an entirely digital currency that aims to solve a single problem: “How can a currency work securely without the backing of a single entity, such as a government or bank”? Other digital currencies existed in the past but Bitcoin was the first to be proven to be secure and protected against double-spending funds. Instead of being backed by a government or bank, Bitcoin is governed by a global network of computers all working together to process and confirm transactions. It’s accepted at stores online and around the world, and is often used as an investment akin to gold. Bitcoin is secured by cryptography and mathematics and is guaranteed to be safe from hacking, apart from the one known weakness: the “51% attack”. This would require controlling more than 51% of the entire network, which is virtually impossible at its current scale and it continues to grow every day. Bitcoins are created during the process of confirming transactions, and it’s coded so that the amount produced is less and less over time until eventually the maximum of Bitcoin that can ever exist have been created, which is 21 million. This forced scarcity is in stark contrast to the U.S. dollar and the Federal Reserve system in which the U.S. government can choose to print more money whenever they think it’s appropriate to try and control inflation. Because of this, Bitcoin has a system of deflation over time, the value increases over time. Bitcoin’s code is open for the world to see and is built and maintained by a community of engineers, not any single company or entity, and anyone is free to participate and contribute.
So how does Blockchain and Bitcoin impact the Financial and Accounting Professions?
We must start at the beginning: A history lesson of Double Entry Accounting.
Every business is required by law to maintain accurate and reliable records that represent the business activity and transaction history. This is true for both financial and taxation reporting purposes. However, the creation of the capital market and the use of a common currency to exchange goods and services between a seller and buyer pushed a new problem: “Is this transaction worth its “weight in gold”? Being able to trust the seller, buyer and even the product, is an age old problem.
How can each party trust the other party? For business transactions, how can anyone rely on the records being presented? The use of accurate record keeping started to address the concern, long before even the Pilgrims landed on Plymouth Rock or the Internal Revenue Service was formed. Hundreds of years ago, mathematicians and business owners alike were looking for a system that aided in providing records that are both accurate and reliable, both for internal and external parties.
Thus came the creation of “Double Entry Accounting”, a process whereby transactions are presented by Debit Entries (left) and Credit Entries (right), flowing through to the “Accounting Equation” (Assets = Liabilities + Equity). The Debit and Credit entries must always equal in every transaction in order for the Accounting Equation to also remain equal. This balancing act creates a form of reliability on the transactions. So, double entry accounting was step one towards bridging the gap of trustworthy accounting records.
The Need for External Auditing.
Once the market place evolved, buyers and sellers started using a third party to facilitate the exchange of goods and services through the common currency such as a bank. The third party acts as a semi-impartial party during the transaction, although they are still close to the exchange (they are paid in fees so they are not 100% unbiased). However, since the event is usually a private event and all parties are biased, the ability to trust the transaction is still limited.
This limitation allowed the accounting industry to evolve as well as to provide external auditing of these business and financial records. The external auditor is a subject matter expert in both record keeping (aka bookkeeping), financial reporting rules and taxation rules that allow the impartial party to provide an expert “opinion” on if the records can be trusted or not. External auditors provide this opinion after they perform certain tests and procedures on the records and accounting systems as a type of scientific study or experiment. This study allows the auditor to provide an opinion on if the records are reliable, accurate and not materially misrepresented, based on the results of these tests.
What the heck does all this have to do with Blockchain & Bitcoin?!
Well, one of the biggest challenges that all parties face in this trust battle is the fact that it is a private event where all parties are connected to the transaction and are biased (except the external auditor). Since Blockchain, the backbone of Bitcoin and other cryptocurrencies, is a technology that is mostly open source and publicly (and permanently) presented, anyone can view and verify each and every transaction. There is the fundamental weakness in human based transactions – human “error” that can happen. However, computer systems and technology, when built properly, can almost entirely eliminate the possibility of “human error” in any given transaction. Due to the inherent benefits, auditors will eventually be able to be more efficient in their tests and procedures over such transaction history.
The regulatory agencies, both in the financial and taxation sectors, such as the Securities and Exchange Commission (SEC), the Financial Accounting Standards Board (FASB) and the Internal Revenue Service (IRS), are all trying to get caught up on how to regulate the technology through reporting rules and taxation requirements. Although still emerging, Blockchain technology, bitcoin and cryptocurrencies are showing the world what is possible.
Current Rulings and Guidelines:
In 2014, the Internal Revenue Service (IRS) ruled that for federal tax purposes, virtual currency is treated a intangible property, much like stocks are treated. This means that although it can handle like a true currency, for federal tax purposes, it is NOT currency.
What this means to the owner of the virtual currency:
- The taxpayer must value the virtual currency, such as Bitcoin, at Fair Value at the reporting or transaction date
- The difference between the original basis, current fair value and the ending fair value will result in a taxable event – either a Capital Gain or Capital Loss. (based on this information, one would pay capital gains/loss when someone converts Bitcoin into another currency such as Litecoin)
Disclaimer: We are not advocating for or against the investment into Bitcoin or other cryptocurrencies. This article is merely informational in nature regarding its impact on the accounting profession.
Further, as of the date of this article, Bitcoin is not a registered offering with the Securities and Exchange Commission (SEC) and as such is not held to SEC standards.
Chairman Jay Clayton of the SEC just recently released a statement on Cryptocurrencies and Initial Coin Offerings providing some fair warnings and great questions to ask before investing.
Rebecca A. Casarez, CPA is the founder of ProAdvisor CPA. She is an experienced CPA with a demonstrated history of working in the accounting industry assisting business owners and accounting professionals. She is a strong leader who provides bookkeeping, financial accounting, tax planning and tax preparation services to business owners and individuals alike. She is also a Co-Founder of Green Ledger CPA. “The Grass is Greener on the side you water”. Follow her @ProAdvisorCPA.