Blockchain usage is increasing, particularly after the COVID-19 pandemic. Last year, the technology was recognized as one of the top 10 technologies by the European Parliamentary Research Service to mitigate the pandemic, particularly in monitoring disease outbreaks, contact tracing, patient information-sharing across various systems. A blockchain is a distributed, immutable, append-only ledger or database that maintains a continuous growing list of ordered records called blocks. Each block contains transaction data and a cryptography tag, which is used for verification and to securely connect the previous block to form a chain of blocks.
Innovative business models that use blockchain technology are emerging, particularly in the banking industry. For example, China Finance Technology (a pseudonym because of anonymity) is a professional service provider that uses blockchain to track and monitor the serial number of renminbi bills in circulation and to present the information flow to the People’s Bank of China. As daily transaction volumes top RMB 1 billion for each of People’s Bank of China designated branches and related commercial banks, using blockchain can reduce the costs associated with interbank transfers and assure transparency.
Blockchain is the technological framework by which bitcoin and other cryptocurrencies operate. Mordecai Lerer, Tax Partner in the Commercial Business Group at Marks Paneth LLP, defines cryptocurrency as a “digital currency that uses encryption techniques, rather than a central bank, to generate, exchange, and transfer units of currency. Unlike cash transactions, no bank or government authority verifies the transfer of funds.”
According to CoinMarketCap, a price-tracking website for cryptoassets, there are over 6,000 cryptocurrencies being traded with a total market capitalization of around US$1.3 trillion as of the end of July. The increasing prevalence of cryptocurrency transactions, including initial coin offerings and cryptoasset transactions, has been an interesting and important topic for professional accountants and auditors.
According to the International Financial Reporting Standards (IFRS) Interpretations Committee agenda decision published in June 2019, cryptocurrencies are classified as inventories (International Accounting Standard (IAS) 2 Inventories) if they are assets held for sale in the ordinary course of business, and otherwise as intangible assets (IAS 38 Intangible Assets).
The Hong Kong Institute of CPAs expressed in its response in May 2019 to the IFRS Interpretations Committee tentative agenda decision that accounting for cryptocurrencies under IAS 2 or IAS 38 may not provide relevant information. This is so because that IAS 38 was developed long before cryptocurrencies and IAS 2 does not measure cryptocurrency holdings at fair value through profit and loss.
Under IFRS, an entity should disclose according to the requirements in the standard but it should also disclose any additional information that is relevant to an understanding of its financial statements.
Auditing and assurance
On the audit and assurance of blockchain, Kathleen Hamm, a Public Company Accounting Oversight Board Member, commented on 2 November 2018 at a symposium: “Blockchain does not magically make information contained within it inherently trustworthy. Events recorded in the chain are not necessarily accurate and complete.”
Two control issues are of importance when it comes to blockchain. First, is authorization. Owners of direct cryptocurrency holdings should use appropriate controls to safeguard and ensure the private key used to authorize a transfer of the cryptocurrencies from one public address to another. If keys are lost or destroyed and backups are not properly secured, the entity would not be able to access the cryptocurrency; and in the case of stolen keys, the cryptocurrency could be transferred to another party and the transfer could be irreversible. Second is transaction controls, such as segregated duties associated with the initiation of cryptocurrency transactions. There should be well-designed manual reconciliations or programmed interfaces between the blockchain and the entity’s books and records, including adequate cut-off procedures.
According to Jamie Hinz, a cryptocurrency specialist at EY, there are four key areas that auditors need to consider when auditing clients with cryptocurrencies and blockchain systems. Firstly, clients are required to perform pre-assessments of business process controls to prepare for the audit. For example, clients must have IT general controls and application controls over private keys to access cryptocurrencies through blockchains. Independent accounting books and records are needed for reconciliation with records found within the blockchain. Clients should assess their process, technology, legal and compliance risks of blockchain systems. Secondly, auditors need to plan discussions with clients so that their expectations of audit effort, cost and timing are realistic. Thirdly, auditors need to regularly communicate with clients about new business activities to minimize surprises. Finally, auditors need to consider the use of experts during audits of blockchain companies. A blockchain specialist may help the auditor to understand blockchain technology and its technical limitations, and provide technical support on the ownership, rights and obligations of cryptocurrencies. Overall, auditors need to work with their clients and other specialists to conduct audit procedures, such as cryptocurrency wallet analysis/verification and transaction analysis/verification.
The second part of the series will look at blockchain’s impact on taxation. This article was contributed by Kang Li, a Blockchain Project Consultant at GF Digital Technology Pty Ltd., and Jim Wang, a research staff at the Department of Accountancy of Hang Seng University of Hong Kong.