Ilia Penkin

Future of Financial Audit: Impact of

Blockchain Technology

Metropolia University of Applied Sciences

Bachelor of Business Administration

European Business Administration

Bachelor’s Thesis
17.05.2019
 Abstract

Author Ilia Penkin

Title Future of Financial Audit: Impact of Blockchain Technology

Number of Pages 31 pages

Date 17 May 2019

Degree Bachelor of Business Administration

Degree Programme European Business Administration

Instructor/Tutor Patrik Pehrsson, Lecturer

The technology of blockchain has been raising interest in different industries, be that law
and economics, or information technology and finance. Blockchain became known for the
fact that it is the technology behind such cryptocurrency as bitcoin. However, this technology
is much more than just the backbone of a cryptocurrency. It enables peer-to-peer
transactions between participants with no trust whatsoever as well as it has the potential to
disrupt many fields.
The purpose of this thesis is to showcase the possible implications of the implementation of
blockchain technology into the domains of audit and assurance.
In order to answer the research question, we reviewed three research papers discussing the
possibilities of implementing blockchain into the domains of audit and assurance. In the first
one, in order to increase the verifiability of business data, provide options to share data with
interested parties instantly, and store the data itself in a more secure manner a triple entry
accounting is suggested which in addition to the conventional double entry registry would
also submit transaction data into the blockchain. Consequently, if such new accounting
system would be implemented, there would be a need for the assurance possesses to be
adjusted accordingly. It is viewed, that the concept of blockchain based assurance would
increase the auditability of the information, with the use of smart controls it would allow near
real-time assurance, as well as automate most of the auditors’ manual tasks.
Another research prepared by the Chartered Professional Accountants of Canada (CPA
Canada) and the American Institute of CPAs (AICPA) analyses in an illustrative way how
such a technological advancement as blockchain could evolve the professions of audit and
assurance and as a result suggest new possible functions for auditors to take up – auditing
of smart contracts, consortium blockchains, system administrators, and arbitrators.
Third research describes an interview with Will Bible, a partner at Deloitte who specializes
in audit innovations, which raises concerns regarding the idea of recording transactions on
the blockchain due to the complexity and high cost.
As a result, there is no clear and unambiguous way to answer the research question due to
the novelty of the topic researched. Thus, further research is advised.

Keywords Audit, Assurance, Blockchain, Accounting, Future

Contents

1 Introduction 1

1.1 Research objectives and research question 1

1.2 Methodology 2
1.3 Limitations 3
1.4 Thesis structure 3

2 Literature review 5

2.1 Audit 5
2.1.1 Defining financial audit 6
2.1.2 Assurance process 7
2.1.3 Audit limitations 9
2.2 Blockchain 10
2.2.1 Defining blockchain 10
2.2.2 Technological background of blockchain 11
2.2.3 Smart contracts 12
2.2.4 Evolution of blockchain from 1.0 to 3.0 13
2.3 Combining the two 14
2.3.1 New accounting system and updated audit 14
2.3.2 Professionals’ point of view 20

3 Research analysis and results 23

3.1 Key findings 23

3.2 Analysis and reality check 25

4 Conclusion 27

5 References 28
Figures

Figure 1. An example of blockchain (Zheng et al., 2018) .......................................... 11

Figure 2. A triple entry accounting information system (Dai, 2017:66) ...................... 17
Figure 3. The vision of blockchain based Audit 4.0 assurance environment (Dai,
2017:77) 19
 1

1 Introduction

The technology of blockchain has been raising interest in different industries, be that law
and economics, or information technology and finance. Blockchain became known for
the fact that it is the technology behind such cryptocurrency as bitcoin. However, this
technology is much more than just the backbone of a cryptocurrency. It enables peer-to-
peer transactions between participants with no trust whatsoever as well as it has the
potential to disrupt many fields.

One way it is undoubtedly significant is the fact that currently, a vast range of economic
activities depend on the centralized and agreed process of recording data so that the
government and authentication of the records are reliant on a trusted third party (be that
banks, firms, or governmental institutions). However, blockchain in recent years has
proven to have the potential to facilitate transactions and disseminate trust without the
need for the trusted third party. Since bitcoin’s example of marketplace disruption,
blockchain gained a lot of attention.

Would this technology have an effect on the profession masters of which for centuries
have been working as trusted intermediaries between the company and the public and
the state? Could it be possible to automate the processes of audit and assurance?

1.1 Research objectives and research question

The purpose of this thesis it to showcase the possible implications of implementation of

blockchain technology into the domains of audit and assurance.

Main research question is formulated as follows:

• How could blockchain technology change financial audit (if at all)?

This question will be divided into sub-questions:

• What is financial audit?

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• What is the technology of blockchain?

• How can they be combined?

1.2 Methodology

This thesis work will be exploiting exploratory research approach which will be based on
the analysis of the literature review. Exploratory research is mainly used to “identify the
boundaries of the environment in which the problems, opportunities or situations of
interest are likely to reside and to identify the salient factors or variables that might be
found there and be of relevance to the research.” (van Wyk, 2012)

We will be concentrating on the use of secondary research material. This is due to

several reasons. One, the novelty of the subject in question has a key role in the
determination of research method as compared to many other research questions there
is comparably less extensive research done on the topic. Another, in case of primary
research where the researcher conducts first-hand data gathering by, for instance,
facilitating interviews, there is a risk for the interviewee to be biased towards one of the
extreme sides (either for or against the implementation of blockchain into the domains of
audit and assurance for various reasons).

When choosing a suitable source of information for research, one needs to evaluate the
appropriateness of the source. For this research, peer-reviewed articles, academic
textbooks, as well as professional research papers, were chosen. In the chapter about
financial auditing, the focus is more on the theoretical aspect of the processes of
assurance; thus, in most cases, academic textbooks were used to describe the concept.
In the chapter about blockchain, the focus is on the theory of blockchain also, but in order
to describe the concept peer-reviewed articles as well as professional publications were
used. In the chapter discussing the combination of audit and blockchain, the focus is on
exploring the possibilities that have been already suggested by other researchers and
professionals in the domains of audit and assurance hence peer-reviewed material and
professional publications were used.

Thus, by conducting the thesis, we are able to identify the concept of financial auditing,
the concept of blockchain. In order to comprehensively analyse the issue, we will present
 3

several studies exploring the combination of the two concepts, followed by a discussion
of the key findings of the research incorporated with the reality check.

1.3 Limitations

However, it is worth mentioning that there are some limitations to this study. Due to the
novelty of the topic under examination and lack of practical implementation, it seems to
be the case that most of the discussion held would be purely theoretical and possesses
illustrative form. As will be seen further in the research, most of the ideas covered are
thoughts or points of view, which might seem to be biased towards one way or another.
Taking this into consideration, it is important to point out that this research should not be
viewed as a single source of information on the topic discussed and that the readers are
highly encouraged to conduct further examinations themselves.

In addition to that, it is important to mention that this research is intended to be viewed

as one to attempt to raise awareness about the topic as in author’s opinion it has a great
potential for the further research.

1.4 Thesis structure

As literature review is the base of the work, most extensive research will be conducted
on this stage. In chapter 2.1, we will cover definitions for the concepts related to financial
audit. Namely, definition of financial audit, the process of assurance, and the limitations
of audit.
In chapter 2.2, we will cover definitions for the concepts related to the technology of
blockchain. Namely, what is blockchain, the technological aspects of blockchain, the
technology of Ethereum and smart contracts, and the evolution of blockchain from 1.0 to
3.0.
In chapter 2.3, we will go through several research papers the authors of which propose
different suggestions to how the technology of blockchain could be implemented into the
domains of audit and assurance. Namely, a proposal for creation of a new accounting
system (a triple entry accounting instead of the conventional double entry one) and as a
consequence having the auditing possesses conducted with the use of blockchain; a
research prepared by the Chartered Professional Accountants of Canada (CPA Canada)
and the American Institute of CPAs (AICPA) evaluating the potential impact on the audit
 4

and assurance profession; Last research in the chapter describes an interview with Will
Bible, a partner at Deloitte who specializes in audit innovations, who raises concerns
regarding the idea of recording transactions on the blockchain for several reasons.
In chapter 3.1 we will have a recap of the key findings from the research conducted.
In chapter 3.2 an analysis and reality check will be conducted in order to evaluate the
research outlines.
In chapter 4 we will conclude the research and propose recommendations for future
research.
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2 Literature review

In this chapter we will cover the following: In chapter 2.1, we will cover definitions for the
concepts related to financial audit. Namely, definition of financial audit, the process of
assurance, and the limitations of audit. In chapter 2.2, we will cover definitions for the
concepts related to the technology of blockchain. Namely, what is blockchain, the
technological aspects of blockchain, the technology of Ethereum and smart contracts,
and the evolution of blockchain from 1.0 to 3.0.In chapter 2.3, we will go through several
research papers the authors of which propose different suggestions to how the
technology of blockchain could be implemented into the domains of audit and assurance.

2.1 Audit

Auditing originated in the 19th century in the United Kingdom and the United States and
was initially designed to serve the purpose of a check on corporations. In addition to
that, the auditors at the time were meant to be independent intermediaries between the
government and the corporation. The process of auditing at the time was focused on the
procedures during transactions and the transactions themselves. Thereafter, when the
laws changed in the 20th century, audits began to focus more on the fairness of the
examined financial statements. Lastly, as a result of companies growing bigger and the
number of transactions becoming immeasurable, the function of auditors changed
significantly as it became impossible to track every single transaction due to time and
resource constraints. (AuditMonk, 2017)

The Big Four accounting firms is a generally accepted term describing the four biggest
accounting corporations in the world. As of the time of this thesis, the Big Four refers to
such companies as Deloitte, EY, KPMG, and PwC.

These corporations are a result of countless mergers of smaller firms, and due to their
current size, they possess the skills and resources to be practically the only ones who
are able to provide the best services for multinational client-companies. To be more
precise, the Big Four provide audits for the absolute majority of the public companies in
the United States and listed companies in Japan and all of the top 100 companies in the
United Kingdom. Thus, as an outcome, we get a cartel-like industry in which the pricing
of the services and the standards are set by the Big Four corporations. (Brooks, 2018)
 6

In most countries, corporations are required to have audits by law. However, instead of
providing the government and the public with accurate data describing company’s
current realities, the Big Four in order to retain customers and the revenue stream are
doing their best to showcase their clients to the government and the public in the best
possible way. This could be done by, for instance, finding tax loopholes, or covering
financial crimes which would profit the corporation and as a consequence, the executives
could extract cash through bonuses, and the audit firms could be assured that the client
will remain.

The above-mentioned begins to feel like an odd loop of conflict of interests. On the one
side, the auditors who are supposed to be independent intermediaries between the
government and the company-client. On the other side, the audit – client company
relationship, where one is paying another to check for fairness the financial statements.
On the third side, the nature of such accounting firms as those in Big Four, where they
as corporations are maximizing profits and at the same time provide an independent and
trustworthy audit report. (Brooks, 2018)

Such an uncertainty begs the question namely how is this situation even possible to
exist? As normally in this kind of situation the government usually interferes as it would
not be a legal practice. However, due to the fact that the government needs the auditors
to check the companies it does not interfere in the process. Additionally, the investors
when making a decision do rely on the information provided by the auditors as the latter
ones are perceived as an independent source of information. But as it was mentioned
earlier the auditors, particularly the Big Four, are not that independent after all as they in
the majority of cases produce information beneficial to the clients. Clearly, these kinds
of practices are appreciated by the corporate world as they are continuing to choose one
of the Big Fours as an auditing service provider. (Whittaker, 2019)

2.1.1 Defining financial audit

We will begin by setting up a definition of the external financial audit. As Oxford Dictionary
puts it, if we talk generally about an audit, it is a process of inspection of the
organization’s accounts, which is frequently conducted by an independent body. (Oxford
Dictionaries | English, 2019) Moreover, a member of academia further elaborates by
saying that the process of auditing could be defined as one when evidence collected and
evaluated by competent, independent individuals forms an opinion which is eventually
 7

communicated to the person interested in the report. (Basu, 2009:1-10) Furthermore, if

we look at a definition provided by one of the Big Four companies (generally accepted
concept of four biggest auditing companies in the world, as of the moment of this thesis
comprises of EY, KPMG, PwC, and Deloitte) in the field of audit, it says that generally
speaking the audit process comprises of evaluation of a subject matter with an intent to
communicate an opinion on the subject of fairness of the matter presented be that matter
an audit of financial statement, or internal control over financial reporting, or even
compliance audit. (Pwc.com, 2017) To sum up, the main purpose of financial audit is to
ensure that the financial reporting systems are in order and that published accounts are
sufficiently trustworthy. (Brody et al., 1998) However, if we dug a bit deeper, we will
realize that audit is only one type of assurance. It is important to differentiate the main
ones: reasonable assurance engagements (i.e., audits of historical financial information),
limited assurance engagements (i.e., reviews of historical financial information, mainly
analytical procedures), and engagements which do not involve assurance (i.e.,
compilation engagements, a compilation of financial information and agreed-upon
procedures). (Bagshaw, 2013:1-10)

In addition to everything stated above, it is crucial to note the importance of audit trail
when discussing examinations of financial statements as they are a product of journal
entries. There are two types of journal entries – a standard journal entry (comes from the
name itself - when an entity records standard or recurring transactions, i.e. sales,
purchases, payments, etc.) and a nonstandard journal entry (when businesses record
nonrecurring transactions, e.g., asset impairment, etc.). The latter has generally been
known to have a higher risk of material misstatement. (DeVries & Kigel, 2004)

2.1.2 Assurance process

In order to understand better the concept of financial audit, we will now concentrate on
describing the steps of the assurance process. The process of assurance itself has four
main steps which are acceptance and planning, conducting risk assessment through
understanding the business’ nature, gathering evidence in order to conduct the
engagement procedures, and finalizing and reporting. We will now explain each one in
more details.
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1. Acceptance and planning

Prior to taking up any assurance engagement, professionals must make sure they are in
compliance with ethical (i.e., making sure they are independent of the entity they are
investigating and qualified to carry out the engagement) and quality control (i.e.,
performing the engagement according to the professional standards and methodologies
set by the firm) requirements. During this step also scheduling of the engagement and
allocation of resources is being performed as well as negotiation of an appropriate level
of fees.

2. Conducting risk assessment through understanding the business’ nature

Each of the engagements involves assessment of risks. For reasonable assurance

engagements a broad analysis of risks linked to internal controls is performed, where
relevant. For limited assurance engagements, however, risk assessment is conducted
only to identify the potential areas which might contain material misstatements.

3. Gathering evidence in order to conduct the engagement procedures

For limited assurance engagements, the process of evidence-gathering focuses

primarily on the above-mentioned established risks of a material misstatement by
addressing them with probes and other appropriate procedures. For reasonable
assurance engagements, the risks are addressed by various tests of control and other
substantive procedures (including a test of details and analytical procedures).

4. Finalizing and reporting

During the finalization step, the management of the company is required to provide proof
that all the necessary information has been provided to the auditors as well as described
the possible subsequent events. In the reporting auditor in charge of the engagement
outlines their opinion on the matter of the engagement and presents the either qualified
or unqualified opinion of how “true and fair” the content of company’s financial statement
is. (Bagshaw, 2013:1-10)
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2.1.3 Audit limitations

As much as the audits are benefiting the companies by assuring the truthfulness and
fairness of the financial statements, as well as pointing out some possible insights on
how to improve controls and processes (Pwc.com, 2017), one should also understand
the possible limitations.

Those limitations might include, for example, a human error when selecting, performing,
and evaluating the procedures. Furthermore, it is important to point out that it is
impossible to perform a 100% testing of controls and processes due to the time and
resource constraints. (Bagshaw, 2013:1-10)

In addition, to the above mentioned, it is crucial to realize that an audit is an opinion, and
not in any ways a guarantee regarding the fairness and truthfulness of the financial
statements. As was stated before, management is still responsible for the fraud of their
making which could cause a collapse of the company. (Bagshaw, 20131-10)

According to DeVries and Kiger (2004), management has been practicing the use of
inappropriate journal entries in order to, in many cases, tamper with the revenue figures
to look more profitable. One of the maybe most known scandals related to tampering
with financial statements was the Enron Scandal when the company declared bankruptcy
after their inability to continue fooling everybody with fake holdings and off-the-books
accounting. (Investopedia, 2019) It is worth mentioning though, that Enron’s auditor,
Arthur Andersen very quickly lost its clients when the reputation of the company was so
damaged after it was suggested that Enron had pressured Andersen to provide “clean”
audits in return for even more lucrative consulting contracts from Enron.

Such scandals as Enron’s case led to calls for the separation of auditors’ audit functions
from their management consulting activities. As of the beginning of 2019, PwC and EY
have presented their plans to eliminate the providing of consulting services to their audit
clients. According to their reasoning, these actions would be done in order to restore
public trust in a sector shaken by corporate scandals. As of this moment, another large
audit corporation, KPMG has already undertaken steps to reduce the consulting services
provided to corporations that have their audits done by them. (Jones, 2019)
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2.2 Blockchain

Due to the lack of proper terminology, blockchain has become a buzzword raising hype
throughout industries making it more complicated to grasp an adequate picture of the
concept. Some say it will be so disruptive that eventually, the need in intermediaries will
drop. Others, more conservatively, tend to believe that it will likely shift the scope of
intermediation towards the reduction of transaction costs and establishment of new
marketplaces. In any case, there is a clear need for a better conceptualization of what
blockchain is for different fields.

2.2.1 Defining blockchain

We will begin setting up a definition of the concept of blockchain. If we look at the

definition of blockchain in Oxford’s Dictionary, they identify it as a system which conducts
a record of bitcoin or other cryptocurrency transactions and is maintained by a peer-to-
peer network. (Oxford Dictionaries | English, 2019) And it is what most of the people
believe technology in question does, sometimes even mixing up the two concepts by
using them interchangeably. However, if one takes the definition to a broader sense, the
technology behind these cryptocurrencies is presented as a peer-to-peer network that is
publicly accessible and keeps track of records securely. (Ortman, 2018)

Historically looking, there have been concepts similar to the one of blockchain proposed
already in the 1990s. For instance, Bayer et al. in their research paper “Improving the
Efficiency and Reliability of Digital Time-Stamping” published in 1992 discuss the
possibility of using cryptographic hash functions and so-called trees that would record
and timestamp the transactions making them “sandwiched securely into [their] place in
history.” This procedure, in their view, would aid the process of digital timestamping by
drastically improving the process for validating a given certificate. (Bayer, Haber, and
Stornetta, 1992)

The concept of blockchain as it is known nowadays started gaining momentum only in

2008 when an individual or a group of people under the pseudonym Satoshi Nakamoto
published a white paper. Nakamoto proposed to use the decentralized mechanism of
blockchain to track and verify the transactions of bitcoin based on a consensus
mechanism (i.e., the actual process when the network validates transactions).
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(Nakamoto, 2008) Only later people began speculating that the need in a central
authority (be that a bank or a government) could eventually drop.

2.2.2 Technological background of blockchain

In order to describe the way blockchain works, the technological background of it, let’s
examine figure 1 presented below.

Figure 1. An example of blockchain (Zheng et al., 2018)

As it is illustrated in Figure 1, a blockchain begins with a genesis block (the first block in
sequence). Every other block in the sequence is called a child block and is connected to
its parent block by a hash function. Every block contains a block header and a body.
The first one comprises of a block version (pointing out the set of validation rules for the
block to follow), a parent block hash (indicates the previous block with a 256-bit hash
value), a Merkle tree root hash (the hash value of all the transactions in the block), a
timestamp as seconds of the current moment in time from first of January 1970, nBits (a
compact format of current hashing), and a nonce (a 4-byte field increases for every hash
calculation and most of the times begins with 0. (Zheng et al., 2018) The concept of
nonce ensures the integrity of the whole sequence of blockchain up until the genesis
block. (Nofer et al., 2017) The block body includes a transaction counter and the
transactions themselves (the maximum amount of which depends on the block’s size
and the size of the transactions). (Zheng et al., 2018)

In order to be able to sign transactions digitally, blockchain technology uses asymmetric

cryptography. This type of cryptography is usually used in the untrustworthy environment
(Zheng et al., 2018), which is precisely our case. Put in a nutshell, signing digitally using
asymmetric cryptography could be described as follows: all users possess a pair of
private and public key, the first one is for signing the transactions, after which
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transactions are sent out to the network and are accessed by everyone using the public
key. (Zheng et al., 2018)

In a couple of words, the concept of blockchain could be portrayed as decentralized

(transactions happen in a peer-to-peer network without the need of a trusted third party
that would regulate the transactions otherwise), persistent (easier to check the validity of
transactions as the network is constantly validating them which makes finding
falsifications easy), anonymous (users interact with each other using a generated
address, and there could be generated lots of them to conceal identity; however one
should also understand that nowadays with technological advancements blockchain can
not guarantee absolute anonymity), and auditable (as in blockchain every transaction is
being validated, recorded, and timestamped by the network, the probability of someone
tampering with the record decreases). (Zheng et al., 2018)

2.2.3 Smart contracts

The process described above requires human in order to be completed. There is,
however, a way to introduce some amount automatization to the process with the
introduction of Ethereum.

Ethereum is based on the technology and basic principles of blockchain. The main
difference to the blockchain which is at the core of bitcoin, for instance, is that the
technology of Ethereum allows developers to write applications that are, among others,
easy to create, scalable, and standardized in use. In addition to that, the concept of
transactions – messages- in Ethereum is different in several ways:

1. messages in Ethereum are created by an external entity or a contract when to be able

to create a transaction in Bitcoin on has to do it only externally;

2. messages in Ethereum can contain data;

3. in case of a situation when a recipient of such a message is a contract account they

are capable of responding. (Buterin, 2014)

Ethereum technology makes it possible and easier to use smart contracts as it works in
an established Ethereum Virtual Machine (EVM) which provides security and
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environment to run code that is not trusted otherwise by computers everywhere in the
world. (Ethdocs.org, n.d.)

A concept of smart contract was first presented to the public in 1994 as electronic,
computable contracts which execute the contractual conditions automatically. (Szabo,
1994) Mentioned technological advancement made it possible to enforce the
performance of the contractual agreements without human intervention which in turn
lowered the risk of fraud or a mistake. (Wright and De Filippi, 2015)

Furthermore, a smart contract could be created by two anonymous parties without any
kind of intermediary, nor they require (in case of printed contracts) to be verified by any
third party. In addition to that, due to the fact that the conditions are executed
automatically the cost and time of settling down a dispute decreases as the need for an
intermediary evaporated.

2.2.4 Evolution of blockchain from 1.0 to 3.0

Blockchain 1.0 entirely concentrates on the cryptocurrency trade incorporating in itself

various functions related to, among others, transfer of digital money and payment which
allowed the introduction of a new ecosystem called the Internet of Money.

Blockchain 2.0 broadened the scope of above-mentioned trading to allow the exchange
of such assets as derivatives, smart property, and others. In addition to that, it also
allowed the use of new types of applications called smart contracts which were able to
execute terms of agreements autonomously. With growing complexity and automation,
the applications of a smart contract could be expanded even more. In future, it is believed
that with smart contracts being automated, the duty of looking after the execution of the
terms of the contracts could be decentralized and the need for a trusted third party (f or
instance governmental institutions) would shrink.

Blockchain 3.0 expands the use of blockchain, even more, disrupting, in theory, such
things as voting systems, attestation services. Even government administration could be
remodeled into a more decentralized, self-managing model. The limit for the use cases
of blockchain at this point of evolution of the technology is only the imagination. (Dai,
2017)
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2.3 Combining the two

2.3.1 New accounting system and updated audit

Jun Dai in her dissertation “Three Essays on Audit Technology: Audit 4.0, Blockchain,
and Audit app” talks about different ways how the field of financial audit could change in
the foreseeable future. The author of the dissertation presents three essays in which she
describes such rather new technologies as Industry 4.0, blockchain, as well as apps,
which in her view could impact on the domain of audit. For the purposes of this thesis we
will concentrate on the first two essays.

In the first essay in the dissertation, the author of the research outlines the evolution of
auditing as profession by going through the stages from Audit 1.0, also known as the
very traditional audit which for many centuries has been fulfilling many needs, to Audit
4.0, which, in Dai’s opinion, would significantly transform the profession of auditing as a
whole with the help of automatization of current procedures as well as expansion of their
scope and shortening the timing which all could lead to better and improved assurance
quality. Furthermore, she proposes a definition for the concept of Audit 4.0 by analyzing
the possible impact of the fourth industrial revolution on the auditing profession by
covering such emerging technologies as the Internet of Things, Internet of Services,
Cyber-Physical Systems, and smart factories. In addition to that, the researcher connects
those two (Audit 4.0 and the emerging technologies) with six technological principles of
the Industry 4.0:

1. interoperability - when systems talk to each other; the author brings the possible
future interaction of cars and traffic lights as an example which could optimize the
movement of vehicles and lower carbon emissions;

2. virtualization - creating a virtual copy of information of smart objects which would

enable a value chain that is more transparent and easily audited; as an example of this
kind of virtual environment Dai brings up so-called mirror worlds, “informationally-
enhanced virtual models (..) of the physical world”, which in her view could greatly scale
down audit professional’s fieldwork as well as operate as an independent party which
would be facilitating and evaluating accounting information. We will cover these in more
detail later on in this part;
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3. decentralization - with business models becoming more and more complex in their
nature and technological ground it is important to understand how decentralization would
be able to aid in the problem of optimization;

4. real-time capability - in the context of technological advancements it is particularly

important to be able to conduct continuous monitoring process in order to make various
decisions in real time;

5. service orientation - services that are available to use to other participants than the
companies and other parties that created them; in terms of Auditing 4.0 this principle
could come handy in order to facilitate interactions of auditors and other service
providers;

6. modularity - systems incorporating such principle are keen to be very adaptable to

change environments and requirements constantly.

She identifies the concept of Industry 4.0 as a manufacturing environment which allows
fundamental improvements of various industrial processes, be that manufacturing,
material usage, engineering, etc. (Dai, 2017:6)

Dai then presents several challenges that might occur. First of all, she explains how Audit
4.0 with all the benefits of digitalizing, optimizing, virtualizing the audit process could be
used in a digital crime by demonstrating an example of RFID (radio-frequency
identification) chips and the case of their fraudulent use. Second, she raises a concern
in regard to data security and privacy in terms of company wise data exchange. However,
the author points out the issue in question could be tackled by encrypting the sensitive
information before transferring it anywhere. Finally, Dai points out the problem of
standardization of data as nowadays it comes in a variety of formats and cleansing it is
compound, complicated, time-consuming. (Dai, 2017: 30-58)

In the second essay, the author of the dissertation discusses the possibility of
implementation of blockchain in accounting and as a consequence audit. In her point of
view, the potential benefits of blockchain in the two mentioned domains are under-
explored. Furthermore, by presenting the idea of creation of a new accounting system –
triple entry accounting instead of the conventional double entry one – Dai suggests
several points how the process of accounting could be improved and made more secure
 16

and trustworthy. Additionally, she proposes to apply blockchain to the process of

assurance in order to, among others, increase the audibility of information, as well as to
make it possible to use of smart controls which would enable close to real-time
assurance. We will now explore more details about how this could be implemented. (Dai,
2017: 59-84)

As it was mentioned before, the second essay covers the introduction of an idea of a
new accounting system based on blockchain and as a consequence development of
continuous assurance with blockchain using smart controls.

To begin with, lets discuss the proposal for a new accounting system. Blockchain based
accounting system incorporated with smart contracts has a potential to disrupt the way
the accounting is done nowadays by increasing the verifiability of business data,
providing options to share data with interested parties instantly, and storing the data itself
in a secure manner. In addition to that, it would not only provide information about the
transactions themselves but also it would allow us to explore the flow of accounting data
within the company.

The proposed triple entry accounting is being discussed as a paradigm which would
enhance the reliability of corporations’ financial statements. Originally, according to Dai
(2017), when this new system was introduced for the first time, the system itself was
based on the idea to have a trusted third party as an intermediary to facilitate to
verification of the transactions. However, with blockchain technology, the need in this
kind of intermediary is eliminated.

Thus, Dai (2017) suggests blockchain based triple entry accounting system which would
work as follows (see Figure 2 for the graphical representation of the proposal):
 17

Figure 2. A triple entry accounting information system (Dai, 2017:66)

According to the presented Figure 2, the system would make a record of the information
of the business transactions and the data flow. Thus, additionally to the traditional double
entry system, every transaction would be stored in the blockchain ledger as a record
which would be presented as a transfer from one account to another. The accounts
would be arranged in a hierarchical system which would allow the aggregation of data at
different levels. Furthermore, it will be possible to investigate possible errors and
fraudulent entries in the accounts in a timely manner as well as allows for automation of
the process of verification of the transactions.

Figure 2 presented above illustrates an example of an ordinary purchase-sell cycle. In

this situation, a company obtains goods from the supplier using credit, which would be
then recorded in the Account Payable and in inventory in the ERP system. At the same
time, this transaction would be submitted to the blockchain ledger as a transfer of digital
token which is considered for recording and tracking purposes. After the submission the
network participants would perform verification procedures to establish the authenticity
of the recording be the company’s ERP system, posting of the transaction, asset transfer,
correctness of the amount and the account, and posting party validity. Due to the nature
of the information handled in the aforementioned example, such an ecosystem could
only be viable in case of permissioned blockchain when only some individuals are
 18

granted rights of use which could cause complications when designing the system so
that it would fit all. (Dai, 2017: 63-73)

We are now moving on to the applications of blockchain in the domain of assurance.

As it has been stated before, the technology of blockchain incorporated with smart
contracts could cause the field of assurance to undergo fundamental changes as it would
allow for the creation of a verifiable and tamper-proof ecosystem.

One of the main benefits of such infrastructure is the increased auditability of the
information. Due to the fact that the blockchain ledger allows to store the data securely
it could also help with some audit-related documents. As an example, Dai (2017:74)
gives a situation when the process of inventory is conducted so that each item is
registered in the blockchain at the time of arrival to the warehouse and the information
about this item is continuously updated generating a history of the item in the system.
Such a registry would be able to provide the user with real-time inventory for the
inspections. In addition to that, in order to speed up the process of examinations, audit
trails could be documented on blockchain.

According to Dai (2017:74-75), another way how blockchain technology could disrupt the
domain of assurance is the implementation of smart controls. In her view, it is no longer
enough to conduct an audit on a quarterly or annual basis as businesses nowadays do
not operate like that. Moreover, she believes that it would be more meaningful for the
businesses if auditors could provide a more near to real-time assurance. However, due
to the number of transactions skyrocketing in recent years, it is no longer possible to
provide a near real-time assurance due to the manual nature of the auditors’ work. Thus,
she suggests the implementation of smart controls which would work as follows:
managers and auditors would set the firm-specific controls into smart contracts which
would track the implementation of the controls; in the case when something goes wrong,
it could be instantly corrected. It is, however, worth mentioning that some sort of authority
oversight is required in such kind of system in order to make sure that the companies
comply with the law and are not doing whatever they want. Additionally, it is important to
understand that in such a scenario when most of the audit processes can be automated
and the role of accuracy verifications would decline, the idea of complete abolishment of
auditing as a profession is an overstatement as eventually the need for their oversight
would increase. Furthermore, according to Dai (2017:76), the aim of the auditing world
 19

would switch from verification and record tracking to more consultancy-like tasks
(systemic evaluation, risk assessment, etc.), and fraud detection.

Lastly, Dai (2017:77-79) proposes to connect blockchain with Audit 4.0.

Figure 3. The vision of blockchain based Audit 4.0 assurance environment (Dai, 2017:77)

As it could be seen from Figure 3, in blockchain based Audit 4.0 assurance ecosystem
could be divided into two parts: the physical and virtual world. Every significant object in
the physical world has a representation in the virtual mirror world. The latter one consists
of three layers – data (handles the records of information needed for audits), service
(grants the possibility for the auditors or other experts to provide various services by
implementing the smart contracts), and payment (an automatic payment environment
where transaction would be completed using smart contracts after, for instance, the pre-
agreed audit services are done).

As much as proposed technological improvements have potential to, in theory, disrupt

the whole profession of audit and assurance, one should understand the challenges in
bringing the ideas to life and to full utilization. According to Dai (2017:80-83), there could
 20

be outlined three major challenges when trying to implement such great changes. First,
the technological context we nowadays live in. In order to be able to operate in blockchain
flawlessly and without complications one needs great amount of resources and
computational power in addition to the knowledge of the know-how from the personnel.
Second, it is the organizational context when for example in large corporations complex
changes such as switching to blockchain could end up being rather difficult and costly.
Finally, the environmental context when the regulators are expected to influence greatly
on the process of adoption of blockchain in the domains of accounting and audit. (Dai,
2017:77-79)

2.3.2 Professionals’ point of view

Let’s now focus a bit on the opinion of the professionals working in the field.

A research prepared by Chartered Professional Accountants of Canada (CPA Canada)

and the American Institute of CPAs (AICPA) called “Blockchain technology and its
potential impact on the audit and assurance profession” suggests several opportunities
of how such a technological advancement as blockchain could evolve the professions of
audit and assurance. As a matter of fact, they propose four new possible functions
(though they do emphasise on the imaginative side of the situation as the list is supposed
to be “illustrative only and not all-inclusive”) for auditors to take up if the technology of
blockchain is to be vastly accepted. (Aicpa.org, 2017)

First on the list comes the idea of auditing of smart contracts. In cases when processes
are automated the contracting parties might want to make sure that the smart contract in
use are constructed in accordance with the business processes as well as do not have
unexpected errors or other vulnerabilities. This would require auditors to obtain rather
specific knowledge about technical programming languages on top of the understanding
of the functions of blockchain. (Aicpa.org, 2017)

Second, on the list comes the idea of service auditor of consortium blockchains. The
main idea behind such an auditor function would be the possible need of an entity for an
independent examination of already existing blockchain based products prior to
subscribing to it. On a continuous basis, such an independent party could be needed to
provide assurance to ensure the effectiveness of private blockchain controls. (Aicpa.org,
2017)
 21

The third opportunity for auditors would be the role of a system administrator. In this role,
auditors would be responsible, for instance, for granting access to the blockchain based
system to users. In order for the administrator to verify the users’ identity, the information
has to go through a process of vetting. In addition to that, as a trusted third-party auditor
could ensure the trust in the blockchain system. (Aicpa.org, 2017)

Finally, in situations when complex business arrangements end up in conflicts auditors

as arbitrators could help to resolve the issues. Especially when talking about consortium
blockchain-based applications participants of which might require a trusted third party
again to enforce the terms of the contract. According to the research, this function would
require conducting further considerations to whether the need to it actually exists.
(Aicpa.org, 2017)

In general, when talking about the reliability of transaction information recorded in a

blockchain one should be aware of the fact that even though blockchain makes sure the
chain is inalterable after the information has been submitted to the chain it still could be
untrustworthy information. As examples presented in the research, such transaction data
could be generally unauthorized, fraudulent, or even illegal, or linked to an agreement
on the side (so-called off chain agreement), or occurred between related parties, etc.

Another research conducted on a similar topic examines the way the mentioned
technology could be affecting auditors’ work. Connor Ortman (2018) from the Claremont
McKenna College in his paper “Blockchain and the Future of the Audit” describes an
interview with Will Bible, a partner at Deloitte who specializes in audit innovations.

According to the cited interview, Bible expressed concern regarding recording

transactions on the blockchain, especially in large corporations. According to him, the
transaction handling processes are in many large firms way too ingrained into the legacy
ERP and CRM environments and kick-starting a switch could be rather complicated.
Furthermore, he believes the most return on investment companies would to get out of
this change of systems would be lowered audit fees, which in many cases are not the
main line of expense. Thus, Bible sees no rush for big corporations to alter their legacy
systems. (Ortman, 2018)

In addition to that, Bible points out that even if the blockchain is to be adopted, taking
into account modern environment, all transactions would need to be stored in two places
 22

simultaneously, which causes inefficiencies and is portrayed as redundant. Thus, it

would require a company to completely change the legacy systems completely to
eliminate such redundancy, which, again due to cost constraints, is highly unlikely.
(Ortman, 2018)

Bible further elaborates that companies do not create their systems to help auditors. On
the contrary, firms create technical environments to suit their needs. Thus, taking into
account the fact that the profession of auditing is mainly customer service, it is auditors’
job to adjust and adapt to the client’s environment. Sure, there will be companies that
operate on blockchain from the beginning, and only in those cases, it would be
reasonable to think about adjusting the accounting systems. (Ortman, 2018)
 23

3 Research analysis and results

In this chapter we will cover the following: In chapter 3.1 we will have a recap of the key
findings from the research conducted. In chapter 3.2 an analysis and reality check will
be conducted in order to evaluate the research outlines.

3.1 Key findings

To recap all that has been said, it would be beneficial to outline the key findings of this
research. So far, we have talked about what is a financial audit, conceptualized the idea
of blockchain, as well as looked at some researches that were examining the possibilities
of implementation of blockchain in the domains of audit and assurance.

In chapter 2.1, we defined that the main point of the audit is to ensure that the financial
reporting systems are in order and that published accounts are sufficiently trustworthy.
Moreover, we described the four steps of the assurance process – acceptance and
planning, conducting risk assessment through understanding the businesses’ nature,
gathering evidence in order to conduct the engagement procedures, and finalizing and
reporting. Additionally, we pointed out the possible limitations of financial audit, namely
human error when selecting, performing, and evaluating the procedures, and time and
resource constraints which do not generally allow to perform 100% testing of controls.
Finally, we mentioned what could happen if management, with the help of auditors, tries
to conceal the real financial situation of the company using the Enron scandal as an
example.

In chapter 2.2, we identified that blockchain is much more than just the backbone of a
cryptocurrency. In the technological background, we mentioned that blockchain is simply
put a chain of blocks that are connected using hashing technology, and it could not be
altered after the block is in the chain. The concept of blockchain is portrayed to be
decentralized, persistent, anonymous, and auditable. We then looked at what are smart
contracts – electronic computable contracts which execute the contractual conditions
automatically when the conditions for it has been met. Furthermore, we outlined that this
kind of smart contracts could eventually make the trusted third party unnecessary in
contractual dealings. Lastly, we went through the evolution of blockchain from 1.0 (the
stage of trade of cryptocurrencies only), to 2.0 (broadened scope of trade, allowing the
 24

use of smart contracts which at this stage allow even more automation), to, finally,
blockchain 3.0 (the stage when the technology of blockchain could potentially disrupt
voting systems, or attestation services allowing the idea of remodelling of the
government).

In chapter 2.3, we reviewed three research papers discussing the possibilities of

implementing blockchain into the domains of audit and assurance. In the first one, Jun
Dai in her dissertation “Three Essays on Audit Technology: Audit 4.0, Blockchain, and
Audit app” talks about different ways how the field of financial audit could change in the
foreseeable future. While examining the dissertation, we focused mainly on the two
essays of the dissertation. First of them talked about the evolution of audit as a whole in
the context of the fourth industrial revolution (she identifies six key technological
principles that would have an effect on audit – interoperability, virtualization,
decentralization, real-time capability, service orientation, and modularity). Dai also
outlines challenges for this concept mentioning that it could be used in a digital crime
using the RFID chips as well as points out the issue with lack of standardized data
formats as nowadays it comes in a variety of formats and cleansing it is compound,
complicated, time-consuming. In the second essay, in order to increase the verifiability
of business data, provide options to share data with interested parties instantly, and store
the data itself in a more secure manner Dai suggests a triple entry accounting which in
addition to the conventional double entry registry would also submit transaction data into
the blockchain. Consequently, if such new accounting system would be implemented,
there would be a need for the assurance possesses to be adjusted accordingly. In her
view, the concept of blockchain based assurance would increase the auditability of the
information, with the use of smart controls it would allow near real-time assurance, as
well as automate most of the auditors’ manual tasks. Lastly, Dai outlines three main
challenges in bringing the ideas to life and to full utilization, namely, in order to be able
to operate in blockchain flawlessly and without complications one needs great amount
of resources and computational power in addition to the knowledge of the know-how
from the personnel, as well as switching to blockchain could end up being rather difficult
and costly, not even mentioning the fact that the regulators are expected to influence
greatly on the process of adoption of blockchain in the domains of accounting and audit.

Second research in chapter 2.3, called “Blockchain technology and its potential impact
on the audit and assurance profession,” was prepared by the Chartered Professional
Accountants of Canada (CPA Canada) and the American Institute of CPAs (AICPA).
 25

They analyse how such a technological advancement as blockchain could evolve the
professions of audit and assurance and as a result suggest new possible functions for
auditors to take up – auditing of smart contracts, consortium blockchains, system
administrators, and arbitrators.

Last research in the chapter describes an interview with Will Bible, a partner at Deloitte
who specializes in audit innovations, who raises concerns regarding the idea of recording
transactions on the blockchain as in his view it would be too complex for many companies
and not worth the investment, as well as he does not see a point to store data
simultaneously in two places as it causes redundancy and is inefficient.

3.2 Analysis and reality check

As we can see from the research presented above, there is no clear and unanimous
opinion on whether or not the idea that blockchain, when implemented into the domains
of audit and assurance, would definitely benefit society.

As it has been mentioned before, on the one hand, we have the idea of automation of
the manual processes of gathering the data required for conducting the engagements as
well as speed and timing. However, on the other side, we have a whole bunch of
challenges and issues slowing the processes down.

For one, we would have the problem of trust. It is natural with all things that are new to
seem untrustworthy at first. As auditors as seen to be the ones who act as a trusted
intermediary between the company and the public and government, it might get tricky at
some point to explain that instead of conventional manual checking of the books there
would be a smart electronic control in place doing that job for them. Time has to pass for
people to adapt to the idea that blockchain is a thing and that I can be trusted as well as
their own solutions that they use currently.

Another issue is the environmental factor. We live in a society which is yet not ready to
make the leap of faith towards a complete digitalization of the financial industry. In many
countries still, till this day credit cards even if exist as a mean of paying for goods and
services not necessarily so common. As it was mentioned before, it is the regulators who
will eventually have to push for the change.
 26

Moreover, if we look at the technological aspect of the matter – nowadays it is very

expensive to have a blockchain system rolling as it requires a lot of computational
resources. Until some sort of a solution is created to bring the cost of maintenance down,
it would not be worth for companies even to try to implement blockchain into their
systems.

Last but definitely not least is the problem of security. There have been talks about the
creation of different kinds of blockchain systems – permissioned and permissionless.
According to their names, the first one is open only to a small number of vetted users,
and the other one is open to anyone. In such political regimes as in China, for instance,
the government would surely want to control what kind of dealings companies make with
each other. And in that case, it would ease the work for the government to arrange
observation and lurking.

Regardless, it feels too early to say anything concrete to whether this would actually work
or when it could be implemented. The main point would be that the potential is huge; the
other question is the implementation.
 27

4 Conclusion

The purpose of this thesis was to answer a question how the technology of blockchain
could change financial audit. Even though the research did not give a comprehensive
and one-sided answer, we managed to look at the issue from different perspectives.

In order to answer the question, we explored the concepts of audit and technology of
blockchain. We identified what is the financial audit, what are the four steps of the
process of assurance, and what are the possible limitations of the financial audit. As for
the concept of blockchain, we identified the definition of blockchain, looked at the
technological background of it, as well as Ethereum and smart contracts, and went
through the evolution of blockchain from 1.0 to 3.0.

In addition to that, we went through several research papers the authors of which
propose different suggestions to how the technology of blockchain could be implemented
into the domains of audit and assurance. Namely, a proposal for creation of a new
accounting system (a triple entry accounting instead of the conventional double entry
one) and as a consequence having the auditing possesses conducted with the use of
blockchain; a research prepared by the Chartered Professional Accountants of Canada
(CPA Canada) and the American Institute of CPAs (AICPA) evaluating the potential
impact on the audit and assurance profession; Last research in the chapter describes an
interview with Will Bible, a partner at Deloitte who specializes in audit innovations, who
raises concerns regarding the idea of recording transactions on the blockchain for
several reasons.

As a result, it is important to point out that due to the limitations of this research it is highly
encouraged to conduct further research on the topic of implementation of blockchain into
the domains of audit and assurance, as this field has a lot of potential.
 28

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