Ramifications of Open Source Accounting

This talk is adapted from our presentation at ETHCC[6].

Accounting is a discipline that sits below our economies and runs like a stream to keep them going. It’s similar to the code that sits beneath our applications. When code runs smoothly, without bugs and in a sturdy operating environment, we can use our apps and other technologies with ease. We’re able to abstract away the “how” of things and reach the core of the app’s usefulness. The same goes with accounting. When the books are balanced and entries in the journal are made properly, we can have confidence that our economic systems are built on a solid foundation and have all of the requisite information to change as needed.

But we have seen this go wrong time and again in the broader economy as well as within our web3 economy. 

We could spend a lot of time analyzing the biggest accounting scandals in recent memory, but here are some highlights from different industries.

The Wirecard fraud was first reported in 2015 and it took until about 2020 to fully unfold (although there continues to be loose ends from the fallout). The was a German based payments processor that essentially inflated their revenue numbers and acted as a very efficient money laundering operation. After years of audit and investigation it was determined that there was 1.9 billion pounds missing from the balance sheet that probably never existed in the first place. The company was dismantled and partially sold off to Santander.

Between 2016 - 2020 a rancher in Oregon started selling cattle to Tyson Foods. The only problem was that the cattle didn’t exist. He extracted $224 million dollars from Tyson who clearly did not properly account for the invoicing/delivery and supply chain of this vendor. 

We are sadly much more familiar with the Celsius and FTX accounting frauds which many people within this ecosystem and outside of it were harmed by and are still dealing with the fallout from.

To note, in 3 of 4 cases here, the accounting fraud was exposed by journalists. Reporters who started lining up the financials that were publicly available against the statements made leadership. The average user of these former services would have had to have spent months combing through press releases or somehow getting access to non-public financial information to have even had a chance to figure out what was actually going on beneath the surface.

So what is open source accounting and how can it help? Open source accounting are 

1) tools for financial record-keeping and analysis, and 

2) a framework which defines the treatment of assets, liabilities and equity.

We have the second part of this - the rules are transparent. In the United States there is GAAP - Generally Accepted Accounting Principles; in Europe and much of the rest of the world there is International Financial Reporting Standards.

It is the technology side that we are lacking. Most businesses use things like Quickbooks or Xero for their record keeping. The importance of these systems is to generate reports that follow the common standards laid out in GAAP or IFRS. But the only way to check now that these reports are being generated correctly is for companies to hire audit firms to essentially double check them. It’s expensive and the incentive alignment of this exercise is way off. An auditing firm doesn’t verify every transaction, they test sample transactions that may or may not be indicative of the broader book of financial transactions. Auditing firms are also paid by the very entities they are supposed to be keeping in check. There are a litany of examples of auditing firms deciding not to bite the hand that feeds them.

Not every company is required, or can afford to, go through a financial audit. So we take their financial statements at their word.

The components of open source accounting tools are that they are rent-free, modifiable, and transparent.

While it seems like accounting in web3 should be easy since all of the transactions should be readable on a public blockchain, what is missing is the analysis part of the equation. There are unclear counterparties, on/off ramping lacks transparency, and the categorization of the different assets are unclear. This is particularly acute given that GAAP and IFRS have not created clear guidance in the rapidly evolving crypto landscape about how these assets should be reported on in alignment with the fiat economy. 

There have been a few solutions that have been floated around about how to create more financial transparency in our industry.

The first and probably oldest idea is around Triple Entry Bookkeeping, which is supposed to be an improvement on our traditional double entry system. In our current double entry system, each transaction has two entries against it in record keeping software - a debit and a credit. With Triple Entry a third entry is added to each transaction which is meant to in some way verify or link the two entries together to “seal” them. Think of it like a financial reporting transaction hash.

This is still a very conceptual proposed idea, there are not to our knowledge any triple entry accounting systems in operation today. They are difficult to deal with because they do not have a method for marrying crypto and fiat transactions together into one report. There are also no auditors out there now that audit triple entry books, the standard lacks practical application.

The other most popular open source accounting proposal that has taken off in the past year or so, led largely by Binance, is Proof of Reserves. This is a public attestation, usually by a crypto exchange, that shows the wallets owned by the exchange which custody user funds. The exchange might sign a transaction in each wallet to prove its ownership. 

This method is obviously flawed. It only shows 1 portion of assets on a balance sheet. We are missing the other assets involved, liabilities and equity. It doesn’t provide a full picture. 

There is also room to improve its presentation. Here is a snapshot off of Binance’s website showing their March 1, 2023 proof of reserves. 

It contains a list of only 24 assets.

It doesn’t link to the wallets directly. In order for us to verify this we need to toggle back and forth between their report, etherscan to find the list of Binance verified wallets, and our own spreadsheet to calculate the conversion price and balance at the time of the snapshot. 

This is also an attestation that is voluntary, there is no requirement to do this, or do it regularly. At best, it helps exchanges avoid a liquidity crisis. It doesn’t help with understanding the efficiency, longevity, or health of a business.

So how do we think about:

1. Creating something that’s easily readable

2. Transparent

3. Accountable

Current financial statements fall short in telling the full story of crypto assets. The main financial statements that companies produce are:

Balance Sheet - shows Assets versus Liabilities + Equity. This is a point in time report that is meant to show the full value of the company.

Income Statement (or Profit & Loss Statement) which shows Revenue against expenses, which indicates profitability. This is a period in time report.

Statement of Cash Flows - shows the differences in balances between assets accounts, essentially how much money is going in and out of an organization in a given time.

We would like to propose a new type of statement called Statement of Crypto Flows which not only shows the inflows and outflows of crypto from company wallets and exchanges, but also their fluctuations in price. Something that is not currently captured well in standard financial statements and is sometimes calculations only done around tax time to calculate capital gains/losses. It would also be organized by asset, rather than listed out by wallet or exchange to give a better picture of the holdings of the asset across the firm.

But this statement only gets to the second part of Open Source Accounting that we reviewed earlier. How do we handle the first point of having the right tools?

Statement of Crypto Flows Template

On the crypto side of things, we have many of the ingredients needed to assemble this report available on the internet.

Price feeds and block explorers are all things that anyone who has done some crypto bookkeeping or their own taxes are very familiar with. 

Along with many other tax preparers and accounting services would like to see crypto exchanges move toward standardizing the reporting outputs from their system so that all who need that information don’t need to go through complex data transformations.

And finally, we are happy to share our template for Statement of Crypto Flows for public use! It is a simple report that can help any company, their investors, customers, or other stakeholders get a better picture of the financial health of the organization. You can check it out here: Statement of Crypto Flows Template.