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Bitcoin for Accountants

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Most blogs, including ours, operate on the WordPress content management system, the most popular blogging platform in the world. Last year WordPress began accepting a new, secure digital currency called bitcoins for payments and donations. This new currency combines open source software with cloud computing to dramatically lower the cost and delay of transferring funds.

Bitcoins are bought with dollars, euros, and other conventional currencies on centralized exchanges much like any other liquid asset. The currency is currently in a bull market, with the price of one bitcoin increasing from $5 to almost $18 over the past year.

Once purchased, bitcoins are used to make payments for goods and services using a distributed transaction clearing system (PDF). Instantaneous fund transfers cost less than a penny and are free if rapid execution is not a priority.  The clearing system continuously broadcasts all transactions between anonymous addresses (hashes of public keys) using a “block chain” or public ledger; the equivalent of check clearing between bank accounts. This level of transparency, combined with modern cryptography (SHA-256 & ECDSA), prevents any tampering or double spending.

Over the last couple of months approximately 1,000 merchants started accepting bitcoins thanks to a start-up called Bitpay. This trend has been driven by the low costs and high security of the Bitcoin payment processing system as well as the monetary stability of the underlying bitcoin currency. Perhaps the greatest advantage of Bitcoin over the current payment system is “immediate funds transfer” or IFT. Rather than wait for overnight clearing through ACH, CHIPS, or SWIFT, payments can be deposited or disbursed instantaneously wherever there is an internet connection.

From a financial and tax accounting point of view, bitcoins are the same as any other foreign currency. However, from an auditor’s point of view they do present an unprecedented peculiarity: the entire system relies on cryptographic proof rather than human trust. It is important for auditors to understand how to verify bitcoin transactions and value a company’s inventory of bitcoins.

The public ledger is called the “block chain” because it is a series of “blocks” that contain information about transactions. All of the bitcoin transfers from one address to another that have ever occurred are recorded in the block chain. This is very convenient for auditors since transactions recorded in the company’s internal systems can be instantaneously verified by searching the block chain for the company’s addresses. The block chain can be downloaded at the cut off date from Sourceforge and its integrity can be checked using the open source Bitcoin client. Not only does the block chain make payment verification simple, it also dramatically reduces the risk of defalcation while simplifying internal controls and bank reconciliations.

It is important for accountants and corporate treasurers to be aware that all bitcoin transfers are recorded in a public ledger and that transaction patterns may reveal the identity of an address. An astute competitor or investors could quickly develop a cash-flow statement from such information. For this reason, it is best practice to generate a new address for each transaction.

Bitcoins are stored in a digital wallet after they are received. The wallet can be cloud-based for mobile payments and browser access or stored on a local system to maximize security. Treasurers should be careful to divide funds into several different wallets stored on separate systems. Managers that would normally sign and countersign checks should similarly be entrusted with the passwords to prevent unauthorized payments.

Once the physical system is properly secured, the only potential threat is the password. Management should have a password policy that balances security with the risk of one person being responsible for an unrecoverable password. Internal control designers and auditors should consult with an I.T. specialist to ensure that the wallet is stored and backed up on encrypted drives attached to dedicated systems.

Similarly, audit teams should employ an I.T. specialist to verify the bitcoin balances held in wallets. Verification includes sending a traditional confirmation letter to a 3rd party wallet custodian and obtaining the balance from the block chain. Tools like Block Explorer make independently authenticating the existence of individual bitcoins straightforward and instantaneous. Control of the addresses themselves can be evidenced with walk-throughs as well as bitcoin transfers to and from an address controlled by the auditors.

After the amount of bitcoins at the balance sheet date has been established, the auditors need to verify that this amount is translated into the reporting currency pursuant to ASC 830-20-25. The currency translation from bitcoins to dollars is effectuated through an adjusting entry that contains the gains and losses reflecting changes in the exchange rate between bitcoins and dollars. This translation must also be done for receivables and payables the company expects to settle in bitcoins. The exchange rate used for measurement at the balance sheet date, called the current rate, can be observed on liquid markets like Mt. Gox.

Cash management with bitcoin is now finally entering the Internet Age: payments are processed around the clock, anywhere in the world, and with little to no transaction costs. We can expect that this disruptive innovation will transform the treasury function just as much as social media transformed marketing campaigns. Does your business accept bitcoin payments? How do you think internal controls and audit planning should adapt to this new digital currency?

Academics, Pierre

Macroprudential Regulation: Moving Beyond Dodd-Frank & Basel III

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Last semester I had the pleasure of taking Law for Finance with the renowned Professor Prentice. It was incredibly helpful to learn how our work as accountants flows through a regulatory framework that seeks to create a level playing field for companies issuing securities and their investors. As auditors we’re most familiar with Sarbanes-Oxley and GAAP/GAAS, but these are only a few pieces of the puzzle that contribute to the rational accumulation and allocation of capital so critical to economic growth.

It’s also important to look at what policymakers call “macroprudential regulation”. These are regulations which seek to mitigate the damage done by the emotional swings among financial intermediaries from exuberant optimism to irascible pessimism, also known as systemic risk or the boom-bust cycle. The Dodd-Frank Act was an important new addition to the macroprudential regulatory framework by requiring the trading of derivatives to be on exchanges and prohibiting banks from gambling with depositors’ money in financial markets. Accountants are instrumental in implementing these regulations and monitoring for continued compliance. Likewise, through the calculation of the Allowance for Loan and Lease Losses (ALLL), accountants must be familiar with the credit risk models mandated by Basel II, an international accord between central banks designed to minimize systemic risk.

During my Big 4 internship I examined credit risk models for a large retail bank to verify that their ALLL was properly calculated. This ALLL feeds into the next pillar of Basel II, capital adequacy standards that help the banking system through downturns and protect deposit insurers like the FDIC.  In light of the 2008 financial crisis, regulators made the capital adequacy guidelines more stringent with the introduction of Basel III. However, few are optimistic that this will prevent future economic bubbles.

Academics have argued that this patchwork of regulations around depository institutions is a case of the doctors treating symptoms instead of the underlying disease. In accounting terms, the disease is that depositors do not have an investing cash outflow when they deposit their money, whereas depository institutions have a financing cash inflow. No other transaction in the economy has this accounting asymmetry, which is commonly known as fractional reserve banking. Professor Jesús Huerta de Soto, from Rey Juan Carlos University in Spain, wrote a book in 2005 (PDF) detailing how this shaky accounting creates systemic risk in the banking system. Most recently, Michael Kumhof, a professor at Stanford University and one of the top economists at the IMF, published a paper (PDF) detailing how a financial system could simultaneously transition from fractional reserve banking to 100% reserves, reduce excessive leverage, and prevent the boom-bust cycle.

I had the honor of meeting Professor Kumhof at the Association for the Study of Peak Oil & Gas’ annual conference which was co-hosted by the University of Texas. He was optimistic that policymakers will come around to what is called the “Chicago Plan”, originally devised by a group of economists at the University of Chicago.

In a nut shell, the plan would have depository institutions finance their investing activities from private investors and loans from the government rather than lending out deposits. Deposits would be much like segregated accounts in a trading house or bailments; the bank is a custodian of the funds but is not allowed to lend them out. This would prevent excessive credit creation since banks would have to borrow real savings, much like a mutual fund or a securitization deal that issues bonds.

Perhaps the most fascinating aspect of the plan is that depository institutions in the United States would have to borrow 180% of GDP from the government to meet the 100% reserve requirement. This would mean that the Federal Government would have a negative level of net debt. Similarly, this would immediately solve the European sovereign debt crisis.

To prevent deflation, the government would have to create and spend new money at a rate of 2 or 3% per year, which would help reduce the budget deficit. This nominal money growth would be one aspect of macroprudential policy under the Chicago Plan. The amount and riskiness of credit creation would still be controlled by capital adequacy rules like Basel III and interest rates would be set by how much the government (or an independent central bank) charges financial institutions for additional liquidity needed to finance large productive investments.

Professor Kumhof estimates that changing the regulation of deposits would result in a 10% boost to GDP growth. This is why he is most optimistic that the Chicago Plan will, over the coming years, become a cornerstone of financial reform. Here is his presentation of the paper he published in August:


Accountants will play an important role in advising depository institutions with restructuring their balance sheet and revising their internal controls to reflect the new accounting treatment of deposits. That said, the greatest benefit for us will be that the manic instability of financial markets will be give way to steady real economic growth.

What benefits or drawbacks do you see from the Chicago Plan?

Academics, Events, Pierre

Analytics in Practice: Going Beyond the Buzzwords

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The MPA Distinguished Speaker Lyceum is one of the most important traditions in the MPA program. Last Tuesday we hosted Ms. Camille Stovall, a partner at Deloitte and the Chief Operating Officer of Deloitte Financial Advisory Services (FAS). The conversational interview between Ms. Stovall, Professor Steve Limberg, and my fellow MPA students ranged from how to approach difficult restructurings to the importance of analytics. The latter prompted Prof. Limberg to ask just how analytics are used in the real world.

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