Blockchain: An Emerging Solution for Fraud Prevention

September 7, 2017

Blockchain is a ledger system that processes, stores and tracks digital information, from crypto-currencies to loan agreements. Because blockchain documents all changes and is hard to tamper with, financial firms and regulators see it as a potential way to make transactions more transparent, auditable and secure.Because of this feature, blockchain can effectively prevent one or several individuals in collusion from overriding controls, or illicitly changing or deleting official accounting records. Moreover, as the embedded rules are automatically followed without much human intervention, it can enforce the operation of controls. By incorporating blockchain technology to their accounting information systems, companies could reduce fraud risk by maintaining a clean, secure database and a strengthened control system.

Using Blockchain to Prevent Fraud

The convergence of accounting and blockchain could create a totally new accounting information system in which every transaction ever executed is publicly available and verifiable in real time. Furthermore, blockchain could be used to prevent and detect fraudulent transactions. Because blockchain keeps the record of an asset transfer, any type of misappropriation can be detected by tracing through the blockchain.

To combat financial reporting fraud, such as overstatement of revenues by means of channel stuffing or round-tripping, the transactional data in blockchain could provide valid evidence showing any potential irregularities involving revenue recognition (Yunsen Wang and Alexander Kogan, “Designing Privacy-Preserving Blockchain-Based Accounting Information Systems,” working paper, 2017). In addition, the continuity, irrevocability, and irreversibility of a blockchain ledger could prevent management from creating fictitious transactions or backdating options. The transparency of blockchain will make it easy for forensic accountants to access and examine the material related-party transactions (Dai and Vasarhelyi 2017). Furthermore, the risk of receiving checks without sufficient funds could be avoided. Therefore, blockchains not only increase the chance of detecting fraud, but also pressure management to reduce earnings manipulation.

Because blockchain keeps the record of an asset transfer, any type of misappropriation can be detected by tracing through the blockchain.

Smart contracts encoded with accounting and business rules could also provide efficient controls of business processes in order to prevent fraud. Smart contracts can be embedded with advanced access control criteria that allow only authorized users to create transactions. A well-designed blockchain should have a precise and dynamically controlled system to designate the roles of connecting to the blockchain, initiating transactions, and creating assets. In addition, the relevant criteria could be encoded in smart contracts to ensure all conditions have been met before recognizing any sales revenue. Moreover, smart contracts could add intelligence into accounting processes by integrating big data and predictive analytics. Combined with big data, smart contracts could layer on top of the reactive-to-predictive transformation to achieve a dynamic, self-optimal, risk-aware measurement of companies’ performance. For example, by encoding a fraud prediction model into a smart contract, a credit card company could adjust the credit limit of an account based on the spending behavior of the account holders (Dai and Vasarhelyi 2017).

 Chinese Banks Want to Use Blockchain to Combat Fraud

Beijing wants banks to adopt the technology to help combat chronic fraud such as fake trade finance deals. Banks including Ping An Bank (000001.SZ) and Bank of China (601988.SS) have unveiled blockchain investments and projects, and around ten banks are looking to hire some 30 blockchain professionals, said Steven Shen, a senior manager at executive search firm Robert Walters in Shanghai.

Chinese banks are hiring blockchain experts as the government pushes use of the technology behind bitcoin to increase transparency and combat fraud in its financial sector. Blockchain more than doubled last year and will grow further this year, headhunters and blockchain professionals say, as lenders scramble to catch up with Western counterparts that have already invested $1.5 billion in the technology.

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