Request Network decentralizes accounting with Triple Entry Accounting
If you are crazy enough to think decentralized accounting can upend the double-entry accounting framework that has been around for more than 600 years, you are in the right place.
Back in 2017, Request Network’s whitepaper put forward the idea of a decentralized network for payment requests. So far Request’s proposal has been successfully deployed on an invoicing app, called Request Finance, which as described takes care of enterprise crypto payments like salaries in a decentralized manner.
Request Network, built on Ethereum, is the only protocol that allows you to have payment request details stored on the blockchain, or in other words, have an immutable, tamper-proof copy of your invoice. Request Network provides a trusted source of accounting entries, subsequently used in the ‘Accounts Receivable’ (AR) and ‘Accounts Payable’ (AP) of enterprise accounting software applications in the case of invoicing.
That begs the question, “Can the technology be extended to also create immutable accounting journal entries on the blockchain?”
Pain points of double-entry accounting
With double-entry accounting, Bob and Alice would separately record the invoice in their respective accounting software apps. And with these software unable to communicate with each other, both Bob and Alice must spend an inordinate amount of time reconciling their accounts at year-end. Additionally, that is the reason why external audits continue to be required – to provide assurance to the shareholders of the entities that management did not abuse their positions of trust.
The irony is that while the blockchain serves as the immutable, shared ledger, companies still retain the practice of transferring historical transaction data from the blockchain, back to traditional accounting software (e.g. Xero, Quickbooks, etc.) which rely on centralized cloud servers where each counterparty prepares their financials separately in silos.
The practice described above is a holdover from an era of traditional payment systems, where only banks were the sources of truth for transaction data. But in a world where currencies and assets are tokenized on distributed ledgers, this practice is becoming obsolete. As Ian Grigg explained in his 2005 paper on Triple Entry Accounting, the “third entry” on the public ledger is digitally signed between the two parties and serves as the proof of transaction.
Web3-native companies like DAOs, or even the growing number of traditional entities like investment banks, which already hold all or part of their treasury on-chain, can readily embrace the benefits of Triple Entry Accounting. By bringing the currently missing element of journal entries also on-chain, the preparation of financial statements like balance sheets, and cash flow statements can be done in real-time through a decentralized accounting software. Here’s how.
How traditional accounting software works
The balance sheet of an entity is essentially the closing position of all the accumulated journal entries since inception. These journal entries are classified into either assets, liabilities, or equity (the company’s accumulated income less expenses).
If the balance sheet contains the closing position, the general ledger is the log of all the journal entries or transaction records. An accounting software is the vehicle that allows companies to prepare the general ledger, and provide a chart of accounts that maps, or labels each individual journal entry to its appropriate category: an asset, liability, income, or expense.
How Request works
When creating an invoice, Request uses the Ethereum decentralized ledger. To save on transaction costs, Request uses a side chain, the Gnosis Chain (formerly XDAI Chain).
Any change in the status of the invoice, from the time it is accepted, to when it is paid by the payer, has to be broadcasted to the network, and these transaction costs are collected in xDAI tokens on the Gnosis Chain. These are then periodically moved to the mainnet as DAI, and swapped into REQ tokens. The swapping reduces the amount of REQ from the total circulating supply. Hence, the more demand for transactions on the Request Network, the more the price of the REQ token appreciates.
The business model for every application built on top of Request Network will vary. For example, the crypto invoicing application, Request Finance, has a service fee of 0.1% of the total amount requested in the invoice, with a maximum fee of $2 per invoice. The fee in this case is paid by the payer and is free for the invoice issuer.
Moreover, anytime the issuer creates an invoice through the Request network, the payer is automatically notified and can accept or reject the invoice (through the app Request Finance and Request Create). By doing so, Request makes possible the idea of Triple Entry Accounting since both counterparties have to digitally sign the invoice on the public ledger.
At the moment, even though these invoices are broadcast to the Ethereum public blockchain, they have to be separately uploaded on a centralized accounting software. The drawback of these legacy systems is that because there is no link between the counterparties’ accounting software, these transactions still have to be reconciled at year-end for audit purposes.
How a decentralized accounting software would work
Today on-chain transactions can be tracked with block explorers like Etherscan, and imported onto your centralized accounting software. However, if a company uses Request Finance to manage their crypto payments, these items of their accounts can be captured on-chain;
- Accounts Receivable
- Accounts Payable
A decentralized journal entry would be created in a similar fashion as a request for payment. Through an application like Request Finance, the user would be able to create the journal entry and enter the corresponding party’s details. Request Network would detect the journal entry and through the application, the counterparty would be notified.
Consider a hypothetical example of a decentralized journal entry. Suppose at year-end, a DAO is being sued and needs to make an on-chain provision for the lawsuit. Currently, the DAO can only do so via a centralized accounting software. That inherently means that even if on-chain data can provide the DAO with real-time accounting of its financials like its balance sheet, this data would not fully reflect the financial position of the DAO, without the ability to create centralized journal entries.
A hypothetical decentralized accounting software would replicate a chart of accounts, used to label each journal entry, and subsequently compile those entries in the companies’ general ledger. Note that here the companies’ general ledger would contain the exact same entries on the public blockchain ledger like Ethereum, but since blockchain transactions are problematic for various accounting, audit, and other compliance reasons.
On-chain transaction data often comes in the form of long hexadecimal strings of alphanumeric characters. It does not contain important details with respect to counterparties’ names (only public wallet addresses), or details of the transaction. That’s where a decentralized accounting software would help bridge that gap.
Here, accountants might be quick to point out that not all transactions would require a counterparty to approve a transaction. For example, for the accounting entry for fixed asset depreciation, or the provision of a bonus for employees.
True, and hence we do not expect 100% of transactions to be digitally signed by the counterparty from the get-go. In accounting, the “Four Eyes” principle (or “Two-man” rule) requires that two individuals approve a transaction before it can be recorded.
Currently, this principle is confined within the walls of the organization. But through the triple entry accounting framework where the journal entry is digitally signed on the public blockchain, and at the same time being accounted for, accounting becomes real-time without the need for reconciliation.
Web3 companies will be the first adopters of real-time, triple-entry accounting since their ecosystem largely resides on-chain. But in a future where cryptocurrencies are bound to become increasingly prevalent, more companies will follow suit to tap into the benefits of real-time accounting.
Web3 apps are interoperable and allow companies to put their money to work via decentralized finance, or DeFi protocols through the click of a button. In such a world, CFOs, financial controllers, and accountants need to be able to capture the full picture of each action’s accounting impact in real-time. The technology is ready, and Request is currently looking to monitor and support developers who will build the next generation of decentralized accounting software.
About Request Network
The Request Foundation’s mission is to re-invent accounting and finance by creating a decentralized network of interoperable apps that promotes transparency and real-time reporting.
We inspire and educate developers, partners, and authorities to use the Request Network and build an ecosystem of financial applications together that is open source, seamless and interoperable.
We’re building a network that connects businesses around the world, giving them ways to make business at the speed of the internet.
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