CFOs and finance departments are always looking for reductions in cost and increases in speed and efficiency in business engagements. One option that's attracting more attention is the smart contract.
A smart contract is an electronic agreement that uses computer programming and blockchain technology to execute without third parties, such as the banks that verify payments, said Stan Sterna, J.D., a Chicago-based vice president with Aon, which provides the AICPA member insurance programs.
The building block(chain) for smart contracts
Blockchain technology is essential for smart contracts to work. To understand why, it's important to remember that a blockchain is a distributed, digital ledger to which certain computers, or nodes, are granted access. The first blockchain was set up to record transactions of the digital currency bitcoin. When a transaction such as a bitcoin sale takes place on a blockchain, the details of the transaction are automatically recorded by both sides of the transaction and stored in a block of information that's immediately shared with and verifiable by all nodes on the blockchain.
In the case of smart contracts, blockchain technology automatically performs contract actions when predefined conditions occur, said Sterna, who has 20 years of experience in consulting CPAs in cybersecurity and risk. The blockchain keeps track of contract terms and enables the automated completion of next steps in the contract process once it verifies that a step is fulfilled.
Let's say you agree to buy goods from a business using a smart contract. The smart contract holds back payment until delivery is confirmed. "The smart contract then releases payment automatically. This process ensures that the outcome executes correctly," Sterna said. The process is faster and less expensive than with a traditional contract and removes a lot of human error, he said. In addition, the inherent transparency and immutability of blockchain technology allow all parties in a smart contract to verify transactions and trust that the contract will be kept safe from tampering and fraud.
Smart contracts generally, though not exclusively, pay out in cryptocurrencies, Sterna said. But they also can be used for non-monetary transactions such transferring real property or handling medical records. A smart contract can verify a transaction and call for completion of an action outside the distributed ledger, he added, such as asking a bank to complete a transfer of hard currency.
"Taking a shipping example, the smart contract could verify the transactional process of the shipment per the distributed ledger. Once it is confirmed that the shipment cleared customs, it could message the customer's bank for payment. If the bank's internal system determines a valid shipment was made per the agreement, it could create a debit in the customer's relevant bank ledger and transfer the sum in the customer's currency," Sterna said.
Uses for smart contracts
Finance departments could see many uses for smart contracts, such as in high-volume transactions where companies track inventory using radio frequency identification tags. "When a distributor receives the inventory, the tags could trigger the settlement of a smart contract with the manufacturer, automating and expediting the accounts payable process," said PJ Sheil, CPA, CFO of Schellman & Company in Tampa, Fla., a CPA firm that focuses on IT audit and certification for service providers.
In another scenario, in the settlement of transactions involving the purchase of real property, which an escrow agent would typically handle, a smart contract could automatically release titles and exchange funds once parties meet the contract terms, Sheil said.
Knowing the conditions that are present in likely smart contract use cases will help CFOs confirm applications for their organization. "I recommend focusing smart contracts on opportunities where you can automate business processes within a well-defined ecosystem of players who are constantly transacting value, such as in the energy, financial trading, and telecom industries," said Vincent Manier, CFO of Spokane, Wash.-based ENGIE Insight, which works with businesses to help manage their resource consumption data.
CFOs can benefit from any use case of smart contracts where the business deals with repeating, frequent transactions between multiple parties, said Gregg Jacobson, Esq., an associate with King & Spalding in Atlanta.
Benefits for finance departments
Finance departments can benefit from the timeliness and shrinking costs that result from using smart contracts. "The smart contract can settle faster at a lower cost, freeing up time and resources that you can focus on other business," Sheil said. Smart contracts also can give you leverage in negotiations. "The ability to offer an expedited payment settlement using smart contracts could enable you to negotiate more favorable pricing with the other party," he said.
For processing payments, you could reduce the receivable turnover time from an average of 45 days, for example, to 15 days, and there is a definite return on investment for doing that, said Shane Randolph, CPA, managing director at energy consulting firm Opportune LLP in Houston.
Another benefit of smart contracts is they minimize theft and fraud, since no one person can alter the immutable blockchain ledger that supports smart contracts, Sterna said. Smart contracts let you see the progress of a transaction in real time; if there is a problem, you will know immediately and can take steps to resolve processing issues, Sterna said.
Smart contracts also reduce the risk of litigation and minimize trapped cash in the value chain of a transaction, said Manier.
Challenges to using smart contracts
Smart contracts, however, are still in very early stages. "Early adopters will face challenges from internal and external constituents who don't understand the technology and are averse to its institutional adoption," Sheil said. Referring such constituents to Meetup groups and other discussion and training forums can help.
Another challenge of technologies in their infancy is their relatively higher cost. The development and integration of smart contracts is expensive, and you will likely need to engage experts in the field to do it, Sterna said.
You can move slowly and methodically to assess whether a smart contract investment is worth it. Determine the internal use cases and resultant benefits; from there, educate internal and external constituents and follow that with a beta program to test the proof of concept, Sheil said.
The fledgling technology's capacity is still another challenge. The maximum number of simultaneous transactions that you can handle with the technology currently limits smart contracts, said Anthem Blanchard, founder of AnthemGold in Austin, Texas, a company with a precious metal-backed cryptocurrency. "The limit is 10–30 transactions per second right now, which becomes an issue as the business scales and more simultaneous transactions come in," said Blanchard. He advised keeping the use cases for smart contracts small in scope due to the limited volume of transactions that are possible.
Finally, smart contracts may find obstacles in regulations and legalities. When moving toward smart contracts, be sure to consider regulatory standards and involve your legal counsel; a smart contract may require different terms than a standard contract. For example, in financial services, when transactions settle using smart contracts, you agree ahead of time on the value of the securities that you will transfer and the price, said Alan Frank, CPA, partner with EisnerAmper in New York. You want legal counsel involved to ensure that the transaction will settle under the terms, conditions, and price that you expect so there is no ambiguity, he said.
From a regulatory perspective, the use of smart contracts might lead to discussions of antitrust investigations if you were to freeze out parts of the marketplace because your company could execute smart contracts while others could not, Frank said.
Smart contract dependencies
Obviously, the success of smart contracts counts on the continued development and acceptance of the underlying blockchain technology and the outcomes of early use cases of these electronic agreements.
The careful navigation and prudent spending of early adopters as they move through those first applications of smart contracts will weigh heavily in those outcomes. The actions of smart contract pioneers could well forecast the course of the technology for the future.
David Geer is a freelance writer based in Ohio. To comment on this article or to suggest an idea for another article, contact Chris Baysden, associate director, content development, at Chris.Baysden@aicpa-cima.com.