Balance Sheets and Blockchains

Published May 10th, 2016 edit replace rm!

Balance Sheets

Balance sheets are useful terms from accounting showing a snapshot of the financial state of a company. Balance sheets consists generally of 3 columns:

  • Assets
  • Liabilities
  • Equity

These map directly to the Rights and Obligations I rambled on about a couple of weeks ago.

An Asset is a Right and a Liability is an Obligation, just with numbers assigned to it. The Equity I will get to shortly.

As an example here is Apple’s latest balance sheet in a simplified form:

Assets Liabilities Equity
305,277,000 174,820,000 130,457,000

For more details see theFull Quarterly Balance Sheet for Apple

This breaks down to what accountants call the Balance Sheet equation:

assets - liabilities = equity

Essentially it is a simple way of getting an overview of the current value of a business. Equity is the current value of the business as owned by the shareholders.

Blockchains are ledgers

Everyone knows that Blockchains are ledgers, but a lot people don’t know what ledgers are.

Essentially ledgers are long lists of transactions between accounts. The transactions are added up to create balances.

Creating a balance sheet is thus pretty simple. Adding up any debts and any assets.

Bitcoin’s balance sheet

Traditional currency accounting has a central issuer that issues currency. All currency issued is a liability on it’s balance sheet which is balanced against assets held somewhere. Traditionally gold now often USD. With Fractional Reserve banking this is a lot more complex, so I won’t go into that now.

Bitcoin does not have an issuer unless you count as some people do Bitcoin as a DAO (Decentralized Autonomous Organization).

So what would be a helpful way of creating a balance sheet for Bitcoin?

Bitcoin’s current circulation is roughly BTC 15.5M.

Using the traditional currency balance sheet:

Assets Liabilities Equity
0 15.5M (15.5M)

This is based on the fact that Bitcoin itself does not have any assets. I’m not sure this is the correct way of modeling it.

Maybe if we look at it as a DAO it makes more sense:

Assets Liabilities Equity
15.5M 0 15.5M

I’m still not 100% happy with it, but I think that is the best way of squeezing bitcoin the currency into a traditional balance sheet.

Balance sheets for Bitcoin Addresses

As I mentioned in the Rights and Obligations article you either own Bitcoin or you don’t in it’s simplest form. This would mean that any bitcoin owned by anyone would just be an asset:

Assets Liabilities Equity
BTC 1 0 BTC 1

So if you look at any address on a blockchain explorer it is pretty easy to work out it’s balance sheet.

What about the Equity? Well a Bitcoin address is not an identity it is just an account. An account has an owner. That owner may or may not be known. But the Equity is the owners share of the account. Which in Bitcoin is always the same as the Balance.

Ethereum Smart Contracts

Ethereum Smart Contracts introduce the concept of obligations into the blockchain world. Therefore we must also talk about liabilities now.

In my previous Escrow Smart Contract example the Smart Contract controls funds sent to it by a buyer to send on to a seller.

Assets Liabilities Equity
ETH 1000 ETH 1000 0

The contract has a balance of 1000 ETH, but those 1000 ETH are owed to the seller, thus it has 0 equity itself.

Token Contracts

Basic Token Contracts with a central issuer are in some respect just centralized currencies. The issuer holds the funds but the token holders are owed some sort of value.

For the token holders each token issued is essentially an asset, which is why us old timers in the Crypto space used to call these Asset contracts instead of tokens.

In the following example I am drastically over simplifying this by having an ETH denominated Token Contract to show the basic accounting.

1000 people have each bought 10 ETH’s worth of our ETHR token:

Assets Liabilities Equity
ETH 10,000 ETH 10,000 0

Again you can see zero equity in this approach, the value is transparent in the contract.

Floating exchanges rates means risk

Where things start getting complicated is if you decide to issue USD denominated tokens instead of ETH denominated tokens.

Lets say your token holders bought with ETH when the USD/ETH price was $5 and now the price is $10.

Assets Liabilities Equity
ETH 10,000 ETH 5000 ETH 5000

You as the issuer have now made ETH 5000 in equity.

But what happens if the price dropped instead? Your token holders bought at $10 and the price is now worth $5.

Assets Liabilities Equity
ETH 10,000 ETH 20,000 (ETH 10,000)

Oops disaster. Now your token holders want to get their money out and you now need to find ETH 10,000.

This is where we need some level of off-blockchain integration. This kind of risk is pretty easy to manage in the “real-world” essentially you would just immediately sell the ETH for USD and keep it in an USD account.

But of-course this is not visible on Ether.Camp, so you will need some kind of legal contract promising off blockchain enforcement of your promises.

The DAO Balance Sheet

All the talk at the moment is about the poorly named The DAO which at the time of writing has issued 371.96M tokens each sold for 1/100 of an ETH.

There are many discussions of what a DAO is, but for the sake of accounting purposes I will define a DAO an organization whose ownership is defined by tokens. This is very similar to a traditional Corporation and the accounting is also very similar.

So at the time of writing the balance sheet of the particular instance of a DAO currently called “The DAO” looks like this:

Assets Liabilities Equity
ETH 3.72M 0 ETH 3.72M

The SmartContract allows any token holder to take out their share of current equity at any point.

The balance sheet gets more complex when Proposals starts being approved. I am currently researching this and will write a more in-depth article about it later.

But to give an example, The DAO could invest a lump sum into a business in exchange for future rewards.

This would lower the liquid ETH assets by the lump sum amount and replace it on the balance sheet with a longer term asset, called Reward Tokens. I’m still trying to understand how Reward Tokens work. But the valuation of them will be important in the future.

Balance Sheets of regular Ethereum Addresses

Regular Ethereum Addresses are similar to Bitcoin Addresses in that they can only contain Assets. We need Smart Contracts to manage Liabilities.

Unlike Bitcoin Addresses they can contain many types of assets. So an Ethereum Address may have bought 10,000 “The DAO” tokens.

This address would currently have a balance sheet looking like this:

Assets Liabilities Equity
ETH 100 0 ETH 200
THEDAO 10,000 0

Mind you the valuation of DAO token will change in the future. Valuation of assets is a complex issue.

There is a fundamental price which is the Stock Holders Equity and there is a market price. In Apple’s example above if you divide the Equity by the amount of issued shares you will probably not get the same number as Apple’s current stock price.

So while it is currently simple to calculate The DAO’s equity value. Future Market price will take into account future revenue, management, risk and sentimental thoughts into account.

A useful tool

The Balance Sheet is only one of the 3 traditional corner stone reports in accounting. The others being the Income Statement (aka Profit/Loss) and the Cashflow Statement.

Balance Sheets can also seem the most abstract and the hardest to understand. Yet it proves a really useful tool for us, in particular in understanding and analyzing Smart Contracts.

Posted May 10th, 2016

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My name is Pelle Braendgaard. Pronounce it like Pelé the footballer (no relation). I live in wonderful Managua, Nicaragua. I work with Clojure, Bitcoin and Ethereum.

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