What is Proof of State?

This is an explanation for the general public about accounting concepts expressed in a manner that we hope is easy to understand.

Auditchain
5 min readJan 6, 2023

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Accounting is the language of business. That will never change. Like ever. Financial reporting is how accounting information is communicated. Audit is an independent examination to determine if the communication or, state-MENTS being made are fairly communicated and presented. Clear so far?

There are a lot of confusing terms in crypto. Proof of reserves was one of them. The public’s misunderstanding of a proof of reserves report is part of the reason that the audit profession fled from the crypto space at the end of 2022. The other reasons will be revealed after this article is published.

The positive side of this controversy and confusion is that the general public is gaining an understanding of the different types of engagements performed by professional services firms and the purposes they serve. The least understood is the Agreed Upon Procedures “AUP” engagement.

The AUP engagement is exactly what it means. It is an engagement where the process and scope of the examination is negotiated and agreed upon between an operating entity and a public accounting firm. There are usually no assurances or opinions given. The report itself makes a bold statement: “You should not rely on this report”. This statement is meant to be taken seriously.

It is our hope (prayer) that the spectacular crypto failures of 2022 combined with the declaration and public testimony of John Jay Ray III about the lack of controls and the absence of reliable financial information of FTX will forever be burned into the consciousness of the general public. The question is: will you learn?

State

Buzzwords, assuming they are not misleading, seem to be cheaper and more effective than a semester of learning. 2022 was certainly a very expensive education for the general public. We promise that this article will be much cheaper.

Proof of State is a dispositional term. We’ll get to the Proof in a minute. State is derived from the attributes of a balance sheet. Its the product of the accounting equation. “Total Assets-Total Liabilities=Equity” OR, “Assets=Liabilities+Owner’s Equity”. There are a few ways to express this simple formula but the product of this formula is the same.

Simply put, a balance sheet is a state — MENT. There are lots of controls at work that are required to accurately populate a balance sheet. So long as the equity is a positive number, and a large percentage of the equity is cash, the operating entity may be considered solvent. Liquidity is a different topic.

The financial condition or “State” of an operating entity is determined, in part by its equity or net worth. The time attribute of a balance sheet in accounting terms is “instant”, or “as of” the end of a specific period or date.

NOW is best in the fast moving and rapidly evolving crypto space. Just a reminder, it is still business. It just moves 10 times faster than traditional business.

A profit and loss state-MENT is duration based. Its the consolidated accumulation of the debits and credits of an account or group of accounts during a period. Profit and loss data is indispensable in determining equity, net worth or “State”. A cash flow state-MENT is also duration based and is also a critical element in the determination of equity, net worth or “State”. A state-MENT of changes in equity articulates the “CHANGES IN STATE” of an operating entity during a period.

All four financial state-MENTS are critical in the determination of the condition of State and the articulation of the changes in State of an operating entity or a financial intermediary. Clear so far?

Wouldn't you want to “instantly” know the condition of the “State” of a custodian BEFORE you entrust value to them?

Where’s the Proof?

Proof is obtained using EVIDENCE. What is evidence? Basic forms of evidence are invoices, purchase orders or the contents of an accounting system. We use cryptography to preserve the reinforcement of processes and volumes of data.

A “volume” of data and a “set” of logic is represented by hash values or “proofs”. They can be recorded on any public blockchain. If the proofs no longer match, it means that the logic set or the volume of data has been tampered with.

Merkle Trees are a cryptographic data structure and play a critical role in the preservation of evidence. These are a critical part of the reinforcement of the functional objectives of the internal controls and the preservation of data.

The Auditchain Protocol features an external validation logic engine, which we lovingly call Pacioli, that verifies or “proves” that the internal controls and volumes of data have not been breached or tampered with. It also verifies the accuracy of the articulation of all four financial state-MENTs.

Assuming the humans managing the operating entity are honest and the internal controls have not been breached or tampered with, the articulation of the financial state will be accurate.

Pacioli Nodes act as the external validators that verify the Proof of State of the operating entity without the need for a centralized third party audit. This method does not fit within any regulatory audit standards yet.

The failures in traditional business despite the performance of audit engagements combined with the withdrawal of the audit profession from the crypto space punctuate the need for changes in audit standards and an upgrade of the skills of public accountants.

In contrast, a set of smart contracts on a blockchain achieves perfect compliance with functional objectives and the proof is already baked in. Systemically and structurally, decentralized finance infrastructure performed beautifully during the failures of 2022.

On a blockchain, miners/validators verify the inclusion of every transaction in the scope of validation. They prove all wallets, all balances and all transactions all the way back to genesis. Genesis is the first block mined/validated on the chain. In accounting speak, its when the books were first opened.

But as you know, where there are humans and money inside of a centralized operating entity, there must be controls. Especially if its other people’s money.

The Auditchain Protocol turns centralized operating entities into a blockchain; its auditors into its validators and all four of its financial state-MENTs into its block explorer.

About Auditchain Labs AG

Auditchain Labs AG (https://auditchain.finance ) developed the world’s first web3 financial disclosure and audit infrastructure that automates and provides proof of assurance on the world’s business and financial information. Auditchain Labs AG is a founding member of the DCARPE Alliance Association and is leading the development and evolution of the Auditchain Protocol with other members of the Alliance.

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Auditchain is a web3 financial disclosure protocol that raises the integrity and reliability of global business and financial information.