Lightning Network financial statements
Part 1: the balance sheet
This article explores how modern financial accounting can help lightning network node operators and companies better understand and evaluate the financial performance of their operations. In a previous article, we dissected the unit economics of a channel and showed the importance of the time value of money in calculating a channel performance metric. This article will demonstrate how the lightning network could benefit from accounting techniques and the standardization of financial metrics.
Financial reporting is a critical tool to provide valuable insights into the financial health of a business. The primary aim of financial reporting is to offer useful information to external stakeholders, including investors and creditors, to enable them to make informed decisions that align with their financial goals. Moreover, leaders and management teams heavily rely on four main financial statements to steer their businesses toward success:
Cash flow statement
Statement of retained earnings
With the continued growth of Lightning Network adoption, businesses are constantly seeking ways to enhance their services to meet the ever-evolving demands of their clients. Among the various needs of lightning node businesses, measuring the financial viability of their activities is of utmost importance in ensuring the sustainability of their operations. In this regard, we sought to envision the integration of Lightning Network operations into existing financial statements, starting with the balance sheet.
The balance sheet
The goal of a balance sheet is to report the position (assets, liabilities, and shareholders' equity) of an accounting entity at a given time. As shown in Table 1, transactions are classified in a standardized format called accounts :
As a general rule of accounting, Assets = Liabilities + Shareholders's equity.
Nodes can drive revenues from at least three activities; routing, financial, and business.
Routing activity refers to forwarding a payment from a sender to a recipient. Nodes will charge a fee for forwarding other users' payments.
Financing activities are the functions of a business related to lending and borrowing money. For LN, buying and selling liquidity is currently the closest activity to be considered as a financing activity.
Operating activities are the functions of a business directly related to providing its goods and/or services to the market. The company's core business activities include manufacturing, distributing, marketing, and selling a product or service (Bitrefill, Opennode, ThunderHub, Zebedee, etc… ).
A business can perfectly combine all these activities or focus on only one. In this article, the accounting entity would be limited to a node whose primary function is to route transactions. Any other business or financing activity has been excluded.
Let's now dive into this article's core and evaluate how lightning network operations can be accounted for.
An asset is a resource with economic value that an individual, corporation, or country owns or controls with the expectation that it will provide a future benefit.
Definition: Accounts receivable are the balance of money due to a firm for goods or services delivered or used but still needs to be paid for by customers.
Currently, accounts receivables don't exist on Lightning Network. Overdue bills, bad debts, or terms of payments are concepts that don't apply to a routing node simply because the protocol ensures instant settlements of transactions. However, the situation might evolve if nodes facilitate lending between each other.
In the following figure, we compare two channel leasing methods and their impact on buyer and seller cash flow.
Use Case 1 is an example of a liquidity leasing agreement for a volume of 10 million sats over 30 days. Currently, the seller opens the channel only after receiving the full payment upfront. However, nodes may offer liquidity in the future with alternative payment models, such as recurring payments or subscriptions.
Use Case 2 illustrates a fictitious form of leasing with monthly payments in which the buyer could buy a channel for an extended period. If the buyer defaulted on one of the payments while the channel remained open, it may result in an account payable for the buyer and an account receivable for the seller.
In the liability section, we explore other scenarios that could lead to the emergence of some form of account receivables.
Cash and inventory
Definition: Cash and cash equivalents refers to the line item on the balance sheet that reports the value of a company's assets that are cash or can be converted immediately.
Pretty much everything in Lightning Network should be considered cash. In a lightning channel, Bitcoins represent the most liquid form of money ever created, flowing at the speed of light. In comparison, on-chain funds, yet very liquid, move slower. The block time on the bitcoin blockchain is 10 minutes on average, or rather; the network tries to reach a confirmation within that time frame.
Node operators have several options to manage the right balance between on-chain and off-chain funds by opening or closing channels or doing submarine swaps. Sometimes, part of the on-chain funds will also be kept in cold storage.
Accounting tends to rank assets by order of liquidity, from the most liquid to the least liquid. If we apply the same rule to a node, the balance sheet will assets section should be organized as follows:
Off-chain - immediately available
On-chain - available after ~10mn
On-chain - cold storage, available after several hours
Note: Inventory represents a company's physical goods, raw materials, and work-in-progress. Just like banks, routing nodes don't have inventory.
The largest lightning network nodes can hold up to several hundreds of bitcoins and be connected to thousands of their peers. We could expect a very high infrastructure cost to operate such a wonder, but it's not even required. There is a form of asymmetry between the relatively low infrastructure costs, which approximate just around a thousand dollars a year for a business, and the value a lightning node can operate. Adding equipment value to a balance sheet for self-hosted nodes sounds reasonable, but that amount would be negligible.
Definition: An intangible asset is an asset that is not physical in nature. Goodwill, brand recognition, and intellectual property, such as patents, trademarks, and copyrights, are all intangible assets.
Even though the lightning network doesn't need trusted third parties to work, the number of transactions a node can route will highly depend on the quality of its neighborhood. Over time, several rankings have emerged to highlight a node's age, uptime, and connectivity, but they have yet to turn into monetary value.
Is the value of a node routing several bitcoins a month more valuable than a node merely routing 100k sats? The obvious answer is yes because it generates more cash flow, but in the future, we could see accountants value the brand of a node with other metrics and reputational scores.
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Accounting practices involve managing financial transactions and preparing financial statements that accurately reflect a company's position. One key aspect of accounting is the treatment of liabilities, which are amounts owed by a person or company to another person or company. Historically, debt emerged as a means to finance activity and growth, allowing businesses to expand beyond their immediate resources. However, with technologies like the Lightning Network, which allows for instantaneous settlements of transactions, the concept of liabilities for routing nodes has yet to emerge.
But as the future unfolds, the professionalization of node operators may lead to more acute capital needs to fuel their growth. The emergence of bitcoin lending services, provided by other nodes or dedicated companies, as a form of short-term or long-term debt may become a reality. If this future unfolds, several new accounts will appear on the balance sheet of a node operator borrowing and/or lending capital.
Shareholders´ equity, also referred to as stockholders' equity or owners' equity, refers to the assets remaining in a business once all liabilities have been settled. This figure is calculated by subtracting total liabilities from total assets.
The owners' investment of cash and other assets in the business is called contributed capital. The amount of profits reinvested in the node operations, which will not be distributed to node owner(s), is called retained earnings. Both of these accounts can be translated to the world of lightning nodes.
Based on the observations developed in this article, we extrapolated the balance sheet of a fictional routing node. As shown in the following figure, we compared the current nodes' balance sheets and possible evolution that could involve some level of liability.
As shown in the 2030 scenario, the balance sheet could include many more accounts as the complexity and variety of operations grow.
Financial reports for businesses are typically denominated in the currency of the country in which they are incorporated. However, all financial statements should be denominated in bitcoins for routing nodes. Nevertheless, lightning businesses will likely keep using fiat currencies as their accounting currency for various activities, including selling products and services, financing, and routing.
Financial statements are provided on a monthly, quarterly, or yearly basis. However, seeing the nature and the speed of transactions on a lightning node, it would make sense to report activity on a daily or even hourly basis for balance sheets. For traditional businesses, a week represents the short term, but if we compare it to lightning speed of operations, a week could be seen as long-term.
As Lightning Network grows, there is a pressing need to adopt some form of standardization of financial reporting techniques that can provide insights into nodes' financial viability. As the industry crosses the chasm, current accounting norms must help lightning operations become more understandable to a broader audience.
This article explored the balance sheet, one of the four financial statements, which provides a snapshot of a company's assets, liabilities, and equity at a given time, and how it can be adapted to a Lightning Network node. Interestingly, we observed that the balance sheet of current nodes doesn't hold any liability, and a node operation is 100% equity based. That situation may change in the future, leading to capital borrowing/lending between nodes.
This field of financial accounting for lightning operations remains uncharted territory, and it will probably require several years before reaching a form of standardization between nodes, businesses, and accounting bodies. Eventually, efforts of standardization should allow the on-boarding of the early majority of accountants and financiers to Lightning Network.
In the next episode, we will talk about the income statement.