Monopoly and Competition: Standard Setting in the Public and Private Sector: Monopoly and Competition: Standard Setting in the Public and Private Sector Karim Jamal, University of Alberta Shyam Sunder, Yale University Faculty Research Workshop Yale School of Management, November 28, 2007


An Overview: An Overview U.S. securities laws induced a shift to written standards The right to write accounting standards is vested in the SEC which has delegated it to the FASB/IASB (monopoly model) This is not the norm in the economy at large; multiplicity of standard setting organizations is the norm Quality and co-ordination demand for standards Compare accounting to other aspects of the economy They seem to flourish under competing standards (including financial services) What is so special about accounting that we have (and should have) a monopoly instead of competition? Could we have Internet services today with the ITU-T monopoly? Could accounting get better under competing SSOs?


Dominance of Accounting Standards and the Larger Context: Dominance of Accounting Standards and the Larger Context Since the passage of U.S. federal security laws, financial reporting has had a sustained movement away from social norms towards written standards Today, this change in the character of financial reporting is taken as a given, and hardly questioned Most research on financial reporting standards examines them in their own domain, with little comparison to the non-accounting world However, standards are used widely in virtually all aspects of modern economies Seek a better understanding of financial reporting through the study of standards in the context of the extent, role, and processes of standardization in the economy at large


Who Writes Standards?: Who Writes Standards? Government agencies (U.S. Department of Agriculture, NIST) Professional associations (IEEE, U.S. Pharmacopeia) Industry organizations (ATIS, American Petroleum Institute) Other not-for-profit organizations (American Association of Blood Banks, Underwriters Laboratory) For-profit organizations (AT&T, Linux, Microsoft) These organizational forms may cooperate


Formation of SSOs: Formation of SSOs Periodic surveys by NIST (Martino 1941, Booth 1960, Hartman 1967, Chumas 1975, Toth 1984, Toth 1991, and Toth 1996b) Most recent edition (1996) lists in the U.S. 80 government SSOs 604 non-government SSOs Out of the 100 government and 1200 non-government organizations invited to participate, 80 + 604 responded


History of Formation of SSOs: History of Formation of SSOs Started soon after the creation of the Union Bureau of Alcohol, Tobacco and Firearms: 1789 U.S. Mint and U.S. Customs: 1792 By 1878 there were 12 government SSOs Private sector organizations had a late start U.S. Pharmacopeia: 1820 Bureau of Shipping: 1862 American Association of Nurserymen: 1876 Figure 1 for the formation during the past 13 decades


Formation of SSOs: Formation of SSOs Formation of private sector SSOs peaked in the 1930s with 97 new organizations created in the New Deal era Sustained decline since then; only 10 new private SSOs in the 1990s Formation of government SSOs seems to follow a generational cycle with peaks in The Progressive era (1900s with Pure Foods & Drug Act 1906; Federal Reserve Act 1913 New Deal era (1930s with securities acts, agricultural products, occupational health and safety, housing and health and human services) Post-Vietnam era (1970s, EPA, mining, transportation and consumer product safety, etc.) Should we expect another peak in the 2000s (PCAOB?) Cheit (1990): Private standard setting is pro-active; government standards are reactive


Private Sector SSOs: Private Sector SSOs Accounting literature tends to focus on securities acts of 1933-4 as the major regulatory events for business But securities regulation was only a small part of the broader trend of government standards listed above In the private sector: grains, scientific testing, adhesives, air transport, plastics and paediatrics in the 1930s construction materials, bar coding, publishing, furniture and accounting standards in the 1970s Many activities which are standardized by the government in the U.S. are handled in the private sector elsewhere (and vice versa)


Number of Standards in Place: Number of Standards in Place Number of government standards rose from 39,500 in 1967 to 52,500 in 1991 1990s saw a concerted effort to reduce government in favor of private standards and reduced the former to 49,000 by 1996 For the first time, no. of private stds > no. of public stds Rapid increase in international standards from 650 in 1967 to 10,745 by 1996 General trend in increasing private and international standards (as well as national standards in individual countries) Accounting standards are late and small entrants to the field


Table 1: Number of Standards In the U.S.: Table 1: Number of Standards In the U.S.


Major U.S. Private SSOs (in 1996): Major U.S. Private SSOs (in 1996) #1: American Society for Testing and Materials (1898): 9,900 standards #11: Underwriters Laboratory (1894): 780 standards #15: American Petroleum Institute (1919): 500 standards By comparison, FASB (1973) had 127 standards in 1996 and 159 in 2007


Table 2: Number of Standards Issued By the Top 15 Private Standard Setters In the U.S.: Table 2: Number of Standards Issued By the Top 15 Private Standard Setters In the U.S.


Classification of Standards: Classification of Standards Economic rationale for standards (Sunder 1988, Krislov 1997) Limitations of standards Generally applicable to all industries including accounting Quality standards Coordination standards


Quality Standards: Quality Standards Specified minima for product attributes Useful when buyer preference (and cost to seller) are monotonic in these attributes Assure buyers of minimum quality Inform seller of the minimum level of buyer expectations Example: Russian milling wheat, 3, sound, merchantable, crop 2005; Test weight: min 78 kg/hl; Protein: min 12.5 pct (Dry matter N 5.7); Moisture: max 14 pct; Wet Gluten: min 24 pct; Foreign matter: max 2 pct; Grain matter: max 3 pct; Falling number: min 250 sec (Hagberg); Insect damage: max 1.5; IDK: max 85


Demand for Quality Standards: Demand for Quality Standards When quality is unobservable to the buyer Danger of “Market for Lemons” (Akerlof 1970) Subject to consideration of cost, it is advantageous for all to define and enforce minimum quality standards (letting individual producers, who so wish, to choose higher quality) A system of grades, ratings, and certification may supplement standards Facilitate transactions by minimizing information asymmetry between parties Government plays an important role in quality standards although there are plenty of private quality standards also


Coordination Standards: Coordination Standards Useful or necessary even when preferences of transacting parties are not monotonic in attributes Example: shape of unified thread standard on a bolt or nut from ASME/ANSI The reason for such standards is coordination A change in angle from 60 to 61 degrees is unlikely to make the shape of threads better or worse for users or manufacturers Intended to obtain a mutual fit among various actions or components for the sake of enhanced efficiency There is no obvious way of ranking or grading products More likely to be created in the private sector


Quality and Coordination Standards by Government SSOs: Quality and Coordination Standards by Government SSOs Toth (1996) data on Voluntary/mandatory Certification/audit service, and In-house/private development We visited websites of 80 government agencies and able to access copies of standards in 64 agencies for Grading scales (pass/fail or multiple grades) Quality or coordination standards Economic, scientific, or social/health related


Government SSOs: Government SSOs Marginally more likely to set quality standards Quality (61%), coordination (39%) Quality standards agencies more likely to provide audit/certification (77%) than coordination standards agencies (28%) Adoption of private sector input is common to both quality (72%) as well as coordination (56%) standards Federal government policy directive to increase reliance on private sector Same for the Canadian Standards Association, a government body that oversees standard setting


Table 3: Quality and Coordination Standards in the Federal Government : Table 3: Quality and Coordination Standards in the Federal Government


Accounting Standards: Accounting Standards Set in private sector Have some attributes of standards often set in government Audit Input from private parties Are accounting standards quality, coordination or a hybrid?


Disclosure and Measurement: Disclosure and Measurement Disclosure standards often regarded as quality standards More disclosure  better accounting (questionable assumption beyond certain limits) Measurement standards often regarded as coordination standards Justified by demand for consistency over time and comparability across firms, industries, and economies This classification is approximate at best


Limitations of Such Classification: Limitations of Such Classification Quality of financial reporting not monotonic in the extent of detail or disclosure Excessive disclosure may inhibit transparency (Enron SPEs) Excessive transparency may not be good for small shareholders due to contracting reasons Proprietary costs Accounting practice does not quite fit the classification Measurement issues subject of great debates, research, audit, restatement, and enforcement actions Much less so for disclosure issues Disclosure and measurement sometimes treated as substitutes (disclosure as a poor cousin to measurement) Plenty of exceptions: lease and pension accounting debates What is the basis of determining “better” measurement in accounting (and SEC’s claim of “higher quality” U.S. standards)?


Accounting Standards Overload?: Accounting Standards Overload? What should the benchmark for overload? Number of accounting standards is small Comparison of FAS with the Internet Engineering Task Force (IETF) standards FASB 159 vs. IETF 4,500 Complexity of language (Flesch-Kincaide index of the number of years of schooling required to read the text: FASB 10.6 vs. IETF 8.5 Complexity by words per sentence: FASB 6.0 vs. IETF 5.5 Complexity by length (number of words in an average standard): FASB 13,670 vs. IETF 8,800 It surprised us that by all three measures, accounting standards are more complex than engineering Should we look elsewhere to assess overload (costs?)


Fig.3A: Standards Overload in Accounting (Number of Standards In Place): Fig.3A: Standards Overload in Accounting (Number of Standards In Place)


Fig.3B: Standards Overload in Accounting (Complexity of Standards: Flesch-Kinkaide Reading Level): Fig.3B: Standards Overload in Accounting (Complexity of Standards: Flesch-Kinkaide Reading Level)


Fig.3C: Standards Overload in Accounting (Complexity: Average Number of Words per Sentence): Fig.3C: Standards Overload in Accounting (Complexity: Average Number of Words per Sentence)


Fig.3D: Standards Overload in Accounting (Complexity: Average Number of Words per Standard): Fig.3D: Standards Overload in Accounting (Complexity: Average Number of Words per Standard)


Standard Setting Processes: Standard Setting Processes Overlapping domains common in SSOs Comparison of FASB with four engineering standards organizations (IETF, IEEE, ATIS, and ITU), see Table 4 in the paper All have elaborate processes for initiating standards, engaging a diverse set of participants, quality control, and editorial processes Numbers: FASB has the smallest number of standards and working groups (12 vs. 124 for IETF) Financing: FASB financed by tax and sale of publications; others financed by membership dues and volunteers with text on the Internet Adoption thresholds: 50%+1 for FASB and ATIS, 70% for ITU, 75% for IEEE, no formal voting in IETF (ascertains rough consensus) IEEE has potential to be captured by a company by stacking membership and a five year sunset clause with automatic review or lapse


Roles of Government: Roles of Government ITU is intergovernmental, IETF has no government participation, the other three have mixed involvement Only FASB’s standards are backed by law, mandatory audit, IEEE has provision for obtaining voluntary compliance certification, other SSOs have none FASB has government sanctions for non-compliance, others have none Ball et al. (2003) and Bushman and Piotroski (2006) consider mandatory audit and enforcement necessary for proper functioning of financial reporting But this is not the norm in the economy for even quality standards to be enforced through government sanctions No evidence that compliance in financial reporting is any better than in fields where there is no mandatory audit or government enforcement


Standards Competition: Standards Competition FASB is the only SSO which faces no competition and does not allow issuance of more than one standard for a particular issue The other four all allow their standards to compete with the standards of other organizations, as well as compete with their own standards IEEE and ATIS sponsor periodic “Olympic” competitions where the winner becomes a standard IETF requires two independent practical operationalizations of a proposed standard before it can be adopted FASB is the only SSO without routine field testing of standards prior to their adoption


Why Such Unique Provisions in Accounting?: Why Such Unique Provisions in Accounting? Each industry in the U.S. is subject to standards set by multiple sets of government, domestic private, and international SSOs Some have to deal with 100+ SSOs (e.g., construction) Multiplicity of SSOs is the norm in the economy One can argue that accounting also has many SSOs (FASB, GASB, IASB, AICPA, PCAOB, SEC, state boards of accountancy, and national bodies in various parts of the world) Attempts to set up one dominant accounting standard setter also finds echoes on some other industries Imposition of a GAAP hierarchy is unique to accounting (no true and fair override permitted) Accounting, law, and tax appear to be the only domains in the economy where a hierarchy of authoritative sources is specified in writing and enforced by law


Internet Telephony: A Case Study: Internet Telephony: A Case Study ITU developed the PSTN (Public Switched Telephone Network) standard It is a circuit switched network (which creates and maintains a circuit between two points for the duration of the event) Over time, it was made more intelligent (ISDN) to provide new Internet services Created and supported by ITU standards (H.323) Billions of dollars spent to create a high quality reliable telephone network worldwide


Figure 5 : ITU-T Protocol H.323 Architecture(*T.120 – Multi-Point Data Conferencing; **T.38 – Group Communication; ***TCP – Transmission Control Protocol : Figure 5 : ITU-T Protocol H.323 Architecture (*T.120 – Multi-Point Data Conferencing; **T.38 – Group Communication; ***TCP – Transmission Control Protocol


An Upstart Band is Formed: An Upstart Band is Formed Telephone services are rapidly migrating to the Internet using a packet switched network standard developed by an upstart organization of volunteers with no government support (IETF) In contrast with circuit switched networks, packet switched networks neither create nor maintain a circuit path between terminals Instead, the data transmitted is divided into small packets and each packet moves independently from origin to termination before being reassembled and presented to the recipient as an integrated message Its Signaling Initiation Protocol (SIP) sets up the connection and gets out of the way and has no awareness of what happens during the event between the terminals until a BYE message is issued and the connection is terminated


Figure 6: IETF SIP Protocol Architecture : Figure 6: IETF SIP Protocol Architecture


Advantage of IETF’s SIP: Advantage of IETF’s SIP SIP advantages: less cost, less complexity, less need for memory and processing capacity, and more scalability, extensibility, and modularity IETF more nimble than ITU-T as a standard setting organization and doesn’t have a slow and deliberate process to seek complete consensus that ITU as a quasi government organization needs. IETF can focus more on technical elegance and less on politics SIP based on a completely different (web-based) architecture; not just an extension of a circuit switch network SIP has helped move the entire telephony industry towards the web. As the effect of legacy PSTN networks weakens with time, it is a fairly safe prediction that in the future all telephony will run on the web (or its future incarnation) and not on circuit switched networks


Competition in Telephony Standards: Competition in Telephony Standards ITU-T: Good track record of international standards (framework, standard for each feature, integrated into a meta-standard) Each additional feature needs adjustment of existing features and their standards Complex but effective global standard setter, responded on timely basis to new technologies over many decades PSTN widely regarded as reliable, good voice quality, minimal delay, and world wide coverage Yet, a better alternative was available and not pursued by ITU-T (historical legacy, billions invested in existing technologies) and the industry would not have leapt to web-based architecture without competitive standards for new infrastructure (SIP) from IETF’s


New World of Internet Telephony: New World of Internet Telephony IETF pursued Internet telephony as a matter of ideology (control at the terminals and users, not at a command center), content neutrality No central control led to Skype, Google Talk, etc. Simplicity, scalability, better able to use intelligent devices and deal with presence, mobility, P2P, and instant messaging Many of these new services were not even envisioned when IETF pioneers conceived the alternative decentralized architecture Is FASB/IASB the ITU-T or IETF of accounting considering cost, complexity, central command, and control type of standard setting model?


Back to Financial Reporting: Back to Financial Reporting Most industries have competing SSOs which protect them from stagnation What are the arguments that are special to accounting that justify a monopoly and to forego this advantage of competition? FASB/IASB convergence project is justified using a coordination argument. The coordination demands in the industries (including financial) listed in Table 4 are hardly less severe and they seem to flourish without monopoly SSOs. The argument that competition among standards will induce a race to the bottom does not seem to hold in these industries. What is so special about accounting?


Complexity: Complexity Is monopoly a solution or a cause of the increasing complexity of financial reporting? Competition in Internet telephony led to a much simpler and cheaper solution that is being adopted by millions around the world because they find it better Government backed monopolies must be slow We have lost the concept of “generally accepted” in accounting Competing standard setters have incentives to carve out niches, and not necessarily pursue universal solutions Just because the existing SSO is doing a satisfactory job does not mean that it would not get better under competition Look at the Internet! We would not be where we are if IETF were trying to harmonize with ITU-T What should we do in accounting?


Thank You.: Thank You. Shyam.sunder@yale.edu www.som.yale.edu/faculty/sunder