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Monopoly and Competition: Standard Setting in the Public and Private Sector

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Title: Monopoly and Competition: Standard Setting in the Public and Private Sector


1
Monopoly and Competition Standard Setting in the
Public and Private Sector
  • Karim Jamal, University of Alberta
  • Shyam Sunder, Yale University
  • Conference on International Financial Reporting,
    Accounting, and Valuation
  • Fox School of Business, Temple University
  • Philadelphia, June 6-7, 2008

2
  • the results are suggested by experience in
    other fields of study and conceivably accounting
    is unlike these in nature and difficulty. If
    accounting differs from other subjects in its
    nature, then the arguments that follow may be
    weakened. But I see no reason to this that it is
    different. William
    Baxter
  • The Wonderful thing about standards is that
    there are so many of them to choose from.
    Rear Admiral (Retd.) Grace Hopper

3
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?

4
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

5
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 (ATT, Linux, Microsoft)
  • These organizational forms may cooperate

6
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

7
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

8
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9
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

10
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)

11
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 gt 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

12
Table 1 Number of Standards In the U.S.
13
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

14
Table 2 Number of Standards Issued By the Top 15
Private Standard Setters In the U.S.
15
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

16
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

17
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

18
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

19
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20
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

21
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

22
Table 3 Quality and Coordination Standards in
the Federal Government
23
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?

24
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

25
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 SECs claim of
    higher quality U.S. standards)?

26
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?)

27
Fig.3A Standards Overload in Accounting (Number
of Standards In Place)
28
Fig.3B Standards Overload in Accounting
(Complexity of Standards Flesch-Kinkaide Reading
Level)
29
Fig.3C Standards Overload in Accounting
(Complexity Average Number of Words per Sentence)
30
Fig.3D Standards Overload in Accounting
(Complexity Average Number of Words per Standard)
31
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 501 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

32
Roles of Government
  • ITU is intergovernmental, IETF has no government
    participation, the other three have mixed
    involvement
  • Only FASBs 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

33
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

34
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

35
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36
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

37
Figure 5 ITU-T Protocol H.323
Architecture (T.120 Multi-Point Data
Conferencing T.38 Group Communication
TCP Transmission Control Protocol
38
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

39
Figure 6 IETF SIP Protocol Architecture
40
Advantage of IETFs 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 doesnt 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

41
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 IETFs

42
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?

43
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?

44
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?

45
Thank You.
  • Shyam.sunder_at_yale.edu
  • www.som.yale.edu/faculty/sunder
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