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
• Faculty Research Workshop
• Yale School of Management, November 28, 2007

2
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?

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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

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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

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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

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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

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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

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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)

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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

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Table 1 Number of Standards In the U.S.
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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

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

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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

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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

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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

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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

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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

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Table 3 Quality and Coordination Standards in
the Federal Government
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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?

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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

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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)?

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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?)

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

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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

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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

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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

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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

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

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Figure 6 IETF SIP Protocol Architecture
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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

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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

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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?

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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?

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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?

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Thank You.

• Shyam.sunder_at_yale.edu
• www.som.yale.edu/faculty/sunder