Financial Transparency and Reform: Dodd-Frank, IFRS, and XBRL

David Blau, George Mason University School of Public Policy, November 2013

Financial Regulation in the United States The first regulation in securities markets was motivated by the fear that companies would, in the absence of government oversight, manipulate financial information as needed to increase the value of their issued securities, and obtain investor financing, at the detriment of the public investor. After the stock market crash of 1929, the United States government felt it needed to restore trust in corporate America. The Securities Act of 1933 required that companies that wished to obtain equity financing by issuing (selling) a security (piece of ownership) had to file financial statements that adhered to a set of guidelines.1 Generally Accepted Accounting Principles (GAAP), the accounting standards and rules by which companies must issue their financial statements to prospective investors, took on added importance because of the need for specific rules to minimize the opportunity for management manipulation of financial information motivated by their self-interest in reported economic position. The Banking Act of 1933, also known as the Glass-Steagal Act, prohibited commercial banks from most securities trading and most affiliations with securities firms. Oversight of these regulations fell under the responsibility of the newly created Securities and Exchange Commission (SEC), tasked with protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation.2 The American Institute of Certified Public Accountants (AICPA) was the only rule-making and oversight body for accounting rules, which it developed out of common professional practices. This continued until 1973, when the SEC established the Financial Accounting Standards Board (FASB).

Carpenter, David H.; Murphy, M. Maureen (2010a), "Permissible Securities Activities of Commercial Banks Under the GlassSteagall Act (GSA) and the Gramm-Leach-Bliley Act (GLBA)", Congressional Research Service Report (R41181), retrieved February 10, 2012.
2

Ibid.

The FASB is now the main rule-making body, and whenever there is an AICPA rule that the FASB has not since contradicted, it can be treated as equally authoritative. Laws enacted by Congress or pronouncements by the SEC are given equal authority.3 The AICPA retained some critical oversight roles after 1973. These included financial statement auditing: performing a set of empirical tests as an independent third party to verify the accuracy of financial information, often in statements on which public retail investors would rely to make investment decisions. This continued until accounting scandals at large, publicly-traded American companies Enron and WorldCom motivated the passage of the Sarbanes-Oxley Act of 2002. Sarbanes-Oxley created the Public Company Accounting Oversight Board (PCAOB), tasked with oversight of financial statement auditing, placing it under government oversight for the first time.4 The Great Recession Repressed interest rates, the housing mandate by the Federal Housing Administration, and pernicious mortgage lenders like Countrywide contributed to an explosion of underserved home mortgage loans. The Gramm-Leach-Bliley Act of 1999 repealed the Glass-Steagal Act, and allowed blending of the line between commercial retail banking and securities trading.5 As a result, banks were able to securitize these mortgages, creating a tradeable commodity based on the value of a collection of slivers of underlying home mortgage loans dependent on mortgage payments for their value, and then to use investor capital to speculate on these highly-volatile investments. Credit default swaps were another speculative financial innovation, essentially providing insurance against mortgage-backed

The Hierarchy of Generally Accepted Accounting Principles: Statement of Financial Accounting Standards No. 162, Financial Accounting Series. Financial Accounting Standards Board. May 2008. pg. 1-2
4

About the PCAOB. http://pcaobus.org/About/Pages/default.aspx Retrieved August 15 2013.

Johnson, Simon and Kwak, James. 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. (New York: Vintage Books, 2010). pg. 89

securities, and also widely-held and highly-volatile. When interest rates inevitably rose, defaults accelerated, and the investments depreciated quickly.6 However, such investments were not explicitly covered under the disclosure requirements of the current regulatory structure: Generally Accepted Accounting Principles (GAAP), the Securities and Exchange Commission (SEC), and legislation passed by Congress, including the Sarbanes-Oxley Act. Credit rating agencies, responsible for rating the financial stability of mortgage lenders and mortgage-backed securities as well as larger financial institutions that invested in these securities, received revenue from the mortgage lenders and banks for other services, in a clear conflict of interest.7 They continued to rate these institutions and investments as safe, even as their value plummeted. Eventually, the truth came out as to how worthless these positions were, and banks with large investments in them experienced a panic that led to the Great Recession.8 Economic crisis decreases national competitiveness and adversely affects both the US trade balance and the aggregate activity of world trade. Financial reform is a trade issue, among other things. The Dodd Frank Wall Street Reform and Consumer Protection Act The Congressional response, the Dodd Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), signed into law July 21, 2010, is the largest overhaul of the regulatory apparatus for the financial system since the Great Depression. Its stated objectives are, To promote the financial stability of the United States by improving accountability and transparency in the financial system, to

Mason, Joseph. The Summer of 2007 and the Shortcomings of Financial Innovation. Journal of Applied Finance, Vol. 18, No. 1, Spring/Summer 2008. This paper provides a thorough, readable, technical background of the causes of the financial crisis. pg. 12
7

United States Senate, Permanent Subcommittee on Investigations, Committee on Homeland Security and Government Affairs. Wall Street and the Financial Crisis: An Anatomy of a Financial Collapse (April 13, 2011) Retrieved January 15, 2013. http://www.hsgac.senate.gov//imo/media/doc/Financial_Crisis/FinancialCrisisReport.pdf?attempt=2
8

Mason, Joseph. The Summer of 2007 and the Shortcomings of Financial Innovation. pg. 12

end too big to fail, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.9 Dodd-Frank is comprised of sixteen Titles (sections). Dodd-Frank at a Glance10 Bold: Critical Issue to Monitor Italics: New Regulatory Agency
Title Title I Name Financial Stability What does it do? Creates the Financial Stability Oversight Council and Office of Financial Research, tasked with oversight of all financial regulatory agencies and chaired by the Secretary of the Treasury. Is the expansion of the regulatory apparatus the solution?* Increases FDIC insurance from $100,000 to $250,000. Establishes a new fund within FDIC for liquidation of troubled financial institutions. Expands the definition of Covered Financial Companies eligible for liquidation. Establishes approval process in Bankruptcy court of Delaware for placing banks into receivership. Overall, this increases the availability of bailout funds. Does this increase the moral hazard that contributed to the last crisis? Abolishes the Office of Thrift Supervision, spreading its responsibilities between the Board of Governors of the Federal Reserve, the FDIC, and the Office of the Comptroller of the Currency. Increases the disclosure requirements for Registered Investment Advisors (including but not limited to Hedge Funds). Narrows the definition of accredited investor (one not requiring full disclosure, because of a presumption of financial knowledge). Establishes the Federal Insurance Office within the Department of the Treasury, tasked with oversight of the insurance industry. Establishes the Volcker Rule: banks may not speculate with investor capital. How will allowed/forbidden entities and investments be strictly defined? How will positions be monitored and enforced? Will this hinder banks abilities to invest, hedge, and deliver

Title II

Orderly Liquidation Authority

Title III

Transfer of Powers to the Controller, the FDIC, and the Fed

Title IV

Regulation of Advisers to Hedge Funds and Others

Title V

Insurance

Title VI

Improvements to Regulation

United States Congress. (2010). The Dodd Frank Wall Street Reform and Consumer Protection Act. H.R. 4173. Retrieved November 18, 2012 from http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf
10

Ibid.

Title VII

Wall Street Transparency and Accountability

Title VIII

Payment, Clearing and Settlement Supervision

Title IX

Investor Protections and Improvements to the Regulation of Securities

Title X

Bureau of Consumer Protection

Title XI

Federal Reserve System Provisions

Title XII

Improving Access to Mainstream Financial Institutions

Title XIII Title XIV

Pay it Back Act Mortgage Reform and Anti-Predatory Lending Act

Title XV Title XVI

Miscellaneous Provisions Section 1256 Contracts

returns? Previously over-the-counter swaps and derivatives, like credit default swaps, are required to pass through a regulated exchange. Can the government require disclosure of public and private data from private exchanges to data warehouses? Who can apply to be a data warehouse, and are they allowed to profit from the data? (both are questions in a lawsuit from the Chicago Mercantile Exchange Group) Tasks the Federal Reserve with establishing uniform risk management requirements for systemically important payment, clearing, and settlement activities. What will the requirements be? What will the penalties and enforcement mechanisms be? What effects will they have on return, and will they effectively reduce risk? Aims to prevent regulatory capture within the SEC with the creation of the Office of the Investor Advocate. Increases enforcement remedies, disclosure requirements for assetbacked securities and credit rating agencies, and numerous other provisions. Does creating another capture-able agency eliminate the threat of regulatory capture?* Creates the Consumer Advisory Board. Regulates consumer financial products and services, with enforcement authority. One-time Audit of the Federal Reserve by Government Accountability Office, new position of Vice Chairman serves as risk controller, more explicit standards for entities regulated by Federal Reserve roughly outlined, but largely to be determined. Given the expansion of scope and funding for the regulatory apparatus, should there be a mechanism for regular audits (oversight) of the Federal Reserve, not just a one-off? With regards to the Feds standards for regulated entities, see questions for Title VIII. Can these standards be crafted to address the questions raised by Title II? Provides for various incentives to lend to lowerincome consumers. Is this consumer credit mandate similar to the one that contributed to the last crisis? Reduces funds available for Troubled Asset Relief Program by $225 billion to $475 billion. Within the Bureau of Consumer Protection, establishes uniform standards for data collection by underwriters of mortgage loans, and that mortgage originators only lend to borrowers likely to repay their loans. Various reports ordered, including on effectiveness of Inspectors General. Ensures that derivatives brought onto exchanges

by Title VII are exempt from Sec. 1256 treatment under the IRS, which would have meant tax penalties for hedging (risk management). *: these questions are related to each other (Title I and IX) and will be discussed below

Dodd-Frank is the product of the view that the regulatory failure of the last financial crisis is the result of a lack of a sufficiently coordinated and robust framework. Whether this is true or not, it fails to address the issue of regulatory capture, that regulators will be captured by the interests of the industry they are supposed to regulate, making their efforts at reform simply kabuki to get reelected, or reappointed, or hired by the same entities they are supposed to regulate after they leave the regulatory agency. The stock market crash in 1929 and the Great Depression inspired the Securities Acts and the creation of the SEC. The AICPA maintained its chief rule-making authority until the creation of the FASB in 1973. It still maintained its oversight of auditing of financial statements of publicly-traded companies until the Enron and WorldCom scandals and the bursting of the dotcom bubble inspired Sarbanes-Oxley and the creation of the PCAOB in 2002. The regulatory apparatus has a tendency, like some generals, to (perhaps sometimes wittingly) want to fight each war like the previous one. Legislation motivated by the most recent crisis addresses well the causes of the previous meltdown, but fails to anticipate the causes of the next one. The only way to do that would be for financial information to be far more timely, robust, and cheap than it is now, and to be more publicly available. Regulatory capture is more likely, and more likely to be dominant, in a traditionally selfregulated, highly-skilled market, which perfectly describes the market for accounting and financial information.11 Regulation was long the sole domain of the AICPA, a private professional society. Kenneth Button notes the work of George Stigler and Richard Posner; that the limitation of regulation

11

Button, K.J. Cost Recovery in Transport: An Introduction. Journal of Transport Economics and Policy Vol. 39 (3), pg 250.

in these markets is that it is frequently captured by the industry under regulation, the regulatory body that had a vested interest in avoiding excessive confrontation. The industry had control over cost information, and there was no incentive to keep costs down when any increase could be passed on to customers. In the case of the accounting industry, these cost increases could be passed to consumers initially indirectly, through encouraging investment in overvalued securities; and later directly, through bailouts. Combating this was difficult for the authorities who, in any case, had minimal incentive to be too robust in their application of the rules because the appearance of high complexity (or really tough reform) justified larger bureaucracies.12 Dodd-Frank justifies a larger bureaucracy through highly complex rules, but does nothing to guarantee robust application or enforcement of those rules. Referring again to the airline industry, Button remarks, In some cases workers or suppliers of inputs further exploited this because they knew there was no incentive for management to fight input cost increases.13 This can be applied to the moral hazard of financial institutions making risky bets with meaningless cost information, because they knew they would be bailed out. It also illustrates, through a pointed example of asymmetric information, how inefficient the market for financial information is. The central question is how to enable regulators to regulate efficiently and effectively. How can they have real-time access to transparent data, cheaply, while making that data available to the entire public, including those lacking technical backgrounds in accounting, finance, or information technology? Open government data in this area is critical to educated and active democratic participation, and acts as a necessary check for

12

Ibid. pg. 50 Ibid. pg. 50

13

the public against corruption.14 The answer is decreasing the costs of providing and obtaining accurate and timely financial information. What Are Our Competitors Doing? Comparable Legislation in the European Union, United Kingdom, and China For the most part, developed countries are attempting to institute changes to financial regulation very similar to Dodd-Frank. In the European Union (EU), the European Market Infrastructure Regulation moves swaps onto regulated exchanges. The Markets in Financial Instruments Directives (I and II) provide for oversight of derivatives and investor protections. The Capital Requirements Directive and Legislation (CRD IV) is similar to the Volcker Rule. In the United Kingdom, the Vickers Report is essentially the same as the Volcker Rule.15 In China, regulators are instituting capital adequacy ratios in line with their own version of Basel III, and providing for more investor protection.16 According to the World Banks Financial Sector Assessment for China, published on November 14, 2011, the regulation of China's financial system still needs to be improved "to ensure it is suited to the challenges posed by a rapidly evolving financial sector." The report suggests that a

14

See Bertot, John C., Jaeger, Paul T., Grimes, Justin M. Using ICTs to Create a Culture of Transparency: E -Government and Social Media as Openness and Anti-Corruption Tools for Societies. John C. Bertot, Paul T. Jaeger, Justin M. Grimes. Government Information Quarterly, Vol. 27, 2010, pg. 264-265. Transparency ultimately serves to keep government honestGood government must be seen to be done. In terms of international practices in transparency, the Interne t has greatly reduced the cost of collecting, distributing, and accessing government information. As a result of these capacities, recent years have seen trends toward using e-government for greater access to information and for promotion of transparency, accountability, and anti-corruption goals In each of these areas, the provision of information to citizens and the ability of citizens to monitor the activities of the government play an important role, both key areas in which egovernment and other ICTs can be used to battle corruption. The inuence of culture often makes social change the largest challenge in openness and anti-corruption initiatives.
15

Shearman and Shearman. (2012). Dodd-Frank, UK, EU & other Regulatory Reforms. Retrieved December 9, 2012 from http://www.shearman.com/dodd-frank/.
16

Lakyara. (2012). Financial Regulation in China After Upcoming Leadership Transition . Retrieved December 9, 2012 from http://www.nri.co.jp/english/opinion/lakyara/2012/pdf/lkr2012130.pdf.

permanent Financial Stability Committee be established in China to consolidate supervision across the industries, which Dodd-Frank does for the US. It also recommends that Chinese regulatory agencies have access to increased resources as their responsibilities expand, implying that the current regulatory structure in China needs expansion. In China, there are rules providing for client confidentiality that could make it difficult to comply with the US plans for registering every swap transaction.17 This raises an additional critical issue: how to deal with jurisdictional synchronization with the various requirements of Dodd-Frank with countries with differing regulation. Chinese banks lack a legal framework underpinning banks' activities. Surveillance has been established, but more attention needs to be paid to illegal investment activities, hedge funds, and private equity funds, according to the World Bank report. An inferior financial regulatory system can have adverse effects on attracting foreign investment, because of a lack of confidence in corporate governance and arms-length. The latter area, according to this report, is one where the US will likely maintain competitive advantage relative to China in the near-term. IFRS versus GAAP: One Small Piece of a Plan for US Competitiveness in Financial Regulation The most striking difference between financial regulation in the US and in other countries, including China, is between GAAP and the International Financial Reporting Standards (IFRS), a different set of accounting rules required for submission of audited financial statements of publiclytraded companies. Where GAAP is a rules-based system, IFRS is more principles-based. In GAAP, specific rules adopted by the AICPA or FASB are interpreted literally. Requirements are specific and court decisions rely on literal interpretation of the rule. The GAAP approach to ensuring investors rights have been preserved has been to have legal requirements for regulatory compliance be

17

Financial Sector Assessment Program. (2011). China Financial Sector Assessment. Retrieved November 25, 2012 from http://www.worldbank.org/content/dam/Worldbank/document/WB-Chinas-Financial-SectorAssessment-Report.pdf.

interpreted as strictly as possible, in order to prevent management manipulation of financial information given to investors. The flaw, illustrated by the most recent financial crisis, is that transactions for which there is no law or rule specifically naming them are exempt from these requirements. Unlisted transactions not explicitly covered by specific rules from the AICPA, FASB, PCAOB, or SEC are not the responsibility of those regulatory agencies. The legislative process and regulatory agencies have not been able to keep pace with new financial innovation, and the result is the failure of the preexisting regulatory apparatus to anticipate the financial crisis. IFRS is a more principle-based system than GAAP. Emphasis is placed on abstract objectives, rather than specific rules. As a result, IFRS is simpler than GAAP, with less emphasis on explicitlycovered transactions. GAAP is more than 25,000 pages, while IFRS is 2,500 pages. Guidelines in IFRS are more easily applied to a variety of situations. Because it prioritizes basic goals of clarity, veracity, and most of all, versatility, without requiring that a specific transaction type be named, IFRS can lead to more stringent reporting requirements for unlisted transactions. This allows the regulatory framework to adapt to new financial innovation to require accurate and fair disclosure and oversight, without the need to pass a new accounting pronouncement as quickly as new types of securities are being invented. The SEC has proven that keeping pace with financial innovation is difficult for them, and thus the political and practical appeal of an incorporation of IFRS standards into the US system is clear. In 2008, the SEC identified the areas designated as high-priority in the process of reconciling US GAAP with IFRS. These included the classification and measurement of complex financial instruments. Standards development began, but was considered less critical, in insurance contracts, consolidation of separate corporate entities, financial statement presentation, and financial instruments

with equity-like characteristics, all of which are relevant to the recent financial crisis.18 In this 2008 report, the SEC argued that compliance would be more effective after IFRS convergence. If financial statements are more comparable across countries, the US remains competitive with other countries for attracting foreign investment. Firms will thus be able to raise capital more cheaply. 19 However; in 2012, convergence had not moved much further. SEC Chief Accountant James Kroeker, who oversaw the SECs two-year study to provide a plan for convergence, resigned the day before the report for this study was released. The plan shows reluctance to implement IFRS treatment on a number of issues. Part of the reason for the lack of progress is illustrative of the drawbacks of IFRS. The gap between treatment on gains and losses on derivatives (relevant to the most recent financial crisis in monitoring bank positions in CDO's and similar instruments) in IFRS and GAAP is particularly large.20 IFRS allows for more creative management manipulation of financial results than GAAP in certain situations. This is because, while IFRS avoids the need to cite specific transactions, more interpretation is allowed in crafting ones own financial results. Comparability for a more casual investor could be adversely affected. Dr. Teri Yohn of Indiana University testified to Congress that investors prefer GAAP to IFRS, and that IFRS provides greater opportunities for earnings management.21 The initial political appeal of IFRS following the financial crisis has disappeared. Unfortunately, no simple political false dichotomy where GAAP represents the greedy American Wall Street bankers, and IFRS is the way of the new progressive international community, applies.

18 19

PriceWaterhouseCoopers. (October 2011). IFRS and US GAAP: Similarities and Differences. Ibid. 2012

20

Selling, Tom. (November 18 2012). The IASBs Stages of Grief. The Accounting Onion. Retrieved December 9, from http://accountingonion.typepad.com/theaccountingonion/2012/11/the-iasbs-stages-of-grief.html.
21

Yohn, Teri. (October 24 2007). International Accounting Standards: Opportunities, Challenges, and Global Convergence Issues. Retrieved November 29, 2012 from http://grovesite.com/GSLibrary/Downloads/download.ashx?file=sites/4/7280/212568/TYohn10242007.pdf.

A blend of the two approaches is most appropriate. The SEC has been trying to achieve this without much success. The only area where IFRS treatment is clearly preferable is in the area of these unlisted transactions, especially those that pose a risk to the greater economy. But how does the SEC detect which unlisted, unknown transactions are dangerous to the economy as a whole? IFRS would provide for oversight only after the problem had become painfully clear. It is only one piece of a solution. Analyzing the differences in treatment between the two systems is an important task for regulatory awareness. The problem of synchronization of regulatory approaches across countries is a big one. The World Trade Organization does not provide for a global accounting authority. Even IFRS, used in a number of countries, is adapted to suit each countrys needs and is as a result not perfectly comparable to each of its own variations. The issue is how to ensure that reported financial and accounting data accurately represent economic position. How can we make that data available in real-time, at a much cheaper cost, to regulatory agencies and the public, to provide transparency into the financial positions of not just financial institutions, but all publicly-traded companies, and the regulatory agencies themselves? The critical mass of a crisis can be the key to reform and improved competitiveness. How can the US government best promote democratic accountability, critical to competitiveness and the public trust required for a democratic system to function? Governments relationship with civil society will be important. Authoritarian mandates without consideration of the political marketability of the message will fall on deaf ears. A successful approach has to be embraced by all stakeholders, investors, consumers, private firms, and the government. Such a technology that satisfies these myriad requirements already exists, and is being used much more widely in China and Japan, by all stakeholders, than in the US.

The Root of the Problem: The Financial Reporting Process, and the Solution: Extensible Business Reporting Language (XBRL) Financial reporting today consists largely of paper documents. PDF and paper submissions for regulatory filings do not easily permit interchangeability across one another, and cannot be automatically read by computers. This even applies to many electronic formats, because these formats are proprietary, and derive much of their value (and cost) from their incompatibility with other file types. Data must be re-entered manually each time into a consistent format, be it for regulatory purposes, internal private firm or government agency efficiency, or evaluation by the public. The data entry of the report may need to be repeated several times. The potential for manual error grows with each repetition of the process. There is a resulting time lag needed to disseminate financial data for regulators to ensure compliance, and for the public to view it. The manual dissemination of the financial data away from its format in order to make it more widely usable also removes meaningful context, the supporting information, from that data. Determining how and why for a number involves going back to the original document and hoping that enough information was bundled with it and is not locked into the originating program, far away from the end-user. The current financial reporting process involves several stages of costs that add no value. These contribute greatly to both the oft-cited costs of compliance for firms, as well as the costs of oversight responsibility for regulatory agencies. The requester of information must gather, document, and format its requirements before sending. After sending, there is a need for clarification for the responder from the requester. Eventually, this back and forth leads to the responder gathering data from disparate sources with varying levels of detail, verifying and reconciling that data, summarizing and formatting it before sending it to the requester. The process can be repeated several times back-and-forth for the same original request as manual processes and systems do not interface, making reconciling compliance a clumsy task. Financial reporting requirements have been a series of disconnected one-to-

one transactions, where for each new reporting requirement, the process must be repeated. Many agencies have their own systems for submission of required information, but then convert it manually, negating any advantage of automation.22 The inability of the SEC to anticipate the risk of bank positions with mortgage-backed securities was partly because ensuring accurate and timely compliance of financial statements had grown too complex and time-consuming using paper documents with their limited manpower and budget. The SEC provides the most direct link between the inability of organizations, be they regulatory agencies or private companies, to quickly assess accurate financial information, and the damage that failure causes to the economy and public trust, but there are other examples. The Internal Revenue Service estimates that the tax gap is roughly $350 billion per year. The most recent estimate dates from 2001. The tenyear delay in estimates is due to the difficulty in processing disparate formats of data and in obtaining an accurate picture of corporations true economic position and accounting data.23 XBRL Extensible Business Reporting Language (XBRL) is a standard for electronic formatting of financial data. XBRL makes financial data more trustworthy and timely. XBRL is a universal opensource language, as opposed to proprietary software. XBRL is a standardized means of representing financial and accounting data, creating a unified framework for that data as it moves from system to system. Creators of the XBRL standard have sought input in its development from a wide range of stakeholders, including those who could be sensitive to such disruptive change. Encouraging the collaboration of those stakeholders is critical to encouraging diffusion of the standard, which is critical

22

Financial Information Sharing Subcommittee: American Council for Technology and Industry Advisory Council (February 2007). Transforming Financial Information: Using XBRL in Federal Financial Management . Retrieved December 9, 2012 from http://www.xml.gov/documents/completed/iac/xbrlwhitepaper.pdf.
23

Internal Revenue Service. (2011). The Tax Gap. Retrieved December 2, 2012 from http://www.irs.gov/uac/The Gap.

Tax-

to the US reaping its benefits. Academics, PriceWaterhouseCoopers and Microsoft, government agencies, the Organization for Economic Cooperation and Development and the AICPA have all been instrumental in establishing XBRL as a standard, and any interested individual can offer input. 24 XBRL development is an example of a new evolution of civil society; the organic communities of the open-source online space, where participation and insight into the development of the technology is free to anyone. Global collaboration has been much more productive and communal in XBRL than in IFRS or regulation. The goal of XBRL is the democratization of accurate, real-time information, and ensuring that it more clearly represents economic position. This is the key to making regulators more effective and efficient. It would help restore public trust if applied to the financial system and to governmental accountability. XBRL attaches semantic meaning, like business reporting unit, location, and chart of account type within the general ledger taxonomy, the most critical accounting definitions, to numerical data. XBRL embeds the meaning and importance behind an accounting number into any format, according to a common dictionary. The metadata contained in the semantic meaning contains descriptive labels, definitions, and links to authoritative guidance. This gives automated systems context, allowing programs to automatically sort data by type, like industry or revenue, across datasets, rather than viewing them as no more than a string of digits (which requires manual reentry). This makes it easier for organizations to obtain and use data from one another quickly, which in turn makes it easier to quickly verify the accuracy of the data. In XBRL, the most useful economy of scale comes from increasing the productivity of information processing, which results in a massive decrease in the costs of information, a welcome improvement to the current financial reporting process.

24

Kernan, Karen. (2009). The Story of Our New Language: Personalities, Cultures, and Politics Combine to Create a Common, Global Language for Business. American Institute for Certified Public Accountants. Retrieved November 18, 2012 from http://dx.doi.org/10.1080/10196780500303029.

With XBRL, a company can use one open-source technology for an entire audit trail, reporting to any outside agency, internal management, forecasting and statistical analysis, including metrics on business operation and social responsibility reporting, all from the same set of data. But, the key is that the data has to originate with XBRL tags. Microsoft has already built the functionality into MS Excel. XBRL filing data for all publicly-traded companies is available free of charge on the SEC's EDGAR database, but requires knowledge of computer science techniques that automatically pull and compile the data. Calcbench (Calcbench.com) and 9W (9Wsearch.com) are the initial startup applications meant to enable anyone, including those lacking any technical computer science background, to use the technology to view financial data from SEC filings much more quickly, with built-in functionality for data analysis and business intelligence metrics, but these last two elements remain underdeveloped. The next steps would be adoption of XBRL at such a widespread level that cheap, real-time, automated updates of financial data would be enabled, along with analytics for fraud detection for both corporations and government agencies, cost-benefit/net welfare analysis and social metric reporting for government agencies and nongovernmental organizations, and other macro and micro-economic research, including that to be gained by combining XBRL with other large data source application programming interfaces. XBRL allows for easier automated report generation and interpretation, reuse of individual information on reports, and manipulation of report information, without the risk of losing the meaning of the underlying format and context. Data for a given account is universally defined. For example, information on cost of goods sold over time for a toy manufacturer would be included on credit risk data as part of a loan application to a bank. The same data at an aggregate level could be automatically grabbed by the bank from the initial data instance for a new report for Basel II risk capital purposes. If the toy company is publicly-traded, bank data on the company should tie to the companys financial statements filed with the SEC. If not, this is an interesting point of inquiry, but the point is that XBRL

enables software to automatically detect this just from the initial filing. This enhances regulatory interagency coordination. The bank could aggregate cost data with an XBRL query on the costs of all toy manufacturing companies to which it has outstanding loans, to analyze credit risk and cost relationships in that industry. Alternatively, any government agency could pull from that same original data point as part of a query for analysis of changes in profitability for the manufacturing sector as a macroeconomic indicator. XBRL allows for all of this analysis from the same cheaply-produced single instance of data. XBRL provides a grand bargain for the current politically polarized budget wrangling. Auditing for Wall Street and government agencies can both be revolutionized by a single more accurate, cheap, quick, and most of all, publicly available format. The FFIEC: Hard Evidence of Dramatic Improvements in Financial Reporting In a 2006 report by the Federal Financial Institutions Examination Council (FFIEC), which includes the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve System, and the Office of the Comptroller of the Currency, XBRL improved government oversight and effectiveness in ways that would apply to any organization, including private corporations and government agencies. The FFIEC was the first organization in the US to implement XBRL on such a large scale. XBRL led to dramatic improvements in accuracy, faster data inflow and access, increased productivity and efficiency, and the ability to adjust the system to changes in regulation much more quickly. Under the XBRL-based system, 95% of submitted data for financial reports from regulated entities was accurate with regards to logical relationships, like that between income on the income statement and income on the statement of retained earnings, as opposed to 66% under the prior system. Mathematical accuracy increased from 70% under the old system, to 100% with XBRL. Staff productivity also increased between 10 and 33% after implementation. Under the old system, banks

submitted their required reports an average of weeks after the end of each quarter. Using XBRL, they submitted the next business day.25 The best way for the US government to ensure effective and efficient financial regulation, and to prevent regulatory capture, is to make the data that is relevant to regulators cheap, public, and available in real-time to any citizen.26 XBRL enables this, provided it is adopted widely enough to ensure its positive network externalities.27 Adoption of XBRL ensures accounting data accurately represents economic position, and can fix the financial reporting process. In China, both tax and financial statement filings in XBRL are mandatory. The SEC, IRS, and FDIC have begun to adopt XBRL for regulatory oversight, with the SEC recently mandating all electronic filings, but they lag behind the equivalent agencies in China. The SEC also requires traditional paper formats, removing much of the benefit of XBRL filing, because companies still retain all the costs of the old approach, and have to recode data into XBRL if they have not overhauled all of their internal accounting systems. While improving, company filings are still error prone. Companies are wary of the dollar and time costs of the tagging process needed to make an average Excel spreadsheet or equivalent legacy system into XBRL, and to simply be held to the inevitably higher standards for financial reporting and economic results that will come with full implementation and adoption of the standard.28 This is surprising, given the dramatic success of the FFIEC as a test case six years ago. So why has XBRL

25

Improved Business Process Through XBRL: A Use Case for Business Reporting . (2006). Federal Financial Institutions Examination Council. Retrieved December 6, 2012 from http://www.xbrl.org/sites/xbrl.org/files/resources/1%20FFIECWhite-Paper-31Jan06.pdf.
26

See Bertot, Peter et al.

27

Saloner, Garth, and Farrell, Joseph. Working Paper: Department of Economics: Economic Issues in Standardization. Cambridge, Massachusetts. Massachusetts Institute of Technology, 1985. Retrieved November 21, 2011 from http://dspace.mit.edu/bitstream/handle/1721.1/63537/economicissuesin00farr2.pdf?sequ nce=1.
28

After all, that is the point of XBRL implementation in the first place.

taken off in China (and Japan, for that matter), but not in the US? How do we encourage adoption beyond SEC filing mandates? Perhaps the financial crisis motivates the most democratically satisficing solutions, like a regulatory overhaul, at the expense of political and institutional support for a cheaper, less politically dramatic solution, that would actually produce the kind of uncomfortable change that occurs when the books are truly open and accurate for both private entities and the government agencies that are supposed to be watching over them. The business community also mostly ignores what could be a profitable technology for its own operational synergy, because of fear of regulation and change. Advanced data analytics and machine learning, integrated with a wealth of new, much cheaper, realtime financial and economic data, would be powerful for both firms and government. While implementing a standardized process comes with initial costs for firms that adopt the technology, the benefits are simpler technology environments and lower costs over the long-term.29 China has longstanding cultural traditions of Confucian faith in a strong central government, while distrust of central government is endemic to the United States. Differences in governmental structure allow the Chinese government greater authority to simply decree a mandate of universal adoption of the standard beyond regulatory filings for publicly-traded companies. Forced adoption of the standard for internal business reporting has helped China to ensure that firms realize (sometimes unforeseen) internal financial data synergies, because they have no choice. A technological standard for data interchange is only effective to the extent organizations use it. The ability to automatically pull data that is easily reused and analyzed is contingent upon the data originating in that format. As more adopters begin to transmit information according to the standard, the value of adopting the standard oneself increases. The goal at this stage is to achieve critical mass,

29

See Saloner, Garth, and Farrell, Joseph. Working Paper: Department of Economics: Economic Issues in Standardization.

where the fear of the inevitability of enough competitors using the standard would motivate everyone to adopt the technology, ensuring the public good of cheap, accurate, timely financial data for everyone. It is important to monitor the critical questions raised by Dodd-Frank as the legislation is implemented, as noted in Table 1, and to implement an IFRS-like approach to unlisted financial innovations, and to continue to study the potential for convergence between IFRS and GAAP. There are also a number of important steps to encouraging standardization of XBRL. Embracing XBRL within the federal government for intra and inter-agency reporting would be an important first step towards encouraging widespread adoption. The SEC currently requires issuers to file both paper and XBRL-based financial statements. The option to file solely in XBRL should be available. The process of tagging documents that originated in costly traditional paper filing formats would be cheaper and quicker if companies did not have to transform existing data from paper to XBRL, because that data originated in XBRL in the first place. The goal is to remove redundant steps. Companies can better adjust to the shock and growing pains of reevaluating their own internal accounting information systems architecture and processes in order to implement XBRL if they are not simultaneously required to process everything by paper. The SEC already uses XBRL data for economic analysis. The need for better insight into government spending, and greater accountability for agency social goals, lends XBRL to use by any agency for similar analysis. The US government should show the business community that it can be a leader in innovation and reform, and implement internal audit systems based in XBRL for its own operations, in order to engender the type of public trust and support it so desperately now needs. Governmental audit and accurate agency reporting are flawed. Implementing XBRL to improve fiscal responsibility and transparency in this area would comprise the needed concession from Democrats in order to generate support from Republicans for similar reporting requirements for corporations. The

US government should also support small independent software developers using XBRL to create paradigm-shifting, cheap alternatives to the current system of expensive, proprietary enterprise resource planning (ERP) software, by making XBRL data and the tools to use it accessible for citizen users with as wide-ranging a level of technical expertise as is possible. Expensive proprietary ERP and similar software systems have expensive aftermarkets for implementation, which is the exact economic case where government standardization creates the least inefficiency with its intervention, and can be best rationalized.30 However, those ERP vendors and implementation consultants will fight vigorously to protect the rents of proprietary systems lacking interchangeability, in long-term implementation contracts ridden with regulatory capture. Widespread adoption of XBRL is an investment in information infrastructure. The investment is infinitely cheaper than the physical type. The returns of that investment, in the form of cost savings in providing information, from anticipating; and maybe even preventing, financial crises; in providing the first accurate government audits for agencies that may or may not be rife with corruption and capture,31 in providing for more accurate social metric reporting to assess whether at-risk social groups agencies intend to help are truly being helped, and in a new wealth of information to datamine, are exponentially better. Information and information infrastructure are the areas where America should focus on maintaining competitive advantage in the future. XBRL is critical to ensuring that domestic and foreign consumers view US companies and governance with confidence.

30

See Saloner, Garth and Farrell, Joseph, The Economics of Standardization.

31

The important point is that there is no way to really know the extent to which this may or may not be true under the current system, where audit for private firms and government agencies remains farce.