Mezias.doc

Regulatory capture, interest group theory, and

institutional mediation: The regulatory politics of

financial reporting rules, 1973-1987

Stephen J. Mezias

Department of Management

The Stern School, New York University

40 West 4th Street, Room 7-04

New York, NY 10012

212-998-0229 (ph)

212-995-4234 (fax)

[email protected]

and

Seungwha Chung

Department of Management

Yonsei University

Korea

Regulatory capture, interest group theory, and institutional mediation: The

regulatory politics of financial reporting rules, 1973-1987

Abstract

Recent work applying an institutional perspective to understand legal environments has

revealed the important role of institutional mediation in determining outcomes such as the

decision to regulate an industry and other forms of legislation. This institutional politics

perspective suggests that the influence of professions, firms, and state actors will differ

depending on the types of process that are executed. We extend this work by applying the

institutional politics model to understand outcomes in the ongoing regulation of financial

reporting. Distinguishing between substantive and non-substantive rules, we show that the

influence of organized actors over regulatory outcomes differs for these two kinds of rules. We

discuss implications for theory and research of this finding.

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The neo-institutional perspective (DiMaggio and Powell, 1991) has been an area of active

research in recent years, providing extensive evidence that institutional environments affect

organizations (Meyer and Rowan, 1977). Initially, institutional change was treated largely as a

backdrop (Oliver, 1991), with persuasive qualitative accounts of institutional change motivating

the hypotheses tested. These studies linked changes in the legal and normative environments

with the diffusion of civil service reforms (Tolbert and Zucker, 1983), the diffusion of modern

personnel administration (Baron, Dobbin, and Jennings, 1986), the expansion of due process at

organizations (Dobbin, Edelman, Meyer, Scott, and Swidler, 1988), the adoption of grievance

procedures and the creation of affirmative action offices (Edelman, 1990, 1992), the spread of

financial reporting practices (Mezias, 1990), the diffusion of equal employment opportunity and

employment-at-will clauses (Sutton and Dobbin, 1996), and the creation of personnel, anti-

discrimination, safety, and benefits departments (Dobbin and Sutton, 1998). Understanding of

institutional change was enhanced by many of the findings in this work: Dobbin (1992) showed

how normative environments shape the goals and actions of interest groups. Edelman (1990;

1992) provided evidence that shifts in the legal environment motivate organizational response

even when no specific actions are mandated. This work has also shown a multitude of ways in

which legal and institutional environments focus the attention of organizational constituencies on

specific issues (Abzug and Mezias, 1993; Kelly and Dobbin, 1999; Fuller, Edelman, and

Matusik, 2000; Edelman, Fuller, and Mara-Drita, 2001).

Researchers applying the neo-institutional perspective have now focused explicitly on the

dynamic nature of legal environments, particularly regulatory initiatives. The emerging

consensus from this work is that regulation is a (Schneiberg and Bartley, 2001: 103) “… a

mechanism for channeling private economic organization and for instituting regulated private

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government as a ‘third way’ between markets or statist regimes.” The model of regulated private

government that emerges from this work emphasizes processes consistent with three prominent

social science theories (Schneiberg and Bartley, 2001). The first is corporate control or

regulatory capture theory, which views regulation as a product of market forces and the interests

of firms in controlling competition or consolidating economic power (Laffont and Tirole, 1991).

The second is interest group theory, which broadens the view of actors involved in the regulatory

process (Stryker, 2002). From this perspective, regulation emerges when political and social

conditions facilitate challenges to corporate control over the private order of the market (Jenkins

and Brents, 1989). As Dobbin (1992: 1420) argued, regulation is constructed by the interaction

of interest groups, whose goals change over time, requiring a focus on “…the contextual factors

that influence those goals.” Understanding these contextual factors is central to the third

prominent theory -- neoinstitutional theory. This perspective suggests that prevailing models of

rationality and fairness are central to an understanding of regulation, implying particular avenues

of theoretical attention. Schneiberg and Bartley (2001) articulated this combination of regulatory

capture, interest group politics, and the neo-institutional perspective the regulatory politics

model, linking it with the institutional politics model (Amenta, 1998). As Amenta and

Halfmann, 2000: 507) observed, the fundamental insight of this model is that political

institutions “…shape the possibilities of social policy and mediate the influence of political

actors on social policy.”

This conjunction of firms acting to capture regulation, the state acting to respond to

interest group pressure, and neo-institutional processes results in a complex regulatory process

that can differ dramatically across times and contexts. For example, Sutton and Dobbin (1996)

found that legalization processes enhance both rights-enhancing and rights-negating rules.

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Abzug and Mezias (1993) compared slow and fast diffusion processes for human resource

management reforms. Schneiberg and Bartley (2001) provided a comparison of states that did

and did not pass fire insurance regulation as well as a distinction between stronger and weaker

forms of regulation. Ingram and Rao (2004) compared the processes that led to the enactment

and repeal of anti-chain store legislation. All of these authors focus on institutional mediation as

a key factor in understanding these different kinds of outcomes. The recent findings of

Schneiberg and Bartley (2001) highlight a key insight of the neo-institutional perspective:

Corporate interests are enhanced when institutional attention is not activated. Weaker forms of

regulation result when processes linked with capture theory dominate because institutional

processes do not facilitate the mobilization interest groups. Stronger forms of regulation result

when processes linked with interest group theory dominate; this occurs when institutional

processes aid interest groups in mobilizing the state against powerful corporate interests.

The evidence supporting this complex, endogenous regulatory process, while impressive,

still requires replication and extension; as Edelman, Uggen, and Erlanger (1999: 407) suggested,

this endogenous model of institutional politics “… should be applicable to other legal areas.”

Along the same lines, further study of how these processes operate after regulation has occurred

is also necessary. As Schneiberg and Bartley (2001: 131 - 132) suggested: “To be clear, further

analysis is needed of the competing theories under consideration since passing regulation does

not signal the end of regulatory politics.” This study is intended to pursue the replication and

extension of the work to date on the institutional model of the politics of regulation. First, by

reviewing the history of financial reporting in the United States (US), we extend the contexts

where the institutional politics model has been studied. In doing this, we hope to clarify how

outcomes of one set of political conflicts over broader macro political-economic institutions

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shape relations among actors and provide resources for subsequent political conflicts over the

content of regulation (Stryker, 2002). Financial reporting in the US emerged from a private

order achieved through the cooperation of accounting professionals and the firms for which they

provided audits (Mezias, 1990; Mezias and Scarselletta, 1992). Second, we do not study the

decision to pass national regulation of financial reporting standards, which occurred in the wake

of the Great Depression (Mahoney, 2001). Rather, we study the evolution of financial reporting

rules under the auspices of the regulatory agency that has been delegated responsibility for the

content of financial reporting rules by the government. In doing this, it is our intention to

compare ongoing institutional politics of regulatory oversight with the processes that have been

found to drive the decision to pass regulation and other forms of legislation (Amenta, 1998;

Schneiberg and Bartley, 2001; Bartley and Schneiberg, 2002; Ingram and Rao, 2004).

We begin by reviewing the history of financial reporting in the US to understand the

origin of private sector accounting standards. We argue that financial reporting became an

important activity, controlled by the private market cooperation of firms and the accounting

profession, long before state governments and finally the federal government became involved.

Then we focus on more recent times to study the institutional politics of the ongoing process of

setting financial reporting rules. We argue that for one class of rules, which we call substantive

rules, the regulatory process tends to promote public interest over private interests, leading to the

passage of substantive change even over the objections of private powerful interests. For the

remaining rules, which we call non-substantive rules, we argue that organized private interests

will have more influence over the content of the rules. Using a sample of financial reporting

alternatives considered by the agency charged with setting rules, we demonstrate the empirical

validity of these claims, which are consistent with past findings. After discussing potential

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limitations, we suggest some implications of our findings for future research on legal

environments, regulation, and public policy.

THE INSTITUTIONAL POLITICS OF FINANCIAL REPORTING REGULATION

Financial reporting refers to a myriad of activities related to preparing documents that

present information about the condition of an enterprise to those outside its immediate

management; it is an activity that has a long history (Carruthers and Espeland, 1991). Financial

reporting became increasingly important in the US as British direct investment in the economy of

its former colony skyrocketed during the 19th century. These investors insisted that financial

statements preparation was in accordance with standards developed by the British accounting

profession. Thus, like the common law system it had inherited earlier, the US inherited a system

of professional accountancy from the United Kingdom. As with many British imports, however,

the Americans soon made the profession their own. State accounting societies arose quickly, and

a rapid professionalization project ensued. The rise of the common stock corporation and

financial markets for the sales of securities issued by firms fed a rapid growth in demand for the

services of accounting professionals. Private sector governance of rules for financial reporting,

without explicit oversight by any state authorities, was well established by the end of the 19th

century (Boland, 1982; Montagna, 1986).

As Stryker (2002: 175) pointed out, “… economic organizational forms created in one set

of political conflicts over broader macro political-economic institutions become actors in, and

provide resources for, subsequent political conflicts over political economic governance.” Thus,

we expect that years of private governance of financial reporting standards by business interests

and the accounting profession would leave them well organized to influence outcomes of

political contests resulting from pressures for state intervention and regulation of financial

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reporting standards. Indeed, as waves of reform, first populism and then progressivism swept the

US, it was likely inevitable that reformers’ attention would at some point turn to regulation of the

growing securities markets. Roe (1994) argued that the self-interest of some business groups and

political ideology intersected to produce financial regulation in the early 20th century; the passage

of financial reporting regulation by the states can be seen as part of this wave of regulation of the

financial markets. According to Mahoney (2003), 47 of the 48 states adopted Blue Sky laws,

that is, some form of regulation of the sale of securities, between 1911 and 1931.

Interestingly, his study of the passage of these laws yielded conclusions quite similar to

those of Schneiberg and Bartley (2001) with respect to passage of fire insurance regulation. In

fact, both forms of regulation can be seen as part of the same wave of progressive reform

(Hofstadter, 1955). A first similarity then is institutional: Schneiberg and Bartley (2001)

concentrated on the creation of administrative capacity to examine the fire insurance industry

and the creation of a climate of crisis surrounding the industry. Mahoney (2003) is more explicit

about linking the passage of Blue Sky laws with overall climate of reform. He found that an

index of progressivism, which measured the tendency of particular states to create regulations

during this period, was significantly associated with the passage of Blue Sky Laws. A second

similarity between the two sets of regulation is the importance of interest group involvement

(Ingram and Rao, 2004). Both studies focus on the relative strength of the agricultural sector,

which they interpret as measuring the ability of interest groups to overcome the business lobby.

Both studies found that more stringent regulations were passed where agricultural interests were

strongest. The converse implication is that less stringent regulations were passed where the

business lobby was more powerful. Indeed, Mahoney (2003) also found that states where

smaller banks represented a greater percentage of deposits were more likely to pass more

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stringent forms of regulation. Again, the converse implication suggests that the financial sector

was able to affect Blue Sky laws: States where larger banks predominated were less likely to

pass stringent regulation. Indeed, looking at the timing of securities regulations by the states also

suggests that where finance was a more powerful industry, Massachusetts, New York, Rhode

Island, Connecticut, New Jersey, and Delaware for example, were among the very last states to

pass any form of securities regulation. Another important outcome of this influence was that

regulation came to focus on the disclosure of information about firms issuing securities rather

than on fraud prevention (Mahoney, 2003).

Federal level financial reporting regulation was resisted successfully by the alliance of

business and professional interests throughout the progressive era. The combination of the 1929

stock market collapse, the Great Depression, and the exposure of financial reporting accounting

scandals that came to be seen as triggering these events, however, proved to be sufficient to

overcome resistance to regulation. In 1934, Congress passed the legislation creating the

Securities and Exchange Commission (SEC). Companies selling equity securities in the US had

to file financial statements with the SEC (Skousen, 1991). Edelman (1992: 1536) specified three

conditions that would make an institutional perspective on legal mandates and regulation more

applicable. The first is that the law is ambiguous with respect to the meaning of compliance.

For example, Dobbin (1992: 1446) found that the state institutionalized retirement without

adequately providing retirement wages. Similarly, we find that the state institutionalized

financial reporting regulation without specifying the content of rules or enforcement. This left

wide latitude for interpreting what the law regulating financial reporting would mean in practice.

What results is consistent with Edelman’s (1992: 1535) observation that firms use “…the

mechanics of the legal process to construct law in a manner that is minimally disruptive to the

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status quo.” Merrill and Palyi (1938: 573) characterized the requirements imposed by federal

regulation of financial reporting as follows: “Much of this information, it should be noted, was

already insisted upon by the exchanges in the conduct of their own activities, so that from this

point of view the control exerted by the federal government was merely an extension of that

already in operation.”

The second condition for a regulatory context to be subject to institutional mediation is

that the law constrains organizational procedures more than the outcome of those procedures

(Edelman, 1992). Like the majority of the state laws that preceded them, laws creating federal

oversight and the SEC focused not on proactive prevention of fraud, a bad outcome, but rather on

ensuring that firms disclose information, a procedural focus. Mahoney (2001: 2) commented on

the evidence that financial reporting regulation changed outcomes by benefiting investors or

improving the functioning of financial markets: “The economic commentary looks for (and

largely fails to find) evidence that the act improved investors’ returns or the informativeness of

prices.” Thus, it would seem that financial reporting regulation focused on requiring specific

disclosure procedures while doing little to change outcomes in financial markets. The lack of a

direct effect on outcomes is related to the third criterion discussed by Edelman (1992): weak

enforcement mechanisms. The legislation creating the SEC gave that agency the right to control

rules governing financial statements, breaking with the long tradition of the private sector

regulation of the content of financial statements. However, the state institutionalized

government control over financial reporting rules without specifying how this would be

implemented. This left wide latitude for interpreting the provision that the SEC should control

the rules dictating the content of financial statements. The two major national groups

representing the public accounting profession merged, and the new national organization lobbied

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to affect implementation of this provision. The result was that the SEC delegated determining

the rules governing financial reporting to a private sector body dominated by accounting

profession and representatives of large firms (Mezias, 1990).

Hypotheses

Having concluded that financial reporting regulation is likely to be a good setting to

apply the institutional politics model to ongoing regulation, we now turn our attention to

developing predictions from this theoretical perspective. We begin by focusing on the actors

who will have influence in the process. We start with the observation by Edelman et al. (1999:

449) that regulation and legal rules “…acquire meaning through dialog across organizational,

professional, and legal fields.” This implies that three sets of organized actors will be important

to the institutional politics of ongoing regulation: professionals, representatives of large, for-

profit enterprises, and representatives of the state. In discussing how these actors might

influence financial reporting, we will use labels for them that correspond to how they are

discussed in the context of financial reporting regulation (Skousen, 1991). Specifically, the

certified public accounting professionals are referred to collectively as the profession. The

representatives of top managers at for-profit organizations are referred to collectively as firms.

Lastly, state actors are referred to as regulators. As we elaborate, there is much in the current

institutional literature of regulation to support the contention that these three actors will be

influential in determining the content of regulation.

Table 1 summarizes the theoretical arguments we make about the important actors, the

mechanisms of their influence, and their aims in exercising that influence. The first set of actors,

labeled professionals, includes members of the certified public accounting profession,

particularly those acting in their roles as licensed practitioners of federally mandated audits.

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According to DiMaggio and Powell (1983) the distinctive source of influence of this organized

actor derives from their control over normative isomorphic pressures. Subsequent work has

borne out their claim: Sutton and Dobbin (1996: 795) summarized their arguments that

professionals responded to legal mandates and government policy by claiming that research has

confirmed the centrality of the professions to understanding legal environments. Schneiberg and

Bartley (2001: 108) articulated the dynamic nature of normative isomorphism in terms of

institutionalization projects whereby professionals “…assert their jurisdiction and institute

models of development, order, or control in an industry.”

In terms of financial reporting regulation, the important professional group is the certified

public accounting profession, which control organizations such as the American Institute of

Certified Public Accountants. This organization determines auditing standards and governs the

body of professional knowledge that drives judgments in the field. At the level of individual

organizations, the profession controls the certification of financial statements. By SEC mandate,

which has the force of law, all financial statements filed with them must be certified by a

professional accountant. A small oligopoly of partnership firms largely control, organize, and

deploy this supply of labor as well as the rules they follow in performing their work. In terms of

motivation, we presume that the profession acts to maintain its control over the knowledge

domain of financial reporting (Boland, 1982).

Hypothesis 1 (H1): Financial reporting rules preferred by professionals are more likely to be adopted.

The second organized actor consists of the firms: for-profit enterprises lobbying to

influence the content of regulatory rules. Their distinctive source of influence derives from their

control over the content of financial statements. Through mimetic isomorphic processes, they

control important precedents embodied in the notion of prevailing practice (Edelman, 1990;

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1992). In terms of describing their motivation and actions, we follow Schneiberg and Bartley

(2001) in using capture theory to describe them; thus, we assume that firms attempt to dominate

regulatory processes to obtain rules that they prefer (Edelman, et al., 1999: 407). In terms of

financial reporting, the prevailing practices of firms in preparing financial statements are an

important precedent, considered by professionals and regulators, as well as other firms, in

evaluating the appropriateness of specific financial reporting practices. In terms of participation

in the regulatory process, representatives of firms are active in all aspects of the process,

including task forces, responding to invitations to comment, responding to proposed regulatory

changes, and participating in public hearings (Mezias, 1990; Tandy and Wilburn, 1992).

Hypothesis 2 (H2): Financial reporting rules preferred by firms are more likely to be adopted.

The final organized actor includes those persons acting as members of the government

and its agencies. The distinctive source of influence of this organized actor derives from their

control over the legal environment (Edelman, 1990; 1992) governing the interactions among the

three actors. As noted by Mezias (1990), a wide variety of state actors can affect the content of

financial reporting regulation. For example, in addition to the SEC, which dictates rules for all

firms filing financial statements, a multitude of other agencies can also dictate rules for specific

types of firms. The Interstate Commerce Commission, the Federal Power Commission, and the

Federal Communications Commission are three; there are many others. In addition, agencies

like the Department of Defense often include provisions in their contracts that affect financial

reporting by suppliers of goods and services. We believe that the process by which these various

regulatory actors have influence is well described by the concept of coercive isomorphism

(DiMaggio and Powell, 1983). Consistent with the concept of the legal environment (Edelman,

1990), we view the isomorphic pressures of law broadly, including both direct legal mandates

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and such actions as litigation, legislation, and administrative initiatives, and exercise of the bully

pulpit. In terms of motivation, we follow Dobbin (1992: 1445), who argued that “… an

institutional explanation links public policy to interest group goals.” Schneiberg and Bartley

(2001: 102 - 3) summarized interest group theory as follows: “Here, regulation emerges when

consumers and other actors are sufficiently powerful to challenge an industry and use the state to

check concentrated corporate power.” Based on these arguments, we claim that regulatory

action can be explained in terms of interest group theory, with a focus on protecting the interests

of the public, broadly defined. In terms of financial reporting rules, this would assume that

government acts in ways that protect the interests of investors and others who use financial

statement information (Skousen, 1991; Miller, Redding, and Bahnson, 1994).

Hypothesis 3 (H3): Financial reporting rules preferred by regulators are more likely to be adopted.

Institutional Mediation of Financial Reporting Rules

Institutional theorists studying regulation have focused on the mediating role of the state.

We apply this literature by discussing how the institutions create different regulatory tracks and

how these mediate the influence of the three organized actors on regulatory outcomes. The

different regulatory tracks that occur for financial reporting regulation mirror a distinction that

has frequently been important in studies of the enactment of regulation: between stronger and

weaker forms of regulation (e.g., Schneiberg and Bartley, 2001: 125). In fact, past work (Briloff,

1986; Tandy and Wilburn, 1992) allows us to categorize financial reporting rules into stronger

and weaker forms of regulation. The essential distinction emerging from these categorizations of

regulation is between substantive standards, which represent a fundamental change to existing

regulations, and non-substantive standards, which clarify previous standards or are new rules that

are so narrow in their application as to have little effect on current financial reporting practice.

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Relevant to the institutional mediation hypothesis, participation in the process of setting financial

reporting rules is greatly affected by the distinction between substantive and non-substantive

rules. Tandy and Wilburn (1992: 58) found that “… substantive standards elicited considerably

more participation than industry standards and amendments.” Our hypotheses about institutional

mediation derive from theoretical arguments about how increased participation will affect the

influence of organized actors for substantive and non-substantive rules.

Our first claim, consistent with H1, is that the influence of professionals will be

significant for both kinds of rules. As Sutton and Dobbin (1996: 795) argued, “… research has

confirmed the intermediary role of the professions …” as legal environments are “… constructed

through the interaction of shifting government policies and professional influence.” We follow

them in expecting professionals to respond opportunistically to changes in the legal environment;

thus, we expect they will remain influential even as there are shifts in government policy that

result in weaker and stronger forms of financial reporting regulation. Regardless of whether

regulatory changes are substantive or non-substantive, we expect there will be a requirement that

(Schneiberg and Bartley, 2001: 108) the “… underlying models are endorsed by professionals.”

This will be especially true in contexts characterized by a strong and successful profession,

which is the case with financial reporting regulation (Boland, 1982; Montagna, 1986). Thus, we

do not expect the influence of professionals to be affected by the different processes that result

for substantive and non-substantive standards.

By contrast, we do expect the influence of firms and regulators to be different for

substantive and non-substantive standards. For non-substantive standards, both new rules of

narrow application and amendments to previous rules, we believe the processes will be similar to

cases of weak regulation. As Schneiberg and Bartley (2001: 133) suggested, most institutional

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activities to organize legal environments “…fly under the radar, evoking little or no controversy

or counter organization.” Thus, we expect a process resembling regulatory capture; the lack of

attention means that interest groups will not be activated to oppose corporate power. In the case

of standards that are classified as non-substantive because they are very narrow in application,

the only interested parties will be the few affected firms and the accounting firms that do their

audits. They will work together to produce regulation that conforms to their interests.

Amendments to prior regulations represent examples of how firms can manipulate even laws

designed to constrain them. As Edelman et al. (1999: 407) argued, “… regulating organizations

is especially open to social construction because the corporate lobby is usually successful in

softening regulation that infringes on corporate interests.” In some instances, amendments may

reflect even more overt manipulation, as illustrated by the reversal of the requirement that firms

expense the investment tax credit (Mezias, 1990). We expect that non-substantive regulations,

like weak regulation, will illustrate that (Edelman, 1992: 1533) “… organizations have a strong

capacity to resist legal control and that both the structure of regulation and the culture of the

business world may buttress that resistance.” Thus, we expect firms to be particularly influential

for non-substantive rules.

For substantive rules, we have drawn the analogy with stronger forms of regulation that

have been studied in past literature. In these instances, interest group theory comes to the fore as

illustrated by Schneiberg and Bartley’s (2001: 102 - 3) claim that strong regulation “… emerges

when consumers and other actors are sufficiently powerful to challenge an industry and use the

state to check concentrated corporate power.” We also expect institutional theory to be more

important in these instances as regulations (Schneiberg and Bartley, 2001: 108) “… arise from

institutionalization projects – concerted efforts by professionals or reformers to assert their

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jurisdiction and institute models of development, order, or control in an industry.” The greater

attention that is devoted to these issues, reflected in increased participation (Tandy and Wilburn,

1992), strengthens the ability of interest groups to overcome pervasive corporate influence to

produce more substantive changes in regulatory rules. Taken together our arguments about the

influence of actors in the substantive and non-substantive financial reporting regulations suggest

two hypotheses.

Hypothesis 4 (H4): The influence of firms will be diminished for substantive changes (relative to all other changes) in financial reporting rules.

Hypothesis 5 (H5): The influence of regulators will be enhanced for substantive changes (relative to all other changes) in financial reporting rules.

SETTING, SAMPLE, AND MEASURES

The legislation creating the SEC imposed two major requirements regarding financial

reporting. First, all firms selling financial securities in the US had to file financial statements on

a regular basis with the SEC. Second, these financial statements had to comply with generally

accepted accounting principles (GAAP), the content of which was to be determined by the SEC.

According to the historical account on the website of the national association of the accounting

profession (http://www.aicpa.org/edu/profissu/century), regulatory control over the content of

GAAP was perceived as “… worrisome professional autonomy problem.” Robert H.

Montgomery, head of one of the two national certified public accounting professional

associations, acted as an institutional entrepreneur in spearheading a merger with the other. The

rationale was explicit: To give the profession “… greater leverage in negotiating with political

leaders to countervail the undesired extension of federal regulatory authority.” This led to the

acceptance by the SEC of the authority of the profession “… as promulgator of standards.”

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In response to this victory of the accounting profession, the SEC since its inception has

delegated the determination of GAAP to an external agency. Our focus will be on the current

agency, the Financial Accounting Standards Board (FASB). Describing how the SEC delegated

authority to set accounting standards to the FASB, Skousen (1991: 118) wrote: The “... SEC

stated explicitly in ASR No. 150 that it considers those accounting principles, standards, and

practices promulgated by the FASB as having considerable authoritative support. ... The SEC

thus recognizes the FASB as the primary standard-setting body.” According to March and Olsen

(1989: 97), this use of organizations “... at the margin of the state has grown. Administrative

functions have been entrusted to semi-autonomous governmental or quasi-governmental

agencies.” Although the specific arrangement between the SEC and FASB may be unique, the

practice of delegating policy authority to an autonomous, quasi-governmental agency is not.

Carmichael and Willingham (1989: 11-12) described GAAP as a hierarchy with the Statement of

Financial Accounting Standards (SFAS) issued by the FASB at the top. Consistent with neo-

institutional arguments, the process to issue these rules is characterized by legalistic procedures

and a lengthy due process (Boland, 1982; Miller, Redding, and Bahnson, 1994; Tandy and

Wilburn, 1992). The formal records produced during the comment period, which commences

when the FASB releases an Exposure Draft describing a proposed regulation, are particularly

comprehensive. Interested parties have a period of weeks or months to write letters of comment

that the FASB will consider before releasing the final standard (Mezias and Chung, 1989; 1991).

For this reason we decided to get the data for our study from the comment periods.

In deciding which SFAS to include in our study, we began with the classification of

standards into substantive and non-substantive. Tandy and Wilburn’s (1992) classification

extends from the inception of the FASB in 1973 through December 1988. Upon review of the

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institutional environment of financial reporting regulation, however, we decided to end our

sample a year earlier in 1987. The main reason was to avoid the effects of mergers among the

eight major firms that had dominated the certified public accounting profession since the

inception of the FASB (Wootton, Wolk, and Normand, 2003). To determine which comment

periods would provide the data for this study, we randomly chose 30 SFAS issued by the FASB

between 1973 and 1987. We based the distinction between substantive and non-substantive on

the work of Tandy and Wilburn (1992). Using this categorization, the thirty SFAS we selected

included five substantive standards and twenty-five non-substantive standards. To test the

hypotheses we needed a way to distinguish the issues that were decided in each of these SFASs.

The comment period always commences with the release of an Exposure Draft; we examined

these documents to determine the issues considered by the FASB in each Exposure Draft. These

documents characterize the decision-making in terms of various financial reporting practices and

present a rationale for why each of these financial reporting alternatives should or should not be

allowed under the new SFAS. The standards included in this study discussed a total of 151

financial reporting alternatives, which is the unit of analysis for this study.

Dependent, Independent, and Control Measures

Table 2 provides an example by outlining the alternatives considered in SFAS # 40; we

discuss several aspects of this information to illustrate how we created our measures. First, it

should be noted that this was a non-substantive standard in the category of those that are narrow

in application; this SFAS would only apply to firms that report holdings of timberlands on their

financial statements. Second, we familiarized ourselves with the context of each statement by

reading the Exposure Drafts and examining other secondary records for each SFAS, e.g., minutes

of any hearings or task force meetings. The four alternatives considered in this Exposure Draft

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were the following: (a) Allow firms to report the value of timberlands using either historical cost,

actual expenditures, or current cost, what those expenditures would cost in current dollars. (b)

Require firms to report the value of timberlands using current cost value. (c) Require firms to

report the values of timberland using fair values. (d) Exempt firms holding timberlands from any

future requirement to report the value of timberlands using current cost accounting. Third, for

this SFAS, the first alternative was adopted, and all other alternatives rejected. However, in

some instances, the decision in the final SFAS was to allow multiple alternatives to be acceptable

under GAAP, which means that more than one alternative was accepted in the final draft. Of the

151 alternatives in our sample, 61 were accepted as part of the final SFAS; 90 were rejected.

Our dependent variable is a dummy variable called Choice: coded 1 if a particular alternative

was accepted in the SFAS and 0 if it was rejected.

To test our hypotheses we examine the association between this dependent variable and

the preferences of the organized actors for particular alternatives. This required developing a

methodology for measuring each organized actor’s preference for particular alternatives. The

ability to measure the actor’s preferences using their letters is a primary justification for studying

the comment period. Thus, we began at the FASB library where all letters written during the

comment period for every SFAS are maintained. The classification of comment letters by the

FASB maps directly onto our three organized actors. For our measure of the preferences of the

profession, we used their category called the public accounting profession; for firms, we used

their category called preparers, and for regulators, we used their category of government. For the

average SFAS, almost one hundred and eleven letters were written, but this distribution is right-

skewed; a few standards with many more letters drive up the average. For the case of standards

with many more letters than average, we believed that we could measure the preferences of

20

organized actors by looking at just a subset of letters. In doing this, we followed these

procedures: For Exposure Drafts with less than 100 letters of comment, all letters were read. For

Exposure Drafts with between 100 and 200 letters of comment, every other letter was read, and

we alternated starting with the first and second letter. For Exposure Drafts with between 200 and

300 letters of comment, every third letter was read; again, we alternated our starting point.

Next we developed a coding scheme to record positions taken in individual letters. Two

researchers began this task by reading fifteen letters randomly selected from the comment

periods of SFAS not among the thirty included in this study. Based on reading these letters, we

developed three straightforward coding rules. First, if a letter stated explicit support for or

opposition to a specific alternative, then it was recorded as favoring or opposing that alternative.

For example, a letter written in response to SFAS #40, which was presented in Table 2, might

state that the author opposed requiring current value accounting for timberlands. Such a letter

would count as opposing the third alternative in the table. Second, if a letter contained a clear

statement supporting the tentative conclusions of the Exposure Draft, it was coded as favoring

alternatives advocated in the Exposure Draft. Third, if a letter contained a clear statement

opposing the tentative conclusions of the Exposure Draft, it was coded as opposing alternatives

advocated by the FASB in the Exposure Draft. This coding scheme recognizes that one letter

may mention several alternatives; thus, a single letter may count as being in favor or against

multiple alternatives. Conversely, not all letters in response to an Exposure Draft mentioned all

alternatives. There were no letters for which a position coded based on one of these rules

contradicted a position coded by applying one of the others. To verify that these narrow, text-

based rules would result in measures with a high reliability, we chose an additional SFAS not

among those included in the study at random. Two researchers read all of the comment letters

21

received in response to the Exposure Draft of the chosen SFAS, which was # 22. For over 95%

of these letters, the assessment of the text was identical for the two coders. Following the

confirmation of this extremely high level of reliability and given the large number of letters, we

used single rater coding for the letters written regarding the 151 alternatives in our sample.

Because only statements that conformed directly to these three rules were counted in creating the

variables, there was a small number of letters, fewer than ten among more than one thousand

read for this study, for which we were unable to code any content. We decided to reread these

letters to see if changes to our coding scheme might account for their content. Ultimately, we

decided to make no changes to our rules, and these letters are omitted from the study as too

ambiguous to code.

A second important decision concerned how to combine the opinions coded from

multiple letters to create a measure of the overall opinion of the organized actors regarding

alternatives discussed in the Exposure Drafts. We assumed that members of the organized actors

were structurally equivalent, which is consistent with both an institutional perspective and how

these letters are handled during the due process of the FASB. By the end of the comment period,

the letters written by all professionals, firms, and regulators have been collected into binders,

sorted by category, are available for review. We considered other ways of aggregating letters.

For example, FASB personnel have espoused the view that the comment period is not an election

and argued that `high quality’ letters have much more impact (Beresford and Van Riper, 1992).

However, we believed that deviation from the assumption of structural equivalence should be

based on a clear theory and the availability of accurate measures. We lacked a compelling theory

of what constitutes a high quality letter to help us calculate a metric other than equal weighting.

Similarly, processes such as reputation or network centrality might imply deviations from equal

22

weighting of letters, but again we were unsure as to how we might proceed in determining how

to measure the effect of these processes.1 Ultimately, we concluded that for this first attempt to

study an institutional politics model of an ongoing process, we should treat entries into the public

record of the comment period from organized actors as equal; thus, all letters are counted as they

are presented in official records of the FASB: one for one.

We created a measure of support for each alternative for each organized actor,

professionals, firms, and regulators, by aggregated the coding of letters from all members of each

organized actor. Our measure calculates the number of net favorable, positive values, or net

unfavorable, negative values, as a percent of total letters using the following formula:

PERCENT =(LETTERS FOR – LETTERS AGAINST)

(LETTERS FOR + LETTERS AGAINST)

It could range from minus one, unanimous opposition, to positive one, unanimous support. This

gives us summary measures of the overall opinion of each organized actor with respect to each

alternative in the sample. Moreover, because this measure is a percentage, it is comparable

across alternatives and across organized actors. These values were calculated for all three

organized actors with respect to the 151 alternatives in our sample and are labeled Professionals,

Firms, and Regulators in our analyses. H1 through H3 are supported if these variables have a

positive, significant effect on the likelihood that an alternative was adopted by the FASB. H4

and H5 refer to the influence of Firms and Regulators over alternatives that were part of

substantive standards. To test them, we began by creating a variable called Substantive, which

was coded one if Tandy and Wilburn (1992) categorized the SFAS for which the Exposure Draft

was issued as substantive, and zero otherwise. To test H4, we examine the interaction between

this variable and the variables Firms and Regulators; these interaction terms estimate the

1 As we mention in our discussion of the results, we did rerun all of the analyses including only letters from Big 8 firms in creating the measure for the accounting profession; this made no difference to the results.

23

mediated effect of the latter two variables for instances of substantive regulations. H4 is

supported if the interaction term for Firms and Substantive, labeled SFirms, is negative and

significant. H5 is supported if the interaction term for Regulators and Substantive, labeled

SRegulators, is positive and significant. We also included the interaction term for

Professionals and Substantive, labeled SProfessionals, to see if it had a significant effect

despite our argument that it would not.

We included four variables to control for differences across alternative that we thought

might account for variation independent of the processes of theoretical interest to us. First, both

as a control for process differences and to allow for more precise estimation of the two

interaction effects that we incorporate for hypothesis tests, we include the variable Substantive.

This will control for any systematic differences in the probability that an alternative would be

adopted depending on whether it was included in the Exposure Draft for a substantive as

opposed to non-substantive standard. Second, we included two variables to account for

differences in the amount of attention that regulatory decisions attract. While we believed

including the dummy variable for substantive standards would control for some of the attention

effects, we also wanted to control for attention specific to the comment period we studied. As a

specific control for attention during the comment period, we introduced a variable called Letters

that is equal to the count of total letters submitted to the FASB in response to the Exposure Draft

for each of the rules in our sample.

We also wanted to control for attention that might be given to an issue prior to the

comment period. After an issue is admitted to the agenda of the FASB, decisions are made

regarding the necessity of engaging in any four possible due process steps, which generally occur

prior to issuing an Exposure Draft. Consequently, they can be seen as part of the context

24

preceding the issuance of an Exposure Draft that structures the attention from organized actors

reflected in the letters of comment. Possible due process steps include the following (Miller,

Redding, and Bahnson, 1994): (1) Forming a task force: The FASB may choose to ask persons

with various expertise on a particular issue to serve in a group that meets to consider the issue

placed on its technical agenda. (2) Issuing a discussion memorandum: The FASB may choose to

prepare a formal document outlining preliminary ideas and logic concerning the issue placed on

its technical agenda. (3) Having an invitation to comment: The FASB may publicly announce its

desire to hear from parties interested in the issue placed on its technical agenda as part of its

early deliberations on the issue. (4) Holding a public hearing: The FASB may choose to

schedule a public meeting for discussion of the issue placed on its technical agenda with

interested parties. We used a count of the total number of due process steps executed for a

particular standard as our measure of the structuring of attention; this variable is called

DueProcess. Finally, consistent with much of the literature on legal environments, Sutton and

Dobbin (1996: 799) noted that outcomes tended to be time dependent. Despite the fact that we

purposely constructed a window of time to avoid major process changes, we did examine FASB

decisions over a period of about fourteen years. To control for possible effects of the passage of

time during our study period, we introduce a control variable called Months. This variable

tracks the passage of time for alternatives in our sample with a count of the number of months

between the release date of the Exposure Draft that corresponds to a particular alternative and the

release date of the earliest Exposure Draft in our sample.

ESTIMATION AND RESULTS

To test the hypotheses, we ran maximum likelihood logistic regression models to predict

whether specific alternatives discussed in the Exposure Draft would be adopted in the final rule

25

issued by the FASB. The dependent variable was a categorical representation of the decision by

the FASB for each of the alternatives in the Exposure Drafts. This variable was coded zero if the

alternative was rejected in the final SFAS issued by the FASB; it was coded one if the alternative

was accepted. This categorical dependent variable is called Choice. The following equation

represents the basic model, which can be estimated using maximum likelihood logistic

regression:

Choicei = 0 + 1Professionalsi + 2Firmsi + 3Regulatorsi + 4Firmsi + 5SProfessionals +

6SRegulatorsi + 7Substantivei + 8Lettersi + 9Monthsi + 10DueProcess + i

where i designates the alternative. To test H1 through H3, we examine the significance and

direction of the coefficients for the variables named after each of the three organized actors.

These measure support (positive values) or opposition (negative values) for each alternative;

positive, significant coefficients are consistent with the hypotheses. To test H4 and H5, we

examine the coefficients of the interaction terms. If the coefficient of SFirms is negative and

significant, then H4 is supported; if the coefficient of SRegulators is positive and significant,

then H5 is supported.

Descriptive statistics for all the variables are reported in Table 3; a correlation matrix for

the variables is reported in Table 4. The values on all of the variables that measure the opinions

of the various organized actors are negative; this implies that organized actors on balance tend to

oppose alternatives more than they support alternatives. Apparently, being opposed to an

alternative is a greater motivation to writing a letter than supporting one. The mean of the

variable Substantive indicates that slightly more than one quarter of the alternatives, 38 of 151,

in the sample are from substantive standards. Not surprisingly, the scope of discussion in these

standards is broader, and more alternatives tend to be considered. The average alternative in our

26

sample was discussed in nearly one hundred and eleven letters. Across the fourteen-year period

of our study, the average alternative was included in an Exposure Draft issued 70 months, or just

under six years after the first. The alternatives included in our sample were not random across

time, but were likely to occur earlier in the time frame of our study. As we will discuss in

reviewing the results, this slowing down of standard setting by the FASB, already evident in

1987, has only become more evident in the ensuing years. The descriptive statistics also indicate

that the average alternative in our sample was derived from a due process that included only

slightly more than one of the four possible steps executed by the FASB.

Correlations among the independent variables are presented in Table 4. There are

significant and fairly large correlations among the independent variables for the several

regression equations that we need to run to test our remaining hypotheses, suggesting the

possibility of multicollinearity. To assess the potential effects on any of the coefficients, we

examined the variance inflation factors for the individual variables. While there is no formal

statistical rule for assessing the influence of multicollinearity on coefficients, the rule of thumb is

to assume that values exceeding ten indicate problems (Allison, 1999); none of the measures for

any of our variable were greater than eight, even in the full model; most were less than two.

Therefore, we conclude that despite the presence of some significant and fairly large

correlations, none of the estimates of the effects of the independent variables was affected

unduly by multicollinearity.

The correlation matrix also reveals some interesting relationships related to the

institutional politics model. First, all of the correlations among the opinions of the organized

actors are significantly greater than zero. Even for the substantive standards for which we

predicted that the influence of regulators will be enhanced and that of firms diminished, the

27

correlation between these two variables is positive. We attribute this to the fact that most of the

participants, even those acting as representatives of firms and as regulators, are certified public

accountants (Mezias and Scarselletta, 1994). The correlations also suggest that the strongest of

these positive relationships is that between the opinions expressed by firms and those expressed

by professionals. The single highest correlation is between the opinions of professionals and

firms for alternatives discussed in substantive standards; the second highest is between the same

two actors for alternatives discussed in all standards. It is also true, however, that correlations

between professionals and regulators tend to be high. The next highest correlation is between

professionals and regulators for alternatives discussed as part of substantive standards followed

by the correlation between the same two organized actors across all alternatives. As would be

expected the correlation between being part of a substantive standard and both the number of

letters written and the number of due process steps executed are positive and significant.

Table 5 presents the results for estimation of the maximum likelihood logit models of

Choice. We begin with a model that includes only the control variables to establish a baseline

for comparison with models including variables of theoretical variables. All of the variables as

well as the model itself are not significant. In fact, no control variable has a significant effect in

any of the models, and this model does worse than chance, classifying just over fifty percent of

the alternatives correctly as either accepted or rejected. Given that 90 of the 151 alternatives are

rejected, i.e., the dependent variable equals zero, a naïve model that simply predicts zero would

achieve nearly sixty percent correct classification. We proceed by adding the variables to test the

influence of the organized actors predicted by the first three hypotheses. All are supported in

one-sided tests against the null hypothesis of no effect; the variables Professionals (p < 0.001),

Firms (p < 0.05), and Regulators (p < 0.05) all have effects significantly greater than zero.

28

Since the variables are all measured in the same units, percentage support or opposition among

all letters sent by members of the respective organized actors, the effects are directly comparable.

The coefficients indicate that the opinion of the professionals group has about twice the effect of

either firms or regulators, which are approximately equal. The model overall is significant (p <

0.001) and achieves more than eighty-six percent correct classification. The estimates reveal

that the effects of shifts in the opinions of the organized actors on the likelihood that an

alternative would be adopted are quite dramatic. Figure 1 depicts these effects, with the lines

showing the effect of professionals, firms, and regulators shifting from uniform opposition to an

alternative (-1) to uniform support for an alternative (1).2 For professionals, the organized actor

with the largest effect, total opposition implies that the likelihood that an alternative will be

adopted by the FASB is barely a fifteen percent. Conversely, total support for an alternative

increases the likelihood of adoption to more than seventy-five percent. The effects for shifts in

the opinions of firms and regulators is similar but of slightly smaller magnitude. Total

opposition from either group reduces the likelihood of adoption of an alternative to about twenty-

five percent; total support from either group raises the likelihood of adoption of an alternative to

about sixty percent.

The final model adds the interaction variables to test the last two hypotheses. The model

overall is significant (p < 0.001); comparison of the test statistics for this model and the previous

model shows that the difference in chi-square is significant, suggesting that the addition of these

variables improves the overall fit of the model. This is also reflected by an increase in the

percentage of correctly classified cases to over ninety percent. Inspection of the coefficient for

the interaction of the opinions of the representatives of firms and substantive standards reveals

support for H4: SFirms is significant (p < 0.01) and negative. The alternatives advocated by

22 Both figures present the effects for each organized actor holding all other significant variables at their mean.

29

firms for substantive standards are less likely to be adopted. Inspection of the coefficient for the

interaction of the opinions of regulators and substantive standards reveals support for H5:

SRegulators is significant (p < 0.05) and positive. The alternatives advocated by regulators for

substantive standards are more likely to be adopted. Figure 2 depicts these effects, with the lines

showing the effect of professionals, firms, and regulators shifting from uniform opposition to an

alternative (-1) to uniform support for an alternative (1). For firms, the organized actor with the

largest effect, total opposition increases the likelihood the FASB will adopt an alternative to just

under ninety-seven percent. Conversely, total support for an alternative decreases the likelihood

of adoption to nearly one in one hundred. The effect for shifts in the opinions of regulators are

the second largest effect, with total opposition by this organized actor decreasing the likelihood

of adoption to just under seven percent; total support from regulators increases the likelihood of

adoption to nearly ninety percent. The effect of professionals is not significantly different for

substantive standards, but the effect of opinions from this group increases once the interactions

are introduced. As visual inspection of the figure reveals, the effect of opinions expressed by

members of the profession is similar to the effect of regulators, but of slightly lesser magnitude.

Reviewing all of the coefficients in the model reveals a most interesting aspect of these findings:

The interaction variables to test the last two hypotheses have the largest effects of any in the

model. The single largest effect is the negative effect of firms for substantive standards; the

second largest effect is the positive effect of regulators for substantive standards. Taken

together, these two effects indicate strong support for the notion that institutional mediation is

important to understanding outcomes in the ongoing regulation of financial reporting.

The variable for the main effect of the opinions of professionals remains significant while

the interaction with the indicator variable for substantive standards is not significant. This

30

indicates that there is no significant difference in the effect of professionals for substantive and

non-substantive standards. This is consistent with claims that professionals adapt to a changing

legal environment (Sutton and Dobbin, 1996) and that the imprimatur of normative support

(DiMaggio and Powell, 1983) is necessary for the passage of both substantive and non-

substantive standards. Interestingly, comparison of the coefficient for Professionals in the

models without and with the interaction effect reveals that inclusion of the interaction effects

increases the estimate of the coefficient by an amount approximately equal to the standard error

of the coefficient. We interpret this to suggest that the true effect of the variable is larger than

suggested by the first model. There is a similar, but even larger change in the coefficient of

Firms, which more than doubles in size after the interactions are added. Lastly, the coefficient

of the variable Regulators, loses significance after the interaction effects are added, indicating

that regulators are influential for substantive standards but have no significant effect on non-

substantive standards. Apparently, the significant, positive effect for this variable in the model

without the interaction terms was driven by its strongly positive effect for only that subset of

alternatives that were part of substantive standards.

Discussion

The support for the hypotheses derived from the institutional politics model is strong and

consistent. Regulatory capture, interest group theory, and institutional mediation are all

important parts of the story; taken together, they provide a more complete understanding of the

ongoing process of regulating financial reporting standards than would anyone of them alone.

These results are also robust to alternate specifications of the model. Using probit estimation

yields the same conclusions with respect to all of our hypotheses. Further, if we treat adoption of

an alternative as an event and use event history methods to estimate the same model, the results

31

do not change from what we reported using maximum likelihood logit. That said, we believe

that the way choices were made, explicitly rejecting or accepting alternatives at fixed points in

discrete time is actually most consistent with the logit framework. We also ran a model that

included only letters from the Big 8 accounting firms in calculating the opinion of members of

the profession. While the effect of this group was weakened slightly by this result, none of the

results for any of the hypothesis tests were changed.

We also estimated two alternative measures of the effects of institutional mediation. In

both cases, while we still found support for H5, indicating that the influence of regulators was

enhanced by institutional mediation, H4 was not supported. We interpret these twin results to

suggest that the support for H4 is more tentative than our other findings. The first alternative

measure of institutional mediation was the variable measuring the number of due process steps;

interactions of this variable and the influence variables leads to a failure to support H4.

Similarly, if we use the count of the number of letters rather than the indicator variable for

substantive standards, the interaction of firms and letters again is not significant, indicating a

failure to support H4. While these two results both suggest that support for H4 should be

regarded as more tentative, we also believe there are several reasons to conclude that the results

from the main model should not be rejected. First, in both cases the sign of the interaction is

negative, that is, in the correct direction. With a sample size of only 151, we may simply not

have enough power to distinguish effects that are subtler than the dichotomous distinction

between substantive and non-substantive standards.

Second, our examination of the data revealed underlying processes driving both due

process and the writing of letters that are independent of processes of institutional mediation of

direct interest to us. In the case of due process, the FASB will sometimes execute steps in

32

recognition of other factors that are at play. For example, there were three due process steps

executed for SFAS 40 and 41, which were not substantive rules, because they were linked with

the then ongoing project on current cost accounting. In essence, these hearings became a forum

to discuss the controversial issue of replacing historical cost accounting with current cost

accounting rather than being a forum for institutional mediation of influence over the content of

those rules. In the case of letters, there was also evidence of processes that might change their

quantity that were unrelated to processes of institutional mediation. For example, we discovered

that for one of the SFAS included in our study an entire undergraduate accounting class was

required to send letters of comment as an assignment by their professor. We think it is fair to

conclude that this participation did not represent facilitation of interest group influence by

processes of institutional mediation. Nonetheless, we do believe that future research should

regard the support for H4 as more tentative; we look for future designs to determine the limits of

our finding that firm influence over ongoing regulation is reduced by institutional mediation.

Future research might also address some other weaknesses in our study. A first is

highlighted by the timing argument that caused us to reject continuous time model: Groups of

our alternatives were decided together. This is related to the fact that we derived these 151

alternatives from thirty FASB rules. The first response to this potential problem is a theoretical

one; both the way the FASB discusses these alternatives as well as how letters written during the

comment period discuss them tends to focus on specific alternatives as choice points. Despite

the fact that Exposure Drafts discuss multiple alternatives, rationales are developed for or against

each alternative, which is accepted or rejected on its own merits relative to an ideal of financial

reporting practice. This is demonstrated by the fact that 61 alternatives, just above two per

regulatory decision, were accepted as part of the SFAS that we studied. Similarly, 90

33

alternatives, three per regulatory decision rule, were rejected in these same SFAS. The best

statistical method to handle this problem would be to include a rule specific fixed effect

parameter. Unfortunately, with only 151 decisions, the addition of twenty-nine fixed effects

parameters results in a failure of the model to converge, no matter which estimation

methodology we use. Given this, we used an alternative method to assess the extent to which

the observations deviate from the independent, identically distributed assumptions required by

the estimation model. We did this by putting the data matrix in order by SFAS so that

alternatives considered as part of a single rule making process were in consecutive rows. This

yielded a set of error terms where the alternatives that were part of the same SFAS are clustered

together. We then conducted two variations on the runs test (Bradley, 1968) to assess any

deviations from independence. In the first, we examined whether consecutive residuals deviated

from the equal likelihood of being positive and negative that would hold if the observations were

independent. In the second, we examined whether consecutive residuals deviated from the equal

probability of being above or below the median absolute value among all the residuals. The test

statistics for both lead to acceptance of the null hypothesis that the values of the residuals are

independent; in both sign and magnitude, the residuals from our estimation do not deviate from

what would be expected if choices among the alternatives were independent.

Another potential problem with our results is that we have examined only one stage in the

decision making process for financial reporting regulation. As Bachrach and Baratz (1962)

observed, power and influence in a decision making process may be exercised to prevent

decisions or issues from ever entering the agenda. Thus, the real power and influence in the

process for regulating financial reporting rules occurs by ensuring that issues which powerful

actors do not wish considered never enter the FASB agenda. This implies that studying the

34

formal process of FASB decision-making is to see only the tip of the iceberg. At least two

implications of this are important to interpreting our results. First, the results of Mezias and

Scarselletta (1994), who studied the agenda process of the FASB, revealed a process in which

the accounting profession and firms dominate just as we found for non-substantive standards.

These groups make decisions about the majority of financial reporting issues without invoking

the full regulatory apparatus of the FASB. Of the minority that makes it onto the formal agenda

of the FASB, which were those included in our study, the firms and the professions again

dominate over the majority. Thus, the substantive rules, for which regulators and professionals

are able to overcome firm opposition, is even smaller relative to the whole of issues than our

ratio of one in five indicates. Second, we wondered whether agenda control has the result that

meaningful and important financial reporting issues never enter the agenda of the FASB. On that

count, we think it is fairly clear that important issues do enter the agenda of the FASB. During

the time frame of our study the FASB was looking at accounting for health care costs and other

post-retirement benefits, accounting for pensions, and towards the end of our study period began

a project on accounting for stock options used in executive compensation. A brief perusal of the

business headlines twenty years’ later reveals that these are important topics.

CONCLUSIONS AND IMPLICATIONS

The strong results of this study in support of the institutional politics model as

applied to ongoing regulation suggest some conclusions and implications. In addition,

the choice of financial reporting standards as the context of the empirical study raises

issues as well. We begin with these by quoting a front-page story in the Wall Street

Journal (February 4, 2002: A1):

As Congress investigated the collapse of a high-profile energy company, it faced a daunting challenge. One senator said that to understand the huge company's

35

shocking failure, lawmakers must consider the regulatory and legal missteps that led to its downfall. How, he wondered, could Congress restore investors' confidence in the financial system? By repealing old laws? Enacting new ones? One of his colleagues answered by recounting an old joke: A man gets a message that his mother-in-law has died. “Shall we embalm, cremate or bury?” it asks. Replies the man, “Embalm, cremate and bury. Take no chances.”

As the failure to name the company hinted, the story is not about Enron, the huge energy

company that had collapsed the previous year; rather it dates from the 1930s and concerns the

bankruptcy of Middle Western Utilities. Scandals arouse the passion to reform and punish, as

did the financial crises of the 1930s; yet, seventy years of history suggest that reforms have not

prevented future crises. We would suggest policy choices based on what Stryker (2002: 176)

termed “… deep historical knowledge …” might be a more effective response. Our review of

the history of regulation of financial reporting in the US reveals that crises are part of a longer

process and need to be understood in that larger context. This is not to suggest that scandals are

not important turning points in regulatory processes or that they should not arouse passions for

reform or punishment. Rather, we would urge policy makers to avoid the urge to view these

crises as the unique result of a series of unusual circumstances and human error (Perrow, 1984)

and urge them to take a more systemic view of the problem (Mezias, 1994).

We interpret our results to suggest some suggestions for the design of institutions that

will mediate regulatory decisions. For example, those who would like to see a more effective

counterbalance to the powerful alliance of corporate and professional interests should try to

strengthen the links between regulators and interest groups in all regulatory decisions, including

the majority that currently fly under the radar. Our evidence demonstrates that substantive

standards present a context where the power of firms is curbed. As Briloff (1986) argued,

because the FASB tends to issue relatively few substantive standards, it does little to establish

rules for financial reporting independent of the power nexus of firms and professionals.

36

Understanding the relationship between amendments and substantive standards is even more

disheartening from the perspective of empowering those who would oppose regulatory capture

by firms. Amendments, being non-substantive standards, tend to be dominated by firms and

professionals, with little input from regulators. Thus, the amendments that interpret the

ambiguities of substantive standards and clarify implementation issues that arise from them tend

to be resolved by processes dominated by regulatory capture. Not content with dominating the

process for most SFAS, firms and professionals lobbied hard to have the voting rules changed

after the close of our study period in 1987. The effect of this change has been to slow down the

pace of new rules at the FASB. Between its founding and the close of our sample, the fourteen

years from 1973 to 1987, the FASB issued 97 SFAS. By contrast, from 1988, the year after our

sample ends through 2005, the FASB issued only 57 SFAS in an eighteen-year period. Events in

the context of financial reporting regulation, particularly the financial scandals that marked the

turn of the century, can be interpreted to suggest that the FASB has done less recently to curb the

power of the alliance of firms and professionals.

As analysts of legal environments, particularly those interested in workplace rights have

noted, the two decades beginning about 1980 were an era in which state intervention was viewed

in a particularly dim light. The regulation of financial reporting standards was not an exception

to this trend. In 1989, the voting rules for the passage of new regulations were changed; from

that year on, a vote of five to two in favor of a new rule was required for it to pass it rather than

the four to three vote required during the period of our sample. This change was enacted amid

widespread criticism that the FASB had issued far too many new rules; the intent was clearly to

slow down the pace of new regulation. Thus, one clear difference between the fifteen years after

1987 and the fifteen years prior, which were the ones in our sample, was that fewer substantive

37

rules were passed. However, opponents of financial reporting regulation were not merely

content to slow down the FASB, they went further; the example of accounting for stock options

is illustrative. In June 1993, the FASB voted to begin the process of passing a new rule on the

valuation of stock options despite intense corporate opposition. Rather than allow the process to

continue, which according to our results would likely have meant defeat for the alternatives

advocated by firms, the corporate lobby went to Capitol Hill. Hearings were held; Senator

Joseph Lieberman introduced legislation to block the proposed rule. Although this legislation

did not pass, he subsequently introduced and Congress passed a non-binding resolution that

claimed a new rule on valuing stock options would have grave consequences for business in

general and entrepreneurs in particular. Congress also threatened to undermine the authority of

the FASB by requiring that the SEC explicitly ratify each decision that it made. Threatened with

these actions, the chairman of the SEC urged the FASB to back down, which it did. Rather than

issue a new regulation that required firms to expense some duly calculated value of stock options

on their financial statements, the FASB instead called only for disclosure of a value for options,

calculated at the discretion of firms and their accountants, in a footnote to the financial

statements (Levitt, 2002).

The best course of action for reformers and regulators who hope to avoid crises and their

attendant costs by reducing firm influence over financial reporting regulation is to use the

momentum for reform that results from financial crises and scandals to create mechanisms that

empower regulators to engage in ongoing public scrutiny of financial reporting practices. As

Schneiberg and Bartley (2001: 132) suggested, a primary goal of research on public policy

should be a better understanding of how public policy can “… reduce the costs of political

organization or provide certain actors with new political advantages.” Putting this

38

recommendation for future research in the context of our results suggests the need for policies

that enhance the ability of public to participate in the ongoing setting of financial reporting

standards. Absent a fundamental redesign of the process, the major substantive changes that

have been enacted in the wake of financial crises at the turn of the current century are likely to be

undone by amendments and other non-substantive changes produced as part of the ongoing

regulatory process.

The results of this empirical study also suggest several theoretical conclusions and

implications for future research. The first conclusion is that strong support for the utility of the

institutional politics model of ongoing regulation. Future research should be aimed at replicating

these findings and extending them to other contexts to develop a deeper understanding of how

regulatory capture, interest group theory, and institutional mediation interact in dynamic

processes of ongoing regulation. A second research implication follows from the use in this

study of a pooled measure of the opinions of organized actors. It may be that influence processes

respond to the identities of individual letter writers even though our measures do not. For

example, a letter from Anheuser-Busch may have a very different effect than a letter from a local

microbrewery. Further, there may leaders in formal or informal networks operating within the

organized actors that we have studied that may have different influence than other members of

the network. We advocate research with a different design to sort out how reputation and

network effects play a role in influencing regulatory outcomes.

A final research implication is suggested by the importance of the distinction between

substantive and non-substantive regulation. While we treated this distinction as exogenous in

framing our study, we also believe that one of the key advantages of an institutional framework

is that it focuses attention on the endogenous determination of sense making in regulatory

39

processes (Edelman, et al., 1999). From this perspective, understanding efforts the slow down

in financial reporting regulation observed after 1987 requires understanding the dynamics of the

logic of regulation (Bartley and Schneiberg, 2002). Our discussion of events since the close of

our study period, consistent with many other recent studies, revealed a shift in legal

environments away from more active regulation in the recent past. One avenue for

understanding this shift is to focus on how the costs and benefits of regulation are defined. In

particular, the issue of how important actors in the processes of institutional politics came to

accept that regulations were too burdensome is likely an important part of the story. This

suggests the need for longitudinal models and a better understanding of cycles of institutional

change (March and Olsen, 1989).

40

TABLE 1: ORGANIZED ACTORS

Organized Actor

Source of Power

Type of Isomorphism

Aims of Action

Professionals Certification: Control of Principles.

Normative: What is appropriate?

Control specific domain of knowledge

Firms Control of financial statements.

Mimetic: What is prevailing practice?

Regulatory capture.

Regulators Enforcement of legal requirements.

Coercive: What is required by law?

Protect the public interest.

41

TABLE 2: Alternatives in the Exposure Draft of SFAS#40: Financial Reporting and Changing Prices: Specialized

Assets, Timberlands, and Growing Timbers

ALTERNATIVE 1: EITHER HISTORICAL COST (CONSTANT DOLLAR) AMOUNTS OR CURRENT COST MEASURE SHOULD BE PERMITTED. ACCEPTED IN FINAL STATEMENT.

ALTERNATIVE 2: THE STATEMENT SHALL REQUIRE MEASUREMENTS ON A CURRENT COST BASIS. REJECTED IN FINAL STATEMENT.

ALTERNATIVE 3: THE STATEMENT SHALL REQUIRE INFORMATION ABOUT FAIR VALUES, DEFINED AS THE PRICES THAT WOULD BE ACCEPTED AS REASONABLE IN TRANSACTIONS BETWEEN A WILLING SELLER AND A WILLING BUYER. REJECTED IN FINAL STATEMENT.

ALTERNATIVE 4: THE STATEMENT SHALL EXEMPT ACTIVITIES THAT USETIMBERLANDS AND GROWING TIMBER FROM REQUIREMENTS TO PRESENT INFORMATION ON A CURRENT COST BASIS. REJECTED IN FINAL STATEMENT.

42

Table 3: Descriptive Statistics

Variable Mean Standard DeviationMinimum

Minimum

Professionals -0.1751 0.7323 -1 1Firms -0.197 0.6878 -1 1Regulators -0.06735 0.6766 -1 1Sprofessionals -0.0449 0.3838 -1 1Sfirms -0.0456 0.3302 -1 1SRegulators -0.0342 0.3668 -1 1Substantive 0.2517 0.4354 0 1Letters 110.9669 75.7845 14 233Months 70.0861 36.6177 0 129DueProcess 1.1258 1.462 0 4

43

TABLE 4: CORRELATION MATRIX1. Firms 2 3 4 5 6 7 8 9

2. Professionals 0.6873. Regulators 0.391 0.4784. Sfirms 0.45 0.444 0.2655. Sprofessionals 0.404 0.503 0.346 0.8956. Sregulators 0.22 0.323 0.538 0.501 0.6487. Substantive 0.013 -0.003 -0.059 -0.239 -0.202 -0.1628. Letters -0.131 -0.106 -0.089 -0.178 -0.127 -0.113 0.4249. Months -0.007 -0.028 0.07 0.213 0.151 0.141 -0.12 -0.17610. DueProcess -0.055 -0.076 -0.088 -0.175 -0.191 -0.12 0.62 0.275 0.112

Correlations with magnitude larger than 0.16 are significantly different from zero, p < 0.05

44

TABLE 5: Maximum Likelihood Estimates

Variable Name Control Variables only

Organized Actor Variables

Add Interactions

Intercept -0.3568 -0.6398 -0.6988

Professionals 1.3801** 1.7685**

Firms 0.6990* 1.4024**

Regulators 0.6852* 0.1559

SProfessionals 1.6430

SFirms -5.2406**

SRegulators 2.249*

Substantive 0.4421 0.0608 -0.4577

Letters -0.0012 0.0024 0.0026

Months 0.0016 0.0035 0.0105

DueProcess -0.1183 -0.0209 -0.0128

Model Chi-Sq. 0.9866 63.988*** 85.154***

* p < 0.05, ** p < 0.01, *** p < 0.001

45

Figure 1: Influence of Organized Actors

0.15

0.25

0.35

0.45

0.55

0.65

0.75

-1-0.9 -0.8-0.69-0.59-0.49-0.39-0.29-0.19-0.090.010.110.210.310.410.510.610.710.810.91

Opinions

Professionals Firms Regulators

46

Figure 2: Influence of Organized Actors over Substantive Standards

0

0.2

0.4

0.6

0.8

1

-1-0.89-0.78-0.66-0.55-0.44-0.33-0.22-0.11

00.110.220.330.440.550.660.770.880.99

OpinionsProfessionals Sfirms Sregulators

47

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