James C. Gaa

The Expectations Game: Regulation of Auditors by Government and the Profession

The actions of members of the auditing profession in the US are constrained by two types of regulation: government regulation, through the Securities and Exchange Commission and the Congress; and self-regulation, through the American Institute of Certified Public Accountants and state boards of accountancy. Controversies about the rights and (especially) the social responsibilities of the profession occur periodically. The most recent of these (the so-called “expectations controversy”) is analyzed as a single play in a repeated sequential game between representatives of the profession and of society, over the amount and mix of the two forms of regulation. The model provides a positive explanation of a number of aspects of this controversy. While the actual historical details and dynamics of these episodes of controversy are quite complicated, the analysis in this paper suggests that a small number of forces may be the primary drivers of the process, and are sufficient to explain at least the broad dynamics found in the history of this dispute.

A game-theoretic analysis of professional rights and responsibilities

Professions are granted autonomy by society, to regulate their own affairs. In return for the economic benefits autonomy grants to professions, society expects professions to act in a socially responsible manner. This paper presents a game-theoretic analysis of the relationship between society and professions, which shows that the relationship is unstable in the face of opportunities for professions to renege on the “social contract.” It also shows how periodic controversies regarding the degree to which professionals act in the “public interest” are expected to occur periodically, and how they are resolved.

Integrity, Auditor Independence, and the Protection of Investors

A basic principle underlying the public securities markets in many countries is that the interests of investors need to be protected. Independence from their clients (i.e., client management) is supposed to make it more likely that auditors will protect investors’ interests. This paper examines the question whether acting in accordance with professional rules governing accounting and auditing is sufficient to provide such assurance. In addition to a set of rules, it is argued that investor protection requires that auditors possess, or act with, integrity. An analysis of the principle of acting with integrity, as contained in the AICPA Code of Professional Conduct, shows that its formulation of the principle conflicts with the concept itself, and thus that the professions commitment to integrity is questionable. Five recent and prominent cases are examined, which show that the required integrity may be lacking. The implications of a lack of integrity are discussed at the end.

The demand for regulation of financial disclosures: The case of the insurance industry

Policyholders and other claimants in insurance companies are interested in “solidity,” i.e., the ability of insurers to meet their claims obligations in both the short run and the long run. Insurance regulators exist in order to represent the interests of consumers. Great emphasis is placed by the regulators of the market on the mandatory and uniform disclosure of relevant financial and operating aspects of insurers. This paper employs simple gametheoretic techniques to address two aspects of the general issue of the desirability of establishing a regulator to assess the solidity of insurers. First, why would uniform information about insurers be desirable? Given that uniformity is desirable, it could be achieved by voluntary agreement of insurers or via regulation. The second issue is how that uniformity is to be achieved; that is, what is the value of a regulator in achieving uniformity? Insurance provides an interesting instance of the general problem. A key determinant is the structure of costs and benefits of securing voluntary agreements across firms.

The Replacement of Scientific Theories: Reduction and Explication

An examination of earlier views yields an account of theoretic change on which changes in theory which do involve changes in meanings of terms are classified as a special (and by no means exhaustive) case of theoretic change which, latter, is construed as a more general phenomenon. Only the general problem is given detailed consideration here. The account given considers the problem of how replacement of intensional theories by extensional ones may be treated within the general framework provided. Among its results is the conclusion that rational changes in a scientific theory may be cogently construed as determined by warranted decisions that a new theory is more adequate (than the old one it replaces) with regard to purposes for which a theory is sought.

Insider Trading, Ethical Attitudes and Culture: An Experimental Market Analysis

Both the economic efficiency and ethical aspects of insider trading have had a great deal of attention for a number of years. This experimental study bridges the economic and ethics literature by addressing the issue of whether market participants respond only to economic factors, or whether non-economic (ethical) factors are also reflected in their behaviour. The experimental evidence indicates that subjects reacted in an economically rational fashion to the profit opportunities afforded by the possession of inside information and to the existence of a penalty. But they also tended to act in accordance with instructions not to use private information, and this behaviour appears to conflict with the widely held economic assumption that agents in a competitive market will exploit all legal opportunities to economic gain.

The Stability of Bargains behind the Veil of Ignorance

Although analyses about what representative individuals would choose behind the veil of ignorance have been regarded as n-person non-zero-sum cooperative games, none of the apparatus of game theory beyond 2-person non-zero-sum noncooperative games has actually been used. The “grand coalition” of all representative individuals emerges from behind the veil of ignorance to form a society unanimously. This paper investigates the consequences of extending the original position to allow three persons the possibility of forming binding coalitions behind the veil of ignorance. Just enough information and structure is added to the traditional analysis, to make bargaining feasible. The result is that whether or not representative individuals know the payoff structure for forming a society, a stable unanimous agreement may not emerge. The analysis shows yet another way in which original position arguments are sensitive to assumptions about information and criteria of rational decision behind the veil of ignorance.