Managerial Overconfidence and Accounting Conservatism
The Harvard Law School Forum on Corporate Governance and Financial Regulation 2012-10-24
In our paper, Managerial Overconfidence and Accounting Conservatism, forthcoming at the Journal of Accounting Research, we provide evidence on the relation between CEO overconfidence, an important managerial trait, and the aggressiveness of financial reporting. Building on a growing literature in finance which shows that overconfidence can distort investment, financing, and dividend policies, we demonstrate that firms with overconfident CEOs make more aggressive financial reporting choices than other firms.
Overconfident managers are defined as managers who overestimate future returns from their firms’ investments and systematically overestimate the probability of good performance. Our first hypothesis predicts that overconfident managers will tend to overvalue net assets as well as delay recognition of losses. In other words, we expect overconfident managers to make more aggressive (or less conservative) financial reporting decisions than other managers. Furthermore, we investigate whether this relation is affected by governance mechanisms. To the extent that governance mechanisms, such as boards of directors or institutional shareholders, view conservative reporting as desirable, external monitoring could constrain the negative effect of managerial overconfidence on conservative reporting. Thus, our second hypothesis predicts that the negative relation between overconfidence and accounting conservatism will be constrained for firms with strong external monitoring.