Managerial Overconfidence and Accounting Conservatism

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday October 24, 2012 at 8:35 am
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Editor’s Note: The following post comes to us from Anwer S. Ahmed, Ernst & Young Professor of Accounting at Texas A&M University, and Scott Duellman, Assistant Professor of Accounting at Saint Louis University.

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.

Our tests are based on a sample of 14,641 firm-years over 1993-2009 from S&P 1500 firms. Our primary measure of overconfidence is based on the timing of CEO options. CEOs are generally under-diversified and should exercise their options and sell shares obtained from exercising options to minimize their exposure to idiosyncratic risk. However, an overconfident CEO believes that firm value will continue to increase and thus chooses to delay exercise and hold options that are deep in-the-money. Our second measure of overconfidence is based on net purchases of the firm’s shares by the CEO. As an overconfident CEO fails to diversify his/her idiosyncratic risk, overconfident CEOs will tend to buy more of their firms’ stock relative to other CEOs. In addition to these measures, we use two other measures based on overinvestment which is a potential consequence of overconfidence: (i) capital expenditures above the industry median, and (ii) excess asset growth. Intuitively, firms with overconfident managers will tend to overinvest in assets resulting in above-average capital expenditures and/or above-average growth in assets (relative to sales growth). We measure accounting conservatism using four distinct measures that are popular in the accounting literature.

Consistent with our first hypothesis, all four of our conservatism measures are negatively related to each of the four overconfidence measures after controlling for firm-specific determinants of conservatism documented in prior research and firm fixed effects. This result survives a battery of robustness tests including the use of industry-differenced dependent and independent variables, first differences, and longer horizon overconfidence measures. An alternative explanation for the negative relation between managerial overconfidence and conservatism is that overconfident managers self-select into firms with less conservative accounting. To rule out this alternative explanation, we examine the relation between changes in firm-specific measures of conservatism and changes in overconfidence following a change in CEO. If our findings are driven by self-selection, CEOs would self-select into firms with their preferred level of conservatism and there should be no change in conservatism after the new CEO takes over. However, using this sample of CEO changes we continue to find evidence of a negative relation between changes in conservatism and changes in overconfidence leading us to conclude that the evidence strongly supports the prediction that overconfidence and conservatism are negatively related.

In our second hypothesis, we test whether strong external monitoring mitigates the negative relation between accounting conservatism and managerial overconfidence. We divide our sample into strong and weak external monitoring groups by examining the characteristics of the board of directors (percentage of outside directors, percentage of outside director ownership, and whether the CEO is also chairman of the board) and the amount of monitoring by institutional shareholders (proxied by the percentage of shares held by institutional owners). However, we do not find that the relation between conservatism and overconfidence weakens for firms with stronger external monitoring. A potential explanation for this result may be that external monitors value certain attributes of overconfident managers and, in some situations, choose overconfident managers to avoid potential costs of conservative accounting.

To summarize, we find that firms with overconfident CEOs tend to use less conservative (or more aggressive reporting) than other firms. Furthermore, this relation is not mitigated by strong governance. Our results are important to users of financial reports and suggest that sophisticated users look at CEO overconfidence in evaluating financial performance and financial strength based on financial reports.

The full paper is available for download here.

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