Managerial Overconfidence and Accounting Conservatism

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Managerial Overconfidence and Accounting Conservatism*
Anwer S. Ahmed Ernst & Young Professor of Accounting Texas A & M University Scott Duellman Assistant Professor of Accounting St. Louis University March 2012

Abstract Overconfident managers overestimate predict that overconfident managers will tend to accelerate good news recognition, delay loss recognition, and generally use less conservative accounting. Furthermore, we test whether external monitoring helps to mitigate this effect. Using measures of both conditional and unconditional conservatism, we find robust evidence of a negative relation between CEO overconfidence and accounting conservatism. We further find that external monitoring does not appear to mitigate this effect. Our findings add to the growing literature on overconfidence and complements findings in Schrand and Zechman [2011] that overconfidence affects financial reporting behavior.

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 We gratefully acknowledge comments received from Philip Berger, Carol Ann Frost, Christo Karuna, Mary Lea McAnally, Mike Neel, Kaye Newberry, Ananth Seetharaman, Yan Sun, Senyo Tse, Ross Watts, an anonymous reviewer, and workshop participants at the University of Houston and the University of North Texas.  

M anagerial O verconfidence and A ccounting Conservatism

1. Introduction

investment projects (Heaton [2002], Malmendier and Tate [2005]).1 Previous research in finance documents that overconfidence affects corporate investment, financing, and dividend policies (e.g., Malmendier and Tate [2008], Cordeiro [2009], Deshmukh, Goel, and Howe [2010], Hirshleifer, Low, and Teoh [2010], Malmendier, Tate, and Yan [2011]). Recent work in accounting examines the impact of overconfidence on the likelihood of an AAER (Schrand and Zechman [2011]) and the likelihood of issuing a management forecast (Hribar and Yang [2011], Libby and Rennekamp [2012]). We extend this line of research by investigating the effects of managerial overconfidence on accounting conservatism. We find consistent and robust evidence of a significant negative effect of CEO overconfidence on both conditional and unconditional accounting conservatism. Investigating the effects of overconfidence on corporate policies, including accounting policies, is important because overconfidence can induce decisions that destroy firm value. For example, Roll [1986] argues that managerial hubris (or overconfidence) explains why firms engage in value-destroying mergers or acquisitions. Similarly, distortions in other investment, financing, or accounting policies can be costly (Malmendier and Tate [2005, 2008], Ben-David, Graham, and Harvey [2010]). More specifically, conservatism is viewed as playing an important role in debt contracting as well as in governance (e.g., Ahmed et al. [2002], Watts [2003], Ball and Shivakumar [2005], Ahmed and Duellman [2007], LaFond and Roychowdhury [2008],                                                                                                                       1

systematically overestimate the probability of good firm performance and underestimate the probability of bad firm performance. Following most of the literature in finance and accounting, we use the term overconfidence and consider it equivalent to optimism.

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Garcia Lara, Garcia Osama, and Penalva [2009]). To the extent that overconfidence reduces conservatism, it can adversely affect the efficacy of conservatism in debt contracting as well as in governance. We hypothesize that if overconfident managers overestimate future returns from their firm delay recognition of losses and use less conditionally

conservative accounting. For example, poorly performing negative NPV projects may be erroneously perceived as positive NPV projects by overconfident managers leading to delayed loss recognition. Furthermore,...
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