Managerial Overconfidence and Accounting Conservatism

Abstract

Overconfident managers overestimate future returns from their firms’ investments. Thus, we predict that overconfident managers will tend to 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 respectively, 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 complement the findings by Schrand and Zechman [2011] that overconfidence affects financial reporting behavior.

Accounting Conservatism: A Literature Review

“…Because losses are recognised in a timely manner while gains are recognised gradually in the future, the distribution of earnings is more likely to be negatively skewed. Consequently, the difference between earnings skewness and cash flows skewness can be used to measure conservatism (Givoly and Hayn 2000;Beatty et al 2008;Ahmed and Duellman 2013;Aier et al 2014). Further, the skewness of earnings (cash flow) is calculated by E[(x − μ) 3 /σ 3 ] , where μ and σ are the mean and standard deviation of earnings (cash flow) over the last five years or five-year window centred on the observation year 3 (hereafter the Skewness measure).…”

“…Timely loss recognition and gradual gains recognition result in negative net accruals. Therefore, the level and rate of cumulative negative net accruals can be used to estimate conservatism (Givoly and Hayn 2000;Beatty et al 2008;Ahmed and Duellman 2013;Aier et al 2014). Accruals measures at the firm-year level are equal to averaged (non-operating) accruals scaled by total assets over the previous five years (with a minimum of two years) or centred on the observation year, multiplied by negative portion of the total unexpected return R that invariably is contemporaneously captured in accounting income X y portion of the total unexpected return R that is not contemporaneously captured in X unless required by accounting conservatism g portion of the total unexpected return R that never is contemporaneously captured in X, but always is incorporated with a lag w an indicator variable that takes the value of 1 when conservative accounting rules and practice lead to the recognition of y in the current period ξ 'noise' in accounting earnings that reverses in the next period † Some scholars, such as Ahmed and Duellman (2013) and Erkens et al (2014), use different definitions of Lev.…”

Overinvestment of Free Cash Flow and Manager’s Overconfidence

“…In this regard, Kramer & Liao (2012) and Ahmed &Duellman (2013) state that the overconfident manager overestimates the return on investment and therefore intends to delay recognition of losses. This leads this type of manager to consider negative NPV projects as positive NPV projects, which increases the risk of over-investment.…”

Persistence of earnings and prediction of future cash flows: the role of timely recognition of bad news

“…The former takes the research and development expenses as its business expenses, while the latter regard it as assets (Ahmed and Duellman 2013). As a matter of fact, the latter took into account the annual depreciation expenses in its calculation of earnings, but the former incorporates the cost of research and development expenses in its calculations; therefore, it is bound to report lower earnings, and concurrently, its conservatism will decrease the persistence of earnings, and vice versa (Ahmed and Duellman 2013). Jarva (2010) considers the reduction of earnings that is due to accruals.…”