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.
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Thus, our first set of hypotheses predict a negative relation between overconfidence and both conditional and unconditional conservatism respectively.2 In addition, we examine whether these effects vary with the strength of external monitoring based on the argument in Kahneman and Lovallo [1993] that overconfidence or optimism is best alleviated by introducing an outside view. Thus, external monitoring could mitigate the predicted negative relation between overconfidence and conservatism. Our tests are based on a sample of 14,641 firm-years over 1993-2009 from S&P 1500 firms that have the available data needed to carry out our tests. Our primary measure of overconfidence is based on the timing of CEO option exercise following Malmendier and Tate [2005, 2008], Hirshleifer, Low, and Teoh [2010], and Campbell et al. [2011]. Intuitively, CEOs are 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 2

While we predict a negative relation between overconfidence and conservatism, we also note in section 2 that there are reasons why this relation could be positive.


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