Saturday, January 31, 2009

Behavorial Accounting? Executive Overconfidence and the Slippery Slope to Fraud by Catherine Schrand, Sarah Zechman

SSRN-Executive Overconfidence and the Slippery Slope to Fraud by Catherine Schrand, Sarah Zechman: Interesting paper.

First from the abstract:
"...executive overconfidence increases the likelihood that a firm commits financial reporting fraud. A manager that faces an earnings shortfall is more likely to manage earnings to overcome it if he believes the shortfall is temporary and, hence, the earnings management will be a one-off event that likely will go undetected....Overconfident managers with unrealistic beliefs about future performance are more likely to find themselves in this situation.....Our analysis that uses firm-level proxies for overconfidence suggests that there are two types of frauds: Those associated with moderate levels of overconfidence, perpetrated by executives who ex post fall down the slippery slope, and those perpetrated by executives with extreme overconfidence that commit fraud for opportunistic reasons ex ante. Analysis of individual executives supports the notion that there are two types of overconfident executives that engage in fraud. Those with opportunistic motives are more likely to....earn more total and have a higher percent of variable cash compensation, and are less likely to have accounting experience. Finally, we document that a matched sample of non-fraud firms do not have stronger governance mechanisms that prevent fraud. This result mitigates [lessens] the possibility that it is weak governance rather than executive overconfidence that is a significant determinant of fraud.

Many interesting things to consider here!
  • The logic that over confident managers are more likely to commit fraud makes perfect intuitive sense and while some might have some reservations with the attempt to determine what industries attract overconfident managers (for instance seemingly these industries have higher variances and thus at times are overvalued and fraud could be partially explained by this (see Jensen 2005,2008)), the notion definitely makes sense.
  • It was interesting (and not very surprising) to see that those who had more to gain (more variable pay) or more to lose (founding families) were more likely to commit fraud, but disappointing to see that common governance measures did not reduce the fraud risk. Not sure what to make of that.
Good stuff!

Schrand, Catherine M. and Zechman, Sarah L. C.,Executive Overconfidence and the Slippery Slope to Fraud(December 30, 2008). AAA 2009 Financial Accounting and Reporting Section (FARS) Paper; Chicago Booth School of Business Research Paper No. 08-25. Available at SSRN.


Anonymous said...

Interesting posts on bonuses, overconfidence, and risk taking. I remember watching a documentary saying that most spies suffered from overconfidence. They thought that the system owed them something AND that they were smarter than the people trying to catch them. These were people who underwent deep background checks and regular polygraphs - and yet still committed major crimes. I wonder how to effectively manage risk taking behavior - incentivizing appropriate levels while disincentivizing the levels that lead to fraud. Until Madoff came along, it seemed like the biggest frauds were the ex post committed by Nick Leeson or the SGS mess. But Bernie redefined the game.

Miguel Barbosa said...

Great find Professor. Keep up the good work. Your blog is a must read for everyone.

Miguel Barbosa