CEO Overconfidence and the effectiveness of internal control over financial reporting

Abstract

In this study, I investigate the association between overconfidence, a cognitive bias of chief executive officers (CEOs), and the existence of internal control weaknesses (ICWs). As suggested in the prior finance literature on the negative impact of CEO overconfidence on corporate policy, overconfident CEOs could disregard the importance of internal control over financial reporting (ICFR), which could negatively affect the firm’s investment for infrastructure to implement effective financial reporting information system (FRIS) and result in less reliable financial information. Empirical test results show that CEO overconfidence is positively associated with the existence of ICWs, particularly with ICWs related to insufficient accounting personnel or ineffective FRIS. Those ICWs subsequently lead to lower earnings quality, higher absolute value of discretionary accruals and lower quality of accruals. Furthermore, potentially negative consequences of CEO overconfidence to the effectiveness of ICFR could downgrade investors’ confidence in the credibility of financial statements.