The real economic effects of financial reporting can be understood by looking into the joint effect of managerial overconfidence and accounting conservatism, specifically regarding the quality of corporate decisions. For instance, under what conditions does accounting conservatism improve corporate performance? Within the context of a firm, a chief executive officer (CEO)—the highest-ranking person in a company or institution—is often in charge of making important managerial decisions. As such the confidence level of a CEO can have a significant impact on a firm’s success.
Previous studies have found that conservatism can serve as a disciplining device to constrain managerial opportunism. In support of this, another study found that conservatism also improves the quality of capital investment decisions. Extending this area of research, a study by Hsu, Novoselov, and Wang hypothesized that conservatism is especially useful when a company is run by an overconfident CEO. Their argument suggests that “accounting conservatism accelerates the recognition of the bad news and its dissemination to gatekeepers, making it more likely that the CEO will acknowledge the problem earlier and start searching for solutions”. As a result, the researchers suggest that CEO overconfidence and accounting conservatism are positive attributes towards a firm’s ability to perform.
A CEO’s confidence to explore unknown possibilities is critical for successful exploration, but the biased perception of an overconfident CEO may lead to situations where crucial information is ignored, until it becomes too late to resolve the problem. This is where accounting conservatism comes into play, as it helps mitigate the shortcomings of overconfidence. When such problems are brought to the attention of other stakeholders (e.g., executives and board members), they can adopt an unbiased view and immediately respond to the bad news. As a result, it is more likely that the CEO will acknowledge the issue and take corrective actions. Hence, the researches argue that accounting conservatism and CEO overconfidence can jointly improve a firm’s performance.
To prove these theoretical predictions, the researchers’ empirical findings used a sample of 19,386 CEO years over 1992–2011, in which CEO overconfidence and accounting conservatism was shown to produce superior financial performance, as measured by cash flows. Moreover, their findings also showed that firms operating under higher uncertainty and less stringent financial constraints were able to benefit even more from the joint positive effect of CEO overconfidence and accounting conservatism.
To reinforce their main findings, the researchers investigated this joint effect on firm welfare under various settings. “In these additional settings, we find that market reactions surrounding acquisitions are more positive, cash flow downside risk is lower, and analyst following is higher for firms with overconfident CEOs and more conservative accounting”. They also found that firms that operate in innovative industries benefit greater from this joint effect as “the marginal benefit of innovation is greater and, thus, firms stand to gain more from taking on bold investment projects and ensuring timely feedback over the course of their realization”.
Their findings are highly significant and contribute to the real economic effects of financial reporting, particularly regarding the quality of corporate decisions.