Overconfident Managers and Internal Controls

Abstract

Overconfident managers tend to pursue innovative growth opportunities and be promoted to CEO, but at the same time, tend to underestimate risks and overestimate their ability to control outcomes. On average, overconfident managers are associated with inefficient investment and lower future profitability. We investigate whether internal controls can help channel the positive aspects of overconfidence, leading to more efficient investment and higher profitability. Alternatively, because a key advantage of overconfident managers is their innovation and risk tolerance, the establishment of internal controls might consume resources better deployed elsewhere and act as a constraint on overconfident managers’ risk-taking, leading to poorer outcomes. We provide evidence that internal controls mitigate the negative effects of overconfident managers. To assuage concerns that some firms are more likely to employ overconfident managers and have ineffective internal controls, we partition overconfidence by CEOs and CFOs and demonstrate that internal controls aid firms with overconfident CEOs with investment efficiency and overconfident CFOs with financial reporting quality. We conclude that firms with overconfident managers experience incremental benefits to internal controls.

Keywords: Overconfidence; internal control; investment efficiency; future profitability

JEL Classification: M41