Schrand Zechman

Schrand Zechman - Executive Overconfidence and the Slippery...

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Electronic copy available at: http://ssrn.com/abstract=1265631 *Correspondence to Catherine Schrand, e-mail schrand@wharton.upenn.edu , Locust Walk, Suite 1300, Philadelphia, PA 19104. The authors thank Gavin Cassar for helpful discussions. We thank Ray Ball, John Jiang, Ed Maydew, and Greg Miller and audiences at Chicago, Illinois, Iowa, Michigan, Michigan State, MIT, Penn State, the Stanford Summer Camp, the FARS midyear meeting, and Minnesota Mini-Conference on Empirical Accounting for helpful comments. Sarah Zechman thanks the Deloitte Foundation and the University of Chicago Booth School of Business for providing financial support. Executive Overconfidence and the Slippery Slope to Financial Misreporting Catherine M. Schrand * University of Pennsylvania, The Wharton School Sarah L. C. Zechman University of Chicago Booth School of Business May 2011 Abstract A detailed analysis of firms subject to SEC Accounting and Auditing Enforcement Releases (AAERs) in the 1990s and 2000s suggests that approximately one-quarter are the result of an act that is consistent with legal standards of intent. In the remaining three quarters, the initial misstatement – generally an overstatement – reflects an optimistic bias that is not necessarily intentional. Because of the bias, in subsequent periods these firms are more likely to be in a position in which they are compelled to manage earnings in growing amounts. Overconfidence is a trait that is associated with optimistic bias. We find results consistent with overconfident executives, who are more likely to exhibit an optimistic bias, being more likely to initially overstate earnings which starts them on the path to growing intentional misstatements. Keywords : executive overconfidence; fraud; earnings management; corporate governance Data Availability : data are available from sources identified in the paper. JEL Classifications : G34; M14; M41
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Electronic copy available at: http://ssrn.com/abstract=1265631 1 1. Introduction We provide a detailed analysis of a small sample of firms subject to SEC Accounting and Auditing Enforcement Releases (AAERs) in the 1990s and 2000s with the purpose of improving our understanding of why firms misstate earnings. All of the AAERs allege intentional misstatements, not errors; however, our analysis suggests two distinct paths to making intentional misstatements. In approximately one-quarter of the cases, the SEC alleges that the primary motive for the misstatement is personal gain and requires the executives to disgorge funds. These aspects of the AAERs are consistent with evidence necessary to support a claim of fraud and thus a violation of SEC Rule 10b-5. In 10b-5 actions, the SEC and other plaintiffs must establish a “strong inference” of scienter , which refers to a state of mind representing intent to deceive, manipulate or defraud. A motive of personal gain and a requirement to disgorge funds are consistent with these pleading standards.
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Schrand Zechman - Executive Overconfidence and the Slippery...

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