Overconfident Managers and Internal Controls

We examine the association between managerial overconfidence and internal controls. We hypothesize and find that firms with overconfident managers are more likely to maintain ineffective internal controls. Moreover, we find no evidence that these managers are more able to mitigate the known negative consequences of ineffective internal controls (inefficient investments, lower future operating efficiency, and lower financial reporting quality). We corroborate our main findings by examining changes around CEO turnovers and differential effects of CEO versus CFO overconfidence. We also document that firms with overconfident managers but strong corporate governance are more likely to maintain effective internal controls, and that better managers — as opposed to overconfident managers — are more able to operate effectively despite ineffective controls. Our findings suggest that the threshold for “cost-effective” internal controls will differ across firms based on the characteristics of their management team. This finding should be of interest to researchers, regulators, and market participants