Managerial Overconfidence and Audit Fees

Abstract

We investigate the association between managerial overconfidence and audit fees, as well as the effect of a strong audit committee on this relation. Overconfident managers tend to overestimate their ability and the future payouts of projects but underestimate the likelihood and impact of adverse events. Auditors may therefore charge a fee premium to compensate for the additional audit effort due to the increased audit risk. Conversely, overconfident managers may demand less audit services due to either hubris in their companies’ financial reporting or a desire to reduce auditor scrutiny over aggressive accounting. A strong audit committee can alleviate the audit risks associated with managerial overconfidence or prevent overconfident managers from reducing audit services thus mitigating the relation between audit fees and managerial overconfidence. We find robust evidence of a negative relation between managerial overconfidence and audit fees for companies lacking a strong audit committee. However, in the presence of a strong audit committee the negative relation is mitigated. In additional analysis, we also find that companies with overconfident managers have a lower likelihood of using a city-industry specialist auditor.