CEO Overconfidence, CEO Compensation, and Earnings Manipulation

In the wake of recent financial crises and corporate failures, chief executive officers (CEOs) are often blamed for their overconfidence leading to earnings manipulation and excessive risks. Why is it then that these overconfident CEOs obtain job offers in the first place? This paper presents a novel explanation for the co-existence of CEO overconfidence and earnings manipulation observed in practice. In an agency model with an external capital market, I identify two potential reasons for a board to hire an overconfident CEO and design a contract that accommodates earnings manipulation: an internal motive, directed at maximizing the ex ante firm value, and an external motive, directed at enhancing the interim market valuation of the firm. The flip side, however, is that the firm can be more likely to become insolvent and bear greater risks of bankruptcy. Some policy implications and limitations are also discussed.