"The Butterfly Effect" Of Executive Overconfidence With Financial Fraud

As a main medium for investors and other financial information users to understand the enterprise’s financial situation and business performance, financial statements have played an irreplaceable role in connecting financial information users and the enterprises. However, in recent years, financial fraud cases such as Enron, Kelon, Guangxia etc. have broken the credibility of the financial statements and brought them wide suspicion. Due to the concealment of financial fraud and the limitation of audit and regulation resources, despite the carefully audit of CPA and the monitor of the regulatory authorities, some financial fraud behavior still can not be timely identified, and the hazards of financial fraud on the users are still exist. False financial information will not only distorts the listed company’s financial results, thereby infringes the legitimate rights and interests of the financial information users who make financial decisions and other decisions based on the financial statements and bring them economic losses, but also brings a very negative impact on the normal development of our economic society. Therefore, how to have a better identification and prevention on financial fraud behavior of listed companies and their executives has long been a research topic of scholars.Previous scholars mainly study the behavior of listed companies and their executives from the perspective of rational person, and believe that executives are rational enough to make the choice of financial fraud based on the fully consideration of all kinds of factors. According to this, they put forward many famous theories, such as the fraud triangle theory, and point out that many factors including unreasonable salary structure may lead to executives’ financial fraud behavior, and they also put forward that people can detect the possibility of financial fraud by abnormal financial indicators. These theories and methods greatly enriched the study of financial fraud, and provide recommendations of how to have a better prevention and detection on financial fraud. However, in some cases, the rational man assumption can not give a perfect explanation to the behavior of a variety of financial behavior on capital market.In terms of financial fraud,"Motivation" is one of the three constituent elements of financial fraud according to the fraud triangle theory. And the rational man hypothesis supposes that all decisions made by people are aimed at maximize their own economic interests. However, a detailed study on our country’s listed companies shows that, the listed companies, in which the executives’initial motivation of financial fraud is personal gaining, account for only a quarter of all listed companies, while the other three-quarters listed companies’executives do not get any personal benefits from their corrupt conduct. This phenomenon is difficult to get a reasonable explanation from a purely financial accounting theory and the rational man hypothesis.This paper is just based on the study on this interesting economic phenomenon. In order to reveal the reason of this phenomenon, this article put away the rational man assumption, and search for the reasonable explanations of the phenomenon described above from the perspective of executives’psychology characteristics as well as from the perspective of human nature. By abundant theoretical analysis, this paper points out the reason of the existence of this phenomenon comes from executive overconfidence. In the next two chapters, the paper verifies the relationship between executive overconfidence and fraud from both positive aspect and negative aspect by using methods such as comparative analysis and regression analysis. And finally, the paper put forwards recommendations based on its findings and indicates the direction of future research.The research ideas of this paper are as followings:In the theoretical inference section, starts from the perspective of irrational executives elaborated by the behavioral finance theory and combines the domestic and international research outcomes on executive overconfidence and financial fraud, this paper blends the executive overconfidence theory and the butterfly effect theory into auditing theory, and put forwards that the reason of the phenomenon described above is that those executives’ final financial fraud behavior simply comes from their initial overconfidence tendency. This tendency, which makes these executives overestimate the company’s development prospects and underestimate the risk of fraud, will produce a butterfly effect and cause their initially purpose of overestimate the company’s performance simply to meet the psychological satisfactory of investors eventually evolve into financial fraud when the company’s profits meet a continuously downward trend.In the theoretical inference section, in order to verify the description above, this paper divides45listed companies which subjected to the punishment of the regulatory authorities for their inflated annual report profits between January1,2002to December31,2011into the overconfidence companies in which executives do not expect personal gaining from financial fraud and the fraud companies in which the executives’mainly purpose of cheating is to obtain private interests. The paper also picks out other34non-fraud companies as a comparison sample. Meanwhile, this article selects110punished executives and a comparison sample of executives in the three types of listed companies for further detailed analysis. The analysis of the motivations of financial fraud as well as the analysis of variation tendency of earnings per share and financial restatements confirm the existence of the butterfly effect; and the analysis of internal control mechanism as well as the analysis of the behavior features and personal characteristics of executives in these three types of listed companies verify the existence of executive overconfidence. The logit regression analysis on the sample of all listed companies in Shanghai and Shenzhen stock markets from2002to2009gives a supplemental examination on the correlation between executive overconfidence and financial fraud.Finally, the paper concludes that executives’ overconfidence tendency can lead to the final financial fraud as the phony profits will continuously expanding when the company meets a downtrend of performance and put out that the listed companies should make a reasonable decision based on their own peculiarities after fully weigh the losses caused by executives overconfidence itself, the loss of fraud companies when their financial fraud behavior be found, the costs of establish mechanisms to detect and prevent the executives overconfidence as well as the loss of missing the positive impact brought by executive overconfidence.The study of this paper expands the academic understanding of executive overconfidence, and enriches the study of financial fraud. It helps listed companies and regulatory agencies to find financial fraud easier, and provides recommendations i.e. take the best measures after have an adequate consideration of various factors to the governance layer of listed companies.