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D espite the many undesirable outcomes of corporate misconduct, scholars have an inadequate understanding of corporate misconduct's causes and mechanisms. We extend the behavioral theory of the firm, which traditionally assumes away the possibility of firm impropriety, to develop hypotheses predicting that top management incentive compensation and poor organizational performance relative to aspirations increase the likelihood of financial misrepresentation. Using a sample of financial restatements prompted by accounting irregularities and identified by the U.S. Government Accountability Office, we find empirical support for both incentive and relative performance influences on financial statement misrepresentation.

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Scholars who study organizational decline have argued that declining organizations reduce or eliminate their riskier activities such as innovation. Further, they cite reduced risk-taking as a primary contributor to further decline. Scholars with an interest in risk per se come to the opposite conclusion: low performing firms often take more risks than other firms and such risks reduce subsequent performance. This study attempts to resolve these conflicting views by examining the risk of firms in decline. Our model, based on Cyert & March's (Cyert, R. M., J. G. March. 1963. A behavioral theory of the firm. Prentice-Hall, Englewood Cliffs, NJ.) behavioral theory of the firm, includes six basic variables: (1) performance, (2) slack, (3) aspirations, (4) expectations, (5) risk (income stream uncertainty), and (6) organization size as a measure of decline. The estimated model includes prior levels of risk and performance in the risk and performance equations respectively as controls. This study uses data on 344 low-performing firms in 19 manufacturing industries to estimate a time-series model that addresses both decline's influence on risk and risk's influence on performance while controlling for firm slack resources and industry factors. The results suggest (1) organizational decline and potential slack (debt/equity) positively influence risk whereas recoverable slack (SGA/Sales), and the difference between performance aspirations and expectations negatively influence risk; and (2) recoverable slack and risk negatively influence performance. We also examined the influences of performance and slack on organizational decline and found that performance associates negatively whereas recoverable and potential slack associate positively with decline. These results challenge the argument that declining firms reduce risk and so hurt their subsequent performance. Instead, the results suggest a cyclical process with positive feedback in which decline and the loss of certain slack resources increases risk which in turn reduces performance and results in further organizational shrinkage. Thus firms facing decline fall into a trap of taking unprofitable risks that ultimately exacerbates the decline. In addition, results relating slack to risk and performance exhibited inconsistent relations across the measures raising questions about the role slack resources play in risk and decline. Previous discussions of this slack implicitly assume all forms of slack have similar influences but our results demonstrate different forms of slack have very different effects.