Incentives to Cheat: The Influence of Executive Compensation and Firm Performance on Financial Misrepresentation

Abstract

Despite 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.

Keywords: corporate misconduct, behavioral theory, executive compensation, relative performance

JEL Classification: D83, G30, M52