Tone at the Top: How management can prevent fraud by example, part one

Preventing fraud is good business. Inspiring employees to follow ethical standards starts with the tone at the top in the executive suite. Learn the steps to prevent fraud in your workplace. 

In January of 2001, Walt Pavlo received a 41-month federal prison sentence for money laundering, wire fraud, and obstruction of justice. Pavlo claimed that he was pressured by his bosses to commit financial statement fraud at MCI WorldCom. As a senior manager in billing collections, he dealt with customer payments, credits, and reconciliations of accounts. Upper management described revenue projections and, according to Pavlo, pressured employees to meet or exceed these projections. As Pavlo watched his bosses manipulate the organization's financial records, he and his colleagues soon began to do the same. Pavlo and his supervisors then began meeting to devise ideas on cooking the organization's books. His supervisors taught him how to conceal uncollectible debt, which boosted the company's assets and profits. Pavlo's employees then followed his fraudulent example. Auditors eventually found Pavlo's unusual journal entries, confronted him, and he confessed.

Similar to others who commit white-collar crime, Pavlo at first didn't believe he was doing anything wrong. He felt that he was just doing his job and making his employers happy by altering the company's financial data. He convinced himself that the problem ultimately would remedy itself - a highly unlikely scenario in which he believed that the company's revenues would grow enough to cover his transgressions.

Even highly educated and well-experienced employees can become white-collar criminals if their bosses pressure them enough. Pavlo held an industrial engineering degree and an MBA and had worked for five years at WorldCom but that didn't stop him from succumbing to the wishes of his supervisors and then corrupting his employees.

After his conviction, Pavlo left behind his wife and two young sons to serve his prison sentence.

What can employers do to prevent the creation of wayward employees? Setting a good tone at the top is a start.

'TONE AT THE TOP' DEFINED
An organization's leadership creates the tone at the top - an ethical (or unethical) atmosphere in the workplace. Management's tone has a trickle-down effect on employees. If top managers uphold ethics and integrity so will employees. But if upper management appears unconcerned with ethics and focuses solely on the bottom line, employees will be more prone to commit fraud and feel that ethical conduct isn't a priority. In short, employees will follow the examples of their bosses.

The National Commission on Fraudulent Reporting (the Treadway Commission) released a groundbreaking study in 1987 that reported the causal factors that lead to fraudulent behavior and financial statement fraud. According to the commission, the tone at the top plays a crucial and influential role in creating a ripe environment for fraudulent financial
reporting.

Corporate greed at the executive level has destroyed hundreds of companies, drained stockholders of their investments, and left innocent employees without work. Ken Lay, Jeffrey Skilling, and Andrew Fastow from Enron; Bernie Ebbers from MCI/WorldCom; and Dennis Kozlowski at Tyco have become household names, and are synonymous with what's wrong with our corporate system. Furthermore, these individuals represent only a small percentage of the executives who have abused their posts of power to commit corporate fraud. According to the SEC, more than 100 public company CEOs have been sued over the last five years for committing white-collar crimes. These CEO criminals were sending a clear (though perhaps unintentional) message to their employees that committing fraud is acceptable as long as it makes the company seem profitable. Obviously, they weren't setting an ethical tone at the top for their employees.

To set the right tone, those in top management positions should follow four important steps according to Dr. Steve Salbu, dean and Stephen P. Zelnak, Jr. Chair, College of Management, Georgia Institute of Technology, communicate to employees what is expected of them, lead by example, provide a safe mechanism for reporting violations, and reward integrity.

MAJOR FRAUD FACTORS
Three major factors common in many large organizational frauds contributed to Walt Pavlo's downfall:

• Meeting analysts' expectations - Upper management and employees who feel pressure to perform to the expectations of analysts can lead to occupational fraud.
• Compensation and incentives - Pavlo was eligible for thousands of dollars in stock options each year, beyond his salary, if he was able to meet his financial targets.
• Pressure to reach goals - Obviously, the greater the pressure and fear employees feel to meet revenue goals, the more likely they are to turn to fraud to meet those goals. With the help of Pavlo's supervisors, he delayed write-offs and dressed-up the revenue to make it appear it was collectible.

COMMON ETHICAL VIOLATIONS
According to the 2005 National Business Ethics Study (NBES), from the Ethics Resource Center (www.ethics.org), the falsification and misrepresentation of financial records constituted 5 percent of the ethical violations reported in its survey. Following are the other common types of ethical violations observed by employees (as well as their corresponding percentages) in the workplace.

• Abusive or intimidating behavior of superiors toward employees (21 percent)
• Lying to employees, customers, vendors, or the public (19 percent)
• A situation that places employee interests over organizational interests (18 percent)
• Violations of safety regulations (16 percent)
• Misreporting actual time or hours worked (16 percent)
• E-mail and Internet abuse (13 percent)
• Discrimination on the basis of race, color, gender, age, or similar categories (12 percent)
• Stealing, theft, or related fraud (11 percent)
• Sexual harassment (9 percent)
• Provision of goods or services that fail to meet specifications (8 percent)
• Misuse of confidential information (7 percent)
• Price fixing (3 percent)
• Giving or accepting bribes, kickbacks, or inappropriate gifts (3 percent)
   

The NBES points out that every organization needs to be able to answer this question: How much misconduct is considered acceptable/inevitable within the organization? This question will help prepare upper management to focus on the ways it can deal with employee behavior problems.

WHY EMPLOYEES DON'T REPORT UNETHICAL CONDUCT
According to the NBES, only 55 percent of employees in 2005 said they reported misconduct that they observed in the workplace, a 10 percent decrease from the previous survey in 2003.

In the 2003 NBES survey, employees under age 30 with little tenure with an organization (less than three years) were the least likely of any group to report ethical misconduct because of their fear of retaliation from management and coworkers. They also felt that managers would consider them "trouble makers" if they reported unethical conduct. Middle managers and senior managers were most likely to report misconduct. However, in 2005, there was no significant statistical relationship between age/tenure and reporting. The top reasons for not reporting unethical conduct, according to the 45 percent of employees who didn't report misconduct, were the following.

No corrective action - Employees who were cynical of their organizations felt that nothing would be done if they came forward and reported misconduct. In 2005, 59 percent of those who didn't report misconduct felt as though no corrective action would be taken if they had reported unethical conduct. However, the NBES states that these employees might have had unrealistic expectations for how organizations should handle misconduct reports. Privacy restrictions might prevent the companies from telling whistle-blowers how the report was handled and what punishments were assessed to the suspicious perpetrator. The organization should stress the privacy factor to convince these employees that their reporting will be handled appropriately even if the whistle-blower might not find out about it.

No confidentiality of reports - Those who see but don't report misconduct, fear that if they were to come forward with a report, their identities would be revealed.

Retaliation by superiors - Not surprisingly, these groups of employees also felt that if their identities were exposed, they would have to suffer retaliation from their superiors.

Retaliation by coworkers - Similar to retaliation by superiors, employees who withheld reporting unethical behavior in the workplace feared that their coworkers would find out who blew the whistle and retaliate against them.

Unsure whom to contact - A small number of the employees who didn't report misconduct (18 percent in 2005) said they were unclear whom to contact about suspicions of unethical conduct.

Employees who witnessed their companies actively following their codes of ethics were the most likely to report misconduct in the workplace, according to the 2005 NBES. They were also more likely to be satisfied with their organization's response to reported misconduct. Those who work for organizations that implement formal ethics programs were considerably more prone to reporting the misconduct that they observed. Those who don't report misconduct might have had a poor experience trying to do so. Executives must reach out to those disenfranchised employees and reiterate that the identity of all whistle-blowers will remain confidential.

DETERMINANTS OF ETHICAL BEHAVIOR
Certain factors will determine the likelihood of ethical behavior within an organization. Pavlo took cues to commit fraud from his bosses and his peers because he was working in an environment that was inundated with fraudulent behavior. Following are some of the determinants of ethical behavior in an organization.

Behavior of superiors and peers - According to the 2005 NBES, employees who feel that top management acts ethically in four important ways (talks about importance of ethics, informs employees, keeps promises, and models ethical behavior) are much less likely to commit fraud versus those who feel that top management only talks about ethics without exhibiting any action to support their words. Similarly, the survey also showed that the way in which employees perceive the behavior of their peers can affect their own ethical conduct. Those who observe their peers acting ethically will also be more likely to act ethically; those who observe their peers engaging in misconduct in the workplace will be more prone to engage in misconduct themselves.

Industry ethical practices - If employees work in an industry where unethical actions are viewed as standard practice, then those actions soon begin to seem normal. For example, if employees see supervisors and others routinely "pad" hourly billings, then they might believe that this is standard operating procedure, without being told so, and do the same. Conversely, employees who work in an environment that strives to maintain ethical conduct will likely view moral practices as normal.

Society's moral climate - Most people don't want to suffer the humiliation and scorn of their friends, family, and community due to moral transgressions. However, if society views a particular unethical behavior as tolerable or acceptable, then people are more likely to engage in that behavior. For example, in the 1950s, manufacturing companies routinely dumped large amounts of chemical waste into lakes and rivers. At the time, there was little societal outrage against the practice. Today, of course, the public views such actions as morally reprehensible.
Formal organizational policy - Organizations should state that unethical conduct won't be tolerated and enforce the policy. If an organization consistently looks the other way on certain violations then employees will believe that those violations aren't that serious.

In the Jan./Feb. issue: negative and positive work environments, types of workplace loyalty, investors' considerations, conveying responsibility and accountability, and suggestions for corporate leaders.

ACFE and AICPA present 'Fraud and the Tone at the Top'

The ACFE and AICPA have teamed up to present a 20-minute, online video presentation that examines the important connection between fraud and the tone at the top in the executive suite.

The program includes insights from Joseph T. Wells, CFE, CPA, founder and Chairman of the Association of Certified Fraud Examiners; and Barry C. Melancon, CPA, President and CEO of the American Institute of Certified Public Accountants.

Walt Pavlo, former MCI WorldCom senior manager and convicted fraudster, describes how he succumbed to his supervisors' pressure to revise the financial records.

The presentation also includes the expertise of Dr. Steve Salbu, dean and Stephen P. Zelnak Jr. Chair of the College of Management at the Georgia Institute of Technology, and a specialist in organizational behavior and ethics.

Suzanne Mahadeo is a business writer/editor at the ACFE and assistant editor of Fraud Magazine.