Using Cultural Audits to Assess Tone at the Top

By Joseph F. Castellano and Susan S. Lightle

E-mail Story Print Story

The Justice Department reached plea agreements in its criminal investigation with all five of HealthSouth’s former CFOs. Six lower-level former executives also entered into plea agreements. According to the SEC complaint, senior accountants, acting on orders from the CEO to “fix” earnings, gathered in what they called “family” meetings to falsify results when HealthSouth’s performance failed to meet Wall Street forecasts. Former CFO Weston Smith also pleaded guilty to filing a false certification statement with the SEC, a violation of the Sarbanes-Oxley Act of 2002 (SOA). Scrushy’s federal fraud trial is set to begin soon, with the defendant entering a plea of not guilty.

HealthSouth is only one example of the financial reporting crises that have come to light over the past three years. In many cases the tone set by top management, especially the CEO and the CFO, played a crucial role in the fraud and misrepresentation. The Wall Street Journal reported that several executives tried to convince Scrushy to stop the manipulations in the fall of 1997, but prosecutors say Scrushy was concerned about the stock price and refused. Midlevel employees also reported that CFO William Owens told them that they were not at risk because they did not certify the financial results. Clearly, the tone at the top at HealthSouth reflected a culture the SEC and prosecutors believe was rife with deception, misrepresentation, and fraud.

SOA clearly raises the stakes for all parties involved in the audit process. While new regulations and legislation have increased the requirements for vigilance by boards, audit committees, and external auditors, there is little evidence that sufficient attention is being given to the effects of the tone at the top on a company’s culture and reporting environment.

In 1987, the National Commission on Fraudulent Financial Reporting (the Treadway Commission) issued a report outlining causal factors of fraudulent and misleading financial reporting. A key objective of the commission was to identify the characteristics of corporate structure that may contribute to fraudulent and misleading reporting. The report identified the tone set by top management as critically important in creating a healthy reporting environment. The commission noted that the “tone at the top” influenced the environment within which financial reporting occurs. According to the report, to set the right tone, top management must identify and assess those risk factors that could lead to fraudulent and misleading financial reporting.

A key risk factor that has not received sufficient attention in the financial press is the unintended consequences of the prevailing management model known as Managing by Objectives and Results (MBO/MBR). The authors believe these consequences and risk factors are directly related to tone at the top, corporate culture, and a company’s ethical climate.

Managing by Objectives and Results

A company’s financial planning and budgeting process clearly creates an expectation about what management believes are possible future outcomes. Component units, whether defined as individuals, profit centers, plants, divisions, or subsidiaries, are assigned targets or goals. These expectations are eventually “rolled up” to top management and ultimately affect the guidance given to Wall Street analysts for revenue and earnings forecasts. The management method used to initiate and manage this process usually involves some form of MBO/MBR. This methodology usually involves the following steps:

• Top management negotiates or imposes numerical goals and targets, in many cases accounting targets, on component units;
• Management uses rewards and incentives to align the behavior of hose responsible for the results and to motivate them to work toward attaining those goals;
• Performance measurement systems are developed to monitor variances between targeted and actual results; and
• Employee performance evaluations are tied to actual results in order to reward or sanction those deemed responsible.

The focus of this approach is on aligning and motivating behavior directed at achieving the forecasted results. Because the often stated goal of publicly traded companies is to maximize shareholder value, it should be no surprise that the MBO/MBR process is strongly related to achieving quarterly and year-end revenue and earnings targets. What seems to have been overlooked in recent discussions involving the pervasive use of earnings management is that the entire financial planning and budgeting process can be effective only if companies manage earnings. As companies attempt to reach sales, cost, and profit targets, they must be engaged in managing and monitoring financial forecasts. Efforts to cut costs through employee layoffs and attrition and reductions in training, travel, and research and development, are all forms of earnings management. While these actions may be ill-advised if they ignore long-term implications, they are not unethical or illegal. In fact, the only way for a company to meet the expectations of its own forecasts and ultimately those of financial analysts is to manage earnings.

Unintended Consequences

The financial planning process rooted in MBO/MBR-style management shapes not only the decisions of managers but also the expectations of financial analysts. Once forecasts shape analysts’ expectations and are reflected in a company’s stock price, these goals and targets become inflexible, and the failure to meet them will have significant negative impact on a company’s stock price. The focus of management shifts from what is in the long-term best interests of the company to “making the numbers.” Strategy, instead of focusing on improving the drivers of outcomes/results, is now defined in terms of what has to be done to achieve the expected income and earnings-per-share target. Strategic interests are abandoned in the interests of achieving a quarterly or year-end target. Not only is the focus of the financial planning process co-opted at this point, the stage is also set to do anything necessary to make the numbers. The risk now exists that benign forms of managing earnings in order to meet forecasts may give way to actions that are unethical or illegal. The MBO/MBR model has the unintended consequence of encouraging earnings manipulation.

Paul Regan, a forensic accountant, in “Accounting Fraud: Learning from
the Wrongs” (Financial Executive, September/October 2000), noted that certain patterns emerge in accounting frauds and irregularities. He indicated that “one is the presence of a tough and powerful CEO who frightens subordinates … It’s a fairly common theme to have a personality like ‘Chainsaw Al’ [Al Dunlap, former CEO of Sunbeam], a domineering bully whom people are fearful of. They are afraid of coming up short of the established goals.”

Gardiner Harris, in a December 2002 Wall Street Journal story, detailed accounts by current and former executives at Bristol-Myers about how that company engaged in earnings management to meet financial targets and earnings estimates. The executives portray “a leadership so intent on closing a gap between its forecasts and reality that it delved repeatedly into inappropriate financial engineering.” Fourteen former and current executives told of how the former CEO, who had promised Wall Street that earnings would grow 12% annually, met with the head of the company’s medicines group. The head of that group, known for speaking candidly about sales prospects that were clearly weakening, was reassigned soon after the meeting. “That meeting,” said one former executive, “sent a huge message across the organization that you make your numbers at all costs.”

The above examples sound hauntingly similar to more recent stories chronicling events at HealthSouth, Enron, and WorldCom. The warnings issued by the Treadway Commission more than 15 years ago are as relevant today as they were when the report was issued. The clear, unmistakable message is that the tone set by top management has a profound effect on the firm’s culture and ultimately on its financial reporting environment. As senior management becomes overly concerned with meeting MBO/MBR targets, the temptation to manage to analysts’ expectations rather than to the company’s capability creates the very tone at the top and accompanying risks that the Treadway Commission warned about.

How Tone at the Top Affects Culture

In outlining the causes of fraudulent financial reporting, the Treadway Commission report noted that “situational pressures on the company or an individual manager also may lead to fraudulent financial reporting.” One example of situational pressures was “unrealistic budget pressures, particularly for short-term results. These pressures may occur when headquarters arbitrarily determines profit objectives and budgets without taking actual conditions into account.” This is precisely the situation that occurred in many of the cases described above. When financial plans and budgets become the basis for the expectations of financial analysts, one unintended consequence inevitably entails how top management will react if actual results begin to fall short of expectations.

Brian Joiner, in his 1994 book Fourth Generation Management, wrote that organizations can achieve targeted results in three ways: They can improve their processes and systems, distort those systems, or distort the measurements that come from those processes and systems. When the tone at the top contributes to a climate of fear, distortion of the system or figures becomes a serious consequence. Two examples make this point. The Wall Street Journal reported in separate stories that three employees of HealthSouth said that they feared for their safety if they tried to expose the alleged fraud that occurred there, while another story detailing the findings of a report about what went wrong at WorldCom noted that while dozens of people knew about the fraud, it remained hidden from public view because employees were afraid to speak out.

The lesson to be learned is that whenever there is pressure and fear to “make your numbers,” the outcome may be figures and results that cannot be trusted. When top management communicates in word or deed that they expect any “gaps” between actual and forecasted revenue and earnings to be filled, this tone becomes embedded in the culture, generating pressure which in turn can create a culture of fear that, when carried to the extreme, results in the kind of fraudulent and misleading reporting that has been witnessed many times in the past three years.

The Treadway Commission also noted that financial pressure resulting from bonus plans that are tied to short-term performance could also create a situational pressure that may lead to fraudulent and misleading financial reporting. While this issue has received sufficient attention in the financial press, especially with regard to top management compensation tied to stock options, an important element of the compensation debate and its impact on a company’s culture has been largely overlooked.

Performance evaluations tied to compensation and bonus programs create enormous internal competition between employees. Because the evaluations used to measure performance often involve some form of component unit performance evaluation (e.g., individual, profit center, plant, division) and the ranking of those being evaluated, the clear connection to the MBO/MBR model is obvious. The internal competition caused by this process has significant potential for a host of unintended consequences. First and foremost is the pressure at the component unit level to “make your numbers” because this was the agreed-upon goal in the MBO/MBR process. Couple this pressure with the fact that each component unit manager will be evaluated and compensated based upon a comparison of actual and expected results, and one can imagine why there would be a great temptation to fill in the “gaps” between actual and expected results.

The Cultural Audit

The current business model used to manage the expectations of Wall Street analysts creates an adverse financial reporting climate and the potential for unintended consequences that can no longer be ignored by directors, especially audit committees, and external auditors.

Almost two decades ago, the Treadway Commission recognized the critical role of internal controls over financial reporting. The internal control framework developed by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission outlined the components of an effective system of internal control. The foundation of that framework is a strong control environment, including tone at the top. More recently, SOA required publicly traded companies to report on internal controls over financial reporting and to have an independent attestation to their assertions about the effectiveness of their control systems. A critical component of internal control reporting and testing must be an assessment of the tone at the top of the organization.

A cultural audit would provide a means for assessing the tone at the top and the attitude toward internal controls and ethical decision-making. Such an audit can play a vital role in helping management shape an ethical climate within the organization and in helping directors and auditors assess the effectiveness of internal controls. To this end, the authors propose that the board of directors, through the audit committee, should retain an outside firm to conduct a cultural audit every three years. In addition, external auditors should include in their internal control assessments and risk management profiles a process designed to assess tone at the top and the resulting impact on a company’s culture.

The specific questions to be asked in the cultural audit are beyond the scope of this article, but three key issues will need to be addressed:

• The degree to which preoccupation with meeting the analysts’ expectations permeates the organizational climate;
• The degree of fear and pressure associated with meeting numerical goals and targets; and
• The compensation and incentive plans that may encourage unacceptable, unethical, and illegal forms of earnings management.

Preoccupation with Wall Street expectations. To be effective, the cultural audit must survey large numbers of employees at all levels within the company in order to identify the key issues affecting tone, cultural, and internal control risk assessment. It should come as no surprise that boards and top management are preoccupied with analysts’ earnings expectations and how their companies will meet them. The question to be answered in an effective cultural audit is how much this preoccupation has influenced the company’s day-to-day operations and culture. Are middle-management employees and their subordinates focused primarily on addressing key process issues associated with how best to become more flexible and responsive in meeting customer needs, or are they spending their time trying to manage costs and revenues in order to meet quarterly earnings targets? More important, to what degree will these same employees identify management policies and procedures that they believe demonstrate a preoccupation with short-term earnings management at the expense of the long-term best interests of the company? Many of the most egregious forms of earnings management involve shipping unordered products, forcing large amounts of inventories on customers, delaying needed expenditures, and capitalizing costs that should have been expensed. These actions must involve numerous midlevel employees. Their input in a well-designed cultural audit could provide valuable assistance to the board and external auditors in their efforts to assess the company’s tone at the top and its impact on the culture.

Fear and pressure to make the numbers. As noted, employees at both WorldCom and HealthSouth were afraid to disclose the fraudulent reporting schemes at their companies. A culture of fear is simply incompatible with a culture of ethics. The pressure to “make the numbers” regardless of unrealistic estimates can lead only to fearful and frustrated employees, a loss of trust in management, and intense internal competition. In such a culture, how could any board of directors really discharge its fiduciary duty to shareholders and comply with related security regulations without attempting to determine the impact this climate of fear has on financial reporting and internal control? A related and important question is how the company’s external auditor can do any meaningful risk and internal control assessment without attempting to assess the cultural impact of the tone at the top.

Compensation and incentive plans. Assessing the unintended consequences of well-meaning compensation and incentive plans is a crucial element in assessing a company’s culture. Most discussions involving compensation focus primarily on whether stock options should be expensed. These discussions often overlook the question of whether management and board policies with respect to compensation are inadvertently contributing not only to a short-term focus but also to inappropriate forms of earnings management. Such an assessment must extend beyond the ranks of top management. Again, large numbers of employees must be involved in the cultural audit in order to determine whether compensation and incentive plans are contributing to a climate of “make the numbers” at any cost and to encouraging unacceptable, unethical, and illegal forms of earning management.

These three issues—pressure to make the numbers, a culture of fear, and compensation and incentive plans—are interrelated. Many of the management policies and procedures that are taken for granted and are related to these three issues may be creating the very tone at the top and culture that could lead to the unintended consequences that are being visited upon so many companies.

Call for Active Engagement

While the business media have done an excellent job of reporting on the fraud and abuse of recent years and the proposed reforms to deal with the problem, what has been largely overlooked is the impact of the prevailing management model on a company’s tone at the top and organizational culture. Given the expanded responsibilities of board members and external auditors to become more involved in preventing fraudulent and misleading financial reporting, it is now more incumbent upon boards of directors and external auditors to become more actively engaged in efforts to assess the tone at the top and its impact on culture and internal control risk assessment.

To this end, the authors propose that boards of directors engage an outside firm to conduct a cultural audit every three years and that external auditors formally include assessment of the tone at the top in their evaluation of internal controls. We believe such an audit will help the board and external auditors identify management policies and procedures and their unintended consequences that may increase the risk of fraudulent financial reporting.