‘Tone at the Top’ Deters Fraud (William Wyngaard Expert Commentary)

The recent acknowledgement by executives at Volkswagen should serve as a warning to all corporate leaders that weak ethical standards can be detrimental to operations. Volkswagen admitted that a tolerance for breaking the rules led to cheating for engines that could not meet U.S. emissions standards.

The fallout of the scandal was immediate. November’s U.S. sales were down 15.3 percent versus 2014, while the industry overall was experiencing increased sales. In addition, Volkswagen has incurred a $28 billion plunge in market value and is expected to incur about $18 billion in EPA fines. Volkswagen must also remedy 500,000 vehicles currently in the U.S. at an estimated cost of $5,000 per vehicle. The complete bill for the scandal is estimated at $54 billion, not including the loss of reputation and consumer trust. Volkswagen is not an isolated case.

Enron, WorldCom and Arthur Andersen are infamous scandals that led to the passing of the Sarbanes-Oxley Act intended to reduce fraud. Debate still exists on whether SOX works, but we know for certain that fraud still occurs and Arkansas is not immune. In December alone, Arkansas Business reported fraud allegations involving the Dollarway schools, the Department of Human Services and businessmen John Rogers and Scott Smith.

In 2014, the Association of Certified Fraud Examiners reported on 1,483 cases in its examination of occupational fraud. The ACFE said that a typical organization loses about 5 percent of its revenue each year to fraud. The median fraud loss is $145,000, with 2 percent of cases resulting in losses of more than $1 million. These amounts are difficult for any company to absorb, but are especially detrimental for small businesses with limited finances.

Even with legislation aimed at reducing fraud, responsibility for fraud prevention lies with company management. Numerous fraud controls are available, including audits, hotlines, management reviews and job rotations/mandatory vacations. These options require planning and money to implement. However, one control — called “tone at the top” — can be implemented immediately with no financial outlay and so provide a cost-effective investment for fraud protection.

Tone at the top is the atmosphere created by management to encourage employees to embrace a climate of high ethics when the behavior is modeled by the top management. As role models, company leaders have an impact on the moral behavior of subordinates. When faced with an ethical dilemma, employees reduce the uncertainty of the dilemma by imitating their leaders’ behavior, which they observe daily.

To be effective, tone at the top must be appropriately modeled and communicated. Leaders must show that ethics matter. Too often, the focus in business is the bottom line. Although profit is necessary for sustainability, a narrow focus on profit can crowd out ethical issues to the point that employees become misguided about the implications of their actions.

As with the Volkswagen case, profit and ethical standards are not mutually exclusive. The two must be interwoven. Fraud investigators Megan F. Hess and James H. Cottrell Jr. declare that the first rule of tone at the top is that “every time a leader talks about profits or efficiency, he or she should also explicitly state the importance of meeting those goals through ethical means — every time!”

To communicate appropriate behavior, leaders should advocate a code of ethics. Codes cannot be simply lip service posted on a website or in the employee handbook. In its annual report, Volkswagen explicitly states that “compliance with international rules … and ethical principles … form an integral part of our corporate culture.” Clearly, that was not the case. To be effective, organizational leaders must value, communicate and model the code of ethics. If employees violate the code, they must be held accountable.

Tone at the top not only works in the positive; it can also create unacceptable conduct. In the Volkswagen case, a tone of tolerance for breaking rules was established by company leaders to increase sales. Do not let an ethical scandal destroy your company’s reputation and sustainability. Set an ethical tone now to prevent fraud and the associated losses.

William Wyngaard, a certified public accountant (inactive), is chair of the business department and an instructor of taxation and accounting at Pulaski Technical College in North Little Rock.