Here’s How to Reduce Unethical Behavior via Comp Plans

In business, there’s a delicate balance between incentivizing employees to achieve financial goals and running the risk of workers fudging their financial reporting for personal gain.

Understanding when people might give in to temptation to boost their own bank accounts is at the root of a recent study, says William J. Becker, co-author of the report and associate professor of management in the Pamplin College of Business at Virginia Tech.

The study, “The Effects of Goals and Pay Structure on Managerial Reporting Dishonesty,” shows the interactive effects on financial reporting in different scenarios involving flat-wage and incentive-paid employees and whether they are given specific targets or not. Becker worked with co-authors Stephen J. Sauer, an associate professor of consumer and organizational studies at Clarkson University’s Reh School of Business, and Matthew S. Rodgers, an associate professor of management at Ithaca College.

The results showed that having cost goals decreases dishonesty when managers are paid a flat wage and increases dishonesty when managers are paid a bonus for hitting certain targets.

Becker says that even though the business school students knew they were participating in a company simulation involving financial reporting information such as time and expense reports, they didn’t have a real-world reason to falsify reports. Yet, they still did, by significant amounts, even when they didn’t have personal gain at stake.

Establishing goals and offering incentives work well separately, Becker says, but when they are linked, it can “supercharge the incentive to hit the target” and downplay values such as accurately reporting the costs and treating the client well. He says other studies have proven that when rational decision-making is in conflict with emotions, feelings always win.

The study also observed a “slippery step” effect, wherein dishonest behavior becomes increasingly worse once managers have crossed a certain threshold of dishonesty, Becker says.

The findings explain in part why business leaders go afoul of ethics and even the law. Scandals have long been in the headlines, from Wells Fargo employees opening accounts without customer permission to Enron’s executives systematically cooking the books, for examples.

The most recent case involves Nissan’s ousted chairman and former CEO Carlos Ghosn, who was jailed last fall while awaiting trial in Japan for allegedly underreporting his earnings and misusing company assets. Ghosn’s case is still under legal dispute, but experts say egregious incidents are relatively rare.

Alan Johnson, managing director at Johnson Associates, an executive compensation consulting firm, put the headlines in perspective: “If you have 10,000 major public companies around the world and we have one, two or three scandals a year, there will always be another one.”

Susan Holloway, director of executive compensation strategy at WorldatWork, says that while incentive plans are a powerful way for a company to put a spotlight on what they want to achieve, she agreed that “if left unchecked, it could lead to unethical behavior.”

Careful compensation plan design, she explains, should discourage “achievement at all costs” through checks and balances. These can include concrete, verifiable numbers, qualitative measures such as customer service or other quality metrics, out-of-chain-of-command review of reports by financial professionals internally or externally, both short and long-term incentive goals, and solid policies for responding quickly and firmly to misreporting.

Johnson adds that creating a compensation plan based on sensible results reduces the chances that people will lie to meet a goal and get the rewards: “If we give you an impossible goal to keep your job, then you’re probably going to cheat. There has to be a linear, rational relationship between the result and the payout.”

Becker, whose background includes investigating workplace ethics and the role emotions play, adds: “We are creatures of our personality, environment and culture. Today, we have a short-term, results-now culture. When you have goals and incentivize them strongly, [people] say they don’t care about being accurate.”

“I think culture and the whole dynamics of the system around your goals is very important,” adds Johnson.  That means good companies acknowledge reasons why goals may not be met and support people to continue trying to reach them.  And, having plans in place to take rapid action if there are serious infractions means that people will know that cheating on the incentive plan “will cost you your job.”

Johnson says companies get into problems when their culture is based on letting different kinds of infractions like cheating, misreporting, and harassment slide “as long as the money is coming in.”

Another way to curb misreporting is to make sure early on that people have the right skills and the capacity to succeed in their role, he notes. Moving people to more appropriate jobs or even out of the company will reduce desperate, emotion-based reporting decisions that could hurt the company’s bottom line.

There is also the argument that removing incentives entirely means that, as Johnson puts it, “no one will cheat but then no one will care, either.”

Don Delves, managing director and executive compensation practice leader for Willis Towers Watson, says that HR plays a role in developing and implementing compensation and incentive plans, but the ultimate check on executive compensation plans is a company’s board of directors.

He notes that a good board will have a degree of skepticism when reviewing financial results: “If a board is asking the right questions and [asking] if there are the right checks and balances in the system, they will ascertain what the risks are and are they being effectively managed.”

It’s also wise, says Delves, for HR to develop a good whistle-blower program that allows employees to anonymously report misdeeds to a board of directors, committee or other organization outside the chain of command.

The bottom line is that, in the grander scheme of things, there will always be people who try to game the system for their own advantage, Becker notes.

Although study participants started out being honest, over the course of simulations, incidents of misreporting gradually increased. That’s because the emotional brake known as guilt gets worn down when temptation is present.

“You start out battling that guilt,” Becker says, “but once you get the reward, it overwhelms your sense of guilt over misreporting. Then the battle’s lost.”

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Maura C. Ciccarelli
Maura Ciccarelli is freelance writer based in Southeastern Pennsylvania. She can be reached at [email protected]