Governance, fraud and corporate culture part two: why it matters

There is a close-knit relationship between governance, fraud and corporate culture that at times is obvious and at other times is not as straightforward or clear-cut. Understanding this dynamic interaction begins fist with defining corporate culture, as discussed in part one of this series. Following here, in part two, learn more about the complex relationship between work environment and fraud risk, and how corporate culture can be quantified. And then continue on to read part three, “Beyond the obvious: recognizing subtle signs”, to learn more.

Why it matters: corporate culture and fraud risk

Virtually all of today’s widely recognized risk management systems or frameworks recognize the implied link between organizational culture and fraud risk. For example, in its 2013 Framework for Internal Control, the Committee of Sponsoring Organizations of the Treadway Commission (COSO) identifies five underlying principles that support the design and implementation of an effective control environment. Many of these are clearly functions of an organizational culture.

Specifically, the COSO framework defines an effective control environment as one in which personnel at all levels “demonstrate a commitment to integrity and ethical values.” It goes on to list other attributes, such as, “the organization demonstrates a commitment to attract, develop, and retain competent individuals in alignment with objectives,” and “the organization holds individuals accountable for their internal control responsibilities in the pursuit of objectives.”

More recently, some contemporary researchers have begun to clarify – and to some extent quantify – the link between culture and fraud risk. A recent study by The Hong Kong Polytechnic University and The George Washington University (GWU) used thousands of employee reviews on the popular Glassdoor social media site to analyze the relationship between workplace culture and fraud. Their research led them to conclude that “the work environment, as perceived by employees, appears to play a critical role in financial reporting risk.”

The Glassdoor application allows employees of companies to submit reviews of their employers for other prospective employees to consider. The Hong Kong Polytechnic and GWU researchers reviewed thousands of such comments submitted between 2008 and 2015, looking specifically at three measures of company culture: 1) the employees’ ratings of a company’s culture and values; 2) the ratings of its senior leadership; and 3) the company’s overall rating. These ratings were then compared to records of fraud enforcement actions by the U.S. Securities and Exchange Commission (SEC) and securities-related class action lawsuits.

After controlling for other characteristics that could influence accounting practices and employees’ opinions, the researchers concluded that firms with lower levels of job satisfaction and lower levels of “culture and values” were more likely to be subjects of SEC fraud investigations and lawsuits. One Glassdoor writer reporting on the research summarized the findings in simple terms: “a dysfunctional culture could lay the foundation for an accounting scandal down the road.”

Other researchers have made similar observations. For example, a recent Harvard Business Review article asserted, “The reality is that culture, which is often thought of as a company’s most precious asset, is increasingly a liability for companies that don’t tend to it.”

A 2019 report in Financier Worldwide made a similar observation: “In (today’s) shifting risk landscape, companies are seeking ways to holistically manage corporate risk – and increasingly turning to corporate culture to help them do so. From an investigations risk perspective, companies that get culture ‘right’ encourage ethical behaviors in difficult situations…companies that get culture ‘wrong,’ by contrast, encourage questionable decisions in critical moments.”

Some examples from recent history demonstrate the accuracy of that assertion. In 2015, consumer electronics and engineering giant Toshiba announced it had overstated operating profits by $1.9 billion over seven years. After the CEO stepped down, a subsequent investigation found there “existed a corporate culture at Toshiba where it was impossible to go against the boss’s will,” which led directly to the earnings inflation.

More recently, in 2020, Wells Fargo, the nation’s fourth-largest bank, agreed to pay $3 billion to resolve investigations into a long-running fake-account scandal, which investigators found was driven by exceptional pressure on loan officers to meet sales quotas.

Shaping the culture: start with a diagnosis

As tricky as defining and measuring corporate culture are, it is even harder to shape and develop it. An October 2020 World Economic Forum paper acknowledged the challenge, noting “how corporate culture is created and changed remains an elusive, complex question, and its measurement subject to intense debate and some confusion...much is implicit, unspoken or even unconscious among its members, making it difficult for them to identify when they might be swimming in cool water or when they might be like frogs slowly boiling to death.”

Many would argue an organization’s culture is not something that can be created or built at all. To paraphrase the point made by MIT’s Schein in the interview cited earlier, an organization’s culture is something that is learned, not created.

Although corporate culture cannot be created, it can be influenced and shaped. An obvious first step in this effort is for management to figure out just where things stand in terms of organizational culture. This means assessing the current state of the culture and determining whether that culture is positively or negatively contributing to the company’s risk management efforts. It also means moving beyond instinct or anecdotal information to seek out objective evidence and metrics.

The Glassdoor study cited earlier offers an example of how such research can reveal useful insights. For individual companies, confidential surveys conducted by neutral third parties can often provide the management team with highly valuable information, particularly when respondents are assured of their anonymity.

Ideally, such confidential surveys would encompass both current and former employees, providing them an opportunity to speak frankly about their perceptions of the organization’s culture – particularly any disparities between the organization’s stated values and its managers’ actual views and its employees’ behaviors. In some instances, a focus on recent hires or even prospective employees could provide other perspectives regarding how the organization’s culture is perceived.

Continue reading our governance, fraud and corporate culture series in the next article “Beyond the obvious: recognizing subtle signs”.