If you are like most Americans, your parents or guardians encouraged you to eat all of the food on your plate when you were a child—including the dreaded broccoli, Brussels sprouts, or whatever food you found unpalatable. It’s also likely that your parents incentivized you to eat all your dinner by offering a yummy dessert if you did. And we really wanted that dessert. So sometimes we would think of ways to not eat the food, but make it seem like we did so that we could get to the treat. Maybe we would slip broccoli florets into our pockets when the adults weren’t looking, feed them to the family pet, or quietly convince a sibling to eat them. The point is, we wanted the incentive so badly that we might even cheat to reach the goal.
Right now, a version of “feed the broccoli to the dog to get dessert” is taking place all over corporate America. Sales professionals, accounts managers, senior executives, and even CEOs are going to great lengths to make it look like they have reached the goals set for them (the proverbial cleaning of the dinner plate) to reap the yummy incentive bonus, even if they did not. They are opening up phony accounts, stuffing sales channels, accelerating revenues, shifting expenses, and even outright cooking the books.
We all know that when done well, incentive compensation plans can improve productivity, induce employees to work harder, focus people on their jobs, and lead to bigger top and bottom lines. Yet there is a dark side to incentive compensation as well. When done poorly they can push employees to unwanted behaviors, such as falsifying documents, cutting corners, and even engaging in fraud. “Companies get themselves into trouble all the time by being too clever with their incentives,” noted Stanford University professor Jeffrey Pfeffer in a 2007 interview.
If fact, several studies have shown that incentive bonuses and pay-for-performance plans can lead employees to unscrupulous behaviors. A 2010 study conducted by researchers at Toronto’s Ryerson University and at the University of Guelph in Ontario found that students cheated significantly more when a target-based compensation system was used as an impetus to reach a goal, compared to other types of incentives. In addition, the closer the participant’s performance was to their goal, the more often they cheated.
“The dark side of behavior can be affected by pay-for-performance schemes,” said Fei Song, co-author of the study and a business professor at Ryerson’s Ted Rogers School of Management. “Faced with certain types of incentives, some people are tempted to make up or misrepresent their performance numbers, which can cause companies to lose revenue.”
That’s where internal audit comes in. In the wake of scandals at such companies as Wells Fargo and Volkswagen, where incentive compensation plans played an important role in massive frauds, boards should be asking internal audit to assess company incentive plans to ensure they are working properly. They should want internal audit to assure the plans aren’t inadvertently pushing employees to do the wrong thing and that they aren’t having an adverse effect on the culture of the organization.
It’s All About the Culture
We are constantly hearing about the importance of culture in an organization. Culture defines what get prioritized, what gets done, and how it gets done. Therefore, many strategic leaders in the internal audit profession make a compelling case that internal audit should review culture, given its pervasive impact on everything the organization does.
Culture in many organizations is embodied, or attempted to be embodied, in the stated core values of the organization (among the triumvirate of mission, vision, and values). At most organizations, senior executives constantly list off the company core values and related materials that extol the strength of the organization’s culture. Almost all of them have the word “integrity” somewhere, even if it isn’t really supported by the actions of top executives.
“Incentives drive behavior, and behavior spawns culture. Do your company’s incentives align with your code of ethics? Or is the code of ethics something that managers must simply pay lip service to while they do the real business of the organization?”
– From a December 2017 Forbes article by Rob Asghar
I strongly contend that some of the biggest forces that can undermine or even completely derail a company’s expressed values and culture are contained in its incentive compensation plans. As is often said, “what gets measured, gets done.” The desired culture might be ignored or circumvented in order to pursue the bonuses associated with what is being measured and rewarded.
Consequently, a poorly designed and poorly executed incentive compensation program can alter or completely redefine an organization’s culture, regardless of the stated core values that hang on the wall, or what executives tout in company-wide meetings and corporate pamphlets.
Integrity Lost: An Example
Perhaps a hypothetical example can help make the point of how much incentive pay can impact culture. Let’s say that a company includes the concept of integrity in its core values. The company also pays employees well and has an extremely competitive benefits package. Initially, it does not have any form of incentive compensation for any of its employees, including its executives, but pays straight base compensation. It goes along doing business, serving customers, and, by design, exercising “integrity” in all its interactions. Employees like working there, and one of the things they talk about is how much integrity the company has and how well it treats its employees, customers, and business partners. The company walks the talk.
New leadership comes in and sees some potential for the company to grow faster and reap greater profits. It designs an incentive compensation system that rewards employees for both company profitability and for individual contributions to the company’s profits. The payouts from the incentive plans, at least for some senior executives, are rather significant in relation to their base salary.
Employees start cutting corners and don’t treat customers, other employees, and business partners the same. The value of integrity remains on the list of company core values, but employees start talking about the fact that the company has changed. Some of them start telling small fibs, especially about performance related issues. Big payouts start to occur from the incentive compensation system, and the downward cycle begins. Employees start doing whatever it takes to get the largest payouts possible, and those who wonder what happened to the company start leaving.
Everyone still claims they want a company that operates with integrity, but the reality is that it doesn’t act that way anymore. The unintended consequences continue to change the culture of the company increasingly over time. At some point, it spins so far out of control that it results in major frauds, fines, and lawsuits, with the organization’s reputation damaged, perhaps beyond repair.
Companies like Wells Fargo, Volkswagen, and former employees of Enron, WorldCom, and Adelphia will likely well recognize this example and the resulting downward spiral. These, and many other such fiascos, are the result of situations where employee and management behavior contradicted the professed culture and more details are just a Google search away. The most common, and egregious, problems with incentive compensation programs often stem from plans that are too aggressive and encourage the wrong behavior from employees to meet targets, or, Importantly, proper safeguards are not built in. But problems can also be more subtle. The concern comes in when the tail starts to wag the dog, achieving maximum incentive payouts begins to take precedent over playing by the rules.
Why Audit Incentive Compensation?
While some boards are expecting internal audit to put incentive compensation programs on the audit plan, far too many have yet to do so. A recent informal poll of internal audit professionals found that 54 percent of responding organizations audit incentive compensation programs, while 46 percent said they do not. Some of those responding “yes” admitted in the comments section that audits really only amounted to checking the math on incentive compensation payouts, not probing into the effectiveness or adverse consequences of such plans.
Unfortunately, internal audit functions that do not explore how the incentives were determined, how they are managed, what they are intended to incent, what the potential unintended consequences might be, and whether they are consistent with the desired culture are missing a critical potential root cause for a whole host of things that could go wrong in an organization.
So, why are so many internal audit functions missing the boat on assessing the design and execution of incentive compensation plans or just checking the math on payouts? Perhaps it’s because initiating an audit of incentive compensation can be a controversial addition to the audit plan. Frankly, many executives (and human resource departments) do not want you to conduct such an audit because they don’t think there is a problem, don’t want you to suggest there is a problem, don’t think you have the competence to do it, or some combination of all three. Executives may fear that an audit could lead to the end of a lucrative avenue for big bonuses. In my experience as an auditor, when someone doesn’t want you to do something, there is almost always even more reason to do it.
So, What Can Internal Audit Do?
Whether or not you are auditing culture, as an internal audit professional you have the benefit of two things many others in the organization do not: you understand what the desired culture is intended to be, and you experience the culture as it really is across the whole organization. Furthermore, you also see what is being done to support the desired culture, and ideally you also see what is being done to thwart, circumvent, or detract from that desired culture.
Therefore, ask yourself a question: How much are the behaviors across the organization, both those consistent with the desired culture and those contrary to it, occurring because people are chasing incentive compensation payouts. It is only rational human behavior to seek maximum payouts of compensation, as we’ve established. Remember how we all pursued that clean dinner plate, honestly or not, in order to get dessert as a child?
Ideally, internal auditors should be looking at incentive compensation plans from three strategic perspectives: 1. What results are they intended to incent? 2. By design, what do they include and exclude? And 3. What are the potential unintended consequences of each element? The last question isn’t easy to answer, but with an auditor’s “what if” mindset and some time to brainstorm you will start to think about what the unintended consequences might be. It’s no different than brainstorming the risks of most anything going wrong, which you do every day. Next use data to confirm or disprove your hunches.
Start Small
While it would be wonderful if you were able to conduct a top down, holistic review of inventive compensation as part of your audit plan, it may not be realistic in some organizations. So, does that mean you do nothing? Absolutely not.
I would argue that you still do something in this regard, it just may be more informal. There is nothing stopping you and your team from taking time out from executing the audit plan to have a few brainstorming sessions around the topic. See what you come up with during a free-wheeling discussion on potential pitfalls of the current incentive plans. It’s as simple as: If employees are incented to do “x,” and the maximum payout is “y,” what might they do that they shouldn’t to pursue that maximum payout?
I have no doubt your team will engage in passionate discussions and walk away from them enlightened about strategy, risk, and the potential ill-fated consequences of incentives. (Bonus points if you can do this brainstorming with some folks in the second line of defense, as they should be concerned about the same things, and the collaboration would serve everyone well.)
Sure, brainstorming sessions may not leave you in the position to formally report on it, but that’s fine. Start small by socializing some of the ideas from the discussions and voicing any concerns you come up with. It’s also important to keep your eyes and ears open to hints or expressions of some of the unintended consequences surfacing, and keep in mind that maybe the behaviors you see that are inconsistent with the desired culture might have resulted from attempts to maximize incentive compensation payouts as a potential root cause. Such discussions might be enough to convince the audit committee to support a full audit of incentive compensation programs on the audit plan.
Sometimes our job as internal auditors is to act as the conscience of the organization. There may be no better opportunity to exercise that duty than when it comes to the risk of unintended consequences from incentive compensation programs. If we are proactive, we might help to prevent a debacle from occurring. And, if we raise concerns early, we may just be able to get ahead of an issue before disaster strikes. If nothing else, we will be much more attuned to the culture, how it operates, and how things can go wrong.
Conducting audits of the organization’s incentive compensation plans might not be the tastiest of audit assignments, but rest assured that, like broccoli and Brussels Sprouts, they’re good for us. Now, what’s for dessert?
Hal Garyn is Managing Director and Owner of Audit Executive Advisory Services, LLC based in FL.