In 2022, auditing firm Ernst & Young (now EY) agreed to pay a $100 million penalty imposed by the U.S. Securities and Exchange Commission after a significant number of its audit professionals were caught cheating on their CPA exams. Two years later, the Netherlands division of one of the other “Big Four” U.S. auditing firms, KPMG, accepted a $25 million penalty for similar cheating by its auditors.
Like organizations in many industries, auditing firms devote considerable resources to encouraging their employees to engage in ethical behavior on the job. A key component of ethical leadership includes motivating employees to meet the organization’s high ethical standards. And when it comes to auditors, their clients and the market more broadly depend on them to audit financial statements accurately and ethically.
So why did so many of these firms’ new auditors cheat on their exams? Ironically, some of the standards that organizational leaders set might have had the unintended effect of promoting unethical behavior, write Jeffrey S. Bednar and his colleagues in new research in the Journal of Business Ethics.
Tolerance Standards and Materiality
As any leader knows, it would be unrealistic to expect employees to execute their responsibilities perfectly at all times. But, how high of an error rate is acceptable? In many industries, tolerance standards are established to specify an acceptable margin of error, or deviations from a standard, note Bednar and his team. Tolerance standards are designed to ensure that end users will not be harmed by the products or services they rely on. Such standards are common in industries where people depend on the quality, validity, or safety of the services and goods provided—such as the audits provided by financial services firms or the results doctors report to their patients.
Given the complexity of large companies and their finances, it would be unreasonable to expect auditors to provide assurance that a company’s financial statements are 100% accurate. Thus, before reviewing a client’s financial statements, auditors typically set a tolerance standard, referred to in the industry as materiality. Materiality stipulates guidelines for errors that are immaterial, meaning they will not adversely affect the judgments and decisions of those who rely on the financial statements.
Before beginning their work, auditors set a threshold for materiality: “the dollar amount that auditors believe would be large enough to influence the judgments of financial statement users,” according to Bednar and colleagues. “Auditors are trained to work regularly with a tolerance standard and to tolerate misstatements below the established threshold.”
The Ethical Downside of Tolerance Standards
While tolerance standards like materiality have a clear and important purpose, they might have a hidden downside, the research team theorized: If employees are encouraged to view deviations from a standard as insignificant, they might begin to “morally disengage their internal self-standards and rationalize small acts of dishonesty as ‘immaterial’ or trivial.”
Indeed, in two experimental studies and one field study, the researchers found that tolerance standards led participants to disengage from accepted moral standards and even behave dishonestly.
In one experiment, business school students completed a simple quality-control task. Some were trained to do so using a tolerance standard; others did the task without the standard. When the task was over, those trained on the tolerance standard were more accepting of questionable ethical statements and more willing to lie about something unrelated—namely, their preparation for a class assignment—than were students who didn’t use the tolerance standard. Similarly, in another experiment, online participants were more likely to lie and to loosen their moral standards when they had completed a quality-control task using a tolerance standard than when they had completed the task without one.
For their field study, the researchers recruited participants with an accounting background: specifically, 129 professional auditors and 101 nonauditor accounting professionals. They had these professionals engage in a coin-flipping task that gave them incentives and opportunities to cheat (without knowing that the researchers could detect any cheating).
Notably, auditors regularly work with tolerance standards, while nonauditors do not. Did the regular use of tolerance standards degrade auditors’ ethics?
Quite possibly, the evidence suggested. When auditors were first primed to think about their work role, they were more likely to cheat on the task than when they were primed instead to think about their leisure activities—suggesting that their job puts them in a less ethical frame of mind. In addition, the nonauditors were less likely to cheat on the coin-flipping task than the auditors were.
Ethical Leadership and Tolerance Standards
Tolerance standards are not inherently unethical, and they serve a useful purpose; yet these research results suggest that such measures can backfire under certain conditions by leading professionals “to rationalize and tolerate moral deviations on unrelated moral decisions,” the authors conclude.
So, what to do? Citing research showing that a “prevention mindset” can protect individuals’ ethics from degrading, the researchers suggest it might be helpful to reframe tolerance errors. For example, ethical leadership might include encouraging employees to “prevent consequential mistakes because they can be harmful” rather than encouraging them to “allow small errors because they don’t matter.”
More broadly, the research reminds us that unethical behavior is often unconscious and unintentional. Ethical leadership involves recognizing that moral pitfalls are often hidden, and must be anticipated and guarded against at every turn.
Question: What other ethical leadership lessons do you take away from this research?
