For Timothy P. Flynn, chairman of the global accounting firm KPMG, ethics and integrity are not just boilerplate language in the company mission statement.

Flynn, who was on campus as part of The 2007 Wharton Ethics and Leadership speaker series, became CEO of KPMG’s U.S. partnership in 2005, just as former partners were being indicted for allegedly creating $2.5 billion in fraudulent tax shelters. “When I took over, it was a very challenging time for the firm,” he said. “There was a very real possibility that the tax situation could threaten our very existence.”

Flynn had to calm clients, regulators and employees, but he said the initial step was to confront the problem. “We had to make a lot of tough decisions, but first we had to admit we had people who did things that were wrong.” The firm settled a government charge against it for $456 million. Three former partners and an outside KPMG lawyer are set to stand trial in the case in U.S. District Court in New York next year. Charges against 13 other partners were dropped after a judge ruled that prosecutors interfered with their right to counsel. The government is appealing that decision.

The experience has made ethics and integrity a critical element of leadership at KPMG, according to Flynn. “Groups often ask what it takes to succeed. I used to say hard work, a little patience, a little bit of luck and taking advantage of breaks along the way. Now I add — and I used to take this for granted — operating at the highest level of integrity.”

‘Everybody Else Is Doing It’

Worldwide, KPMG is headquartered in Amsterdam, has more than 123,000 employees in 145 countries and performs auditing as well as tax and advisory services. Flynn was appointed chairman of the international firm in October 2007 and remains CEO and chairman of the U.S. partnership.

Flynn noted that over the past several years, newspaper headlines have trumpeted ethical problems in the executive suites of leading companies. Big business is not alone. He pointed to steroid use in major league baseball, cycling and track, and scandal in the clergy. “You have to ask yourself, ‘Why do good people do bad things?'”

In hindsight, it seems foolish to risk the fallout from unethical behavior, but Flynn said he has identified three reasons why good people choose the wrong path. First is rationalization. People who wind up with ethical problems focus on the intent of the actions, not the actions themselves. For example, they might tell themselves they are doing something wrong in order to help a client, or boost the stock price — which will help investors. “In many cases, they know right from wrong, but it comes down to rationalizing their behavior.”

Another pitfall is “implied permission,” the kind of thinking that says: “Everyone knows I’m doing it and nobody is telling me to stop so it must be okay.” Flynn repeated Warren Buffett’s observation: The five most dangerous words in business are, “Everybody else is doing it.”

Finally, employees violate ethical codes out of fear. Even if they don’t do anything wrong, they are reluctant to blow the whistle on others. They are thinking that, “It’s not my job to stop this. I might lose my job. I’m going to keep my head down and just do my job.”

Leadership is important in assuring integrity throughout an organization, Flynn stated, adding that even though only a few people at KPMG had behaved unethically, their actions slipped through a larger control system. To restore credibility to the firm as the indictments were about to be made, Flynn asked his partners for their trust and 90 days to re-establish relationships with employees and clients. On a conference call, he asked the partners to submit any questions they had for him by e-mail. He answered all the questions the next day: “I took the toughest ones first and answered them straight up.” He said the firm only lost five of 1,500 partners that summer and no Fortune 500 clients.

Flynn then set out to change the firm’s governance structure and culture. “To me, it was a real lesson in leadership. It’s about trust — earning the right to have others trust you and living out that responsibility.”

Flynn was asked about refusing revenue to maintain integrity. He said raising revenue was probably the motivation behind the actions of those partners in the firm who devised the allegedly fraudulent tax shelters. The revenues generated by those tax shelters came to about $125 million over five years.Some people might think that was a lot of money, Flynn said, but in reality, it was only a fraction of the firm’s revenues at the time, and the cost to the firm’s reputation far outweighed the revenue earned. “What seemed like a good opportunity had a huge cost later on,” he noted.

He pointed to another link between revenue and integrity. At a service firm like KPMG, employee engagement in the company is the major driver of revenue. “If people don’t feel good where they are, they’re not as good for the customers or the clients.” He said employee satisfaction at KPMG is up to 80% compared to 53% five years ago just prior to the tax-shelter scandal.

‘Conversation Touch-points’

KPMG now has what he calls a values-based compliance culture. While rules deal with clear standards, values tend to be shaped out of professional responsibility and boil down to how people treat one another. One way to develop values in a business organization is to create “conversation touch-points,” in which employees who are concerned about an ethical problem feel free to discuss it with a peer or a superior.

The firm also runs training sessions and publishes case studies to help guide employees through sometimes murky conflicts over values. For example, one case study lays out a common dilemma: At KPMG, the firm pays for a car service home or to a train stop for employees who work late into the evening. What if an employee works late three nights one week, but does not use the car service. She then schedules a car to go out to dinner Saturday night. “She’s thinking, ‘Well, I’m owed three nights,'” said Flynn. But then, when she fills out a fraudulent expense form saying she used the car Tuesday night, the ethical lapse seems to reach another level.

Another example KPMG uses in its training sessions focuses on a young associate working at a client site who receives a notice to save all work papers because of litigation. The associate then notices a senior partner destroying papers. KPMG trainers suggest that associates might first ask if the partner has seen the notice. Flynn warned that it is important not to be judgmental when developing a values-compliant culture.

If the associate does not feel comfortable with a confrontation, the firm offers other options, including an employee hotline to report misconduct. What’s most important, Flynn said, is for employees who become aware of improprieties to talk to someone. “What’s not acceptable is to put your head down and do nothing.”

Flynn acknowledges that, in the real world, right and wrong is not always black and white. “The question is: ‘How [do we] keep it between the white lines so we don’t get in the ditch and [find] it’s hard to get back up on the road?'”

Flynn was asked whether the structure of the accounting industry and its reliance on fees from the clients it audits is an inherent conflict that will continue to generate ethics crises. Flynn’s response was that this might have been an issue at the time of Arthur Andersen’s collapse in the Enron scandal. Today, following governance reforms, audit firms are clearly working for the board’s audit committee, not management. “Boards are active in hiring and firing auditors,” he said. “We work for the shareholders.”

Asked about current issues in accounting, Flynn said he believes that some of the requirements of the Sarbanes-Oxley Act will be scaled back for smaller firms which find compliance a burden. “The framework for a large multinational is different than for a small company,” he noted, adding that he favors development of a new compliance structure for small cap firms that should undergo pilot tests before taking effect.

He also said he is in favor of limiting liability for auditing firms which could be ruined by lawsuits stemming from a single client. Flynn challenged his audience to think of another business that faces this much risk without the ability to insure against it or charge enough to compensate for that risk. If massive fraud occurs at a firm that later goes bankrupt, he said, shareholders will automatically turn to the auditors for compensation because the corporation and management are gone even though they clearly bear at least some responsibility.

Flynn favors a system of proportionate liability in which audit firms would be granted some protection from liability if they displayed good faith and sound judgment while auditing a firm that develops problems. In October, Treasury Secretary Hank Paulson appointed Flynn to a special committee that is reviewing regulation of the accounting industry. The committee is expected to make recommendations next summer.

Finally, Flynn was asked if he has any regrets. He said his biggest struggles came in the wake of the tax-shelter scandal when he had to let partners go and refuse to pay their legal bills. “There were a lot of tough personnel and people decisions that I regret having to make, but I don’t regret making them.”

In the top leadership job, he added, any issue that reaches his desk is either really good news or really bad news. “There’s not much in between, so you’ve got to make decisions. I go to sleep and I get up tomorrow and don’t look back very often, because if I do, then I can’t look at today.”