Disclosure: The Real Challenge of Sarbanes-Oxley

The uncertainty surrounding implementation of the Sarbanes-Oxley Act has settled. CFOs have reassured themselves and their boards of compliance with its requirements, are confidently signing 10-Ks and 10-Qs, and have completed internal audits to ensure that compliance is truly achieved. Anxiety about reporting and corporate governance is now possibly lower than it has been for many years.

There is no reason, however, to be self-satisfied. Compliance with the Sarbanes-Oxley Act’s legal requirements is one thing; compliance with its spirit is another. The fundamental message running right through the act is that CFOs and boards must know their businesses better. To comply with the act, organizations must ensure that their senior finance managers really understand the increasing complexity of diverse operations, are constantly attuned to changes that impact financial reporting and business performance, and can talk knowledgably about their business to others.

The act covers this aspect of corporate governance most succinctly in section 409, Real Time Issuer Disclosures:

Each issuer … shall disclose to the public on a rapid and current basis such additional information concerning material changes in financial condition or operations of the issuer, in plain English, which may include trend and qualitative information and graphical representations, as the Commission determines by rule is necessary or useful for the protection of investors and in the public interest.

Companies need to communicate to investors, analysts, and the public material changes in their business that are likely to impact financial performance, as soon as they happen. The following are a few scenarios where section 409 might apply:

Each scenario represents a material change for a company. Even though financial performance may not be impacted for some time, each is obliged to disclose the event almost immediately under section 409, together with quantitative and qualitative guidance on the potential impact. In such a situation, many companies may be unable to provide reliable future earnings estimates, and may issue pessimistic earnings warnings.

Companies’ continued reliance on the annual budget as their major, and sometimes only, performance management tool will adversely affect their ability to provide analysis. Budgets typically contain high-level revenue and cost projections by line item and cost center, and every month a variance analysis is performed against them. But for the most part they are cast in stone during the prior year’s laborious budgeting cycle. Faced with the act’s disclosure requirement, stripping out the lost revenue would be fairly easy. But because few budgets contain nonfinancial operational information, such as key driver data, they are limited tools when it comes to assessing a major event’s impact on costs.

Few organizations will be able to identify the cost involved in servicing key customers, to quantify the complete operational and support costs underpinning key product ranges, or to see how an escalating customer attrition rate will impact future years’ earnings. The only current way to do this is to go back to each responsibility center and ask them to reforecast their cost base. Not only is this unlikely to be as “rapid and current” as the act requires, there is no telling how reliable the results will be.

A 2002 CFO Research survey found that 50% of leading companies intend to incorporate operational driver data into planning and budgeting within the next three years. By using new planning and budgeting software that models the business across responsibility centers and time periods, they can reforecast more frequently and cut scenarios on demand, simply by updating driver data and consumption rates. Not all relationships between drivers, resources, and their costs are easy to establish. It may be simple to assess the impact of losing a key account on revenue and direct volume-related operational costs. Assessing the impact on resource requirements in shared services functions and other indirect volume-related costs, however, is more difficult.

One way to understand resource consumption and costs across all functions within an organization is to include a high-level activity layer. This links resources and their costs to key business activities, which in turn are linked to the products, customers, and channels which consume them. This effectively unites traditional financial metrics with an operational perspective.

This allows the CFO to provide more accurate income and cost projections on demand. When there is a need to quantify events such as the loss of a key customer, all the costs, including the indirect costs in the back office and shared services functions, are much more readily quantifiable, together with a clearer view of which are fixed and which are variable. Because of the deep operational perspective provided by including all cost drivers, organizations can quickly assess what new resource levels are required, and realign their operations.

Only when it reaches this point has an organization prepared itself to address section 409. Although the Sarbanes-Oxley Act encourages organizations to improve their performance management processes and applications, their motivation should go beyond mere compliance, to include creating shareholder value.

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