Tuesday, January 18, 2005
Consolidating with Compliance
Driving compliance efficiency in the Sarbanes-Oxley environment.
By Robert Kugel
Section 404 of the Sarbanes-Oxley Act will force companies to make fundamental changes in their financial processes to regain efficiency lost in a more formal control environment. Legal and financial consolidation is one area ripe for change. Ventana Research asserts that companies can and should shift from a traditional bottom-up, sequential consolidation method to a more centralized approach. In doing so, they can cut costs, shorten reporting intervals, enhance the accuracy and reliability of the process, and achieve greater control. Some companies already have the IT assets in place to accomplish this, while others will need to make changes to their consolidation and reporting systems.
So far the focus of the work done by corporations to achieve Sarbanes-Oxley Section 404 compliance has been on ensuring that existing financial systems and processes have adequate controls to prevent financial fraud. Few recognize the longer-term implications of the auditing community's decision to adopt the "COSO Framework" as a cornerstone for enhancing financial controls. The Committee of Sponsoring Organizations of the Treadway Commission (COSO) envisioned shifting the emphasis of fraud control away from heavy reliance on personal integrity, common sense and after-the-fact audits, to a method emphasizing preventative measures and ongoing monitoring.
Manufacturing organizations have realized substantial value from adopting a total quality management approach that designs quality into processes and continuously monitors performance, instead of relying on final inspection to weed out mistakes. Finance organizations in US reporting companies can and should do the same, because most will find that what might have been cost effective before is likely to be expensive and inefficient in today's formal control environment. To this end, consolidation is a financial process ripe for change.
Today, companies consolidate their financials in a sequential, bottom-up process: lower-level entities perform their closing process (accruals, adjustments, etc.) and then pass the results up to the next level of the company. When books were kept by hand, this was usually the only feasible method. Even after the introduction of consolidation software applications, this was still the preferred method. However, the best practice now is to perform consolidations in a more centralized, synchronous fashion.
The bottom-up approach is still adequate, but it suffers from defects. First, it is inherently less controllable from a financial fraud standpoint. Lower-level managers can create misleading financial statements. Certainly, audits can pick up fraudulent entries and auditors pay a great deal of attention to this area because of its vulnerability. For now, senior executives can rely on 'deniability' to distance themselves from lower-level fraud. In their periodic attestations, these managers will have signed off on the accuracy of the financial information they provide. We expect that soon this will no longer be enough as auditors continue to raise the bar on acceptable levels of financial controls maturity. This is an area on which they are sure to focus.
Beyond the issue of compliance, a more centralized, synchronous consolidation can save money and time. Because it is less controllable, the bottom-up method is more laborious. It requires more controls, more tests, inspections, and more auditing time. From a process execution standpoint, it requires more people to perform the consolidating and closing transactions. It is more time-consuming than a synchronous approach, requiring a longer interval between the end of an accounting period and completion of the close.
Moreover, since it takes that much longer, companies are not able to get management accounting data to interested parties as soon as they could. In this respect, it also is not consistent with the requirement for increasing the speed with which public companies report. On the management accounting front, the bottom-up approach encourages business units to futz with the numbers to meet their objectives, slowing the process of getting actionable information to the field. Often we find larger companies will issue "flash" results to overcome this problem, consuming even more resources.
Certainly centralization has its limits, both legal and practical. For fiscal reasons, it still will make sense to consolidate at a country level (both in local GAAP and in parent GAAP). From an operational standpoint, unless they have harmonized their charts of accounts, companies with multiple business segments (e.g., plastics, jet engines, medical systems and financial services) will find it most useful to centralize around like businesses (i.e., ones with similar charts of accounts).
Ventana Research recommends that finance departments briefly catch their breath after their initial Section 404 audit and then get back to work redesigning processes to improve their control efficiency. We expect there will be substantial changes to "best practices" in corporations as they adapt to new regulatory environments. Centralizing consolidation is one area where technology can enable a more efficient, more controllable finance environment. Organizations must determine if their consolidation and reporting systems are adequate for this purpose, and make improvements where necessary to make a more centralized, synchronous approach feasible.
Robert Kugel is CFA, VP & Research Director - Financial Performance Management at Ventana Research.
posted by Brian Moran @ 3:22 PM