Six Sigma, Financial Reporting, and Corporate Governance: The Shape of Things to Come

Recent revelations of fraud and mismanagement have led to a widely publicized erosion of confidence in corporate America. Legislative and regulatory enactments have fundamentally changed the game for senior leaders and boards of directors, and further action seems likely. As corporate officers face increased personal exposure to fines and imprisonment, the ability to demonstrate disciplined application of financial best practices is assuming unprecedented importance. Indeed, the Sarbanes-Oxley Act specifies establishment of enhanced disclosure controls and procedures – without clarifying the mechanism by which these are to be implemented.

When augmented with techniques from economics and finance, Six Sigma – the methodology adopted by leading companies worldwide to revolutionize all aspects of corporate performance – provides the basis of a new paradigm for financial reporting and corporate governance. In light of demands from numerous constituencies for improved oversight, Six Sigma’s customer-focused approach and numbers-friendly analytical tools are a natural for defining the standards of a new, more disciplined, corporate financial culture. In what follows, we’ll explore the how and why of applying Six Sigma to assure quality in financial reporting.

For one thing, senior corporate leaders, their boards and investors, analysts and regulators, need a common methodology for determining which financial metrics are worth reporting. Traditionally, attention has focused principally on numbers that appear in a company’s financial reports, plus a relatively small set of quantities calculated from them (growth rates, expense ratios, etc.). Today, it’s common to hear debate as to which metric provides the best measure of a company’s performance. There are advocates of EBITDA, free cash flow, working capital turns, ROanything, various debt ratios, and so on – each of which is viewed by its proponents as best capturing the essence of corporate financial well-being. Ironically, the problem with these arguments is that almost all of the contentions put forth are correct. Different metrics do reflect different aspects of corporate performance, and will catch – or miss – particular types of problems or issues. And that’s precisely why no one metric offers the solution to corporate performance monitoring: only collectively can financial metrics present a comprehensive assessment of a company’s status. Only by selecting a set of complementary metrics can we capture a true picture of a company’s total performance.

And that’s where Six Sigma shines. An integrated financial reporting system needs to adopt a disciplined approach to selecting a set of related metrics that will be responsive to the needs of all constituencies. In many other venues, Six Sigma has addressed this multi-customer environment with great success. Six Sigma methods use a facilitated focus group setting to identify the critical needs of all concerned through an orderly and structured process. The effectiveness of alternative proposals is then evaluated and ranked. In the case of financial reporting, the outcome is a list of key business metrics that will convey a holistic picture of a company’s status, and assure all constituencies’ needs are met.

Next, each of the key metrics being tracked needs to be assigned a range of values that reflects normal behavior. Outside this range, it will be presumed that some significant event or change has occurred. These “baselines” need to be built not on hunches, opinion, or rules of thumb, but on sound analyses of business data. And here, too, Six Sigma’s strengths come into play. Six Sigma tools for measuring variability, estimating trends, and evaluating probabilities provide an objective means for assessing what constitutes normal behavior of business metrics. In so doing, they also yield an unbiased determination of when aspects of a company’s performance are no longer within established historical or industry norms.

But Six Sigma has the power to go beyond identifying key metrics and providing a sound basis for monitoring their behavior. Applied to internal corporate data, Six Sigma analysis techniques can uncover relationships between performance metrics and the underlying key drivers that shape them. This has extraordinary value in several regards. First, these links are frequently not previously known, or at least not quantified. Second, drivers of corporate performance can often be measured in advance of the performance metrics themselves-so quantifying these relationships has predictive value for giving management advance notice of what’s over the horizon. It is often possible to anticipate values of key business metrics by 1-2 months or more through this approach. What’s more, these relationships capture fundamental characteristics of a company’s business structure. Using Six Sigma to monitor relationships, as well as metrics, gives all constituencies clearer insight into the evolution of a firm’s business picture – highlighting potential issues sooner, identifying causes more clearly, and affording increased insurance against manipulation or malfeasance.

And that’s not all. When augmented with techniques from economics, finance, and operations management, the resulting enhancement of Six Sigma can be taken still further. These techniques leverage external data to identify leading indicators of corporate performance. Demographic, economic, industry, and other data sources can be called upon to develop predictors not only of high level corporate metrics, but even of fairly specific business unit performance measures. The resulting benefits parallel those of identifying key drivers, but with lead times that commonly reach 6-9 months.

In conjunction with one another, key drivers and leading indicators provide senior management the tools to exercise a steadier hand on the wheel: opportunities to reallocate resources, mitigate risk, manage finances, and adjust strategy.

With the business metrics identified and baselined, and their relationships to key drivers and leading indicators established, all of the pieces are in place for establishing routine monitoring of the corporation’s financial metrics and structures. The resulting Six Sigma reporting system supplements existing financial practices and controls, and in due course, is likely to become fully integrated with them.

Once Six Sigma monitoring is in place, companies need to decide how, when, and to whom key business metrics should be reported. In light of the various constituencies being served, different metrics will most probably be sent to different recipients at different times. Some quantities, usually including financial metrics useful in operations, will be selected for routine report-outs (weekly or monthly, for example, or even on-line as management dashboards), usually with management as the key customer. This is the case with GE senior management’s “digital cockpits”, for example, which are specifically targeted toward operational and financial management. Other metrics, particularly those with implications for regulatory compliance, financial reporting, or corporate governance, will be reported not only regularly (e.g., in quarterly reports), but also on an exception basis when values deviate from their baselined ranges. Internal auditors might typically be the first to be notified in such cases. Although deviation from established norms is by no means presumed to indicate any impropriety, it does signify natural change points at which it is appropriate to re-examine fundamentals, identify root causes, and understand whether there is cause for concern.

Of course, disciplined reporting and response plans must be in place for acting upon any issues that are brought to light. The essence of these plans is root cause analysis – tracking down the explanation for a question that has been raised. To assure proper oversight, selected auditors and/or ombudspersons should be notified whenever an inquiry is underway, even though there is no presumption that any impropriety is involved. Six Sigma corporate monitoring systems will – and should – from time to time detect changes that are positive results of shifts in management strategy, economic conditions, etc. Nonetheless, the purpose of posing a barrier to fraud or mismanagement requires that effective oversight procedures be in place at all times. Concerns regarding proprieties of corporate governance would be raised with the board, and, if required, presented for regulatory review.

The disturbing course of recent events in American business has pointed up a clear need to revise corporate financial reporting practices, and to provide regulators, analysts, directors, and shareholders with the information they need to apply more rigorous and quantitative standards in evaluating a company’s performance. New certification requirements for senior management and new expectations of corporate boards impose heightened personal accountability at a company’s highest levels. More than ever, this compels top executives to have reliable means for seeing into the inner workings of the organizations they head.

Financial Quality practices, rooted in Six Sigma, can help corporate leaders manage more effectively, promote legal and regulatory compliance, reaffirm a culture of corporate financial responsibility, and ultimately restore investor confidence in America’s business institutions.