Linking Quality with Financial Metrics – Invoking key points from the Sarbanes-Oxley Act

Out of the total 11 titles in the Sarbanes Oxley act, two titles
(Title III and Title IV) aid in linking financial metrics to quality.

Title III – Corporate responsibility

Key points:

1. Section 302 requires that the financial reports filed under the Securities Exchange Act of 1934 present true status of financial position and the results of operations.
2. As per this section, if cost of quality is material then it needs to be accurately reported. This amounts to having appropriate metrics to measure the cost of quality.
3. The International Accounting Standards Board (IASB) defines materiality as: “Information is material if its omission or mis-statement could influence the economic decisions of users taken on the basis of financial statement.” From this point of view, it can be argued that since financial statements are about the cost of doing business and these costs include cost of quality, the omission of these costs from the general ledger is a federal crime, particularly so if these costs are high.
4. This suggests the need for embracing and more fully understanding the implications for quality by top management. The cost categories of failure, appraisal and prevention can be mapped into appropriate items of general ledger as follows:
   1. Failure category measures include such items as: scrap, rework, labor, sorting,
            downtime, slowdowns, complaints, investigations, travel, recall, unpaid invoices and lost sales. These can be mapped into operating costs, operating expenses (labor), variable expenses and losses items of general ledger.
   2. Appraisal
            category measures include such items as: receiving, in-process and final
            inspection, test equipment, test technicians, special tests, lab maintenance, quality control, QC overhead. These can be mapped into operating expenses, fixed expenses, depreciated assets (equipment), fixed assets (technicians).
   3. Prevention category measures include items such as: quality planning, design
            tolerances, training, house-keeping, packaging, special sourcing, life cycle tests, field tests, pre-production tests, shelf tests, inventories, cash flow. These can be mapped into operating expenses, fixed expenses, variable assets (cash flow) and inventory.

Title IV – Enhanced financial disclosure

Key points:

1. Section 404 requires that top management verify the effectiveness of internal controls in the areas of finance and operations. While the extent of operations that must be verified is not yet resolved, the consensus as of now is that IT controls must be verified since most of the financial data resides in IT system.
2. The definition of internal control as used by the Securities and Exchange Commission (SEC) and adapted from the Committee of Sponsoring Organizations of the Treadway Commission (COSO) says that internal control is a process to ensure the effectiveness of operations, reliable records and reports and compliance with standards.
3. To meet Sarbanes Oxley Act compliance, management must come up with a set of internal controls for finance and IT and this requirement will need to extend to other processes identified as material.
4. A common metric can be used by mapping IT Governance Institute’s standard control objectives for information and related technology (CobIT), ISO 14001 and other standard requirements into the appropriate compartments of ISO 9001 in terms of policies, procedures, controls, audits and practices.
       

Source: “Financial Control and Quality,” by William Stimson
and Tom Dlugopolski, Quality Progress, May 2007, 26-31.