The Impact of Sarbanes-Oxley on Supply Chain Management

The financial accountability law offers an opportunity to elevate the importance of Supply Chain to the C-level suite

When the Sarbanes-Oxley act (SOX) was signed into law on July 30, 2002, it changed the way executives at nearly every public company thought about their business. While SOX gained attention in 2003 and 2004 for its focus on financial and accounting issues, the focus in 2005 has shifted to other functional areas such as Supply Chain, Human Resources and Information Technology. Looking toward 2006, it is clear that this trend will continue, and for supply chain leaders, the time is right to establish an active role in your company's corporate governance strategies.

As we know, SOX legislation was enacted in response to the serious misconduct of the 1990s, which had a profound impact on institutional and private investors' 401(k) accounts. The legislation has brought the need to have transparency in financial statements to the forefront of corporate issues. For publicly traded companies listed on U.S. exchanges, there are three primary areas addressed by SOX:

  1. Internal process controls (Sections 302& 404): Calls for the creation and maintenance of viable internal controls.

  2. Off-balance sheet obligations (Section 401a): Requires the listing and disclosure of off-balance sheet transactions and obligations.

  3. Timely reporting of material changes (Section 409): Requires the timely reporting of events that materially impact financial reporting.
SOX will force CEOs and CFOs to rely on their supply chain leaders to take a proactive role in corporate governance. It is the supply chain leader's responsibility to interpret the impact that SOX compliance has on a company's supply base and to work with the company's compliance leaders to ensure that supply chain processes have appropriate controls.

The Issues and Implications for Supply Chain Leaders

While there are clear SOX implications throughout all areas of Supply Chain Management (SCM), the law does not mandate how a company must address them. SOX also doesn't determine what is or is not material, as it leaves each individual company to identify independently what material events or actions will have an impact on the organization. So what does all this mean for us in Supply Chain Management?

It means that supply chain managers, together with their CEOs, chief financial officers (CFOs) and/or chief compliance officers (CCO), must take an active, collaborative approach to implementing a corporate governance program if they want their SCM organizations to be SOX compliant. Also, with the SOX requirement for CEOs and CFOs to quarterly certify financial statements (section 302), you can rest assured that supply chain leaders are going to be summoned to attest that their organization and processes are compliant.

Are Your Processes Under Control? (Section 404)

As a result of Enron, WorldCom and other corporate failures, regulators realized that many companies lacked the kind of policies, procedures and training necessary to ensure a company's quarterly financial statements accurately reflected reality. What regulators and policy- makers also realized is that this shortcoming in corporate management may not be limited to the auditing and financial controls function. In fact, a number of inadequate supply chain process controls may need to be identified and corrected.

  • Inventory and Fixed Asset Reconciliation and Inventory Write-offs: Accurate and timely accounting requires a systematic and consistent review of materials to ensure that the material is physically there and that the inventory value is correct and accurately represented within the accounting system.

    Because CEOs and CFOs must validate financials quarterly, the law significantly raises the importance of inventory reconciliation as well as the pressure on executives to accurately account for their inventory. Traditionally, inventory reconciliation has been done on a yearly basis. Under today's compliance laws, however, processes must be in place to confirm that what a company says it owns each quarter is truly in its possession. For example, if a company says it has $40 million in inventory but can only definitively account for $35 million, it will have to make an adjustment and write off $5 million for the quarter. The underlying process generating this discrepancy also needs to be investigated and corrected.

    There have been some cases in which a company will conduct a physical inventory and find that a particular machine is obsolete. If this obsolescence is not communicated to Accounting, the asset will remain on the financial statements at an inaccurate value. In some situations the value may have decreased based on market conditions, which should be shared with Accounting in order to adjust the value of the asset if necessary.

    Another example of an inventory valuation issue is when a company is carrying a raw material, work in process or finished goods inventory and the asset or a key component of the asset drops in value. Carrying original cost without devaluing or adjusting to the new, lower market value leads to inaccurate financial statements.

  • Material Transfers and Poor Inventory Accuracy: As more and more supply chain leaders are being asked to assume responsibility for materials management, internal procedures and controls are being scrutinized to ensure inventory accuracy. When organizations operate in a lean environment, inventory control often takes a backseat. Too often material transfers are not processed in a timely manner and a true "inventory to records" situation is difficult to achieve. Under SOX, all movements of inventory or fixed assets must be recorded in a timely fashion given their definitive financial impact.

  • Segregation of Duties in the Procure-to-pay Process: While many companies have fundamentally sound policies and procedures in place that segregate the duties of receiving, order placement, invoice processing and establishing vendor masters, supply chain executives need to ensure that adequate approval processes and procedures are also in place to help ensure that fraud or theft will not occur. Furthermore, they need to document the controls and completed testing to validate that these controls are working.

  • Viable SCM Processes: SCM organizations utilize numerous tools to either assist or monitor the execution of company expenditures. These include, but are not limited to, procurement cards, e-procurement and blanket order releases. To be SOX compliant, companies must establish adequate controls to monitor expenditures and to ensure transactions have appropriate approval authority.
Have You Met Your Off-balance Sheet Obligations? (Section 401a)

One of the key tenets of SOX is that publicly traded companies must provide financial transparency in preparing their financial reports. In the area of Supply Chain Management, we are making deals and agreements each day that may contain vital information for the CFO or chief compliance officer. If any of our agreements have provisions that call for a financial obligation or penalty, we should be advising the CFO or CCO of these obligations. Naturally, the chief financial or compliance officer will want to know what these obligations are and will determine the need to include them as time-phased listing of obligations in the company's quarterly report.

Areas where such agreements could impact off balance sheet obligations and provisions of SOX are:

  1. Vendor Managed Inventories (VMI) : We continue to trend towards relying on our key supplier base to assume more responsibilities with inventory. In doing so, if we have any financial penalty clauses in the agreement and do not use the inventory they are stocking for us, this is a financial obligation that does not show up on the balance sheet.

  2. Long-term Purchase Agreements: Similar to VMI, any agreements that include a financial obligation in the event of cancellation, established restocking charges or other provisions should be reported to your CFO or CCO as a means of advising where potential obligations could exist.

  3. Lease Agreements: In our day-to-day business we often are faced with the fundamental decision to purchase or lease. Our decisions are unique to our companies and to our internal requirements, and the decision to pursue lease agreements versus purchase will be based on a variety of factors. Keep in mind that any penalties or other financial obligation outlined in the agreement for early termination are financial obligations that cannot be seen in our standard financial statements but certainly could have a significant impact on our financials if we elect to end the agreement early. Again, it is imperative to keep our CFO and/or CCO fully aware of which agreements contain these obligations.

  4. Letters of Intent: These are common and are used in capital intense situations whereby we need to get in the production schedule for long lead time deliveries. Although this wouldn't seem to relate to SOX compliance, in fact, the same principle applies: If the letter of intent has a cancellation clause with financial penalty, then we need to ensure that we are keeping the CEO/CCO informed.

Are You Reporting Material Changes? (Section 409)

As organizations trend toward more outsourcing, supply chain managers must be aware of the potential impact this will have on compliance. The outsourcing of goods and services is a fundamental make-or-buy procurement decision, and SCM organizations are held responsible for ensuring those decisions are sound, vendor relationships are stable and all contracts are executed as agreed. If the outsource provider has a supply disruption, for whatever reason, is there a process in place to report in a timely manner the financial impact of the disruption? SOX tells us that there needs to be.

Where to Start?

As a supply chain manager charged with compliance responsibilities, it is crucial that you identify risk areas, such as weak controls that could lead to fraud. You also need to identify controls in the process and decide how they relate to financial assertions and other material events. Once that is complete, and assuming you've discovered you have some work to do, the remediation process will need to take place.

To ensure compliance with supply chain policies and procedures, it is imperative that you communicate them on a frequent basis to all business units. As an additional form of internal control, supply chain executives can educate their vendor base about the policies and procedures the company has in place, ensuring the vendor will not proceed without the proper approvals.

The SCM organization is in the midst of evolving into something much more strategic and mission critical than one could have imagined just two years ago. SOX has given us the opportunity to champion our organizations with senior management and demonstrate true leadership within an extremely challenging regulatory environment. Supply chain managers need to bring these concepts to the attention of their SOX owners so a resolution can be achieved that will enhance the supply chain for the betterment of the company. SOX is also an ideal opportunity to legitimize additional investments into the SCM organization and elevate its importance and impact to the C-level suite.

About the author: Robert J. Engel has been in the supply chain profession for more than 35 years, beginning Shell Oil Company's staff development program for procurement and supply management professionals. Currently he is national director of client service for the Supply Chain Management practice at Resources Global Professional (