Upfront: Six Sigma Meets Financial Reporting

Could -- and should -- the statistical tools of Six Sigma, a quality discipline used in manufacturing and service processes by such behemoths as GE, Motorola and IBM, be applied to the financial reporting process? A recent research report by The Faltin Group in Ballston Spa, N.Y., suggests that if the methodology had been applied to WorldCom's financial reporting, it could have prevented billions of dollars in losses.

Six Sigma tools are designed to help users understand normal operations, then to raise questions about any unusual behavior. Using publicly available data, the Faltin Group tested the theory that this approach can uncover problems in financial reporting.

The firm found that starting in April 2002, WorldCom began to dramatically restructure its debt. Investors enjoyed share prices around $15 in mid-2002, but the research indicates that Six Sigma might have signaled the company's failing financial health at that time, prompting an inquiry into its causes.

"What's important for tracking any company's performance," notes Frederick W. Faltin, managing partner and author of the report, "is that rigorous systems be in place for analyzing a comprehensive group of key financial measures and for asking questions when unusual patterns arise." In WorldCom's case, intervention might have led to management changes in time to save the company from collapse.

Faltin emphasizes that Six Sigma, when augmented with techniques from economics, finance and operations management, can improve the timeliness of corporate financial monitoring because decision-makers no longer rely on metrics that lag actual corporate performance. Plus, the Six Sigma methodology enables managers to create metrics that are difficult to falsify, facilitates common practices across companies and makes malfeasance detectable at levels below the corporate office. These benefits are available to both internal auditors and outside analysts or regulators.

"To me, the key is whether Six Sigma is viewed as an approach to process improvement or a target," says David Axson, senior vice president and co-founder of The Hackett Group in Hudson, Ohio. "As an approach, it has merit since it lays out a systematic and disciplined approach, which will result in higher quality. As a target, the value is less clear, since achieving Six Sigma can be very expensive and time-consuming, and there is a tradeoff between risk and cost that has to be made. Clearly, at present the pendulum is at the point where no risk is acceptable, but that is not sustainable.

"Financial reporting is really the sum of all the other processes in a company, such as sales, purchasing, HR, etc.," Axson adds. "It is very difficult to isolate reporting and make it Six Sigma without it being a broader effort. You could argue that if all the upstream business processes are Six Sigma, so the financial reporting process will be as well."