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Sarbanes Oxley : Auditing : Thought Leader
Sales Compensation Management: SOX (And Beyond)
By
Christopher Cabrera
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Christopher Cabrera
Founder, President and CEO
Xactly
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Throughout the technology boom of the late 1990s, investors lost billions of dollars backing companies that owed their "success" to the creative use of smoke and mirrors. When the inevitable meltdown hit, scandals involving major companies such as WorldCom, Tyco and Enron drew national attention to the fact that many corporations did not have proper financial controls and corporate governance in place; in response, Congress passed the Sarbanes-Oxley Act to force companies to create a paper trail of financial information so that data could be easily tracked. One area that companies are beginning to monitor more closely than ever before is sales compensation management.
Most companies use Excel to manage their sales compensation programs. Spreadsheets are fine for sorting tables of data, but they weren?t designed to provide the kind of sophisticated financial transparency that businesses need to manage sales compensation. Despite the nearly universal recognition that Excel isn't an adequate tool - spreadsheets have an error rate of 7-10% - even the most sophisticated enterprises still use spreadsheets to manage their sales compensation programs. Not only is this an inconvenience for the accounting department, it's also a source of liability for the company as a whole.
In contrast to the unreliability of spreadsheets, automated sales compensation management systems provide an archive of all incentive transactions and offer a full audit trail of every transaction and payment. The result is that the CFO, whose responsibility it is to ensure compliance, can see company's commission responsibilities in real time, as well as track any changes made to the plan. From a management perspective, automated solutions offer visibility and feedback that is essential to addressing questions as they come up, rather than at quarter close - and before the auditors arrive.
Calculating sales compensation seems like a fairly straightforward proposition. After all, most field professionals earn a combination of salary and commission, so it should be fairly easy to tally exactly how much they should take home each pay cycle. The reality is that managing compensation is a complex process that demands a tool designed to handle the intricacies of compensating a sales team. And CFOs can no longer brush this off as ?someone else?s problem? ? today?s regulatory standards mean that the responsibility for tracking sales compensation goes all the way up to the top of the corporate ladder.
The Cost of Non-Compliance
The Sarbanes-Oxley Act (better known as SOX, but officially known as the Public Company Accounting Reform and Investor Protection Act of 2002) requires companies to establish and maintain internal financial controls. One of the major provisions of SOX is that systems need to provide an archive or audit trail ? which is something that spreadsheets simply weren?t designed to do. As a result, companies that still use Excel for their sales compensation management functions face major financial and legal exposure. CFOs need to ask themselves the following question: "Can we afford not to have a sales compensation management solution?"
Four years after the passage of the Sarbanes-Oxley Act, the practical implications for public companies are well understood. Aside from macro-level disclosures, certification, and audit requirements, at the business execution level the Act mandates that every company have a set of internal procedures designed to ensure accurate financial disclosure. In the context of incentive compensation management, this has a number of specific consequences:
- Compensation Plan Coverage: companies must be able to demonstrate that all incentive compensation is paid in compliance with agreed-upon compensation plans
- Calculation Validity: companies must be able to demonstrate the validity of their compensation calculations from transaction event to actual payment
- Change Control: companies must be able to demonstrate auditable controls over changes made to the data that drive calculations
- Certification: companies must certify that incentive payments made to recipients were based on the formal compensation plan, and that no undisclosed side agreements were in effect
By providing detailed documentation of sales plans, compensation rules - and by managing all incentive compensation through a single, validated process - a dedicated sales compensation management system ensures a company?s compliance to Sarbanes-Oxley with respect to its incentive compensation.
Planning Pay, Paying the Plan
Given the unreliability of Excel for many complex business functions, it's surprising how ubiquitous spreadsheets really are. In 2004, financial intelligence firm CODA reported that 95% of U.S. firms use spreadsheets for financial reporting; this was just one of many studies all pointing to the same conclusion. Given the widespread adoption of Excel, it is not surprising that the majority of companies rely on spreadsheets to plan and track their incentive compensation programs. While Excel has long been a tool of choice for financial analysts, its advantages of desktop accessibility, familiarity and flexibility rapidly become liabilities when applied to the world of variable compensation. First and foremost, extensive studies of spreadsheets used in financial reporting have shown that 94% of all financial spreadsheets contain errors. More importantly, recent studies have shown that fully 91% of spreadsheets contain material errors?that is, errors large enough to produce a 5% or larger error in the bottom line value of a key financial variable . The potential complexities of variable compensation plan structures put them at high risk of falling into the material error trap.
While the development of spreadsheet-based compensation plans is itself error-prone, rolling out the plans to sales people has its own inherent set of challenges. Because sales professionals are often on the road with limited access to back-office data and support staff, communicating the structure of the plan can be difficult. Many companies still distribute paper-based compensation plans to individual sales reps that are required to review them and indicate with a signature whether they accept or decline the plan. Getting itinerant sales people to accept and approve their compensation plans - and rolling this approval up each successive level of the sales hierarchy - can be frustrating for overburdened compensation analysts.
Dr. Raymond R. Panko, a professor of IT management in the College of Business Administration at the University of Hawaii (Panko, Raymond R. (2006), Spreadsheets and Sarbanes-Oxley: Regulations, Risks, and Control Frameworks, Communications of the AIS), has authored numerous studies about the reliability of spreadsheets in financial reporting. In his recently published article Spreadsheets and Sarbanes?Oxley: Regulations, Risks, and Control Frameworks, Panko provides compelling evidence that Excel-based systems are leaving companies vulnerable to running afoul of the new federal regulations:
The Sarbanes?Oxley Act of 2002 (SOX) has forced corporations to examine their spreadsheet use in financial reporting. Corporations do not like what they are seeing. Surveys conducted in response to SOX have shown that spreadsheets are used widely in corporate financial reporting. Spreadsheet error research, in turn, has shown that nearly all large spreadsheets have multiple errors and that errors of material size are very common. The first round of Sarbanes-Oxley assessments confirmed concerns about spreadsheet accuracy. Another concern is spreadsheet fraud, which also exists in practice and is easy to perpetrate. Unfortunately, few organizations have effective controls to deal with either errors or fraud?
And in case you're one of those people who rolls their eyes whenever academic studies are cited, perhaps this piece of Panko's research will grab your attention: companies experienced an average stock price drop of 4% right after announcing that their financial controls were materially deficient. In addition, the Dutch research firm ARC Morgan found that in more than 60% of all cases, the chief financial officer (CFO) was replaced within three months after a company reported material weaknesses.
SOX Compliance in the Real World
Redback Networks Inc., a leading provider of next-generation broadband networking systems, recently deployed a sales compensation management system to support Sarbanes-Oxley compliance, streamline plan document approvals and provide sales compensation management supporting over 12 currencies for 135 sales professionals worldwide. ?It has really helped us to proactively address SOX compliance requirements,? said Tom Cronan, the company?s CFO. ?Now, in real-time, I can see what our commission exposure is as well as providing me with an archive and audit trail of any changes including when and by whom.?
Running afoul of Sarbanes-Oxley isn?t as hard as one might think. According to The Hill, in the first half of 2006 more than 12 percent of companies filing under Section 404 - including General Electric, Eastman Kodak and Goodyear - were found to have a ?material weakness? in their financial controls. In addition, one of the major features of Sarbanes-Oxley is that it penalizes individuals, not just companies, for malfeasance. In past years corporations that did not keep adequate tabs on their data might have gotten a rebuke ? today, CFOs and other top managers are personally on the line for financial missteps. And statute is unlikely to go away any time soon. The act?s co-author, Rep. Michael Oxley, stated that the $11 billion Fannie Mae accounting scandal demonstrates the need for Sarbanes-Oxley compliance. "It was not until Fannie had to comply with Sarbanes-Oxley requirements that executives at the company finally admitted that the company's internal controls over financial reporting were ineffective."
Preventing Other Legal Liabilities
Companies are scrambling to implement software tools to help them stay on the right side of new regulatory statutes, but having a coherent system for managing sales compensation can have far broader legal benefits. One area is in the resolution - or prevention - of legal disputes over pay for sales professionals. In many cases, a lack of clearly defined data and a complete paper trail can create legal exposure for companies that get sued over pay. Without a real-time record that explicitly spells out commissions and other compensation due to its sales staff, companies simply don?t have the ability to produce the ironclad evidence they need to defend themselves.
One doesn?t need to look too hard to find real-world examples of sales professionals taking their employers to court over pay disputes. In the Tennessee S. BOWMAN REID v. EXPRESS LOGISTICS, INC. case, the courts intervened in favor of a former sales manager who felt that he was denied compensation for deals that had been signed during his tenure at the company. One of the centerpieces of the case (which was won by the employer but ultimately decided by the appeals court in favor of the plaintiff) was that there was no written agreement outlining the terms of compensation. The entire case could have been resolved ? and three court trials avoided ? if the company had put a system in place to track employee compensation and clearly define the terms of its pay program.
As is the case with most things in life, the best defense is the truth. Unfortunately, in sales compensation cases proving the truth is far more difficult than just being right, and a lack of accurate, incontrovertible data can put companies in serious legal jeopardy. Buying a real-time automated system to track how much employees are owed can be expensive: not buying one could prove to be far costlier.
It is now widely recognized that improvements in information technology are essential to becoming Sarbanes-Oxley compliant. While companies initially viewed achieving Sarbanes-Oxley compliance as a project, it is more properly viewed as an ongoing approach to doing business that requires pervasive changes to both processes and enabling technologies. Exempt of the Sarbanes-Oxley directives, private companies will nevertheless benefit from the kinds of process definition, execution consistency and audit-worthiness that Sarbanes-Oxley mandates in the public realm. During the same time period that Sarbanes-Oxley awareness crystallized, the broader discipline of incentive compensation management established a substantial value proposition that includes addressing a number of Sarbanes-Oxley issues. Incentive compensation management is aimed at allowing companies to design, implement, manage, audit and communicate their sales compensation programs. By integrating variable compensation financial and internal control monitoring and reporting, a dedicated sales compensation management system can put public and private companies on the road to Sarbanes-Oxley peace of mind.
Christopher Cabrera
Founder, President and CEO
Xactly
Christopher W. Cabrera is Founder, President and CEO of Xactly Corporation (www.xactlycorp.com)and the co-author of Xactly Sales Compensation for Dummies. Prior to founding Xactly, he was senior vice president of operations for Callidus Software. A Silicon Valley resident, Cabrera earned a bachelor?s degree in business administration from USC and an MBA from Santa Clara University
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