The SEC´s Interpretive Release on MD&A

Originally published January 11, 2004

On December 19, 2003, the SEC issued an interpretive release on the disclosure requirements known as Management’s Discussion and Analysis of Financial Condition and Results of Operations. See Interpretation: Commission Guidance Regarding Management’s Discussion and Analysis of Financial Condition and Results of Operations, Release Nos. 33- 8350; 34-48960. MD&A is the centerpiece of SEC filings on Form 10-K and 10-Q as well as SEC registration statements for the sale of securities. The Release does not change existing disclosure requirements for MD&A. Rather, its purpose is to present the SEC’s views on how companies can better comply with existing MD&A requirements, based on the recent review experiences of the SEC staff and particularly its review of the SEC filings of Fortune 500 companies. Accordingly, we believe the Release is essential reading for public company executives involved in the disclosure process, as well as for the lawyers and accountants who advise them.

The Release emphasizes, as a general theme, that the purpose of the SEC’s MD&A requirement is to provide a narrative explanation of a company’s financial statements that enables investors to see the company through the eyes of management and to provide the context within which financial information should be analyzed. It is intended to give investors information about the quality and the potential variability of a company’s earnings and cash flows so that investors can assess the likelihood that the company’s past performance is indicative of its future performance. Another general theme of the Release is that MD&A should not be simply a mechanical recitation of financial statements in narrative form (such as descriptions of the dollar amounts and percentage changes in income or other financial statement line items) or a series of technical responses to MD&A disclosure requirements (such as identifying an accounting principle used, without discussing potential uncertainties in applying the accounting principle or in making material estimates that the accounting principle requires). Rather, MD&A should tell the story behind the results and share with investors management’s thoughts about the future.

The Release also makes several specific recommendations for improving MD&A disclosure. In particular, companies should:

• give the greatest prominence to the most important disclosure;

• avoid immaterial or duplicative disclosures that can obscure the presentation of important matters;

• consider starting MD&A with an executive level overview that provides context for the remainder of MD&A;

• identify and discuss in MD&A key performance indicators that management uses to manage and evaluate its business, even if the indicators are non-financial in nature;

• focus particularly on identifying and disclosing trends, events, demands, commitments and uncertainties that are reasonably likely to have a material effect on a company’s financial condition or operating performance; and

• be careful, not only to disclose factual information that is responsive to MD&A’s technical requirements, but also to include an analysis of that information that explains management’s view of its implications and significance.

The Release observes that many companies’ MD&A sections have become confusing and unnecessarily lengthy and offers the following suggestions to remedy this problem:

• Consider whether including tabular presentations could make MD&A more understandable by assisting in the comparison of financial line item results from different periods.

• Consider whether the section headings used in MD&A promote investor understanding and whether additional headings might be helpful.

• Consider using a "layered" approach that makes most prominent the information and analysis that is most important. As an example, companies could begin MD&A sections containing period-to-period comparisons with a discussion of the principal factors and trends that explain the results described in the sections.

The SEC also believes that an introductory or overview section can provide a highly useful discussion of the key financial and operating factors that affect the financial periods discussed in MD&A. For instance, an MD&A introduction or overview might discuss economic or industry-wide factors relevant to the company’s results, how the company earns revenue and income and generates cash, the company’s principal lines of business, and its principal products and services. It also can provide insight into the material opportunities, challenges and risks facing the company on which the company’s executives are most focused for both the short and the long term, as well as the actions they are taking to address these opportunities, challenges and risks. The SEC emphasizes that any introduction or overview should include only the most important matters on which a company’s executives focus and should not be a duplicative layer of disclosure that merely repeats the more detailed discussion and analysis that follows. The SEC further states its view in this regard that the failure to include every material item in an introduction or overview section should not automatically trigger the application of the so-called "buried facts" doctrine, which some courts have used to conclude that disclosure is false or misleading because material information is "buried" in an obscure place, such as in a footnote or an appendix.

The Release points out that, as a company’s business changes over time, the MD&A overview should change over time as well. This reflects the general theme in the Release that companies should not prepare disclosure documents, and MD&A in particular, by simply "marking up" prior disclosure documents without regard to changes in business or financial conditions.

The Release advises companies to review their MD&A sections with a view toward emphasizing material information and de-emphasizing or deleting immaterial information and to be sure that their MD&A presents both a short-term and a long-term analysis of the information provided. Companies should be careful to include all material factors, even if they are not financial in nature. As examples, the SEC points to macro-economic factors such as interest rates or economic growth rates as well as industry-specific measures. In addition, in the Release, the SEC tells companies to consider including in MD&A financial and operating data discussed in earnings releases, conference calls with investors and securities analysts or companion website postings. (An important consideration in this regard is that earnings releases and conference calls may include the disclosure of non-GAAP financial information that may not be disclosed in MD&A because of Item 10 of Regulation S-K.) The Release states that companies need not follow the order of information presented in Item 303 if another order would better facilitate a reader’s understanding. Finally, the Release points out that companies should discuss their failures to achieve their objectives, as well as their successes, if material to an understanding of their results of operations.

The Release also calls on companies to consider whether their MD&A includes information that is no longer material or useful and therefore should be deleted. For example, if issues discussed in prior periods are no longer material or helpful in understanding current results, discussion of those issues can be deleted. The Release discusses the common practice of comparing line items from financial statements with those from prior periods. It states that line item comparisons are unnecessary if immaterial and often result in duplicative disclosure. The SEC suggests grouping related line items as a possible alternative.

The Release also states that the MD&A sections in quarterly reports are complementary to the MD&A in annual reports. As a result, if an issue is adequately disclosed in an annual report and the disclosure remains current, it may be omitted from the MD&A section of subsequent quarterly reports.

The Release emphasizes the importance of disclosing and analyzing trends, demands, commitments, events and uncertainties that could be material to investors. In particular, the Release points out that companies should be careful to correlate financial and operating trends with future variability in its earnings and cash flow so that readers can assess the likelihood that past performance is indicative of future performance. The Release goes on to explain that the obligation to address material trends and uncertainties should not be confused with optional forward-looking information. In particular, the Release states that "material forward-looking information regarding known material trends and uncertainties is required to be disclosed as part of the required discussion of those matters and the analysis of their effects."

The Release also cautions companies against merely restating financial information; rather, management should provide an in-depth analysis of the information. For example, if a company’s financial statements show materially lower revenues resulting from a decline in unit sales when compared to a prior period, the MD&A should not only identify the decline in sales volume but also should discuss and analyze the reasons for the sales decline, such as difficulties in manufacturing, a decline in product quality, a loss of competitive position and market share, or some combination of conditions. In addition, where the financial statements reflect material restructuring or impairment charges, the MD&A should also discuss the reasons for the charges, such as an inability to realize previously projected economies of scale or the failure to renew a key customer contract. Finally, management should discuss and analyze one-time or difficult-to-repeat events that may make it hard to sustain a particular level of revenue or income.

The Release calls on companies to evaluate and, if necessary, to disclose in MD&A their ability to meet upcoming cash requirements over both the short and the long term. Merely stating that a company has adequate resources to meet its cash requirements is insufficient unless no additional detail or nuance is material. In particular, "such a statement would be insufficient if there are any known material trends or uncertainties related to cash flow, capital resources, capital requirements or liquidity." The Release states that companies that have incurred debt in material amounts should explain their reason for incurring that debt and how the proceeds will be used, and should then analyze how the incurrence of the debt fits into their overall business plan. With respect to cash requirements, the Release further states that companies should make particular efforts to assess the effect of uncertain events, such as loss contingencies, on their cash requirements and their liquidity and also whether the cash generated or consumed by reportable segments would be material to investors.

The Release points out that MD&A should discuss, if material, a company’s external debt financing, its use of off-balance sheet financing arrangements, its use or purchase of derivative instruments linked to its stock, its use of stock as a form of liquidity and the potential impact of a known or reasonably likely change in credit ratings or of the inability to improve its credit rating in the future. Furthermore, where additional financing is required, companies should discuss the various types of financing that might be available and the various impacts of each method of financing on the company’s cash position and liquidity.

The Release cautions companies to consider the possible need to discuss material covenants in their outstanding debt instruments in MD&A. In particular, the Release states that such disclosure may be required when a company is in breach of its covenants or is likely to be in breach in the near future. The discussion should include the steps that the company is taking to avoid, or to obtain a waiver of, the breach, the likely impact of the breach on its overall financial position, including the effects of resulting cross-defaults of other debt instruments on its financial condition or operating performance, and whether the company has alternative sources of funding available to refinance indebtedness in default. Discussion of a debt covenant also may be required in MD&A sections where the covenant either limits, or is reasonably likely to limit, the company’s ability to obtain additional financing necessary for its business. Finally, the Release states that companies should describe known material trends or uncertainties with respect to their capital expenditures, noting that a decision by a company in a capital-intensive business to reduce capital expenditures may materially impair long-term operations and should be disclosed.

The Release also addresses the use of estimates and assumptions in preparing financial statements in accordance with generally accepted accounting principles. It points out that companies should assess in MD&A sections material uncertainties in estimates and assumptions and disclose the implications of possible inaccuracies. This discussion should supplement, rather than duplicate, the description of accounting policies that is contained in the notes to the financial statements.

The Release states that companies should specifically address why accounting estimates and assumptions might be inaccurate or might change over time. In particular, once an estimate has been made, companies should disclose, if material, how they arrived at the estimate, how accurate the assumption or estimate has been in the past, how much it has changed over time and whether it is reasonably likely to change in the future. Companies also should analyze the susceptibility of the estimate or assumption to change based on various outcomes and, if material, disclose the effect of such a change on the company’s future results. Companies should provide qualitative and quantitative disclosure of these issues if reasonably available and if material to investors.

• Consider whether it would be helpful to include in MD&A an introductory or an overview section.

• Consider whether presenting financial results in a tabular format would aid investors’ understanding.

• Determine what headings and subheadings will make the MD&A more reader-friendly.

• Consider whether the MD&A should include information (like measures of financial or operating performance) that is discussed in conference calls with investors or securities analysts.

• Determine if there are any topics that have been included in past MD&A disclosures that are no longer relevant and can thus be eliminated from ongoing discussions.

• Be sure that the MD&A analyzes all material trends, events, demands, commitments and uncertainties, discussing not only their immediate effects, but also the underlying reasons for them and their possible future effects.

• Review debt agreements to see if there are particular covenants or "tightness" issues that might be material to investors and whether a discussion of financing alternatives is required.

• Give a balanced view of the company’s successes and failures.

• Review key accounting estimates and assumptions and consider the possible need to disclose matters such as the accuracy of prior estimates and the likelihood that the estimate or assumption will change in the future.

• Review the MD&A with an eye for the elimination of duplicative disclosure. To get the benefit of a reader’s, as opposed to the writer’s, perspective, it might be helpful for this review to be performed by persons who are knowledgeable about the Company’s financials as well as the SEC’s MD&A requirements, but who are not one of the primary drafters of the MD&A.

• Expect a renewed focus on MD&A by the SEC staff when they are reviewing filings. This is of particular importance now that the Sarbanes-Oxley Act of 2002 requires the SEC to review every issuer’s SEC filings at least once every three years.

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