SEC Issues MD&A Guidance for 2004

On December 19, 2003, the Securities and Exchange Commission ("SEC") staff published interpretive guidance (the "Release") on how public companies can improve their Management’s Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") in their upcoming quarterly and annual reports. The staff’s general dissatisfaction with the quality of MD&A disclosure prompted the Release. Over the past year, the staff has publicly complained that MD&A disclosure has become too boilerplate, repetitive and parrots the presentation of information in a company’s financial statements. The staff’s guidance does not amend the current disclosure requirements of MD&A or its past guidance, but highlights areas of MD&A that need improvement. The Release provides insight as to where the staff will focus its comments in connection with its review of registration statements and periodic reports in 2004.

The Release does not contain specific guidance. It broadly focuses on:

• the overall presentation of MD&A;

• the focus and content of MD&A;

• liquidity and capital resources; and

• critical accounting estimates.

Highlighted below are some of the more specific "MD&A drafting tips" offered in the Release. The Release is available in its entirety on the SEC website at http://www.sec.gov/rules/interp/33-8350.htm.

The Release recommends that companies include an introductory section to their MD&A. The introduction would highlight the most important developments of the period being reported without being repetitive of or summarizing the ensuing discussion. In past public statements, the staff has suggested that such an introduction be similar to management’s letter to shareholders appearing in a company’s annual report to shareholders. According to the staff, a "good introduction or overview" would be written in Plain English from the CEO’s perspective, focusing on topics "that keep him or her up at night." Such topics could include:

• economic or industry-wide factors relevant to the company;

• how the company earns revenues and income and generates cash;

• the company’s lines of business, locations of operations and principal products and services without being repetitive of the Description of Business section; and

• the material opportunities, challenges and risks that management are most focused on for the short and long term, as well as actions that they are taking to address these opportunities, challenges and risks.

Rather than present financial information from the current period and comparable past periods in a line-by-line narrative format, the staff suggests using tabular presentations to present the information. The accompanying narrative could then be used to discuss and analyze known changes, events, trends and uncertainties.

Currently most companies divide their MD&A discussions under two headings, Results of Operations and Liquidity and Capital Resources. The staff encourages companies to use additional headings to assist readers in following "the flow of MD&A."

The Release encourages companies to provide more nonfinancial information when such information is used by management to evaluate the company’s business. Depending on the circumstances, microeconomic information, such as sales information measured in units or volume or business strategy, may be integral to a company’s business. In 2003, the SEC issued rules and interpretive FAQs governing the public release of non-GAAP financial information (see our legal update, SEC Adopts Final Rules for the Use of Non-GAAP Financial Measures and the Furnishing of Earnings Releases on Form 8-K, February 2003). The Release reaffirms the staff’s position from those earlier releases that any analysis of whether non-GAAP financial information is appropriately presented is separate from the consideration of whether MD&A should address "key performance indicators" of a company. The implicit message from the staff is that when non-GAAP financial information is publicly disclosed to analysts and in press conferences, management must evaluate why this information is being released and whether MD&A requires similar disclosure.

The staff is encouraging companies to trim their MD&A. Companies should evaluate whether information already disclosed in prior periods continues to be material for a current period. Though MD&A still requires a comparison of material financial information from a current period against a past comparable period, the staff recommends that companies focus on whether the financial information should be discussed in the first place. The staff recognizes that different quantitative and qualitative information may be material for a company’s quarterly and annual MD&A disclosures.

The Release reaffirms the staff’s past position that, as a general rule, forward-looking information is optional disclosure¹. However, the staff also reaffirms that disclosure of a known trend, demand, commitment, event or uncertainty is required unless a company is able to conclude either that the trend, uncertainty or other event is not reasonably likely to occur, or that a material effect on the company’s liquidity, capital resources or results of operations is not likely to occur.

Detailed Disclosure of Cash Requirements and Sources of Cash

Companies are required to evaluate their ability to meet upcoming cash requirements over both the short and long term. Routinely, companies have recited how they have spent cash during the period and have represented that "existing capital resources are adequate to meet the company’s short and long term needs" or "for the foreseeable future." The Release indicates that these types of disclosures are insufficient unless additional more detailed information about known material trends or uncertainties related to cash flow, capital resources, capital requirement or liquidity is not known. The staff intends to use a company’s tabular disclosure of its contractual obligations as one means of evaluating the adequacy of a MD&A description of a company’s future cash requirements and capital resources.

Disclosure of Critical Accounting Estimates versus Accounting Policies

Since the SEC issued interpretive guidance concerning critical accounting estimates in December 2001 and then proposed specific MD&A disclosure of critical accounting estimates in May 2002, there has been uncertainty as to what level of disclosure is currently required. The Release clarifies that under the current requirements, companies should consider disclosing accounting estimates or assumptions where:

• the nature of the estimates or assumptions is material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change; and

• the impact of the estimates and assumptions on financial condition or operating performance is material.

Such disclosures should supplement, not duplicate, the description of accounting policies required in the notes to the financial statements. The accounting policy note to the financial statements generally describes the method used to apply an accounting principle while the MD&A disclosure should present a company’s analysis of the uncertainties involved in applying a principle at the current time or the variability that is reasonably likely to result from its application over time.

The SEC staff had promised this Release for several months and much of the guidance is derived from its publicly-announced review during 2002 of all Fortune 500 companies. This guidance, though derived from a review of the MD&A of a select group of the largest, most diverse multinational companies, undoubtedly signals a more focused staff review of the MD&A disclosure of all public companies in 2004 and beyond. As a result, the number of MD&A comments is likely to increase and the pressure to draft more meaningful MD&A disclosure will increase.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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