A checklist for management discussion and analysis.

A CHECKLIST FOR

MANAGEMENT DISCUSSION

AND ANALYSIS

Management discussion and analysis (MD&A) recently has experienced increased attention as a result of actions by the Securities and Exchange Commission. The SEC published Financial Reporting Release no. 36, An Interpretative Release Regarding Management's Discussion and Analysis of Financial Condition and Results of Operations, to provide reporting companies with additional guidance.

This month, Karen L. Hooks, CPA, PhD, associate professor, School of Accountancy, University of South Florida, Tampa, and James E. Moon, CPA, PhD, associate professor, School of Accountancy, University of South Florida, provide an MD&A checklist of current SEC standards they developed to be used as a compliance tool for preparing and reviewing SEC filings. The checklist details items mentioned in current MD&A standards.

The MD&A checklist, which is divided into four sections, is consistent both with FRR no. 36 and the typical organizational of annual report MD&A disclosures. Because MD&A disclosures are intended to provide interpretive or "soft" information, the format can vary to best reflect an individual company's circumstances. Many of the disclosures will not be appropriate for every company in every year since some are appropriate only when particular events have occurred. Many forward-looking disclosure requirements are voluntary--encouraged but not required.

THE SEC'S STUDY AND THE

STANDARDS

The SEC has completed a three-year review of MD&A disclosures. The first part of the study addressed companies in 36 industries. The remainder was a reexamination of companies from industries targeted earlier in the study. The SEC staff performed an "issuer review" on the companies selected; that is a review concentrating on the registrant's recent filings rather than examining one specific filing.

Over 530 companies were studied, resulting in the issuance of over 500 comment letters. Although the study produced encouraging results, the potential for compliance improvement still exists. However, the SEC plans no new MD&A standards.

Deficiencies uncovered in the review motivated the SEC to issue FRR no. 36 in 1989. Its intent is to expand and provide additional disclosure guidance on previously issued MD&A requirements.

PROSPECTIVE INFORMATION

The major import of FRR no. 36 is disclosure of forward-looking or prospective information, which can be either "known" information with a future operations impact or "anticipated" trends with a less predictable effect. Disclosures of both types of information are protected under the SEC's "safe-harbor" provisions.

FRR no. 36 provides a new disclosure standard for forward-looking information described as "reasonably likely to have a material effect." According to this criterion, management must make two assessments if a trend, demand, commitment, event or uncertainty is known:

1. Is it likely to come to fruition? If so, disclose.

2. Can the assessment about likelihood be made? If not, disclose the consequences, assuming it will occur.

Although disclosure of anticipated trends data is strongly encouraged in FRR no. 36, it is voluntary. To assist it in making this disclosure, management must assess the future material effects that will result from currently developing known and anticipated trends.

THE CHECKLIST

The checklist is designed to aid company management and CPAs in the preparation and review MD&A. It may also help others to understand current SEC requirements.

The following discussion provides an overview of the broad checklist categories. The numbers in parentheses refer to the numbers in the checklist (see pages 96-97).

Capital resources and liquidity. The SEC's concept of liquidity differs from the definition provided by the Financial Accounting Standards Board in Concepts Statement no. 5, Recognition and Measurement in Financial Statements of Business Enterprises. For FRR no. 36 disclosures, liquidity is defined as a company's ability to generate cash and meet cash demands. This concept is broader than the FASB's liquidity definition but similar to its definition of financial flexibility. In Concepts Statement no. 5, financial flexibility is defined as "the ability of an entity to take effective actions to alter amounts and timing of cash flows so it can respond to unexpected needs and opportunities."

Many companies combine the discussion of liquidity and capital resources (1-36), an approach acceptable to the SEC. Forward-looking information must be emphasized in the liquidity and capital resources discussion. Capital expenditures commitments (1), the purpose of commitments (4) and anticipated funding sources for commitments (2) are required MD&A disclosures.

Registrants should reference trends affecting liquidity and capital resources, as well as prospective information affecting both short- and long-term sources of (5) and needs for capital (6). New disclosures standards encompass anticipated trends in liquidity (14, 20) and capital resources (7, 8). These disclosure requirements are applicable to changes in the mix and costs of resources (9, 10). Discussion must be directed toward changes in the registrant's debt, equity and off-balance-sheet financing (12) and the effects on financial condition or results of operations (11).

Registrants are required to identify and describe internal and external liquidity sources (29) and discuss unused sources of liquid assets (30). The SEC expects liquidity information comparability to be enhanced as a result of implementing FASB Statement no. 95, Statement of Cash Flows. Registrants must use Statement no. 95, along with other indicators, in presenting a balanced discussion of liquidity affecting financial statement items (31), especially cash flows from operations (33), financing and investing activities (34) and balance sheet conditions (32).

Known trends, demands, commitments, events and uncertainties that may cause liquidity to change (13-24) are to be identified in MD&A disclosures. If a liquidity deficiency is projected, the registrant is to indicate the course of action taken or the plan to remedy the deficiency (25-27). Interestingly, a disclosure requirement exists for situations in which there is either an inability to make a decision or the lack of a decision to address a liquidity deficiency (28) or the choice not to commit capital resources when the choice would create growth uncertainty (3).

Results of operations. Result of operations disclosures should include appropriate identification and quantification of material changes (40, 41) and known (43, 44) and anticipated (46, 47) trends necessary to understand changes in sales, revenues or income. Repetitive line-by-line description is not required. Registrants should identify trends that will affect operating results or cause changes in cost and revenue relationships (45, 48). Registrants should identify significant components of continuing revenue and expenses (42) that will aid a user's understanding as well as items that may not indicate future operating results (54).

Changes in reported revenue are to be identified as attributable to changes in prices (49), sales volume (50 or introduction (or discontinuance) of products or services (51). Also, operations disclosure results should include the impact of inflation, including income and revenue effects (52, 53).

Unusual or infrequent events are to be described in relation to effects on reporting income from continuing operations. Registrants must provide adequate discussion and quantification of factors affecting material changes, unusual transactions, discontinued operations and extraordinary items (37-39).

Business structure. Segment information disclosure traditionally has been required if it is necessary for an understanding of the registrant's business (55-59). This disclosure is added to the liquidity disclosure requirement caused by material restrictions on fund transfers between parent and subsidiaries (35-36). More disclosure may now be necessary to satisfy this requirement if consolidation of previously unconsolidated subsidiaries has resulted from the application of FASB Statement no. 94, Consolidation of All Majority-Owned Subsidiaries.

Additional MD&A disclosure may be necessary because Statement no. 94 requires grouping companies with different operating characteristics, possibly resulting in consolidated information that is not sufficiently informative (57).

Current MD&A guidelines could be misinterpreted to mean a company is expected to disclose merger plans prematurely (60). However, as indicated in FRR no. 36, the SEC does not expect a company to disclose in the MD&A any items that might jeopardize a merger. The SEC's stated intent is to balance investors' information needs agasint the risk premature disclosure could damage negotiations in process. Once the premature disclosure phase is over, the MD&A standards of known trends, demands, commitments, events and uncertainties require disclosure of probable, acquisitions, dispositions or mergers.

Other. Registrants must direct attention to disclosures of participation in high-yield investments and highly leveraged transactions (61-62). Even though these disclosures may be included in other parts of SEC filings, the effects on financial position and results of operations should be analyzed in MD&A.

Disclosure guidance encompasses the effects of federal assistance on operations of financial institutions. Disclosure is required for assistance that has materially affected or will reasonably likely materially affect future financial condition or results of operations. Specifically, guidelines call for disclosure of the nature (63), amounts (64) and effects (65) of federal financial assistance.

FLEXIBILITY

FRR no. 36 permits flexibility in approaches to MD&A disclosures, but requires comprehensive discussion of capital resources, liquidity and results of operations. The disclosure standards are applicable to relevant segments or subdivisions and to the entity as a whole when the financial statement user's understanding of the business would be enhanced. With the exception of inflation, disclosures also are applicable to interim reporting. The MD&A is potentially a major source of risk information.