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How good is MD & A as an investment tool?

Annual reports were found to be much better at predicting good news than bad news.

The Securities and Exchange Commission mandated in 1980 that public companies' annual reports include a management's discussion and analysis (MD&A)

section that assesses the enterprises' liquidity, capital resources and operations in a way many investors can understand. One of the goals was to make public information about predictable future events and trends that may affect future operations of the businesses.

Has the SEC goal been fulfilled? This article examines that question and comes up with some disturbing answers.

Eight years after the MD&A ruling, the SEC concluded that the reports were not meeting this goal. As a result, the agency issued guidelines on exactly what data it expected companies to incorporate in MD&A statements. It said it wanted each business to provide information about company-specific and industry-specific trends affecting its bottom line. Currently, many in the SEC staff still are not satisfied the agency's original goals are being met.


To test that contention - and to determine whether the data in MD&As provide useful clues to a company's future performance - we randomly selected 25 companies from Moody's Handbook of Common Stocks. The publication evaluates public companies' performances on a quarterly basis, reviews their financial performances and stock prices and, most important for our purpose, lists events (labor conflicts, new competition, etc.) that appeared to influence a company's financial performance during the previous quarter.

To determine the value of each piece of information disclosed by the selected companies in their MD&As, we considered whether it related to their actual performances a year later. If the information was accurate and had any value, we would have expected a close correlation: A predominance of positive forecasts should have resulted in improved performance and a predominance of negative expectations should have produced the opposite.

Generally, this wasn't the case. While most companies did a good job of describing historical events, very few provided useful and accurate forecasts. Further, when prospective information was disclosed, we found a strong bias in favor of correctly projecting positive trends, but negative trends tended to be either ignored or not fully reported. In other words, we found MD&As to be much better at predicting good news than bad news.

To quantify our examination, we itemized all the important economic events Moody's reported as affecting each selected company. Then we classified each event as specific to the company, the industry or the overall economy. For example, if a toy manufacturer's sales decreased because a particular board game had declined in popularity, the decline was classified as company-specific. If the drop in sales was attributed to a decrease in consumers' interest in games in general, it was classified as industry-specific. And if the drop in sales was attributed to a general economic recession, it was considered specific to the economy. We also classified each statement as either positive or negative on the basis of its effect on company operations.

We also classified each MD&A statement into one of two categories: backward-looking, which included historical data, and forward-looking, which included prospective information and a discussion of trends and future demands, commitments, events and uncertainties. Within the forward-looking category, we further classified each statement according to the same categories used for economic events: company-, industry- and economy-specific. Finally, as already noted, we compared MD&A statements against actual company performance in the year following the MD&A statement disclosure.

Historical disclosures. All the companies provided at least minimal discussion of the historical items required by the SEC. In fact, most went into great detail. As a practical matter, this history is of limited use to investors interested in forecasting future performance.

Forward-looking disclosures. Many companies made practically no predictions. For example, 20% failed to correctly project any of the events cited in Moody's. Only 12% correctly anticipated every item cited by Moody's. The exhibit on page 53 summarizes the relationship between MD&A disclosure of prospective information and actual performance. Out of the 104 economic events cited by Moody's, only 40% were correctly projected in the MD&A sections of the annual reports. But on average, the companies were more than twice as likely to correctly predict positive economic events than negative ones. We think there is no reason to believe managers are better able to predict good news than bad news. Our conclusion is that managers withheld information about trends that would negatively affect their businesses despite the SEC's demand for an unbiased disclosure of both good and bad news.

Industry-specific disclosures. On average, management was more successful at predicting company-specific events than either industry- or economy-specific ones. MD&As correctly anticipated 49% of the company-specific events and just 25% and 13% of the industry- and economy-specific events, respectively.


We understand why many managers may hesitate to forecast bad news. They probably are sensitive to the potential legal liability of their forecasts. Managers also probably fear a loss of business flexibility if they articulate future plans in writing.

On the other hand, in our opinion, increased disclosure, through a reorientation of the MD&A, offers management an opportunity to improve corporate communications, enhance credibility and improve investor decision making. To accomplish this, we believe management should

* Discuss company-specific information. Does management know information about the company (for example, the probable cancellation of a large contract) that an investor needs? If so, this should be disclosed.

* Explore industry trends. Does the company's budget rely on explicit or implicit assumptions about industry growth? Investors have a right to this, too.

* Relate economic forecasts to company performance. Does management expect the recession to continue through next year? If so, how will this affect the company?

* Make sure the report is unbiased. The MD&A report will be evaluated after the fact. It has to be neutral. The MD&A should be neither overly optimistic nor overly pessimistic.

The MD&A was initially designed to improve corporate communications. Many investors can't understand financial statements and put little stock in historical data. It is time to provide the owners of corporations with information that helps them understand what has already happened and what lies ahead. The MD&A, as envisioned by the SEC, is a good idea. It's time that management and accountants implemented it.


* The SEC is not satisfied with the management's discussion and analysis (MD&A) sections in public companies' annual reports. The sections are supposed to provide investors with information about predictable future events and trends that may affect businesses' future operations. * In investigating MD&As, the authors discovered that while most companies did a good job of describing historical events, very few provided forecasts and projections that were useful and accurate. * When prospective data were disclosed, the authors found a strong bias in favor of correctly projecting positive trends, but negative trends tended to be either ignored or not fully reported. * Many companies made practically no predictions. Only 12% correctly anticipated every item cited by Moody's Handbook of Common Stocks, a business-reporting publication. And on average, the companies were more than twice as likely to correctly predict positive economic events than negative economic events. * Managements were more successful at predicting company-specific events than either industry- or economy-specific events.
Relationship between 1989 MD&A predictions and
actual performance in 1990
This table summarizes the percentage of actual company events in
1990, as listed in Moody's
Handbook of Common Stocks, that were correctly predicted in the
1989 MD&As. The totals
row is not the average of positive-events-only rows and
negative-events-only rows; positive
events and negative events are not evenly distributed.
 Percentage of correct forecasts
 Company- Economy-
 Full specific Industry- wide
 sample only specific only
Number of events 104 73 16 15
Positive events only 56% 56% 50% 67%
Negative events only 26% 39% 21% 0%
Totals 40% 49% 25% 13%



The Securities and Exchange Commission has made it clear: It wants business to be more forthright in the information it provides investors.

In an action filed against Caterpillar, Inc. last April, the SEC sent an unambiguous message actually addressed to corporate management of all public companies: If management continues to ignore regulations calling for forecasts of a business's future operations, penalties will be levied. The agency accused Caterpillar of failing to disclose in the management's discussion and analysis (MD&A) section of its annual report that about a quarter of its 1989 income, coming from its Brazilian unit, will be nonrecurring.

In a settlement negotiated with the SEC, Caterpillar did not concede it did anything unlawful but agreed not to commit the same act in the future.

James Adelman, branch chief in the SEC Division of Enforcement, characterized the action by the SEC against Caterpillar as a "message ... that we take MD&As seriously."

MOSES L. PAVA, PhD, is Philip H. Cohen Chair of Accounting at Sy Syms School of Business, Yeshiva University, New York. He is a member of the American Accounting Association, MARC J. EPSTEIN, PhD, is a visiting professor of business administration at the Graduate School of Business administration, Harvard University, Boston. He is editor in chief of Advances in Management Accounting and a member of the AAA and the Institute of Management Accounting.
COPYRIGHT 1993 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Title Annotation:management's discussion and analysis
Author:Epstein, Marc J.
Publication:Journal of Accountancy
Date:Mar 1, 1993
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Next Article:Cash flows: another approach to ratio analysis.

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