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Spotlight on management's discussion and analysis: What does the SEC expect this year?


What does the SEC expect this year?

It's annual report writing time! This year, companies registered with the Securities and Exchange Commission will have to pay special attention to the management's discussion and analysis (MD&A) section of their reports to accommodate the SEC's May 1989 interpretive release (see exhibit 1 on page 68). This article will focus on how registrants should approach drafting their MD&As.


The SEC adopted its first requirement for an MD&A in 1968, with the current framework being instituted in 1980. That framework arose from the SEC's concerns that the earlier MD&A requirements had developed into the practice of mechanistic commentary on percentage variations. The 1980 requirements changed the focus--from a summary of earnings to the financial statements as a whole. They required a discussion of

* Liquidity.

* Capital resources.

* Results of operations.

* The future impact of known trends, demands, commitments, events or uncertainties that may affect operations.

The change was intended to give the investor an opportunity to look at the company through the eyes of management.

Although the SEC made many public remarks about the quality of MD&As during the 1980s, no specific action was taken until early 1988 when it began a comprehensive review of MD&A disclosures. The first phase of the review covered 218 companies in 12 industries. The reviews focused on the registrant rather than on any one of its reports. The reviews focused particularly on the disclosures made in response to the 1980 MD&A requirements. Of the 218 companies, 206 received letters of comment from the SEC either requesting supplemental information, compliance with the rules in future filings or amendments of existing filings. In fact, 72 of the companies amended their filings.

A second phase of the review program started in late 1988 with 141 companies in another 12 industries. Of this group, 139 received comment letters and another 53 companies filed amendments. More than half of these amendments contained substantively expanded MD&As. Six companies were referred to the SEC's Division of Enforcement--primarily because of accounting issues, but in several instances MD&A disclosures also were affected.

The SEC now has moved into a third phase of its review program with another 12 industries. This phase will focus on form 10-Ks filed for fiscal years ended November 30, 1988, and later.


A review of selected comment letters (not cited in the interpretive release) during the past 18 months helps to answer the elusive question: "What does the SEC expect?"

1. Shoe manufacturer with large domestic manufacturing capacity showing consistent losses: The SEC asked the company to discuss.

* Its plans, if any, to return to profitability.

* How management planned to use excess domestic manufacturing capacity.

* Why the percentage of cost of sales had risen in recent years and any plans to reverse the trend.

2. Biotechnology company showing flat results and little indication of what the future holds: The SEC asked about

* The company's expectations for continued receipt of contract research and development revenues.

* The consistent decline in research and development expenditures.

* What portion of the increase in product revenue was due to price increases compared with volume increases.

3. Chemical company showing reasonable growth and profits: The SEC commented the company should

* Revise its MD&A to provide a more balanced presentation.

* Consider quantification and discussion of divisional performance.

* Discuss long-term prospects for certain chemical products given present environmental concerns.

* Discuss the impact on liquidity and capital resources of recent material acquisitions.

4. Operator of healthcare facility experiencing financial difficulty: The SEC asked the company to discuss

* Labor costs, including the impact of the shortage of nurses and the resulting impact of salaries.

* Economic and demographic trends relevant to the company's areas of operation and a comparison of those trends with national trends.

* The impact of regulatory trends, such as rating systems for hospitals and staff.

5. Computer manufacturer doing moderately well in its industry: The SEC asked the company to

* Discuss individually the business reasons for the changes in service revenues and equipment sales.

* Analyze the impact, if any, the recent chip shortage had, or was expected to have, on operations.

As these cases demonstrate, the SEC's concerns about the quality of the MD&A applies to mature, successful companies as well as troubled companies.


In its formal enforcement actions, the SEC has been quick to cite deficiencies in MD&A disclosures. Its comments in this regard are similar to those noted above. Here's a selection of cited MD&A deficiencies noted in the past several years:

In the Burroughs Corporation proceeding, the SEC concluded the MD&A omitted material information about the increase in work-in-process inventory in excess of 30 months' demand and the increase in the amount of unreserved-finished-goods inventory more than two years old. The SEC argued that in the computer industry, where change is rapid, this information was important to shareholders and investors.

Allegheny International, Inc. failed to include information about a sale of real estate in its MD&A. According to the SEC, this caused Allegheny's 1983 annual report to be false and misleading. The SEC contended this sale constituted an unusual and infrequent event that had a material impact on pretax income.

Hiex Development USA, Inc. was cited for failure to disclose a major commitment to purchase equipment over a 10-year period. In addition, the SEC said Hiex didn't disclose certain pertinent information about its ability to remedy a negative working capital situation.

The Charter Company's chief accounting officer and its controller were cited when the SEC concluded the company's MD&A was false and misleading. The SEC claimed the MD&A failed to disclose the company had experienced a continuing loss of its unsecured or open trade credit provided by its suppliers. This affected its ability to make a necessary level of purchases and constituted a threat to operations.

The Baldwin-United Corporation's chief financial officer was the target of an SEC enforcement action because he had reviewed the company's MD&A. That MD&A didn't disclose Baldwin's failure to achieve certain investment assumptions of its earnings model and insufficient taxable income to use the tax benefits inherent in the earnings model.

These enforcement actions--both those against the registrants and individual members of management--clearly demonstrate the SEC believes the MD&A should provide investors with a realistic assessment of corporate objectives and results.


Perhaps the most difficult aspect of the SEC's MD&A regulations is the requirement to discuss known trends, demands, commitments, events or uncertainties the company reasonably expects will have a material impact on operations or liquidity or would cause historical "financial information not to be necessarily indicative of future operating results or of future financial condition." Because the SEC often can use hindsight to judge the adequacy of disclosures actually made, companies must assess these factors carefully in preparing their MD&As.

The new interpretive release attempts to explain the difference between a forecast (disclosure not required) and a known trend, demand and uncertainty. To some observers, however, this is a circular argument. As a result, the registrant is placed in a difficult position when trying to comply with the new guidance in a meaningful way and maintain its public position of not providing forecasts to the marketplace.

From a practical viewpoint, the best starting point in complying with this aspect of the MD&A interpretive release is the company's business plan for the next year. That plan should provide answers to some, if not most, of the disclosure issues. After considering the business plan, which is often optimistic, management should assess the downside risks carefully. Could these risks be tied to a known trend, demand, uncertainty and so forth? If so, after assessing the probability of occurrence, these factors and their impact may need to be disclosed.

It's also helpful in complying with the SEC release to do a top-down analysis of known trends, demands, uncertainties and so forth. A logical starting point is the economy as a whole, then the company's broad industry group and finally company-specific items. Specific product, geographic and customer concentrations also should be analyzed as areas of potential change (positive or negative).


The guidelines for the MD&A are relatively brief, and the SEC doesn't provide a standard format or cookbook for writing it. Thus, management has flexibility. Nevertheless, before starting the writing exercise, management needs to set a tone that says: If I were an investor, what would I want to know about this company's liquidity, capital resources and results of operations that the financial statements don't spell out clearly? What known trends, demands, commitments, events or uncertainties would affect my judgment about the company?

Making comments about liquidity, capital resources and operations requires input from the company's experienced and knowledgeable managers. In addition, budgets, capital plans, sales reports or other middle management tools become invaluable sources of MD&A information. Top-level executives also must be involved in the drafting because they provide the perspective and judgment needed to meet the SEC's expectations.

Using the SEC's MD&A interpretive release, a company can approach the drafting process by asking the following questions:

* Why did sales and revenues change--volume or price?

* Are there any trends--either favorable or unfavorable?

* What's behind the variations in expense categories?

* What unusual or infrequent events and transactions materially affected operating results?

* Does any segment contribute disproportionately to results or require disproportionate cash needs?

* What planned capital expenditures are material?

* What are the cash needs?

This list can be expanded and tailored to a particular company and its business environment. The point is that in preparing the MD&A, management needs to ask and answer questions about matters affecting liquidity, capital resources and results of operations.


Preparing an MD&A that meets SEC standards requires considerable time and study and involvement by top management. The MD&A should present a discussion of both the positive and negative factors that affected the company's revenues and costs in the past, thus influencing its historical results, as well as the factors that might affect future operations in terms of material changes or impacts on trends. The discussion should not be viewed as a risk disclosure document. Instead, it should be forthright and present in management's words a balanced view of where the company stands today and what it knows about the future given known events, demands, trends and so forth.

Unfortunately, management must be prepared to defend its analysis in hindsight. Nevertheless, if the company has done a forthright job in analyzing its current financial condition and liquidity as of year-end, if it has considered all known factors and if it has made an honest attempt to discuss those factors, it should be in an excellent position to overcome any subsequent SEC challenges.

In the SEC's view, MD&A is a focal point in the disclosure system of the securities acts. The SEC has enhanced and expanded it through recent releases. Although the SEC appropriately concluded no new regulations are required, MD&A drafters must read and understand the SEC's latest interpretive guidance and not simply rely on the initial regulations. The interpretive guidance does provide significant information to assist management in drafting a meaningful MD&A.


A summary of the SEC's MD&A interpretive release

The SEC's Financial Reporting Release no. 36, Management's Discussion and Analysis of Financial Condition and Results of Operations, of May 18, 1989, does not change the MD&A requirements. It attempts, however, to explain what's required by certain provisions of its MD&A regulations. Here's a summary of the interpretive release:

* Prospective information and the discussion of trends, demands, commitments, events and uncertainties. The release requires management to make two specific assessments:

1. Is the known trend, demand, commitment, event or uncertainty likely to come to fruition? If it's not reasonably likely to occur, no disclosure is required.

2. If management can't make the above determination, it must evaluate objectively the consequences of the known trend, demand, commitment, event or uncertainty, on the assumption that it will come to fruition. Disclosure is then required unless management determines there's little likelihood there will be a resulting material effect on the company's financial condition or results of operations.

* Liquidity and capital resource needs. The MD&A must address any material deficiency in either short-term or long-term liquidity and capital resources (cash needs) and disclose any proposed remedy. It also must disclose that no remedy has been decided on or that the deficiency cannot be currently addressed. The MD&A must address material capital expenditures, significant balloon payments, payments on long-term obligations and off-balance-sheet items due beyond the next 12 months.

* Use of statement of cash flows. Registrants are expected to use their cash flow statements (prepared according to Financial Accounting Standards Board Statement no. 95, Statement of Cash Flows) in analyzing liquidity. They should present balanced discussions of the cash flows in terms of investing and financing activities as well as operations. The MD&A must address matters that have materially affected the most recent period presented but that are not expected to have short-term or long-term implications. It must also analyze matters that haven't materially affected the most recent period presented but that are expected to affect future periods materially.

* Year-to-year financial statement changes. The interpretive release requires a discussion of the impact of discontinued operations and extraordinary gains and losses that had a material effect or are reasonably likely to have a material effect on financial condition or results of operations. Companies must analyze changes in financial statement line items, particularly when those changes result from two or more factors--for example, price and quantity.

* Interim period MD&A. In light of the obligation to update MD&A disclosures periodically, the company must disclose the impact of known trends, demands, commitments, events or uncertainties arising during the interim period that are reasonably likely to have material effects on financial condition or results of operations.

* Segment data discussion. An analysis of segment information is required if any segment contributes in a materially disproportionate way to revenues, profitability or cash needs or if the discussion on a consolidated basis would be an incomplete and misleading picture of the company.

PHOTO : MD&As must discuss the future impact of known trends, demands, commitments, events or uncertainties.

RICHARD DIETER, CPA, is a partner and director--SEC practice of Arthur Andersen & Co., Chicago. He is a member of the American Institute of CPAs SEC regulations committee. KEITH SANDEFUR, CPA, is a principal in the accounting principles group of Arthur Andersen.
COPYRIGHT 1989 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1989, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Author:Sandefur, Keith
Publication:Journal of Accountancy
Date:Dec 1, 1989
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