What the SEC wants to see in your MD&A.
The SEC recently issued interpretive guidance for preparing Management's Discussion and Analysis (MD&A) of Financial Condition and Results of Operations in its Financial Reporting Release (FRR) 36. The guidelines reiterate the SEC's view on the importance of the MD&A to a company's financial reporting, as well as highlight the need for companies to carefully consider existing disclosure requirements in order to improve the quality of MD&As.
The release explains the overall framework of the MD&A rules and addresses a number of areas where the SEC believes improvements need to be made. Its principal focus, however, is on improving disclosures pertaining to currently known trends, events, and uncertainties that might impact the financial statements in the future ("prospective information"). While this is not a new disclosure requirement, we believe the SEC's interpretation of matters to which it applies will require that many companies rechallenge their approach to the MD&A.
Recent MD&A developments
In 1980, the SEC departed from a fairly rigid set of MD&A rules and replaced them with a set of general requirements. At that time, the SEC staff expected that the new approach would elicit more meaningful analysis and would avoid the inclusion of boilerplate discussions.
Although the SEC believed this approach generally worked well, it issued a release in 1987 that solicited comments on a number of MD&A issues, including whether the disclosures went far enough with respect to disclosure about risks and uncertainties. Most commentators to that release believed that no rule changes were necessary and suggested that the SEC address individual disclosure concerns through the staff's normal review and comment process.
As a result, the staff undertook a major project to review 1987 and 1988 annual reports, with a focus on MD&A disclosures. Special review procedures were developed to enhance the staff's understanding of each company selected for review. For example, press releases and other public information about the company and its industry(ies) were considered.
To date, reviews of more than 350 companies in 24 industries have been completed, and reviews of approximately 150 more companies are scheduled. The SEC believes that the results of the review process indicate improvements are needed - amendments to existing filings were made by approximately 35 percent of the companies selected for review. While some of the amendments were confined solely to MD&A disclosures, a significant number of the amendments required changes to the financial statements.
What's in FRR 36?
In addition to offering a discussion of the MD&A rules, FRR 36 includes several examples of disclosures the Commission believes are appropriate for companies to remember. These generally are not new issues and the examples in the release are clear-cut and would not be surprising to most executives.
For example, FRR 36 addresses the following types of disclosures:
* Liquidity and capital resources - The SEC notes that registrants that have disclosed plans for future expansion should discuss prospective information regarding sources of capital to fund the planned expansion. They should also provide trend analysis for expected material changes in the mix and relative cost of capital resources. * Material changes - Registrants should give reasons for any material year-to-year changes in line items of the income statement and balance sheet to the extent necessary to obtain an understanding of the company's business as a whole. * Interim period reporting - Registrants should update the MD&A in interim periods to reflect the effects of significant events. * Segment analysis - MD&A disclosures should be provided on a segment basis where the various segments contribute disproportionate amounts of revenues, profits, and cash flows. * High-yield investments - The SEC believes investments in high-yield financings or non-investment grade loans offer potentially greater returns and pose greater risks than other investments. Thus, the Commission believes registrants should consider MD&A discussion of participation in these transactions.
Wanted: more prospective
The SEC's statements relating to disclosures of prospective information are, however, more complex. The Commission appears to have lowered the threshold for disclosing this type of information. While it encourages, but does not require, disclosures of forward-looking information (e.g., forecasts), it does require that companies disclose presently known trends, events, and uncertainties that have had or are reasonably expected to have material effects on a company's financial position and results of operations.
In this regard, the SEC believes that the principle objective of MD&A disclosures is: "to give investors an opportunity to look at the registrant through the eyes of management by providing an historical and prospective analysis of the registrant's financial condition and results of operations, with particular emphasis on the registrant's prospects for the future."
The most frequently cited MD&A deficiency noted during the SEC's special review of filings was in this area. FRR 36 interprets the existing rules by indicating that disclosure is required unless management (1) determines that the known trend, event, or uncertainty "is not reasonably likely to occur" or (2) determines, assuming that the known trend, event, or uncertainty comes to fruition, that its consequences would not be reasonably likely to have a material effect on the company's financial condition or results of operations.
We believe these disclosures will be very difficult for a company because of the judgments that must be made about whether an event is likely to occur and its potential impact. While many companies have disclosed known trends, events, or uncertainties that are reasonably expected to have a material impact, FRR 36 requires disclosure unless management is able to make an assessment that the known trend, event, or uncertainty is not reasonably likely to occur.
Furthermore, it appears that the SEC is increasing the pressure for an event to be disclosed at an earlier stage. Whereas, in the past, management may appropriately have concluded that disclosure of an event was not necessary because it was premature to determine whether the event would occur, FRR 36 now requires disclosure unless a positive assessment can be made that the event will not occur.
FRR 36 provides a summary of disclosures that should be provided with respect to prospective information:
* Expected future effects of known or reasonably expected uncertainties - The SEC staff believes registrants should discuss how known factors - such as material uncertainties about pending EPA investigations, upcoming labor negotiations, or changes in product mix or customers - will impact the company's business.
With respect to potential EPA violations, the staff generally has commented about the need for disclosure of any material impact that might result from the EPA's investigation.
However, companies also should continue to be alert for the need to record loss provisions under FASB Statement 5, Accounting for Contingencies. Further, disclosures relating to environmental matters may be required under legal proceedings pursuant to Item 103 of Regulation S-K, notwithstanding a determination that any potential exposure is not material to the financial statements. * Expected effects of known trends on future operations - As an example, the SEC indicates that disclosure of the reasonably likely effects of an expected further decline in unit sales of mature products is appropriate. * Prospective effects of events that have had a material effect on past operating results - For example, completion of an important contract may have significantly benefitted past operating results; future contracts may be expected to be less profitable. * Effects of events that have occurred or are anticipated - For example, a registrant might know that a competitor has discovered a way to deliver products more efficiently, and that the registrant's existing contracts therefore may not be renewed. Disclosure is required for known uncertainties reasonably likely to have material future effects.
In contrast to its views on other types of uncertainties, the SEC has carved out the need to make the same disclosure assessment of preliminary merger negotiations. Although these negotiations could be viewed as a required MD&A disclosure because they usually represent a known event or uncertainty reasonably likely to have material effects in the future, the SEC believes that the information needs of investors must be balanced against the risk of premature disclosure that could jeopardize completion of the transaction. Therefore, FRR 36 indicates that where disclosure is not required and has not otherwise been made, the MD&A need not contain a discussion of the impact of such negotiations if management concludes that any discussion would jeopardize completion of the transaction.
In short, financial executives will need to make significant and difficult judgments about disclosing prospective information. Adding to the difficulty in this area is the SEC's acknowledgement that it has and will continue to use the benefit of hindsight in evaluating the adequacy of MD&As. Companies therefore should carefully consider all known trends, events, and uncertainties as part of the MD&A planning process and identify their reasons for disclosure or nondisclosure.
-Robert K. Herdman and Robert D. Neary
The authors are partners in the national office of Ernst & Young. They thank colleagues James R. Bradow and Mark L. Fagerholm for their assistance.
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|Title Annotation:||Financial Reporting; management's discussion and analysis; Securities and Exchange Commission|
|Author:||Neary, Robert D.|
|Date:||Nov 1, 1989|
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