Effective December 29, 2003, the Securities and Exchange Commission issued detailed interpretive guidance regarding disclosure in Management's Discussion and Analysis (MD&A), developed from the SEC's recent experiences, including enforcement actions and its 2002 review of the annual reports and MD&A disclosure of the Fortune 500 companies. We previously provided a checklist based on the SEC's preliminary review of those filings. Please see our April 22, 2003 update "Current Issues Checklist Based on Recent 10-K Filing Season and SEC's 'Fortune 500' Report." We recommend that drafters recognize that the SEC will continue to focus on MD&A in the near future, and therefore should carefully consider the guidance from the December 2003 release. We urge CEOs and CFOs to become familiar with these SEC expectations for purposes of certifying the MD&A in their company's annual and quarterly reports, and to take an early and active hand in fashioning the "executive-level" overview that the SEC calls for in the interpretive release. Audit Committee members who review MD&A on a quarterly basis should also become familiar with these SEC expectations.

The SEC emphasized the following key concepts in the interpretive release:

Purpose of MD&A

• The purpose of MD&A is to enable readers "to see the company through the eyes of management" and to provide readers with the information they need to readily understand the company's financial condition and performance.

Overall Presentation

• Include an executive-level overview to provide a context for the presentation. Encourage top-level participation in the drafting process.
• Give the most important information the greatest prominence.

• Omit duplicative information (e.g., information already included in financial statement footnotes).

Focus and Content

• Identify and discuss the key performance metrics that management uses to run the business.
• Focus on material information and eliminate the immaterial.

• Disclose known trends and uncertainties and their impact on the company's prospects (this is required MD&A disclosure – not just a best practice).

• Explain management's view of the significance of the information presented.

Substantive Guidance

• Liquidity and Capital Resources – refocus analysis on sources and uses of cash, especially companies using the indirect method in preparing cash flow statements, and consider enhanced disclosure regarding debt instruments, guarantees and related covenants.

• Critical Accounting Estimates – consider enhanced discussion and analysis for accounting estimates and assumptions that are subjective and require judgments for highly uncertain matters or are susceptible to change and may have a material impact on financial condition or operating performance.

MD&A Drafting Tips

Overall Presentation

• Tables. Use tables to show comparisons of results in different periods, followed by a narrative analysis of results.

• Placement of Information. Give the most material information and analysis the most prominence.
• Consider using a "layered" approach such as a lead-in "high level" statement introducing each section with a description of the principal factors, trends or other matters discussed in the section.
• Executive Summary. Begin MD&A with an introductory "executive-level" overview that summarizes the key metrics and variables management looks at in managing the business and assessing the company's financial performance. This discussion should orient the reader and provide context for the more detailed discussion and analysis to follow.

Practical Tip: Ask CEO & CFO to Provide Guidance on or Draft an MD&A Overview The SEC states in the interpretive release that management should have "early top-level involvement" in "identifying the key disclosure themes and items that should be included in a company's MD&A." These key disclosure themes should be reflected in the "executive-level" overview. Although the content of an introduction or overview will depend on the circumstances of each particular company, the SEC believes a good overview should discuss: Economic or industry-wide factors relevant to the company. How the company generates revenue, cash flow and net income. The company's lines of business, locations of operations and principal products and services (but not a duplication of the Business section of the Form 10-K). Material opportunities, challenges and risks, such as those presented by known material trends and uncertainties, on which the company's executives are most focused for both the short and long term, as well as the actions they are taking to address these opportunities, challenges and risks.

Consider asking your CEO or CFO to sketch out a one-page narrative or outline addressing these factors in his or her own words as a starting point for the MD&A overview.

Focus and Content of MD&A

• Use Key Indicators. Disclose key indicators of financial condition and operating performance that management uses in running the business as a way to show the company "through the eyes of management."

• Examples of these key indicators might include: financial measures based on revenue, units sold, gross margin, operating margin, cash flow, net income or other financial statement items; measures of customer satisfaction and customer acquisition and attrition rates; product development measures including product pipeline, average time-to-market, and ability to achieve scheduled development milestones; interest rates, currency rates and other external market indicators; employee productivity, morale and retention measures; return on equity, return on assets and similar measures; market share and other competitive performance indicators; and any pertinent macroeconomic measures.
• Review Informal Communications. Evaluate the information disclosed in earnings press releases, analysts' calls, website postings and other informal communications to determine whether material information addressed in those communications should be included in MD&A.

Trap for the Unwary: Some Key Indicators May Be Non-GAAP Measures Often, many of the "key indicators" that management and analysts use in evaluating a company's business are "non-GAAP" financial measures. Non-GAAP financial measures that are included in periodic reports are subject to Item 10(e) of Regulation S-K. Among other things, Item 10(e) requires quantitative reconciliation of the differences between the non-GAAP measure and the most directly comparable GAAP measure. Certain types of non-GAAP measures, such as those measures that exclude charges or liabilities requiring cash settlement (other than the measures of EBIT and EBITDA), are specifically prohibited from inclusion in SEC reports. See our February 5, 2003 update "SEC Issues Final Rules Governing Non-GAAP Financial Information."

• Focus on Materiality. Focus on material events and uncertainties that would make the historical information not indicative of future results. Omit disclosure that is duplicative or no longer material and useful. Don't discuss every line item of the financial statements if the discussion is not material to an understanding of the company's financial condition

• Focus on Material Trends and Uncertainties. A principal objective of MD&A is to provide information on the quality and potential variability of the company's earnings and cash flow to enable the reader to assess future performance. Focus on known trends, demands, commitments, events and uncertainties that could impact the company's future financial condition or operating results. If such information is reasonably available, quantify the material effects of those trends and uncertainties.
• Focus on Analysis. As part of the "analysis" required by MD&A, explain management's view of the implications and significance of the information that is disclosed. When discussing the effects of trends, demands, commitments, events and uncertainties, also describe the underlying reasons for those effects.

Practical Tip: How to Assess Known Trends and Uncertainties

In previous guidance the SEC stated that management should perform a two-step analysis in assessing whether a known trend or uncertainty should be disclosed:

• Is the known trend, demand, commitment, event or uncertainty likely to come to fruition? If management determines that it is not reasonably likely to occur, no disclosure is required

• If management cannot make that 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 that a material effect on the registrant's financial condition or results of operations is not reasonably likely to occur.

The SEC has previously stated that the evaluation of whether a trend is "likely to occur" should be made on an objective basis, viewed as of the time the determination is made. "Likely" is generally evaluated in terms of probability. If a reasonably prudent manager knowing all of the facts believes that the trend is probable or "within the realm of credibility" to occur, it should be discussed.

Liquidity and Capital Resources

• Discuss Cash Needs in the Long and Short Term. Evaluate the company's ability to meet upcoming cash needs over both the short term (less than 12 months) and the long term (more than 12 months) in terms of maintaining current operations and achieving stated objectives and plans in light of known trends.

• Explain Why Debt Is Incurred .Explain the reasons for incurring debt, the use of debt proceeds and the way in which the debt fits into the company's overall business plan.
• Discuss Working Capital Needs. If debt has been incurred for general corporate purposes, discuss the anticipated amount and timing of working capital needs.
• Use Table of Contractual Obligations as a Starting Point. Use the table of contractual obligations that is now required in MD&A as a starting point for the discussion of cash requirements in the liquidity and capital resources section. See our February 14, 2003 update "SEC Issues Final Rule Requiring Enhanced MD&A Disclosure of Off-Balance Sheet Arrangements and Aggregate Contractual Obligations" for more information on the required table.
• Discuss Sources and Uses of Cash. Address the primary drivers of cash flow (e.g., cash receipts from the sale of goods or services and the cash payments to acquire materials or goods) and the changes in these drivers that took place during the periods covered by the report. If a company has negative cash flow, discuss the operational reasons for this condition. If the company intends to meet its cash requirements through financing arrangements, evaluate whether such options are "reasonably likely to be available."
• Discuss Restrictions on the Ability to Access Cash Flow. For example, discussion may be required where a company is unable to access the cash flow or other assets of consolidated entities due to insufficient voting rights or the legally isolated nature of the assets.
• Describe Sources of Financing. Describe the financing sources available, or reasonably likely to be available, to the company, as well as those sources that may not be available but that the company would want to use.

Trap for the Unwary: Describe Future Financing Plans with Care The interpretive release states that if a company has decided to raise material debt or equity financing, or if it is reasonably likely to do so in the future, the company should consider discussing the amounts or ranges involved, the nature and terms of the financing and the impact of the financing on the company's cash position and liquidity. However, in order to prevent a company from "conditioning the market" for a public offering, the Securities Act of 1933 limits the amount and type of disclosure a company can make about a future financing that takes the form of a public offering prior to the filing of a registration statement with the SEC. Therefore, company counsel should carefully review any disclosure of the type recommended in the interpretive release in order to avoid Securities Act violations.

 

Disclose the impact of material debt covenants and guarantees. The interpretive release suggests there are two scenarios in which a company should discuss material debt covenants:

 

• if the company is in breach, or is reasonably likely to be in breach, of such covenant and the impact on the company is material and
• if the covenants limit, or are reasonably likely to limit, the ability of the company to undertake additional debt financing.

Analyze the Impact of Decisions Related to the Uses of Cash. For example, a company in a highly capital intensive business should describe the material long-term effects of its decision to spend significantly less on plant or equipment.

Critical Accounting Estimates

Determine Whether Disclosure is Required. Include disclosure of critical accounting estimates if:

• 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.

If Disclosure is Required, Discuss the Following Topics:

• why the estimate or assumption bears the risk of change,
• how management arrived at the estimate,
• how accurate the estimate has been in the past,
• how much the estimate has changed in the past,
• whether the estimate is likely to change in the future, and
• the specific sensitivity of the company to change, based on other outcomes that are reasonably likely to occur and would have a material effect.

Text of the Interpretive Release

This Update is only intended to be a summary of the interpretive release. You can find the full text of the interpretative release at http://www.sec.gov/rules/interp/33-8350.htm.

You can find a general discussion of related proposals and of other recent laws, regulations and rule proposals of interest to public companies on our website.

 

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