“Management’s Discussion and Analysis of Financial Condition and Results of Operations” (MD&A) has long been a central element of each public company’s financial disclosure. The SEC has stated that MD&A should satisfy three related objectives:
- providing a narrative explanation of the company’s financial statements that enables investors to see the company through the eyes of management;
- improving overall financial disclosure and providing the context within which financial statements should be analyzed; and
- providing information about the quality, and potential variability, of a company’s earnings and cash flows, so that investors can ascertain the likelihood that past performance is indicative of future performance.
- the selection of appropriate accounting policies;
- the proper application of appropriate accounting policies;
- the disclosure of financial information that is informative and reasonably reflects the underlying transactions and events; and
- the inclusion of any additional disclosure necessary to provide investors with a materially accurate and complete picture of the company’s financial condition, results of operations and cash flows.
- what the company does and how it makes or plans to make money;
- key drivers that are critical to the success or failure of the company;
- the financial metrics that management uses to measure the company’s performance;
- the most significant recent developments or trends;
- management’s principal concerns; and
- where appropriate, information about management’s expectations for future periods.
- accounting estimates a company makes in applying its accounting policies; and
- the initial adoption by a company of an accounting policy that has a material impact on its financial presentation.
- the accounting estimate must require the company to make assumptions about matters that are highly uncertain at the time the accounting estimate is made; and
- either (A) the accounting estimate must have been one of a range of different estimates that the company reasonably could have used for the accounting estimate in the current period, or (B) changes in the accounting estimate that are reasonably likely to occur would have a material impact on the presentation of the company’s financial condition, changes in financial condition or results of operations.
- Include a separate, detailed discussion of the company’s critical accounting policies. The SEC has encouraged companies to include in their MD&A sections, in “plain English,” full explanations of their “critical accounting policies, the judgments and uncertainties affecting the application of those policies, and the likelihood that materially different amounts would be reported under different conditions or using different assumptions.”
- While there is no maximum or minimum number of critical accounting policies a company should discuss, most companies should expect to identify approximately three to five critical accounting policies for discussion in MD&A.
- Note that the SEC has stated that “boilerplate disclosures, or disclosures written in overly technical accounting terminology, would not satisfy the proposed requirements.” The MD&A discussion of a critical accounting policy should not simply repeat the policy description from the notes to the financial statements—rather, the discussion in MD&A should focus on how different estimates required under the policy would affect the company’s operating results or financial position.
- Disclosure of unusual or infrequent events or transactions or significant economic changes that materially affected the amount of reported income from continuing operations and the extent to which income was affected; and any other significant components of revenues or expenses that should be described in order to understand results of operations.
- A discussion of known trends or uncertainties that have had, or that management reasonably expects will have, a material favorable or unfavorable impact on net sales or revenues or income from continuing operations, and known events that will cause a material change in the relationship between costs and revenues. According to the SEC, management must consider whether a known trend or uncertainty is likely to come to fruition. If the answer is no, then no disclosure is required. If the answer is yes, disclosure is required. If management is unable to answer the question, then it must consider whether, if the known trend or uncertainty occurred, a material effect on the company’s financial condition or results of operations would be reasonably likely to occur. If so, then disclosure is required.
- A narrative discussion of the extent to which material increases in net sales or revenues are attributable to increases in prices or in the volume or amount of goods or services being sold, or the introduction of new products or services.
- A description of the impact of inflation and changing prices on the company’s net sales and revenues and on income from continuing operations.
- When stating two or more reasons for an increase in revenues, the SEC requests that companies quantify each of the reasons. For example, the SEC often requests that companies quantify the extent to which changes in revenues were due to changes in prices, changes in volume, the introduction of new products or services or the effect of acquisitions or dispositions. If quantifying the effect of each factor is impracticable, the company should include qualitative disclosure indicating the relative importance of the stated reasons. Companies should also disclose the reasons for the changes, such as changes in the competitive landscape, a change in a company’s pricing strategy or a change in the overall level of demand for a company’s products or services.
- The SEC is strongly encouraging companies to provide quantified disclosure of the individual components of operating expense. In particular, where expenses have decreased as a percentage of net sales, but increased on an absolute basis (or vice versa), the SEC is requesting both a discussion of the trend as a percentage of sales and a quantification of the reasons for the opposite trend on an absolute dollar basis.
- Where material, offsetting factors should be separately presented and quantified, rather than just presented as a net number. For example, it is not adequate to simply say that expenses were flat when, in reality, certain expenses significantly increased, but other unrelated cost savings offset the increase.
- Consider the need to address collectability or billing problems that a company may be having with its customers. The SEC has been requesting companies to focus on any significant changes in credit terms (for example, extended payment terms), increased collection efforts, and changes in credit or delinquency policies.
- A discussion of the company’s financial condition and changes in financial condition, including the information specified in the following bullets, and any other information necessary to an understanding of the company’s financial condition and changes in financial condition.
- With respect to the liquidity of the company, identification of known trends or known demands, commitments, events or uncertainties that will result in, or that are reasonably likely to result in, liquidity increasing or decreasing in any material way. The course of action that the company has taken or proposes to take to remedy any material deficiencies should be indicated. Internal and external sources of liquidity, as well as any material unused sources of liquid assets, should also be identified and separately described.
- With respect to the capital resources of the company, a description of material commitments for capital expenditures as of the end of the latest fiscal period, and an indication of the general purpose of such commitments and the anticipated source of funds needed to fulfill them.
- A description of any known material trends, favorable or unfavorable, in capital resources. Any expected material changes in the mix and relative cost of such resources should be indicated.
- provisions in financial guarantees or commitments, debt or lease agreements or other arrangements that could trigger a requirement for an early payment, additional collateral support, changes in terms, acceleration of maturity, or the creation of an additional financial obligation, such as adverse changes in the company’s credit rating, financial ratios, earnings, cash flows, or stock price, or changes in the value of underlying, linked or indexed assets;
- circumstances that could impair the company’s ability to continue to engage in transactions that have been integral to historical operations or are financially or operationally essential, or that could render that activity commercially impracticable, such as the inability to maintain a specified investment-grade credit rating, level of earnings, earnings per share, financial ratio or collateral;
- factors specific to the company and its markets that the company expects to be given significant weight in the determination of the company’s credit rating or that will otherwise affect the company’s ability to raise short-term and long-term financing;
- guarantees of debt or other commitments to third parties; and
- written options on non-financial assets (for example, real estate puts).
- an obligation under certain types of guarantee contracts;
- a retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to such entity for the transferred assets;
- an obligation under certain derivative instruments;
- material variable interests in unconsolidated entities that provide financing, liquidity, market risk or credit risk support to the company, or engage in leasing, hedging or research and development services with the company.
- the nature and business purpose of the off-balance sheet arrangements and, if necessary to an investor’s understanding, the significant terms and conditions of the arrangements;
- the importance of the arrangement to the company for liquidity, capital resources, market risk or credit risk support or other benefits;
- the financial impact of the arrangement on the company and the company's exposure to risk as a result of the arrangement; and
- known events, demands, commitments, trends or uncertainties that implicate the company’s ability to benefit from its off-balance sheet arrangements.
In addition, the disclosure should provide investors with insight into the overall magnitude of the company's off-balance sheet activities, the specific material impact of the arrangements on the company, and the circumstances that could cause material contingent obligations or liabilities to come to fruition. Additional disclosure is required to the extent material and necessary to investors’ understanding of:
- the amounts of revenues, expenses and cash flows of the company arising from the arrangement;
- the nature and amount of any interests retained, securities issued and other indebtedness incurred by the company;and
- the nature and amount of any other material obligations or liabilities (including contingent obligations and liabilities) of the company arising from the arrangement that are, or are reasonably likely to become, material and the triggering events or circumstances that could cause them to arise.
For further information, please see Release No. 33-8182.
Other Significant Issues in Drafting MD&A
Use of Non-GAAP Financial Measures
On January 15, 2003, the SEC adopted final rules relating to “non-GAAP financial measures.”6 The final rules apply a two-pronged approach to regulating the use of “non-GAAP financial measures”:
- Regulation G, which will apply whenever a public company publicly discloses material information that includes a non-GAAP financial measure; and
- Item 10(e) of Regulation S-K, which will apply stricter requirements when non-GAAP financial measures are included in an SEC filing.
The transition provisions applicable to these new rules have some unusual results for companies filing an annual report on Form 10-K for fiscal periods that ended prior to March 28, 2003. First, Regulation G applies to all public disclosures of non-GAAP financial measures on or after March 28, 2003. As a result, Regulation G will not be in effect until after many calendar year-end filers have filed their 10-K. However, a calendar year-end company that does not file its 10-K prior to Friday, March 28 will need to comply with Regulation G to the extent its 10-K includes non-GAAP financial measures. Second, the amendments to Item 10(e) of Regulation S-K apply to any annual or quarterly report filed with respect to a fiscal period ending after March 28, 2003. As a result, the amendments to Item 10(e) of Regulation S-K will not technically apply to 10-Ks being filed by calendar year-end companies.
What is a “Non-GAAP Financial Measure”?
A non-GAAP financial measure is a numerical measure of a company's historical or future financial performance, financial position or cash flows that:
- excludes amounts, or is subject to adjustments that have the effect of excluding amounts, that are included in the most directly comparable measure calculated and presented in accordance with GAAP in the statement of income, balance sheet or statement of cash flows (or equivalent statements) of the company; or
- includes amounts, or is subject to adjustments that have the effect of including amounts, that are excluded from the most directly comparable measure so calculated and presented.
This definition is intended to capture all measures that have the effect of depicting either:
- a measure of performance that is different from that presented in the financial statements, such as income or loss before taxes or net income or loss, as calculated in accordance with GAAP; or
- a measure of liquidity that is different from cash flow or cash flow from operations computed in accordance with GAAP.
Examples of non-GAAP financial measures include:
- measures of operating income that exclude one or more expense or revenue items that are identified as "non-recurring;"
- measures of operating margin where either the revenue component or the operating income component of the calculation, or both, were not calculated in accordance with GAAP; and
- EBITDA (earnings before interest, taxes, depreciation and amortization).7
Non-GAAP financial measures do not include:
- financial measures required to be disclosed by GAAP, SEC rules or a system of regulation of a government or governmental authority or self-regulatory organization that is applicable to the company (including segment information required to be disclosed by GAAP);
- operating and other statistical measures (such as unit sales, and numbers of employees, subscribers or advertisers);
- ratios or statistical measures that are calculated using exclusively one or both of (i) GAAP financial measures and (ii) operating and other measures that are not non-GAAP financial measures; 8 and
- financial information that does not have the effect of providing numerical measures that are different from the comparable GAAP measures, such as:
- disclosure of amounts of expected indebtedness, including contracted and anticipated amounts;
- disclosure of amounts of repayments that have been planned or decided upon but not yet made; and
- disclosure of estimated revenues or expenses of a new product line, so long as such amounts were estimated in the same manner as would be computed under GAAP.
Whenever a company, or a person acting on its behalf, publicly discloses any material information that includes a non-GAAP financial measure, Regulation G will require that the non-GAAP financial measure be accompanied by:
- a presentation of the most directly comparable GAAP financial measure9; and
- a reconciliation (by schedule or other clearly understandable method) of the non-GAAP financial measure to the most directly comparable GAAP financial measure. This reconciliation must be quantitative for historic measures, but may be qualitative for forward-looking information if a quantitative reconciliation would not be available without an unreasonable effort10
In addition, a company, or a person acting on its behalf, may not publicly present a non-GAAP financial measure that, taken together with the accompanying information, misstates a material fact or omits to state a material fact necessary to make the presentation of the non-GAAP financial measure not misleading in light of the circumstances under which it is presented. In particular, the SEC cautioned companies to consider whether a change in the method of calculating or presenting a non-GAAP financial measure from one period to another, without a complete description of the change, complies with this requirement of Regulation G.
As indicated above, Regulation G will apply to any 10-K filed on or after March 28, 2003. However, it would be prudent for companies to comply with Regulation G even if their 10-K is being filed prior to the rule becoming effective. Once the amendments to Item 10(e) of Regulation S-K that are described below become effective, the only requirement imposed by Regulation G that exceeds the provisions of Item 10(e) will be the requirement that the presentation of non-GAAP financial measures may not be inaccurate or misleading in any material respect.
Additional Requirements of Item 10(e) of Regulation S-K
New Item 10(e) of Regulation S-K requires that companies including non-GAAP financial measures in filings with the SEC provide:
- a presentation, with equal or greater prominence, of the most directly comparable GAAP financial measures;
- a reconciliation (by schedule or other clearly understandable method) of the non-GAAP financial measure to the most directly comparable GAAP financial measure (this reconciliation must be quantitative for historic measures, but may be qualitative for forward-looking information if a quantitative reconciliation would not be available without unreasonable efforts);
- an explanation of why the company’s management believes the non-GAAP financial measure provides useful information to investors regarding the company’s financial condition and results of operations; and
- to the extent material, a statement disclosing the additional purposes, if any, for which the company's management uses the non-GAAP financial measures presented in the filing.
In addition to these mandated disclosure requirements, Item 10(e) of Regulation S-K prohibits:
- excluding charges or liabilities that required, or will require, cash settlement, or would have required cash settlement absent an ability to settle in another manner, from non-GAAP liquidity measures, other than the measures EBIT (earnings before interest and taxes) and EBITDA (earnings before interest, taxes, depreciation and amortization11;
- adjusting a non-GAAP performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual, when (1) the nature of the charge or gain is such that it is reasonably likely to recur within two years, or (2) there was a similar charge or gain within the prior two years;
- presenting non-GAAP financial measures on the face of the company's GAAP financial statements or in the accompanying notes, or on the face of any GAAP required pro forma financial information; and
- using titles or descriptions of non-GAAP financial measures that are the same as, or confusingly similar to, titles or descriptions used for GAAP financial measures.
For further information, please see Release No. 33-8176 (January 22, 2003).
Related Party Transactions
The SEC has cautioned that where related party transactions are material, MD&A should include a discussion of those transactions to the extent necessary for an understanding of the company’s current and prospective financial position and operating results. The MD&A discussion of material related party transactions should include discussion of the following:
- the business purpose of the arrangement;
- identification of the related parties;
- how transaction prices were determined by the parties;
- if the company represents that the transactions have been evaluated for fairness, a description of how the evaluation was made; and
- any ongoing contractual or other commitments of the company resulting from the arrangement.
In addition, the SEC has urged companies to consider disclosing transactions with persons who technically fall outside of the definition of “related parties” but “with whom the [company] or its related parties have a relationship that enables the parties to negotiate terms of material transactions that may not be available from other, more clearly independent, parties on an arms-length basis.” One example offered by the SEC is a transaction with an entity formed by former senior management of the company.
MD&A and “Plain English”
The SEC’s “plain English” rules require that companies present information in registration statements in a clear, concise and understandable manner. In particular, this means that the presentation should comply with the following standards:
- using clear, concise sections, paragraphs and sentences;
- using descriptive headings and subheadings;
- avoiding defined terms;
- avoiding highly technical legal or business jargon;
- eliminating imprecise “boilerplate;” and
- avoiding repetition of identical disclosures.
While MD&A in a Form 10-K or Form 10-Q is not required to be presented in “plain English,” companies that contemplate issuing securities in a public offering should consider doing so because companies and underwriters often choose to include the MD&A section from the company’s most recently filed Exchange Act report in an offering prospectus. Although MD&A is not specifically required to be included in an S-3 registration statement, the SEC has made clear that any provisions that are physically included in a prospectus must be presented in compliance with the “plain English” rules.
Moreover, in order to respond to the SEC’s direction to make MD&A clearer and more understandable, companies should incorporate “plain English” standards into their MD&A, regardless of whether they expect to be filing a registration statement in the near future.
In drafting MD&A, companies should make use of the safe harbor for forward-looking statements afforded by federal securities laws. In general, companies and their officers, directors and employees will not be liable for a forward-looking statement contained in MD&A so long as the statement was (i) made in good faith and (ii) identified as a forward-looking statement and accompanied by “meaningful cautionary statements identifying important factors that could cause actual results to differ materially” from those predicted.
Forward-looking statements should be presented as management’s current expectations or targets—not as fact. All forward-looking statements should be accompanied by appropriate qualifiers such as “plans to,” “expects to,” “anticipates” or “scheduled to” in order to identify the statement as forward-looking. More protection under the safe harbor is likely to be afforded where companies include a complete set of detailed, specific risk factors within MD&A. This “risk factor” or “factors affecting future results” section should be carefully reviewed and, if necessary, redrafted each time that it is used, in order to reduce allegations that the disclosures are not “meaningful” under federal securities laws.
1 Release No. 33-8176 (January 22, 2003) and Release No. 33-8182 (January 27, 2003).
2 Release No. 33-8098 (May 10, 2002).
3 Release No. 33-8056 (January 22, 2002).
4 Release No. 33-6835 (May 18, 1989).
5This summary was posted on the SEC's website on February 27, 2003 at www.sec.gov/divisions/corpfin/fortune500rep.htm .
6 The final rules use the term “non-GAAP financial measures” instead of “pro forma financial measures” in order to minimize confusion resulting from the fact that GAAP requires “pro forma” financial statements in connection with certain business combinations.
7 As discussed below in more detail, EBIT and EBITDA are given special treatment under one provision of Item 10(e) of Regulation S-K, notwithstanding the fact that they are non-GAAP financial measures. Other than the measures EBIT and EBITDA, Item 10(e) of Regulation S-K prohibits the exclusion of cash charges and liabilities from non-GAAP liquidity measures.
8 Examples of ratios and measures that would not be non-GAAP financial measures include sales per square foot (assuming that the sales figure was calculated in accordance with GAAP) and same store sales (assuming the sales figures for the stores were calculated in accordance with GAAP).
9 Although the SEC has provided registrants with the flexibility to determine “the most directly comparable” GAAP financial measure, the SEC is of the general view that (i) non-GAAP financial measures that measure cash or funds generated from operations should be balanced with disclosure of amounts from the statement of cash flows and (ii) non-GAAP financial measures that depict performance should be balanced with net income, or income from continuing operations, taken from the statement of operations.
10 If the GAAP financial measure is not available on a forward-looking basis, the company must disclose that fact and provide reconciling information that is available without an unreasonable effort. In addition, the company must identify information that is unavailable and disclose its probable significance.
11 Companies must still comply with the other requirements of Item 10(e) with respect to EBIT and EBITDA.