The MD&A Challenge
The difficulty of crafting a quality disclosure.
| EXECUTIVE SUMMARY | |
CPAs HELPING COMPANIES DRAFT THEIR MD&A do so at a time when the SEC’s Division of Corporation Finance is increasingly unhappy with the quality of these disclosures, and in the wake of civil fraud charges against the former CEO and CFO of Kmart alleging the MD&A in a 2001 quarterly report provided less than a clear and candid disclosure.
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| DONALD H. MEIERS is a partner with the law firm of Steptoe & Johnson LLP in Washington, D.C., and a member of its Business Solutions group. His practice focuses on securities law matters and corporate finance. His e-mail address is dmeiers@steptoe.com . |
nnual report season is upon us. In the coming weeks CPAs in public companies across the country will face the difficult task of helping executives draft “management’s discussion and analysis of financial condition and results of operations,” better known as MD&A. As if the stakes weren’t already high enough, in August 2005 the SEC filed civil fraud charges against the former CEO and CFO of Kmart Corp. alleging the MD&A in a 2001 quarterly report provided less than a clear and candid disclosure.
For the past two years the staff of the SEC’s Division of Corporation Finance has frequently told SEC-reporting companies that their MD&A disclosures fell short of the staff’s expectations, highlighting the degree of the problem by encouraging companies to throw their existing MD&A templates “out the window.”
This article focuses on the process-oriented issues that impede robust, quality MD&A. These issues will resonate with CPAs who work for SEC-reporting companies and have a role in or responsibility for drafting these disclosures. Awareness of these issues, combined with the suggestions made throughout this article, will help CPAs raise the quality of their company’s MD&A in future periodic reports and other SEC filings. Higher quality should translate into more complete, candid and accurate disclosure, resulting in reduced liability exposure under federal securities laws.
| The purpose of MD&A is to provide an analysis of a company’s business, results of operations and financial condition “through the eyes of management.” |
THE ART OF MD&A
In light of the SEC staff’s mandate under the Sarbanes-Oxley Act to examine the filings of SEC-reporting companies not less than every three years, CPAs soon may find themselves on the receiving end of a staff comment letter reflecting the importance the SEC places on MD&A as demonstrated by its lawsuit against the former Kmart officers. In December 2003 the SEC staff issued a release that provided fairly detailed guidance on how to craft MD&A disclosures. It emphasized points relating to presentation, content and focus, including specific suggestions to
Use an executive-level summary or overview that provides foundational information for the remainder of the text.
Layer information.
Use headings that help readers follow the flow.
Avoid repetition and overly lengthy disclosure, reflecting inadequate filtering of nonmaterial information.
Use clear, understandable language.
Go beyond an analysis of intermediate cause-and-effect relationships influencing period-over-period operating results or financial condition to address the root or underlying causes.
Focus on key indicators of a company’s performance and financial condition (in the form of financial and nonfinancial measures—be they industry or company-specific or reflective of market conditions).
When I first read the December 2003 release, it reminded me of a handout one of my teachers gave me in elementary school on how to write an effective report. I spotted some clear parallels: Inform the reader at the outset of major themes or points; provide necessary foundational information so the additional detail later in the report can be fully understood; use topic sentences and paragraph breaks tied to those topic sentences; use active voice; vary sentence length to keep the reader interested; and make sure cause-and-effect relationships are clear.
If the keys to crafting robust, quality MD&A disclosure are no different than those required for other forms of effective writing, is the subject matter itself the problem? The purpose of MD&A is not complicated—it’s to provide an analysis of a company’s business, results of operations and financial condition “through the eyes of management.” In other words, the subject matter is one management should know better than anyone. So why is it that financial analysts’ reports are often more insightful than the company’s own MD&A?
Without question a significant concern is the reluctance of public companies to disclose what they see as competitively sensitive information. Yet when asked why particular information is sensitive, company representatives often will concede the information already is widely known among industry peers. Characterizing the information as competitively sensitive frequently amounts to little more than a natural resistance to acknowledging the company is not doing well. For example, a company with declining revenues may be willing to confirm it is in a contracting industry but generally won’t want to reveal it is losing market share or explain the underlying causes out of fear peer companies will seize on such an admission in a way that will result in a loss of customers.
The SEC’s allegations in the civil complaint against the former Kmart officers suggest this was the issue in the company’s quarterly report. It also highlights how less-than-forthcoming disclosures can expose a company to SEC or private litigation that alleges a disclosure is materially incomplete or inaccurate. In the Kmart complaint, the SEC alleged that “instead of candidly admitting the fact of an ill-advised overbuy [of inventory] and the significant impact it had on the company’s liquidity, [the former officers] dealt with Kmart’s liquidity problem by secretly slowing down payments owed vendors,” many of whom stopped shipping their products to Kmart.
In my experience the concern about disclosing competitively sensitive information can, in almost all instances, be overcome by simply dedicating more time and care to phrasing the portion of the MD&A text touching on that information. This can be done without undermining the objective of providing complete, accurate, candid and transparent disclosure.
So, what is the real problem? Based on my experience helping SEC-reporting companies prepare MD&A disclosure, I believe the stumbling blocks are related to the process companies use to draft the disclosure. The most common mistakes—and some suggestions for avoiding them—are described below.
Don’t use a prior-period MD&A as a starting point. By encouraging companies to throw their existing MD&A templates out the window, Alan Beller, who heads the SEC’s Division of Corporation Finance, tacitly acknowledged that some companies use the MD&A from a prior period report as the starting point for the current one. The common practice of providing narrative disclosure of (and period-over-period percentage changes in) income statement line-item amounts—information anyone can readily glean by reviewing the financial statements themselves—is testimony to the tendency to shortcut the drafting process by simply plugging updated numbers into otherwise unchanged text. If the prior period report included a perfunctory explanation of the factors contributing to the period-over-period changes, those working on the current report may conclude the explanation is still relevant and leave the text unchanged.
This minimalist, “why reinvent the wheel?” approach is rooted in the view that the company does business in a mature industry characterized, in the short term, by little change. While there is wisdom in considering market dynamics from a longer-term perspective, there are few, if any, companies today whose businesses are not influenced daily by general economic conditions, global or regional market forces and other factors. The minimalist approach represents the antithesis of what the SEC staff believes investors would consider a high-quality disclosure and is completely unacceptable in the current climate.
Avoid sticking too close to the financial statement “script.” In the December 2003 release, the staff encouraged “early top-level involvement” by management in identifying the key disclosure themes and items that should be included in a company’s MD&A. As the release says, companies today have access to and use substantially more detailed and timely information about their operating performance and financial condition than they did 10 years ago. With this relative wealth of real-time information, management knows, or at least has a good feel for, the market dynamics, trends and factors currently influencing (or expected to influence) a company’s operating results and financial condition. Accordingly, management can and should articulate the key disclosure themes to those drafting the MD&A even before the company’s financial statements are available internally.
For CPAs creating the first draft of the MD&A, doing so without the financial statement information may seem counterintuitive. Nonetheless, I frequently suggest drafters prepare the executive overview or summary section, which lays the foundation for the remainder of the MD&A, without including any quantitative information. This suggestion is typically met with resistance. People aren’t comfortable moving so dramatically away from the traditional approach of letting the financial data drive the disclosure. But “reverse-engineering” the MD&A by developing key disclosure themes and then using financial statement and other quantitative data to illustrate or confirm those themes is a far more effective way to ensure the disclosure gives investors the context they need to understand the financial information being presented.
Be sure to consult or “circle back” with sources. Good MD&A disclosure requires active participation and input from a variety of disciplines in a company, including operations, finance, accounting and legal. Portions of the initial draft may come from multiple sources and be assembled by one or more persons, typically in a company’s accounting department. The number of people involved increases if the company has multiple business areas or segments.
From my experience, all of the personnel who contribute information to the initial draft are not kept in the loop throughout the drafting and review process. As a result, the accounting personnel who may have overall responsibility for the MD&A often find themselves being asked questions about the proposed disclosure—by the company’s disclosure committee, board of directors, external auditors or outside counsel—that they are not able to answer. If these questions come late enough in the process, they easily can lead to some of the problems the SEC staff identified in its release.
For example, explanations of cause-and-effect relationships influencing a company’s operating results or financial condition may address only intermediate causes. CPAs may not have an opportunity to bring to management’s attention any internal company or market data at odds with one or more aspects of the MD&A narrative. And they may not have the opportunity to draft the clearest and most understandable text addressing technical or relatively complex accounting matters, such as a company’s risk management activities, including its use of derivatives.
Don’t allow too many cooks in the kitchen. Having too many people involved in preparing the MD&A can undermine efforts to craft a robust disclosure. None of the contributors of information or draft text will take ownership of the entire document and some will be reluctant to provide critical feedback about others’ contributions. Such reluctance will increase as the draft progresses. As a result the final version may lack a single “voice” or writing style, show poor organizational flow, lack a layering of information or inadequately filter nonmaterial information.
The involvement of a disclosure committee, typically composed of senior management, in reviewing the MD&A does not appear to make a noticeable difference to the process. This may be because committee members perceive that, at the point they review the draft, too great an investment of time has been made to make drastic or fundamental changes, particularly when they did not participate in some or all of the meetings that led to the draft under review. It also may be a function of the disclosure committee itself having too many members.
While the suggestion to avoid involving too many “cooks” may seem at odds with the earlier suggestion to keep all sources of information in the loop during the drafting and review process, this is not the case. Personnel with primary responsibility for the company’s MD&A need to understand that they must take full ownership of the disclosure as if they were providing the certification Sarbanes-Oxley now requires of CEOs and CFOs—with the accompanying liability. In so doing these individuals should ensure they completely understand the information provided by other sources within the company while taking greater control of the integrated draft as it evolves.
Double-check linkage between business description and MD&A. An SEC-reporting company tends to prepare the description of its business to be included in the annual report in advance of the MD&A. Work on the MD&A typically awaits the internal release of the company’s financial statements. The SEC’s acceleration of the deadlines by which companies must file periodic reports has made it increasingly important to complete work on sections not significantly tied to the financial statements before the internal release. This enables company personnel to dedicate more time to crafting the MD&A during the relatively short window of time between the financial statement release and the due date for filing the periodic report.
In working with SEC-reporting clients on their annual reports, I have suggested they view the business description as the equivalent of the balance sheet and the MD&A as the income statement. While the analogy may not be perfect, it highlights the importance of a close linkage between these two sections of the annual report. This is particularly true if the business description addresses topics such as key industry trends and how they influence the company’s growth strategy and competitive position.
Robust MD&A disclosure should elaborate on the actual or anticipated financial implications of the trends, events, commitments and uncertainties that underlie the company’s growth strategy and competitive position, as discussed in the business description. However, a cross-check of these two sections, and the natural iterative evolution of the disclosure in each based on this cross-check, often simply does not occur. At the time the company circulates the initial MD&A draft for internal review, the reviewers may see the business description as etched in stone and not subject to further revision. As a result, the disclosure in these sections tends not to reflect the necessary degree of integration, taking away from the effectiveness of the “analysis.” In addition the report tends to be characterized by unnecessary repetition, which obviously adds nothing to investors’ understanding.
Check other public disclosures. The SEC’s MD&A release emphasized the importance of evaluating whether information in a company’s other public disclosures (press releases, analyst briefings, Web site information and the like) should be reflected in the MD&A, either because the information falls within the MD&A disclosure requirements or because omission would make the filing incomplete or misleading. When reviewing a company’s periodic reports, the SEC staff apparently looks more closely at these other public disclosures. Companies should adopt procedures to ensure they evaluate their other public disclosures as a matter of course. In my experience most companies typically limit this evaluation to determining whether a matter covered by some other public disclosure is material or otherwise appropriate to be included in the MD&A. This approach often does not include assessing whether the level of detail in the MD&A is comparable with that of an earlier press release or is otherwise sufficient to provide readers a complete understanding of the matter.
Flex the MD&A disclosure. In the accounting profession, it’s common for CPAs to “tick and tie” financial data. Accountants check essentially every figure or percentage in the MD&A against the financial statements, ensuring that columns of figures foot. This is a painstaking but largely mechanical process.
A far more challenging task is flexing the MD&A narrative disclosure. This entails a concentrated focus on examining asserted cause-and-effect relationships and testing whether available data support the qualitative statements. Flexing the MD&A, a skill for which CPAs have a natural proclivity, is critical to the effort to eliminate any statements or omissions that 20/20 hindsight may show to be inaccurate or incomplete in some material respect.
WE CAN DO BETTER
The SEC’s civil complaint against the former Kmart officers should serve as a wake-up call about the increasing importance the SEC staff and investors place on MD&A disclosure. The media have commented on the unusual nature of the complaint, which does not allege the financial statements in Kmart’s periodic report were false or misleading. However, a senior representative of the SEC enforcement staff has made it clear the commission has a long history of enforcing the law to prevent use of the MD&A section to mislead investors.
Alan Beller has signaled that if SEC-reporting companies don’t dramatically improve their MD&A disclosures, his division may move forward with an MD&A rule making. Public companies should move now to address process-oriented and other stumbling blocks to producing robust, quality MD&A disclosure.
