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Securities Act Release No. 6349 Exchange Act Release No. 18120 Accounting Series Release No. 299 September 28, 1981
Managements Discussion and Analysis of Financial Condition and Results of OperationsACTION: Discussion of Item 11 of Regulation S-K: Managements Discussion and Analysis of Financial Condition and Results of Operations.SUMMARY: The Division of Corporation Finance and the Office of the Chief Accountant are issuing their assessment of certain initial disclosures made in response to the newly adopted requirements of Item 11 of Regulation S-K for managements discussion and analysis of financial condition and the results of operations. The new requirements (issued September 2, 1980) for the managements discussion entailed significant changes in the content of the discussion; however, in order to encourage flexibility the requirements themselves were intentionally general and offered a minimum of detailed provisions. The Commission Staff has now had the opportunity to review a number of 1980 disclosures. Based on that review, the Staff is issuing this release to discuss its assessment of the initial responses to this requirement and to provide registrants with examples of disclosures made under the new format. FOR FURTHER INFORMATION CONTACT: Registrants with specific questions should contact the staff members directly responsible for reviewing the documents they file with the Commission. Division of Corporation Finance, Securities and Exchange Commission, 500 North Capitol Street, Washington, D.C. 20549. SUPPLEMENTARY INFORMATION: On September 2, 1980, the Commission issued Securities Act of 1933 Release No. 6231 [45 FR 63630], which rescinded the old requirements for managements discussion and analysis of the results of operations and replaced them with the new and broader requirements of Item 11 of Regulation S-K [17 CFR 229.20], Managements Discussion and Analysis of Financial Condition and Results of Operations, hereinafter sometimes referred to as "MD&A." The requirements of Item 11 were intentionally general and nonspecific in order to encourage registrants initiative in discussing those matters most significant to individual circumstances. The Staff has now completed a review of a number of 1980 disclosures in managements discussion. Overall, the Staff was pleased with the quality of the discussion for the first year covered by the new regulations and does not believe it necessary to propose more specific requirements at this time. The Staff believes that adequate guidance can be provided through periodic releases which, in addition to discussing the views of the Staff regarding the necessity of including more or different information, also include examples of how various companies have sought to meet the new requirements.
I. GeneralA. IntroductionOn September 2, 1980, the Commission issued revised requirements 1 for the preparation of managements discussion and analysis of financial condition and results of operations. These revisions arose from the Commissions concern that the previously existing managements discussion and analysis of the results of operations had developed into an often mechanistic commentary on percentage variations. Thus, it was not fulfilling its originally contemplated objective of providing investors with a realistic management assessment of corporate objectives and numerical results. Moreover, the focus on operations alone was insufficient to cover all aspects of an enterprises financial situation in todays complex economic environment. Consequently, the revised requirements requested information on financial condition as well as operations, with an emphasis on liquidity, capital resources and the impact of inflation, and, within each of those areas, a focus on trends and material changes, events and uncertainties. In order to allow registrants to discuss their businesses in the manner most appropriate to individual circumstances and to encourage flexibility, the provisions were intentionally general and offered a minimum of specific requirements. The Staff has now had the opportunity to review a number of examples of Managements Discussion and Analysis from 1980 annual reports. Based on the review, the Staff is issuing this release to discuss its assessment of the initial responses to this requirement and to provide registrants with examples of disclosures made by various issuers under the new MD&A format. B. Summary Evaluation of Responses.In line with the flexibility in the wording of the release, the MD&A sections varied considerably in content, format and extent of coverage. Overall, the Staff noted major improvement in the quality of managements discussion of the results of operations. Many registrants focused their analysis on segment data and information about significant events and trends, resulting in presentations which were generally more readable and informative than previous mechanical discussions of percentage line item changes. As to the new requirements to discuss financial condition and changes in financial condition, registrants provided considerably more information than in the past, in a variety of formats. There were also discussions of other economic, industry and specific company factors and uncertainties relevant to an accurate understanding of the companys operations and financial condition. The Staff encourages registrants to continue to address such matters. Of particular importance are factors which are expected to make reported historical results and trends either indicative or not indicative of future operating results and related financial condition. Thus the regulations specifically state that the MD&A should discuss known trends and describe any matters which have had an impact on past operations but are not expected to continue to do so, as well as any matters expected to impact future operations even though, they have not had an impact in the past. Item 11 also encouraged, but did not require, forward-looking disclosures. The Staff was pleased that a number of registrants elected to include such information. Forward-looking disclosures were most frequent in the area of expenditures which are by nature future oriented. However, certain registrants also provided forward-looking information with respect to operations and liquidity. The disclosures, which varied from brief comments to broader discussions, including in some cases a five-year forecast of revenues and cash flow, demonstrated that the discussions need not be quantitative to be meaningful. The Staff feel that registrants may benefit from seeing a sample of different approaches to the various disclosure requirements, especially in the more novel disclosure areas. It must be recognized however, that the examples were chosen solely as a means to illustrate a particular point and do not represent the Staffs views as to the preferable method of responding to the new disclosure items or as to the adequacy of a given disclosure illustration. Moreover, as these examples, by necessity, have been removed from their context as part of a larger document (an annual report), they may appear to be incomplete in some respects. Finally, in light of the unique circumstances of each registrant, these examples should not be viewed as being necessarily appropriate in any other circumstances. It is the responsibility of management to identify and address those key variables and other qualitative and quantitative factors which are peculiar to and necessary for an understanding and evaluation of the individual company. II. Observations.A. Results of Operations.1. Background and Evaluation of 1980 Disclosures. As mentioned above, registrants made much progress in the form and content of their 1980 discussions of the results of operations, particularly in redirecting the general thrust of the discussion to an analysis of the reasons for and implications of reported results. 2 The Staff found that where discussions in terms of three and five- year trends, as well as segment disclosures, were included they were generally very informative and encouraged more widespread use of these formats. Certain registrants also provided meaningful discussion of the implications of significant events or uncertainties which were expected to materially impact future operations--for instance, the decontrol of U.S. oil prices, the proposed Canadian oil production taxes and price restrictions, or, for railroads, the Staggers Act. The Staff wants to emphasize the need to identify and discuss such significant events whether they be internal or external to the company. 3 2. Examples of Disclosures. Included below are several brief examples of disclosures in some of the areas identified in the adopting release. Inflation disclosures are covered in a separate section. a. Examples Discussing Significant Events and Economic Changes.Example 1. Note that this example discusses the impact on pre-tax income of closing certain unprofitable facilities: Second, as part of our efforts to improve future profitability, we permanently closed, during the first three quarters of 1980, a small West Coast ship repair yard, a manufacturing facility of our... Tank operation, and two coal mines, each of which had become unprofitable to operate. In addition, during the fourth quarter, we permanently closed another unprofitable coal mine and sold our 14% interest in... a Canadian company. These actions, combined with a loss on the sale of .... a crude oil carrier, reduced 1980 pre-tax income by $15 million. Example 2. In this case, the company cites a general economic trend as well as two specific events which led to improved results in 1979: Improved market conditions in 1979 as compared to the depressed 1976 through 1978 periods restored the Companys profitability. Besides significantly improved market conditions, two other events in 1979 resulted in a strengthening of the Companys financial condition. These were the sale of certain ... assets, which resulted in a net gain of $23,522,000 and the repayment of $58,000,000 of the Companys domestic bank indebtedness from the proceeds of such sale, which reduced interest expense for the Company. Example 3. This example describes the effect of LIFO inventory liquidation on pre-tax income for 1980 and the prior two years. Profitability was affected by a variety of factors. First, pre-tax income for 1980 was increased by $73 million as a result of reductions in certain inventories accounted for by the LIFO method. Approximately $43 million of this increase was attributable to the Basic Steel Operations segment and $29 million to the Fabricating and Other Steel Operations segment. Pre-tax income for 1979 and 1978 was increased by $25 million and $41 million, respectively, due to LIFO inventory liquidations. Almost all the LIFO profits in 1979 and 1978 were attributable to Basic Steel Operations. [the companys] inventories were generally reduced in the third quarter of 1980 because of planned reductions in the level of operations in response to the rapid fall-off in steel shipments. Operations were maintained at reduced levels during the fourth quarter despite an increase in shipments. As a consequence, inventories were further depleted. These depletions occurred principally in semifinished and finished goods inventories. b. Examples Discussing Known Trends and Uncertainties.Example 1. This example discusses a three-year adverse industry trend and managements expectation of future improvement. Results of Operations The Companys overall decrease in net sales during the past three years was mainly due to the 42% reduction of tire manufacturing. The ability, however, to recover cost increases through pricing within this segment of our business was the primary reason that the corresponding sales reduction was limited to 19%. Other factors limiting this reduction included mix changes and increases in volume within the Companys distribution subsidiaries. Currently the tire division is producing at 100% of its normal capacity ... Although the tire industry is still in an over-capacity condition, with the large number of plant closings in 1979 and 1980 within the industry, this situation has been partially remedied enabling tire prices to increase to keep pace with current increases in material, labor and energy costs. Short of events such as a resumption of the 1974 oil embargo, which would impact the entire rubber industry, the Company expects to continue to maintain its present gross margins in the future. Example 2. This financial institution explains a slowdown in the growth of net interest income, which it described as the most significant factor to earnings: Net Interest Income, the difference between Interest Income and Interest Expense, is the most significant component of a commercial banks earnings. The Corporations Net Interest Income for 1980 rose to $1.1 billion, 11.5 per cent above the $948 million reported in 1979. Net Interest Income for 1979 was in turn 16.8 per cent above the $812 million recorded in 1978... As the following table illustrates, the interest rate spread declined steadily over the past three years, from 2.17% in 1978 to 1.82% in 1979 and 1.49% in 1980. This narrowing of the rate spread indicates that the Corporations interest rates paid on purchased funds have risen to a greater extent than the rates on earning assets. This has the effect of slowing growth in Net Interest Income, particularly in a period which has seen increasing reliance placed on interest bearing sources of funds to support growth in earning assets. c. Examples Containing Narrative Discussion of Changes.Example 1. This company defined gross profit as a key indicator of operating results and explained the 1980 increase in terms of efficiency: Costs, Expenses and Earnings Gross profit as a percent of sales was 23.5 percent in 1980, up sharply from 19.9 percent in 1979. A major factor contributing to this increase in gross profit was the margin improvements in the industrial heat transfer plant ..... Controls installed over manufacturing in late 1979 and quality circles formed by the workforce itself allowed this plant to achieve excellent efficiency levels in 1980. Example 2. This discussion analyzes changes in revenue by segment. Note also the effective presentation of price and volume data for the predominant railroad segment. During 1980 revenues increased 23% to $4.0 billion compared to $3.2 billion and $2.5 billion for 1979 and 1978, respectively, largely due to the railroad, air freight forwarder, and oil and gas operations. Rail transportation revenues were responsible for 85% of the increase in 1980 revenues and 74% of 1979s increase, as [the Companys] rail volume expanded by 15%, and 16% for 1980 and 1979 and freight rates increased. Pretax income for 1980 increased $132.3 million or 75% over 1979, with rail pretax income accounting for 95% of the improvement. Pretax income of $41.3 million from oil and gas operations also increased, reflecting this segments strong performance during 1980. The third largest contributor to the increase in pretax results was [the Companys] air freight forwarding operation which overcame the effects of a weak economy during 1980, successfully entered the express packaging business, improved its unit volume growth, and reported a pretax income of $22.9 million, up 18%. Pretax income from coal and minerals and other minerals and other operations also increased, while land and real estate declined. Forest management and forest products manufacturing also declined, largely due to the nationwide slump in the construction industry.... Pretax income from [the Companys] rail operations increased to $165.3 million from $39.4 million in 1979 .... The increase in pretax income was largely due to increased traffic volume, general freight rate increases and increased operating efficiencies .... d. Examples Involving Discussion of Operations by Segment.Example 1. The tabular format used in this example summarizes relative segment performance both for the current year and on a trend basis. The tables show both dollar revenues and percentage increases by segment. The discussion then analyzed the factors (price, volume, new operations) contributing to increases for each segment. The presentation for the gas gathering segment was as follows: The increases in gas gathering and processing revenues were attributable primarily to volume increases (decreases) and expanded operations as follows: Example 2. This Company analyzed its operations by geographic location rather than by segment and pointed out that U.S. increases were largely the result of an acquisition [significant event]. Sales in 1980 totaled $408.2 million, an increase of $39.1 million, or 11% over 1979. Price increases in Canada and price and volume increases in Brazil were mainly responsible for sales increases in these two areas of the Companys operations. The sales increase in the United States was largely due to the acquisition of the [A] Division from [B] Corporation on March 28, 1979. Also, the absence, in 1980, of sales from certain industrial gas business disposed of on June 6, 1980, offset some of the sales increase in the United States. 3. Forward-Looking Information. There were a number of discussions of forward-looking information with respect to operations. The examples below are representative of these disclosures, which varied from general statements of managements expectations to a full five-year sales forecast. Example 1. This example represents a forward-looking analysis based on expected changes in past trends in several of the companys operating segments: Trends The Company has experienced dramatic growth in all of its industry segments since 1978. The increase in revenues from the oil and gas segment of 36% in 1980 and 45% in 1979 was primarily attributable to the higher prices received for oil and gas sold, resulting from partial deregulation of both oil and gas pricing during the periods. Although oil and gas prices are expected to continue increasing in the future, the Company does not expect increases of the magnitude enjoyed in the recent past. Although the Company anticipates continuing increases in demand for our disposal services segment, its capacity to meet such demand will be quite limited unless the necessary approvals required for the installation of additional disposal sites can be secured. The drilling and well servicing segment is expected to have excellent gains in revenues and profits in 1981 after experiencing dramatic growth in 1979 and 1980; the long term outlook for this segment, however, is for lower profit margins once an over-supply of rigs or well servicing units develops in our area of operations. Accordingly, the results of past operations as indicated below should not be considered indicative of the Companys future operating results either for the Company as a whole or for its industry segments. Example 2. In this forward-looking example, the company describes a pending event (labor contract negotiations) which may adversely impact future operating results. In 1981, a new teamster contract is to be negotiated. Historically new labor contracts have had an adverse effect on labor costs in the year of settlement. Management is continuing to address cost containment in all areas and increase productivity in labor in order to maintain a satisfactory earnings level. Example 3. The following example, a full five-year sales forecast by segment, was included in a companys annual report to security holders following its MD&A in that report. Note the comparison to actual five-year results, the disclosure of underlying assumptions and managements explicit expression of confidence in the forecast. We have prepared and are including in this annual report a sales forecast for each of our major product lines and operating groups for 1985. While we recognize that long-term forecasts are subject to many variables and uncertainties, our experience has been that our success is determined more by our own activities than by the performance of any industry or the economy in general. In addition, the balance and diversity of our products and markets have been such that a shortfall in expected performance in one area has been largely offset by higher than anticipated growth in another. Although variations may occur in the forecast for any individual product line, we have a relatively high level of confidence that our overall five year growth forecast is achievable. ASSUMPTIONS USED IN FORECAST 1. Average 1-2 percent annual real growth in GNP.2. Average inflation 7-9 percent.3. Present tax structure to continue.4. No net foreign translation gains or losses.5. No acquisitions.6. No additional financing.7. Dividend payout ratio 20 percent.8. Four percent after-tax return on investment of excess cash.9. No exercise of stock options.10. No conversion of convertible debentures.B. Liquidity and Capital Resources.1. General Concept. Item 11 defines liquidity as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprises needs for cash." As pointed out in the item, liquidity has both short-term and long-term aspects. It involves internal as well as external sources and is often closely associated with an enterprises capital resources. 4 The rules thus provide that the discussions of liquidity and capital resources may be combined when the two topics are interrelated. By and large, registrants addressed at least some aspects of liquidity and capital resources. Although the Item draws a distinction between liquidity and capital resources, in 1980 many registrants interpreted liquidity not merely as interrelated with capital resources, but as encompassing capital resources. This release will therefore discuss the two topics together. 5 The staff wishes to emphasize that the liquidity information should serve to assist users in evaluating a companys ability to generate cash to meet cash needs both currently and in the future. The scope of the discussion should thus address liquidity in the broadest sense, encompassing internal as well as external sources, current conditions as well as future commitments and known trends, changes in circumstances and uncertainties. From this perspective, the discussion of liquidity goes beyond a simple review of current assets and liabilities at a given date. For both the short term and the long term, it should compare assured available resources to expected requirements and address any identified deficiencies as well as the course the issuer intends to take to meet such deficiencies. Existing sources of liquidity include cash balances and assets readily convertible to cash as well as current operating cash flows. The narrative should describe how known trends, changes in circumstances or significant events may impact operating cash flows, making past results indicative or not indicative of the future. Any other factors significant to individual companies or industries should also be discussed. Last, the discussion of liquidity should describe the registrants liquidity requirements and, where deficiencies are identified, address the available remedies. Issuers are encouraged to include in such discussions of remedies a description of any anticipated cash resources, such as potential cash flows from expanded levels of operations, additional external financing or sale of non-operating assets. Liquidity requirements vary among industries but include demands such as capital expenditures (including any off-balance sheet commitments), expanded working capital needs, or scheduled debt repayments. Throughout the discussion of liquidity, it is also necessary to identify those balance sheet, income and cash flow items believed to be indicators of liquidity. The discussion will be enhanced by an explanation of the reasons why particular indicators are appropriate for the individual registrant. In this sense, unused credit lines, debt-equity ratios, bond ratings, and restrictions under existing debt agreements may be indicators of liquidity. The staff also encourages registrants to identify and discuss those factors relevant to an understanding of the companys future objectives, plans and its ability to complete those plans. Anticipated sources of financing are particularly important to capital intensive enterprises where planned expenditures also are many times more meaningful than legal commitments. Similarly, the anticipated cost of capital as well as its expected availability may be a key consideration for highly leveraged companies. 2. Evaluation of Disclosures. The 1980 disclosures which the Staff reviewed concerning short-term liquidity generally addressed working capital, a concept with which companies are familiar and comfortable, frequently supplemented only with information on funds flow from operations computed on a working capital basis. The staff wishes to urge companies to be certain that the discussion be sufficiently expansive to fully address the subject of liquidity since the ability to generate cash to meet cash needs generally depends upon a more extensive, group of factors than working capital alone. 6 For that reason, it is often necessary to expand the discussion to include cash flow from operations and other sources. In this sense, the concept of cash flow from operations should not be limited to net income adjusted for non-cash charges and credits, but should also consider changes in the relevant components of working capital--such as receivables, payables and inventory. Cash flow from operations, thus computed, is an especially helpful indicator, and the staff encourages its display as a three-year trend. It should be noted that this measure is frequently very different, from "funds flow from operations" computed on a working capita basis and the captions should not be used interchangeably. Besides cash flow from operations and related working capital, considerations, assessments of liquidity should, as discussed in section 2 above, include consideration of matters such as the following: (i) Available unused sources of financing, including existing lines of credit, ease of access to markets, and convertibility of noncurrent assets to cash. (ii) Trends in liquidity and known commitments. (iii) Known or likely deficiencies and remedies. (iv) Significant events and uncertainties, including flexibility to adapt to change. The examples included below have been organized along these topical lines. 3. Examples of Disclosures. These examples each address one or more of the various aspects of liquidity in the broad sense. It should be noted that many of the discussions have a forward-looking perspective as to both the nature and amounts of expected expenditures and the mix and cost of financing. a. Examples Discussing Cash Flow from Operations and Working Capital Items Example 1. This first example discusses cash flow from operations as a three-year trend. Note that management has chosen also to incorporate a discussion of internal and external sources of funds (capital resources) for capital expenditures and specifically addresses the shortfall between operating cash flow and cash requirements for plant additions: Corporate Liquidity ... The major elements of the net funds used for operating transactions during the past three years are: Capital expenditures increased substantially in 1979 as a result of starting up several major projects and then declined in 1980 to nearly the same level as in 1978. Funds used for the acquisition of property, plant, and equipment exceeded amounts flowing from other operating transactions in all three years. Capital expenditures in 1979 were largely offset by other funds flowing from operations. However, 1978 increases in working capital items along with the expenditures of funds for capital assets and financing transactions required the company to liquidate cash and short-term investments and to use bank borrowings. Reductions in inventories in 1980 improved the flow of funds from operating transactions and partially offset capital asset acquisitions. The remaining cash requirements for 1980 capital expenditures were obtained by additional long-term debt. This company also commented on the increase in receivables shown in its trend analysis: The investment at year-end in receivables represents 54 days of sales in 1980 compared with 50 in 1979 and 48 days in 1978. The unfavorable increase in 1980 resulted from selected extended-term marketing programs to U.S. distributors and financial difficulties of certain customers. Example 2. The same company whose five-year sales forecast was presented above also included a five-year forecast of cash flow. This table shows that management anticipates a substantial increase in actual cash balances: Example 3. Note the following explanation of the reason as to why the current ratio is not necessarily a valid liquidity indicator for this company: The companys short-term liquidity,is much stronger than its current ratio of 1.54/1 at December 31, 1980 would indicate. As indicated in note 1(d) to the Financial Statements, the excess replacement value of inventories over the LIFO cost amounts to some $260 million, and these inventories are primarily crude oil and refined products which are readily marketable at these values. The company intentionally from time to time keeps relatively high inventory stocks of crude and products became of anticipated price increases or possible shortages. Example 4. This example focuses on a working capital definition of short-term liquidity but further analyzes working capital balances by use of trend indicators of "nearness to cash." It also points out that the statistics presented are based on LIFO inventories and includes a specific explanation of the meaning of such statistics. Liquidity and Capital Resources The company uses a number of measures of liquidity for internal management purposes. These measures include working capital, profitability and activity ratios, all of which are set forth below. Leverage is not a factor as the company has no debt, either current or long-term. Note that the following ratios are based on LIFO inventories. Working capital (in millions): the ability to meet short-term obligations. ... Activity ratios which should be helpful in evaluating liquidity, are shown below: The liquidity trend is most favorable as it shows a gradual improvement in credit and collections, a reduction in inventories and a continuing comfortable relationship between sales growth and working capital, which simply means the company is not forced to borrow money to support higher sales. The companys liquidity trend is quite positive and provides surplus cash that enables it to invest in short-term investments and provide for continuing plant modernization and new equipment without having to borrow funds. Example 5. This example describes a negative working capital trend typical of the industry and then explains why the Company does not believe it represents a short-term liquidity deficiency: Historically, [the companys] current liabilities generally have exceeded current assets. This is characteristic of the ... industry. The following table includes selected working capital information for the last three years. The above data are not indicative of a lack of liquidity, as the company maintains sufficient current assets to settle current liabilities when due. Current asset balances are minimized as one way to help finance required capital acquisitions .... The company periodically negotiates commitments from its banks to lend additional funds under revolving credit line agreements. At the end of 1980, two such agreements were in effect for commitments totaling $250,000,000 of which only $50,000,000 had actually been borrowed. As the company is not restricted as to the use of funds borrowed under these credit agreements, such commitments represent an additional and immediate potential source of liquidity, subject to meeting certain lender issuance tests for the occurrence of additional long-term debt. b. Examples Discussing Available Sources of Liquidity.Example 1. Note that this discussion relates the companys working capital requirements to subsequent cash collections and unused short-term credit facilities. The company plans to meet its 1981 anticipated working capital requirements with funds from operations and short-term bank loans. A significant portion of the accounts receivable balance of $45,269,000 shown on the consolidated balance sheet at December 31, 1980 is related to the companys Christmas business and has been collected during the early part of 1981. In addition, as disclosed in Note 6 to the financial statements, the company at the end of 1980 had approximately $56,000,000 available and unused under various lines of credit with banks. Under a revolving credit arrangement the company has the option of converting up to $23,000,000 to an eight year term loan. Example 2. This example discusses financing for near-term capital spending as well as other operating needs in light of historical trends and bond indenture restrictions which prohibit any significant increase in debt without additional equity increases: Historically, the company has funded its capital requirements through a mixture of internal and external sources such as short-term bank borrowings and permanent financings. During the past three years internal sources have provided on the average 44.6% of the annual funds required. Generally, short-term borrowings have been converted to permanent financings as the marketplace would permit. As of December 31, 1980, the company had $22.4 million of capital commitments, $19.7 million of which were related to the ... coal conversion project. It is anticipated that the [coal conversion project] commitments will be funded through the revolving bank credit agreement on a short-term basis and converted into permanent financings as market conditions permit. The other commitments are expected to be funded through the companys regular bank lines of credit and internally generated funds. The recently granted $11.7 million rate increase should provide sufficient cash flow for this purpose. The company also has $1.2 million in commitments for inventory and maintenance items that will also be provided for through internally generated funds. The most significant restriction to the companys permanent financing program is a bond purchase agreement provision that limits long-term debt to 65% of the capital structure. As of year end 1980, the companys long-term debt capitalization ratio (including current maturities of long-term debt) was 63%. It is the Companys long-term goal to increase its equity position to a more favorable level, both through the issuance of equity securities and through adequate earnings. Because of these two factors, the companys 1981 financing program anticipates some equity financing. Example 3. In this liquidity discussion by an insurance company, management discusses a break in the normal trend of internal financing. Our insurance subsidiaries can normally satisfy cash needs out of operating cash flow. Occasionally relatively small cash amounts may be needed to meet temporary needs. The holding company maintains a facility where affiliates can borrow from the holding company to meet temporary needs and can revest short-term funds with the holding company. [The subsidiary] makes investment commitments based on expected future cash flow. In 1980, it overestimated cash flow and borrowed to meet its investment commitments. These borrowings reached a maximum of $125 million during the year and were reduced to $45 million by year end. 1981 investment commitments are relatively small, so we expect to repay the remainder of its debt during the year. c. Examples Discussing Trends in Liquidity and Known CommitmentsExample 1. The following example is a discussion of capital resources and liquidity by a large, relatively capital intensive company. Note the following elements of the disclosures: trend data including a chart of changes in cash balances for the past five years, focus on both short-term and long-term needs, identification of factors considered to be key indicators, forward-looking information on planned expenditures and a definitive statement that the company will be able to meet its future cash needs. Financial Condition During the three-year period 1978-1980, the Companys financing needs were met largely through funds provided by operations. In 1978 and 1979, overall net cash inflows from operations resulted in reductions in borrowings and increases in cash and marketable securities at year-end. In 1980, however, the combined impact of lower net income, higher capital expenditures and increased working capital resulted in a net cash outflow. This outflow was financed by a reduction of $151 million in cash and marketable securities and the net addition of $164 million in borrowings .... A number of programs were implemented in 1980 to meet the Companys external financing needs... This additional debt resulted in a total capital ratio of 21 percent at year-end 1980, compared to 20 percent and 22 percent at year-end 1979 and 1978, respectively. The Company has unused bank credit lines of approximately $1.4 billion part of which support outstanding commercial paper balances. These lines provide for short-term borrowings at the best available commercial rates, and are more than sufficient to support [the Companys] day-to-day business operations. Looking to the future, further increases in capital expenditures to approximately $2.8 billion over the next two years are planned. Continued increases in working capital are also anticipated, both to support higher levels of business and to cover inflation. The major portion of the Companys cash needs is expected to be financed through internally generated funds, although additional external financing will be required. The Companys conservative debt structure and strong financial position enhance its ability to obtain the funds required .... The company included various charts and graphs such as this one summarizing five-year changes in cash and short-term securities: Example 2. This example presents a trend discussion of the debt-equity ratio as a key liquidity indicator for a capital intensive company. The second paragraph discusses existing commitments. Liquidity and Capital Resources The Company, being in a capital intensive industry, must utilize the debt markets to the extent its cash flow is insufficient to meet its requirements. Accordingly, the ratio of its long-term debt to total capitalization (long-term debt plus equity, including preferred stock) is critical since it indicates what potential it has to utilize the debt markets. This ratio was 31% at the end of 1980, compared with 33% at the end of 1979 and 39% at the end of 1978. However, since the Company had excess cash at the end of each year which is available to pay off long-term debt, this ratio can be,viewed as 26%, 31% and 38% at the end of 1980, 1979 and 1978. This ratio is at a reasonable level and has improved since 1978. It is expected that projected 1981 cash flow, and the December 31, 1980, excess cash of $21 million and unused long-term credit lines available through 1987 of $51 million will be sufficient to enable the Company to finance all of its 1981 capital programs, cash dividend requirements and working capital requirements, and the previously announced agreement in principle to purchase the... industrial gas business of [x company] without any material effect on its long-term debt to equity ratio. Example 3. This disclosure, which appears responsive to the Commissions requirement to discuss liquidity on a consolidated basis, outlines a subsidiarys estimated five ,year expenditures under a limited partnership agreement. Item 11 requires discussion of such off-balance sheet commitments. In the third quarter of 1980, a new subsidiary of the company entered into a limited partnership agreement with the [XYZ] Oil Company whereby the subsidiary will invest funds in a major portion of [XYZ] onshore exploratory drilling activities in the United States and obtain a net revenue interest in hydrocarbon reserves that result from that program. Total expenditures required for the program are expected to be in the range of $120 million over the next five years. Most of these expenditures will be required in the next three years, and the company does not anticipate profit contributions from the program during the early years of operations. d. Examples Discussing Known or Reasonably Likely Deficiencies.Example 1. This example discusses a liquidity deficiency, efforts to remedy it, and the related uncertainty as to the enterprises future operations. Primarily as a result of the losses incurred during 1979 and 1980 and the substantial purchases of property and equipment during each of the last three years, the corporations working capital has decreased by $153,262,000 to a working capital deficiency of $143,242,000 at December 31, 1980. In addition to the decrease in working capital, the corporations cash requirements over the three-year period were met primarily by the net addition to long-term debt of $310,956,000, the proceeds from the disposition of... property of $244,841,000 and from the issuance ... of $35,000,000 of preferred stock during 1980. Commencing in 1980 the corporation... experienced a severe shortage of cash. Effective March 2, 1981, the corporation and its principal subsidiaries arranged with their private debt-holders for the deferral until July 1, 1981 of the principal and interest payments due during the period February 10, 1981 through June 30, 1981. These companies are commencing negotiations with these lenders to restructure their outstanding debt. The ability of the corporation and its subsidiaries to continue as a going concern and to meet their obligations as they come due will, in the short term, be dependent upon a restructuring of their outstanding debt, the ability to successfully complete the cash sale of surplus [equipment] and ultimately upon a return to successful operations. Example 2. Here, management discusses operating and financing plans to remedy a current cash flow deficiency in light of certain related uncertainties. Note also the statement that the capital expenditure program is now substantially complete. The operations of the company, excluding current expenditures related to the new automated panel facility, generated a positive cash flow in both 1979 and 1980 as a result of the sustained growth in the companys Engineered Composites Division .... Based on current estimates, the company believes that the new panel manufacturing facility will generate a positive cash flow at such time as it reaches a production level of approximately 20% of design capacity. Although the company is hopeful that this level will be obtained within the present year, such level had not been met as of March 1, 1981 and the company continued to operate at an overall negative cash flow. Management believes that external financing is necessary to replenish working capital to permit the company to meet its obligations on a timely basis; and to provide the additional working capital which will be required to sustain the expected growth to be derived from the new panel facility. Accordingly, the company is exploring the possibility with certain investment firms, brokerage houses and institutions of issuing approximately $1 million of financing through private placement of convertible debentures or promissory notes and stock purchase warrants. The company anticipates that the private placement transaction will be completed during the first half of 1981. In the event it is unable to obtain additional financing from the offering, the company intends to seek to refinance its present obligations or pursue new sources of funds. The company believes that the failure to raise the required working capital will substantially impede the development of, and the revenues to be derived from, the new panel manufacturing facility and thereby postpone the rate at which operations of such facility is expanded. In addition, any significant diminution of business in the Engineered Composites Division may adversely affect the companys ability to meet its obligations... Management believes that the companys capital spending program has, with the start-up operations in the new automated panel facility been substantially completed and that there are no unforeseen material commitments for capital expenditures other than as outlined above. Management further believes that following completion of the private placement, future capital expenditures will be financed from the companys results of operations. e. Examples Discussing Significant Events and Uncertainties Which May Affect Liquidity Example 1. In this example the company links a decline in its bond rating to internal cash generation problems and discusses the associated uncertainties for its short and long-term capital spending plans: Internal cash generation, however, provided a negative 11% in 1980, and average 3% for the five years 1976-1980, of total [company] construction expenditures (in both cases excluding noncash AFC). For 1981, and for the five years 1981-1985, funds from operations are estimated to provide 0% and average 72%, respectively, of total [company] construction requirements (excluding AFC). Primarily as a result of this existing and projected near-term lack of internal cash generation, the three principal security rating agencies down-rated the companys major securities in 1980 to the [x] level thus limiting the ability of fiduciary institutions to purchase these securities in certain cases. In January 1981, Standard and Poors further reduced the companys preferred stock rating to [y]. The companys ability to continue its planned construction program ... depends upon receipt of adequate rate relief and the ability of the company to sell permanent securities in planned amounts. This will be particularly true in 1981 when capital requirements and permanent financing are expected to be at record levels before declining in 1982 and 1983. Thereafter, the companys financial position will depend upon the extent of expenditures required to convert existing or build new generating units to burn coal. Example. 2. This discussion outlines the companys construction commitments and financing objectives and comments on contingency plans if the desired financing mix is not attained. Liquidity and Capital Resources The Companys construction program for 1981, 1982, and 1983 is estimated to be $262,000,000, $273,000,000 and $360,000,000 respectively. The Companys objectives for the financing of these expenditures include: internal generation of at least one half of the funds required; maintenance of a sound capitalization structure consisting of not less than 40 percent common stock, not more than 45 percent long-term debt and the balance in preferred stock; and, the maintenance of high credit ratings for its securities. If these objectives cannot be attained without significant equity share dilution from the sale of common stock below book value, the estimated construction expenditures previously set forth may be reduced. Under such circumstances, construction will be limited to commitments previously made. Example 3. Another company considers its ability to react to a general economic recession: The capital appropriations budget does not contemplate a significant deterioration in the national economy during fiscal 1981. If such a deterioration were to occur, however, the company has the flexibility to significantly adjust these expenditures downward, as was the case during fiscal 1975. C. Inflation Disclosures. 1. General Concept and Evaluation. In the proposing release, the Commission expressed its concern about the adequacy of disclosures with respect to the impact of inflation and changing prices on individual registrants businesses. 7 Although the provisions of SFAS 33 apply only to companies meeting certain size criteria, the Commission believes that management for all registered companies should focus on translating the potentially confusing situation concerning inflation into a meaningful discussion of the effects of changing prices on the registrants business. Consequently, Item 11 as adopted required that registrants include at least a narrative discussion of the effects of inflation and changing prices. For companies not subject to the provisions of SFAS 33, voluntary compliance with SFAS 33 was encouraged but not required. The Commissions objective was to elicit useful disclosures concerning the impact of inflation without imposing an undue computational burden. 8 Registrants required to include SFAS 33 disclosures were allowed simply to provide a cross reference to the location of such information. The Staff believes that many registrants would benefit from an opportunity to view the approach taken by other companies in responding to this type of disclosure. Accordingly, set forth below are certain illustrations of the types of approaches used by non-SFAS 33 registrants in preparing responses to this item and which generally did not appear to be burdensome to develop. These disclosures have been organized into the following categories, which while they may be representative of the impact of inflation, are not intended to be and are not all inclusive: (i) Impact of Inflation on Sales (ii) Impact of Inflation on Monetary Assets/Liabilities (iii) Impact of Inflation on Inventory and Cost of Sales (iv) Impact of Inflation on Plant Assets and Depreciation (v) For Financial Intermediaries: Impact of Inflation on Purchasing Power and Equity and Deposits. 2. Examples of Disclosures.a. Examples Discussing Impact of Inflation on Sales.Example 1--Information on Price/Volume/Mix. The Companys 1980 net sales of $89,755,667 were 10% above the 1979 level, which, in turn, were 19.1% ahead of 1978 sales. Unlike the sales gains of 1979 and 1978, which reflected a combination of price increases and gains in unit volume, the sales increase for 1980 was primarily the result of price increases as unit volume (gallons sold) declined approximately 5%. The unit volume decline occurred during the second and third quarters of 1980 when the economic recession became firmly entrenched. Unit volume resumed an upward trend during the final quarter of the year, but not in an amount sufficient to offset the declines experienced during the spring and summer months. Example 2--Inability of Selling Prices to Keep Pace With Inflation Net sales in 1980 decreased $28,278,000 or 24% from net sales in 1979. Net sales to original equipment manufacturers decreased 29% and net sales to the replacement market decreased 9% from 1979 levels. Selling price increases in 1980 were approximately 7% to original equipment manufacturers and 12% to replacement market accounts. Selling price increases, due to depressed market conditions and the effects of increased competition, have not kept up with inflation. Management expects this trend to continue until market conditions improve. Example 3--Presentation of Constant Dollar Sales Information On an historical basis, electric revenues excluding fuel related revenues, have increased $18.1 million from 1977 to 1980. However, when adjusted for general inflation, they have only increased by some $3.7 million, despite the 1979 general increase. At the same time, operating expenses excluding fuel and adjusted for general inflation have increased $5.1 million. b. Examples Discussing Impact of Inflation on Monetary Assets and Liabilities Monetary assets and liabilities represent claims to receive or obligations to disburse fixed amounts of cash. They include cash and most receivables and payables. During an inflationary period, companies experience purchasing power gains from holding net monetary liabilities and losses from holding net monetary assets. Where material, it is suggested that registrants discuss their net monetary position and any corresponding purchasing power gains and losses, as illustrated below: Example 1. Inflation also affects our assets and liabilities when the amounts are fixed without reference to specific future prices. However, since our monetary assets (cash and receivables) are less than our monetary liabilities the Company will achieve some benefits by paying its fixed debts with dollars that have decreased in purchasing power. Example 2. To the extent that the general rate of inflation exceeds the interest rate yield of the Trusts mortgage loan portfolio ($5.8 million at an average interest rate of 9.5% at November 30, 1980), the economic value of the receivables, stated in dollars of constant purchasing power, may be less than their carrying value. c. Examples Discussing Impact of Inflation on Inventory and Cost of Sales Generally accepted accounting principles require companies to use historical costs in valuing their inventories and cost of sales. In periods of changing prices, these historical costs will differ from the current costs of inventory. The nature and extent of the distortion depends upon the cost allocation method selected by the company. Under the first-in, first-out (FIFO) method, the oldest inventory costs flow to cast of sales, with the most recent costs remaining in inventory. Cost of sales thus tends to be understated. The last-in, first-out (LIFO) method reverses this pattern and generally results in understated inventory balances. 9 Where such distortions are material, companies should indicate their existence and direction. Regulation S-X requires companies using the LIFO method to indicate by footnote disclosure the replacement cost of inventory. Most companies approximate this amount by reference to the FIFO valuation of their inventory. The Staff encourages companies to refer to this computation in the discussion and analysis section. Example 1--Impact of FIFO Method. The Company uses the FIFO method of accounting for its inventories. In a period of rapidly escalating costs, this method results in understating the cost of products sold with a corresponding overstatement of income. Management has considered the advantages and disadvantages of changing to the LIFO method of accounting for its inventories, but no final decision has been made. Example 2--Impact of LIFO Method. However, the company uses the LIFO method of accounting for its inventories. Under this method, the cost of products sold reported in the financial statements approximates current costs and thus, reduces distortion in reported income due to increasing costs. d. Examples Discussing Impact of Inflation on Plant Assets and Depreciation Under generally, accepted accounting principles, companies record plant assets at actual cost and allocate these costs to income over the assets useful lives. During inflationary periods, therefore, depreciation charges are understated and net income overstated to the extent that the current costs of plant assets exceed original costs. To reflect this situation, SFAS 33 requires the largest companies to indicate in a supplemental note the current costs of plant and depreciation. The Commission does not require such calculations by non-SFAS 33 companies, but does encourage at least some narrative discussion of the extent of the difference between historical cost and current cost. If information on relative asset ages can also assist users in developing their own estimates of price-adjusted amounts. Example 1. Like all companies, we could not replace our plants and equipment today for the historical cost value at which they are carried on our books. We doubt that we, or any other company, would ever replace existing assets with carbon copies of our present plants and equipment. Many technological advances have occurred since those assets were acquired. Putting this recognized problem in measurement aside, and applying the constant dollar indexing methods of FASB Statement No. 33, we estimate that 1980 depreciation expense Would be about $2.6 million greater than reported on the historical cost basis, compared with $2.0 million in 1979. Our use of accelerated depreciation methods for tax purposes partially reduces the impact on cash flows. Example 2. Eighty-six percent of the Companys property, plant and equipment has been acquired in the past three years while fifty-seven percent of leasing fleet owned by the non-consolidated subsidiary was acquired in the same time period.As a result, depreciation charges in the income statement for the three years ended December 31, 1980 reasonably approximate current dollars. e. Examples Discussing Impact of Inflation on Financial IntermediariesInflation substantially impacts the financial position and operations of financial intermediaries, such as banks, savings and loan companies and finance companies. These entities primarily hold monetary assets and liabilities and, as such, can experience significant purchasing power gains and losses over relatively short periods of time. In addition, interest rate changes during inflationary periods change the amounts and composition of assets and deposits held by financial intermediaries and often result in creditor and regulatory pressures for additional equity investment. Examples addressing these issues follow: Example 1. During periods of inflation, the holding of a net positive monetary position (monetary assets exceeding monetary liabilities) will result in an overall decline in the purchasing power of the institution. Monetary assets and liabilities are those which can be converted into a fixed number of dollars, and include cash, loans, deposits and borrowed funds. The monetary assets of the Company, as in the case of most depository institutions, exceed monetary liabilities so that the purchasing power of the Companys net positive monetary position declined in 1980. There is no clear evidence establishing a relationship between the purchasing power of a depository institutions net positive monetary position and its future generation of earnings. Moreover, the Companys ability to preserve the purchasing power of its net positive monetary position will be partially reflected in the effectiveness of its asset/liability management program referred to above. Example 2. One way inflation affects the banking industry is the requirement that more capital be committed to the corporation because of the growth of assets required to keep pace with inflation. The continuing requirement to increase equity capital at higher than normal rates is necessary to maintain an appropriate equity capital to asset ratio. This results in a reduced portion of earnings paid out in the form of dividends. Reported earnings have been affected by inflation; however, there is no simple way of separating the effects of inflation. All facets of the banking business from salaries to other miscellaneous expense, are impacted by inflation. Of more importance is the effect of inflation on the various categories of deposits. Because interest rates are regulated on certain types of deposits, we are unable to adjust the rates paid to market levels, causing a change in the mix of deposits. Deposits, once considered core deposits, become more volatile, thus requiring the acquisition of more purchased funds. This requires the continued building and improvement of capital ratios in order for us to attract deposits and to meet competition. III. ConclusionThe principal purpose of the above discussion has been to assist companies in complying with the major disclosure requirements in Item 11 of Regulation S-K by providing illustrations of various approaches used by certain companies during this initial period. The staff anticipates that the disclosures made in response to these requirements will continue to improve over the years. The Staff of the Division of Corporation Finance, with the assistance of the Office of the Chief Accountant, intends to continue its review of the MD&A responses and, if necessary, will provide additional guidance in a subsequent release: By the Commission. 1 See Item 11 of Regulation S-K, Securities Act of 1933 Release No. 33-6231 [45 FR 63630]. 2 The text of the portion of Item 11 of Regulation S-K relating to results of Operations reads as follows:
3 Although the regulations state that the MD&A need not repeat information included in the financial statements, it would be necessary for the MD&A to analyze any material implications of matters concerning the companys operations, liquidity or resources, which are merely described in the basic financial statements. The description, however, need not be repeated. 4 The release adopting Item 11 states that "Discussions of liquidity and capital resources may be combined whenever the two topics are interrelated." The Item then reads as follows:
5 When viewed to encompass capital resources, the Commissions. Concept of liquidity is Comparable to the Financial Accounting standards Boards ("FASB") concept of financial flexibility or the ability of an enterprise to adjust its future cash flows to meet needs and opportunities, both expected and unexpected. Financial flexibility is broader than the FASBs concept of liquidity (defined as short-term nearness of assets and liabilities to cash) because it includes potential internal and external sources of cash not directly associated with items shown on the balance sheet. (See FASB Discussion Memorandum, "Reporting Funds Flow, Liquidity and Financial Flexibility", December 15, 1980, pp. 88, 107.) 6 Working capital: (current assets less current liabilities) may potentially mask both the uncertainty and timing of the conversion of current assets to cash. It also fails to give credit for strict cash management techniques which deliberately minimize current assets in relation to current liabilities or to consider the impact of unused available short-term credit or of inventory costing techniques such as LIFO which may greatly understate inventory values. in inflationary periods. Thus, alone, it may significantly misrepresent a companys liquidity position. For example, disclosure that a companys ratio of current assets to current liabilities is 3:1 could lead the reader to assume that the company has ample ability to generate cash to meet its obligations in a timely manner. If, however, the current assets consist of 10% cash, 50% receivables and 40% inventory, with approximately 3/4 of the inventory in raw or uncompleted form, it may be necessary to know turnover rates to evaluate the companys cash position accurately. A recent example of a situation in which a companys working capital position failed to reveal its cash flow problems was the W.T. Grant Company, which filed for Chapter XI on October 2, 1975. Despite positive working capital positions, cash generated by operations had in fact been negative for its last five years. 7 See Securities Act of 1933 Release No. 6176, (January 15, 1980) [45 FR 5972]. 8 The requirements for inflation disclosures in Item 11 is as follows:
9 In those periods in which sales exceed purchases, the older costs from beginning inventory flow to cost of goods sold, understating that figure. |
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