Release No. 33-6711

Release No. 34-24356

April 17, 1987

Concept Release on Managements Discussion and Analysis of Financial Condition and Operations

ACTION: Advance Notice of Possible Commission Action and Request for Public Comment

SUMMARY: The Commission is seeking comment on issues relating to the Managements Discussion and Analysis ("MD&A") of financial condition and operations. In particular, the Commission is seeking comment concerning the adequacy of current rules and the costs and benefits of suggested revisions made by certain accounting firms. The Commission will review comments received in response to this release to determine whether future rulemaking is appropriate.

DATE: Comments should be received by 60 days after publication in the Federal Register.

ADDRESS: Comment letters should refer to File S7-14-87 and be submitted in triplicate to Jonathan G. Katz, Secretary, U.S. Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549. The Commission will make all comments available for public inspection and copying in its Public Reference Room at the same address.

FOR FURTHER INFORMATION CONTACT: Brian J. Lane (202) 272-2589, Office of Disclosure Policy, Division of Corporation Finance or Laurel Bond Mitchell (202) 272-2130, Office of the Chief Accountant.

SUPPLEMENTARY INFORMATION: In this concept release, the Commission requests comment concerning Managements Discussion and Analysis. This requirement is the subject of recommendations from members of the accounting profession calling for a more specific approach to requiring disclosure of business risks and uncertainties, as well as additional board of director scrutiny and independent auditor association with these disclosures.

Table of Contents

I. Background and Overview

Managements Discussion and Analysis is required by Item 303 of Regulation S-K. ¹ This Item calls for a discussion of liquidity, capital resources, results of operations, and "other information that the registrant believes is necessary to an understanding of its financial condition, changes in financial condition and results of operations." ² Pursuant to this Item, registrants are required to disclose presently known material changes, trends, and uncertainties that the registrant reasonably expects will have a material impact on future sales, revenues, or income from continuing operations. ³ Additionally, they are encouraged, but not required, to supply other "forward-looking information". ⁴

A. Historical Development of MD&A

The origins of MD&A date to 1968 when the Guides for Preparation and Filing of Registration Statements were adopted. ⁵ These guides, which reflected the policies and practices of the Commissions Division of Corporation Finance, called for a summary of earnings. This included a discussion of unusual conditions that affected the appropriateness of the earnings presentation and footnotes indicating adverse changes in operating results subsequent to the latest period included in the earnings summary.

In 1974, the Commission amended Guide 22, which covered the summary of earnings for Securities Act registration statements, and adopted an identical Guide 1 for filings under the Securities Exchange Act, which covered the summary of operations. ⁶ In addition to the summary required prior to 1974, the amended Guides called for a full narrative explanation of the summary to enable investors to appraise the quality of earnings or operations. A separate discussion and analysis of the summary was required, including explanations of "(1) material changes from period to period in the amounts of the items of revenues and expenses, and (2) changes in accounting principles or practices or in the method of their application that have a material effect on net income as reported." ⁷ As Guide 22 stated, this discussion was intended "to enable investors to compare periodic results of operations and to assess the source and probability of recurrence of earnings (losses)." ⁸

To give guidance as to what was material, a percentage test was adopted. Registrants were required to discuss items of revenue or expense that changed more than 10% from the prior period or changed more than 2% of the average net income or loss for the most recent three years presented. However, disclosure also was required if an item did not meet the applicable percentage test but was necessary to an understanding of the summary. Conversely, where a registrant believed that a particular item was unnecessary to an understanding of the summary, the Division considered petitions for exemptions where the percentage test was met.

As part of the new Form 10-K project, ⁹ in 1980 the Commission revisited the requirements of MD&A because it believed that the guides were not fulfilling their objectives, their focus was too narrow, and the percentage tests were being applied mechanistically without regard to materiality or relevance. ¹⁰ As a result, the Commission made numerous changes. The changes, in part, reflected the Commissions concerns about the economic climate of the time. High interest rates and inflation were significant problems and the revised MD&A was designed to foster disclosure of trends and uncertainties arising from these and other factors.

Specifically, the Commission adopted MD&A as a separate requirement and (1) changed the focus from the summary of operations to the financial statements as a whole; (2) required a discussion of three financial aspects--liquidity, capital resources, and results of operations; (3) within each of these, required disclosure of favorable or unfavorable trends and identification of certain material events or uncertainties; (4) required disclosure about the effects of inflation and changing prices; (5) deleted the percentage tests of the guides; and (6) encouraged, but did not specifically require, forward-looking statements.

These changes made the rules far more comprehensive. Nonetheless, the rules remained intentionally general in nature. The Commission believed that a flexible approach would elicit more meaningful disclosure and avoid boilerplate discussions which a more specific approach could foster. Further, the Commission reasoned that, because each registrant is unique, no one checklist could be fashioned to cover all registrants comprehensively.

One year after adopting the new MD&A requirements, the Commission published a release giving examples of MD&A disclosure by several registrants, without expressing a view as to the quality of each example. ¹¹ The release stated that the staff of the Division of Corporation Finance, with the assistance of the Office of the Chief Accountant, would continue to monitor MD&A responses and, if necessary, would provide additional guidance in a subsequent release.

II. The Purpose of MD&A and Current Requirements

The Commission has long recognized the need for a narrative explanation of the financial statements, because a numerical presentation and brief accompanying footnotes alone may be insufficient for an investor to judge the quality of earnings and the likelihood that past performance is indicative of future performance. MD&A is intended to give the investor an opportunity to look at the company through the eyes of management by providing both a short and long-term analysis of the business of the company. The Item asks management to discuss the dynamics of the business and to analyze the financials.

As the Commission stated more than ten years ago, it is important that investors understand the extent to which accounting changes and changes in business activity "have affected the comparability of year-to-year data and they should be in a position to assess the source and probability of recurrence of net income (or loss)." ¹² Material facts that must be disclosed elsewhere in the filing also must be analyzed in the MD&A section if they have had or may have a favorable or unfavorable effect upon the amount of net income, the earnings trend, or the financial condition of the company and its prospects.

A wide range of corporate events and changes may warrant MD&A disclosure. The examples provided by the Commission in 1974 are still useful illustrations:

While it is not feasible to specify all subjects which should be covered in the discussion and analysis of the summary, the following are examples which registrants should consider in making disclosure:

1. Material changes in product mix or in the relative profitability of lines of business;

2. Material changes in advertising, research, development, product introduction or other discretionary costs;

3. The acquisition or disposition of a material asset other than in the ordinary course of business;

4. Material and unusual charges or gains, including credits or charges associated with discontinuation of operations;

5. Material changes in assumptions underlying deferred costs and the plan for amortization of such costs;

6. Material changes in assumed investment return and in actuarial assumptions used to calculate contributions to pension funds; and

7. The closing of a material facility or material interruption of business or completion of a material contract. ¹³

Perhaps the most misunderstood aspect of MD&A is its relationship to statements of a prospective nature. MD&A requires disclosure of "known trends or any known demands, commitments, events or uncertainties that will result in or that are reasonably likely to result in the registrants liquidity increasing or decreasing in any material way." ¹⁴ Additionally, the Item calls for a description of any known material trends in the registrants capital resources and any expected changes in the mix or cost of such resources. ¹⁵ Elsewhere, the Item requires disclosure of known trends or uncertainties that are reasonably expected to have a material impact on net sales, revenues, or income from continuing operations. ¹⁶ The Instructions add that MD&A "shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition." ¹⁷

Conversely, Instruction 7 of Item 303(a) states that registrants are encouraged, but not required, to supply "forward-looking" information. The Instruction was not intended to detract from the requirements noted above but instead to make clear that "forward-looking information" (as that term is used in the Instruction) should be distinguished from presently known data that is reasonably expected to have a material impact on future results.

Both required disclosure regarding the future impact of presently known trends, events or uncertainties and optional forward-looking information may involve some prediction or projection. The distinction between the two rests with the nature of the prediction required. Required disclosure is based on currently known trends, events, and uncertainties that are reasonably expected to have material effects, such as: a reduction in the registrants product prices; erosion in the registrants product prices; erosion in the registrants market share; changes in insurance coverage; or likely non-renewal of a material contract. In contrast, optional forward-looking disclosure involves anticipating a future trend or event or anticipating a less predictable impact of a known event, trend, or uncertainty.

III. Proposals from the Accounting Profession

It has been over six years since the MD&A rules were adopted and concerns are again being raised about the adequacy of MD&A requirements. In particular, members of the accounting profession have made recommendations to amend MD&A. While the Commission has not concluded that any change in MD&A requirements is necessary, it is soliciting comment on these recommendations and other possible changes in the MD&A requirements.

In 1986, Coopers & Lybrand submitted to the Commissions Office of the Chief Accountant a proposal calling for increased MD&A disclosure of risks and recommending auditor association with MD&A disclosure ("Coopers Proposal"). Shortly thereafter, the managing partners of seven major accounting firms issued a white paper entitled "The Future Relevance, Reliability, and Credibility of Financial Information: Recommendations to the AICPA Board of Directors" ("7 Firms Recommendations"), ¹⁸ The 7 Firms Recommendations similarly call for increased disclosure of risks and audit coverage of MD&A.

A. Coopers Proposal

The Coopers Proposal would require (1) a more focused disclosure of business risks; (2) review and approval of these disclosures by the registrants board of directors; and (3) a determination as to the reasonableness of these disclosures by independent auditors. This proposal would restructure Item 303 into three substantive parts: analysis of historical financial information; assessment of risk factors, future financial condition, and results of operations; and managements representations.

The historical section would call for year-to-year comparisons of financial information. The Coopers Proposal would require discussion of unusual or infrequent events that materially affect the amount of reported income and discussion of significant components of revenues or expenses that are necessary to an understanding of the results of operations. If there are material changes in net sales or revenues, the registrant would be required to explain the extent to which these changes are attributable to sales prices, amount of goods or services sold, or to the introduction or discontinuance of products or services. Additionally, Coopers would require an impact analysis of inflation on net sales and revenues.

The second section would cover information for one year in the future, with information beyond one year encouraged. Information would be required with respect to known trends, events and uncertainties concerning the following categories; liquidity, capital resources, results of operations, principal products, legal proceedings, and key personnel. Coopers specifically would require disclosure relating to: restrictions that may limit dividend payments; competitive position; new products; sources and cost of raw material; sources and cost of labor; technological obsolescence; customer dependence; pending legislation; and socio-economic factors such as political unrest and foreign exchange rates.

The third section relates to managements representations. Management would be required to indicate specifically whether future operating results are expected to vary from historical patterns and disclose any significant declines in revenues, stockholders equity, or working capital that are anticipated.

B. 7 Firms Recommendations

With respect to MD&A, the 7 Firms Recommendations are not as specific as the Coopers Proposal. ¹⁹ The 7 Firms would require increased financial statement disclosures of risks and uncertainties and audit coverage of MD&A. As to risks, the proposal would require that risk disclosures required in registration statements pursuant to the Securities Act of 1933 be adapted for disclosure in annual financial statements filed under the Securities Exchange Act of 1934. This risk disclosure section would be audited and be separate from the MD&A. The 7 Firms state that the current MD&A requirements are helpful but have two weaknesses: "The requirement is stated too generally to result in meaningful disclosure and managements discussion and analysis is not subject to audit coverage." ²⁰

C. Comparison of the Proposals to Current Requirements

Much of what Coopers recommends is required specifically by current rules. Coopers recognizes that fact, but states that the information "is not drawn together in one location and discussed in a focused manner." ²¹ The most significant structural change in MD&A proposed by Coopers is the shift in emphasis to a discussion of risk factors similar to that required in a prospectus pursuant to Item 503(c) of Regulation S-K. ²² The 7 Firms Recommendations call for similar disclosure, but would require a separate risk factor section, rather than incorporating it into MD&A.

Coopers advocates another change from the present rules in requiring, rather than encouraging, forward-looking information in 15 areas; current rules require information in many of these areas as listed.

Proposed Disclosure Item                              Present Rule Provision ²³
1. Year-to-year comparisons                       17 CFR 229.101(b)
2. Unusual events that affect income          17 CFR 229.303(a)(3)(i)
3. Analysis and discussion of significant      17 CFR 229.303(a)(3)(iii)
    changes in net sales or revenues
4. Inflation impact analysis                          17 CFR 229.303(a)(3)(iv)
5. Analysis of significant changes in            17 CFR 229.303(a)(1)
    major balance sheet accounts
6. Risk factor assessment for one year for: ²⁴17 CFR 229.201(c)
    a) liquidity                                                17 CFR 229.303(a)(2)
   (i)   possible dividend restrictions             17 CFR 229.303(a)(3)
    b)  capital resources                                17 CFR 229.101(c)(i)
    c)   results of operations                          17 CFR 229.101(c)(1)(x)
    d)  principal products                                17 CFR 229.101(c)(1)(ii)
        (i)   competitive position                       17 CFR 229.101(c)(1)(iii)
        (ii)  new products                                 17 CFR 229.101(a)(2)(4)
        (iii) sources of raw material                  17 CFR 229.101(c)(1)(XIII) ²⁵
        (iv) labor                                               17 CFR 229.101(c) ²⁶
        (v)  technological obsolescence            17CFR 229.101(c)(1)(vii)
                                            (generally)
        (vi)Customer dependence                    17 CFR 229.303(a) ²⁷
        (vii)pending legislation                         17 CFR 229.101(d)(2) ²⁸
                                            (generally)
        (viii) socio-economic factors                  17 CFR 229.303(a)
                                            instruction 11
    e) legal proceedings                                 17 CFR 229.103
     f) key personnel                                      17 CFR 229.401 ²⁹
7. Management statement on whether        17 CFR 229.303(a)
    future results are expected to vary            
    from historical patterns
                                            instruction 3
8. Management statement on whether        17 CFR 229.303(a)(3) ¹⁰
    declines in revenue, shareholders equity,
    or working capital are expected
9. Managements going concern statement  17 CFR 211, Subpart A ³¹        

Certification of Financial Statements,

²³ In addition to specific provisions, disclosure of some of the proposed
         items may be required pursuant to general materiality principles such as
        15 U.S.C. 78j; 15U.S.C.77q;17 CFR 230.408; 17 CFR 240.12b-20.
²⁴ Coopers would require risk assessment for one year subsequent to the
         last financials in the areas under point six above. The current rules are
        more broadly written and do not focus on risk assessment.
²⁵ Item 101(a)(4) requires disclosure of anticipated material changes in
         number of employees in the various departments while 101(c)(1)(xii)
         requires disclosure of the number of employees in general.
²⁶ The current rules do not require expressly that technological
        obsolescence be disclosed, but it is required generally by provisions such
        as 101(c)(i), (ii) and (x).
²⁷ Pending legislation is not required specifically in the current rules;
         however, MD & A requires disclosure of material uncertainties affecting
         liquidity, capital resources, or operations. Thus, if pending legislation is
         reasonably likely to have a material impact upon one or more of these, it
         must be disclosed under Item 303.See, e.g., FR-26 Securities Act
         Release 33-6671 (October 23, 1986)15FR39652(disclosure of future
         effects of the new tax code).
²⁸ Item 101(d)(2) concerns risks to foreign operations. Coopers Proposal
        mentioned political unrest or extreme inflation in a foreign country as
        examples of socio-economic risks. Thus, 101(d)(2) may be relevant. Item
        303(a) Instruction 11 concerns foreign registrants and policies of their
        home country that could affect operations.
²⁹ Item 401 requires disclosure concerning directors, executive officers,
        promoters, and control persons. Coopers would require disclosure of
        dependence on key personnel.
³⁰ This requirement applies to sales or income only.
³¹ Section 607.02 of the Codification of Financial Reporting Policies,
        containing the substance of FR-16 Securities Act Release 33-6512
        (February 15, 1984)49FR6707, states that a filing containing an
        accountants report that is qualified as a result of questions about the
        entitys continued existence must contain appropriate disclosure of the
        registrants difficulties and viable plans for continued operations.

Current practice does not require MD&A to be audited. The 7 Firms call for audit coverage and Coopers would have independent auditors directly associated with the disclosure to assess the reasonableness of managements analysis by requiring the auditor to review the disclosures and modify the standard auditors report if he is in disagreement with the information disclosed.

Although there is no current requirement that any of the MD&A disclosures be audited or covered by the auditors opinion, the auditor is expected to have subjected the disclosures to some degree of review and evaluation. In 1975, Statement on Auditing Standard No. 8 (AU Section 550) was issued by the Auditing Standards Board. The Statement addresses the auditors responsibility with respect to "Other Information in Documents Containing Audited Financial Statements." The standard indicates that while the auditor is not obligated to perform any procedures to corroborate information outside of the financial statements identified in the audit report, he should read the other information included in the document containing his report to determine whether such information or its manner of presentation is consistent with the financial statements on which his opinion has been expressed. The standard goes on to suggest the steps which the auditor may consider if he becomes aware of a material inconsistency or misstatement. ²³

IV. Request for Comment

To assist the Commission in its determination as to the need for any revision of current MD&A requirements, commentators are asked to comment on the costs and benefits of the Coopers Proposal and 7 Firms Recommendations. ²⁴ Other comments concerning the costs and benefits of specific revisions of MD&A generally are encouraged. Commentators are requested to address specifically the following issues:

1. Are the present MD&A disclosure requirements attaining the Commissions objectives?

2. Should the MD&A be changed to become more of a risk analysis?

3. Should MD&A be audited or be subject to limited review procedures by independent accountants? ²⁵ Does the expertise of auditors enable them to assess the judgments made by management in determining the content of its MD&A disclosure?

4. Would an audit of non-historical information change the nature of the information reported and, if so, how?

5. Would more specific MD&A requirements result in improved disclosure? If so, what specific new disclosure requirements would result in improved disclosure?

6. Pursuant to current MD&A requirements, is sufficient forward-looking information being disclosed? If not, are there feasible ways to elicit more forward-looking disclosure?

7. Should all related disclosure of risks be included in MD&A?

8. Should annual financial statements be accompanied by a risk disclosure section similar to that required in a prospectus?

9. Should MD&A be required for offerings registered on Form S-18? ²⁶ Should it be required only in S-18 offerings where there is a two or three year operating history?

10. What impact, if any, would adoption of the proposals have on the incidence of litigation concerning the adequacy of disclosure?

11. How will the proposed revisions to MD&A alter the allocation of liability among auditors, board members, registrants, and others, in the event of litigation over the accuracy or adequacy of the MD&A disclosed?

12. What are the costs and benefits of the accounting profession proposals? Are there other more cost-effective alternatives?

By the Commission.

Jonathan G. Katz

Secretary

¹ 17 CFR 229.303.

² 17 CFR 229.303(a).

³ 17 CFR 229.303(a)(3)(ii).

⁴ 17 CFR 229.303(a) Instruction 7; see also 17 CFR 230.175; 17 CFR 240.3b-6; Securities Act Release 33-6084 (June 25, 1979) 44 FR 33810 (safe harbor rules for projections).

⁵ Securities Act Release 33-4936 (December 9, 1968) 33 FR 18617.

⁶ Securities Act Release 33-5520 (August 14, 1974) 39 FR 31894.

⁷Id., Guide 22(b).

⁸Id.

⁹ Securities Act Release 33-6231 (September 2, 1980) 45 FR 63630.

¹⁰Id.

¹¹ Securities Act Release 33-6349 (September 28, 1981).

¹² Securities Act Release 33-5520 (August 14, 1974) 39 FR 31894.

¹³Id., Guide 22(d).

¹⁴ 17 CFR 229.303(a)(1).

¹⁵ 17 CFR 229.303(a)(2)(ii).

¹⁶ 17 CFR 229.303(a)(3)(ii).

¹⁷ 17 CFR 229.303(a) Instruction 3.

¹⁸ The 7 Firms are: Arthur Andersen & Co.; Arthur Young; Coopers; Deloitte Haskins & Sells; Ernst & Whinney; Peat, Marwick, Mitchell & Co.; and Touche Ross & Co. Price Waterhouse has its own proposal which does not address MD&A specifically.

¹⁹ The 7 Firms made eight recommendations: 1) improve disclosure of risks and uncertainties, 2) audit the risk disclosure, 3) require membership in the SEC Practice Section of the American Institute of Certified Public Accountants ("AICPA"), 4) extend SEC jurisdiction to any companies with a public interest, 5) enhance the AICPAs Auditing Standards Boards capacity to develop auditing standards, 6) enhance public perception of the independence and objectivity of auditors, 7) enhance public confidence in the Special Investigations Committee of the SEC Practice Section of the AICPA, and 8) eliminate opinion shopping.

²⁰ 7 Firms Recommendations at 4.

²¹ Coopers Proposal at 3.

²² 17 CFR 229.503(c). Item 503(c) applies only to high risk or speculative offerings.

²³ Much of the information disclosed in the MD&A relates to matters that the auditor normally considers during the audit of the financial statements. For example, analytical review procedures and the auditors review of contingent liabilities, changes in accounting principles, accounting estimates, and the entitys status as a going concern may all provide information relevant to MD&A. Therefore, the auditor generally should be in a position to assess the accuracy and completeness of MD&A disclosures.

²⁴ Copies of the two proposals will be placed in the public file to assist commentators.

²⁵ On February 14, 1987, the Auditing Standards Board issued an Exposure Draft of a proposed Statement on Standards for Attestation Engagements entitled "Examination of Managements Discussion and Analysis." The Exposure Draft, if adopted, would establish performance and reporting guidance when an entity voluntarily engages an auditor to attest to representations in MD&A.

²⁶ 17 CFR 239.28.