The SEC has long expressed concern with the quality of management's discussion and analysis of financial conditions and results of operations ("MD&A"). Accordingly, it undertook a long-term project to perform an indepth review of MD&As for selected industries. The recently completed first stage of the project has resulted in the issuance of a release that reemphasizes, but does not change, the provisions of Item 303 of Reg. S-K. However, it does provide extensive guidance for upgrading MD&A disclosures, which registrants must consider.

SEC Seeks Improvement

The SEC staff reviewed the MD&As of over 350 companies in 24 selected industry classifications. Based on the results of the study, the SEC believes that there is substantial room for improvement across the board--of the 359 companies reviewed, 345 received comment letters. These letters required 211 companies to reflect the comments in future filings and 134 to amend previous filings.

The common deficiencies noted in the review formed the basis of the interpretive guidance contained in Financial Reporting Release (FRR) 36, which addresses the deficiencies in and requirements for:

* Forward-looking information;

* An analysis of historical operating results;

* A discussion of liquidity and capital resources;

* Segment analysis;

* Interim period MD&As; and

* Certain industry-specific or potential merger related disclosures.

The SEC will continue to devote substantial resources to its review of MD&As. A new round of MD&A reviews has started, involving 12 different industries, and it appears likely that these special reviews will become a continuing practice.

This article summarizes FRR 36 supplemented by information obtained in informal discussions with the SEC staff who participated in the MD&A reviews and the preparation of the release.

Forward-Looking Information

Many companies believe forward-looking discussions are entirely voluntary. As a result, a number of MD&As have been limited to an analysis of historical operating results. However, FRR 36 points out that this discussion is merely supposed to be the starting point for the required discussion of any known trends or demands, commitments, events or uncertainties that will, or are reasonably likely to result in:

* Increasing or decreasing liquidity;

* Changing the source, mix or cost of capital resources;

* Materially impacting revenues and income from continuing operations; or * Causing the historical financial information to not be necessarily indicative of future operating results or financial conditions.

In interpreting the reasonably likely standard, the SEC clearly places the burden of proof on the company. To eliminate the need for discussion or disclosure, a company must be able to conclude that:

* The trend, demand, commitment or uncertainty is not reasonably likely to materialize; or

* Assuming the trend, demand, commitment or uncertainty does materialize, it is not reasonably likely to have a material effect on financial conditions or the results of operations.

Management must not only consider whether the historical operating trends will continue, but also whether they will be replaced by new trends. Registrants need to consider the following factors:

* Will the historical increase or decrease in sales prices and volumes continue? What effect will known trends or uncertainties in the competitive environment have on sales?

* Will the historical trends in gross profits continue? If the company has been able to pass increased raw material or labor costs on to customers, will it continue to be able to do so? If those costs have not been increasing, are they likely to in the future, and if so, can sales prices be increased?

* It is likely that specific events that caused fluctuations in operating expenses, such as significant advertising or research and development projects, will recur?

* If general and administrative expenses have increased due to a general expansion in operations (i.e., added personnel, etc.), is that likely to continue, or can the present level support anticipated growth? Conversely, if historical growth has not required such increases, can that continue?

Similarly, the discussion of historical trends in liquidity and capital resources should be the starting point of a forward-looking discussion that considers, among other things:

* Will the historical relationship between changes in operating results and changes in operating cash flows continue or change? If significant growth is anticipated, will liquidity be affected due to required increased investments in inventories or receivables?

* Will there be a change in the nature, mix and cost of the sources used to finance operating cash flow deficiencies, capital expenditures and debt repayments?

Many companies believe that disclosure was required only for legally enforceable commitments for capital expenditures. However, FRR 36 emphasized that the disclosure requirements go further. For example, planned capital expenditures may result from a demand for changes in a product, or may be necessary to continue current growth trends.

As a result, a company that views these expenditures as discretionary, and therefore not disclosable, must consider whether the failure to make those expenditures will create an uncertainty about continuing the current growth trends. Disclosure in these circumstances would be required unless it was not reasonably likely that these factors would have a material effect on financial condition or results of operations.

Analysis of Historical Operating

Results

MD&A requires a discussion of the reasons for material year-to- year changes in the results of operations. This includes:

* A significant increase or decrease in an income statement line item; or

* A significant change in the historical relationship between income statement line items (e.g., a change in gross profit percentages).

The SEC found that many companies did not adequately describe the reasons for a change, or did not discuss and quantify the extent to which two or more factors contributed to a material change. For example, an increase or decrease in sales often is the combined result of changes in the price of each unit or product or service sold and the number of units sold. It is not enough to state "sales increased $XXX due to an increase in prices, partially offset by a decrease in sales volume." The effect of each factor should be quantified to the extent practical, and the use of words or phrases such as "principally" or "in large part" do not appear to be sufficient. Specifically, the release states that "quantification should otherwise be as precise, including use of dollar amounts or percentages, as reasonably practicable." For example, the analysis of a change in sales could indicate one of the following:

* "Sales increased $XXX due to the $XXX effect of an increase in sales prices, offset by a $XXX decrease in the sales volume;"

* "Of the $XXX increase in sales, X% was due to an increase in prices, while the remainder resulted from an increase in volume."

Discussions with the SEC staff have indicated that the following should also be considered in analyzing the reasons for significant changes in sales:

* If a change in sales volume is a significant factor, it may be necessary to discuss whether that change was the result of an overall increase or decrease in the market demand for the type of product or service, or a change in the company's market share.

* If including a purchased business had a significant effect on sales and those new sales are expected to continue to be material, MD&A should discuss whether they are increasing or decreasing. This can be done by analyzing pro forma amounts. For example: "The $XXX increase in sales was the result of $XXX of sales of the acquired ABC Division and a $XXX increase in the volume of sales by other divisions. On a pro forma basis, sales decreased $XXX as the result of a $XXX decrease in the volume of sales of ABC compared to last year, offset by the increased sales of the other divisions."

While a detailed discussion of material changes in sales is necessary, it may not always be necessary to discuss an increase or decrease in cost of sales. That amount would normally be expected to vary in line with sales; so MD&A generally should focus on changes in the gross profit percentage, or the failure of an expected change to materialize. Such discussions also should highlight the amount and reasons for changes in fixed and variable costs. The analysis of changes in selling, general and administrative expenses should quantify the effect of each key factor contributing to the overall increase or decrease. In that regard, MD&A should discuss the extent to which those items represent non-recurring or discretionary changes, rather than increases or decreases needed to support overall changes in the level of operations. Changes in interest expense should be quantified between the impact of interest rate swings and changes in the borrowing levels.

Liquidity and Capital Resources

The SEC expects the statement of cash flows to be the starting point for the discussion of trends and changes in liquidity and capital resources. The discussion should analyze operating, financing and investing cash flows.

One approach to satisfying this requirement might be to discuss the extent to which changes in net income have resulted in similar changes in cash flows from operations. For example:

* How much of the increase or decrease in net income was attributable to non-cash items and therefore did not result in increase or decrease in contribution to operating liquidity?

* To what extent have increases in income not resulted in immediate increases in operating liquidity, because expanded operations have required increased investments in receivables or inventories not accompanied by increased financing through payables?

* Has increased operating cash flow resulted from increased payables financing or decreased inventory and receivables levels?

* If operating cash flows have been insufficient to fund daily operations, capital commitments or debt repayments, what alternative sources of liquidity have been used? (Following this discussion, material changes in line items for investing and financial cash flows can be analyzed.)

Using the discussion of historical cash flows as a starting point, MD&A should then go on to discuss the company's need for and proposed sources of capital on a short-term (i.e., 12 months) and long- term basis, for:

* Capital expenditures;

* Debt repayments;

* Off balance sheet items such as operating lease commitments; and

* Anticipated operating cash flow deficiencies.

Segment Analysis

FRR 36 lists several factors management should consider when deciding whether MD&A should discuss the results of operations, liquidity and capital resources on a segment basis:

* Have individual segments contributed disproportionately to changes in operating results or liquidity?

* Do legal or other restrictions exist on the free flow of funds among segments, subsidiaries, etc.?

* Do the known trends, demands, commitments, events or uncertainties which must be discussed differ significantly among segments?

* Are there significantly differing levels of financial flexibility among the segments (i.e., ability to sell or leverage assets or reduce operating expenses)?

In practice, it is usually difficult to analyze material changes in operating results of a multi-segment enterprise without a discussion of segments. The reasons for changes in sales, gross profits and operating expenses usually differ among segments, as do the likelihood that those trends will continue. So, for example, in discussing the reasons for the aggregate change in consolidated sales, it is usually necessary to start by segregating the change by segment.

Other Issues

Interim Reports. FRR 36 reminds companies that MD&As relating to interim period financial statements (e.g., in Form 10-Q) are intended to update the prior annual discussion for material changes. Accordingly, the MD&As should discuss the potential impact of known trends, demands, commitments, events or uncertainties which are reasonably likely to impact changes during the period, or that first arise during that interim period.

Participating in High-Yield Financings. Companies that have significant investments in high-yield financings, including financing highly-leveraged transactions, non-investment grade loans or low down payment uninsured mortgages, should discuss the nature, significance and company policy regarding these activities, the extent to which these investments produce significantly higher returns and may pose higher risks, and the actual and reasonably likely future effects of such activities on financial condition or results of operations.

Effects of Federal Financial Assistance. Financial institutions receiving financial assistance as the result of federally assisted acquisitions or restructurings should discuss the effects (or reasonably likely future effects) of such assistance on financial condition and the results of operations.

Preliminary Merger Negotiations. MD&A does not require disclosure of preliminary merger negotiations if: 1) disclosure is not required elsewhere in the filing; or 2) disclosure has not otherwise been made and, in the company's view, disclosure in MD&A would jeopardize completion of the transaction. The release points out, however, that while 1934 Act filings only require the disclosure of consummated business combinations, 1933 Act filings must disclose probable acquisitions.

The Outlook

It is clear that the SEC's review process will continue to focus heavily on MD&A. FRR 36 announces that the staff has already begun another series of special MD&A reviews involving selected companies in twelve new industry groups, and many believe projects such as this will be a continuing practice. Whether a filing is reviewed because it is a part of one of these samples, or for other reasons, MD&A will receive considerable attention.

If the 359 companies discussed in FRR 36 are at all a representative sample, most companies will find that a careful study of FRR 36 will identify some deficiencies in their own MD&A. Changes to eliminate those deficiencies must be made as quickly as possible. Because FRR 36 represents interpretive guidance on existing rules, rather than the issuance of new or amended rules, it has no "effective date." Registrants are expected to consider this guidance in the next MD&A (annual or interim) they prepare.