The SEC is re-examining one of the most important disclosures companies provide – Management’s Discussion and Analysis, or MD&A.  I’ve read lots of MD&As in my time, and to be completely candid, many of them – or at least too many of them – are poor.

There are lots of ways in which MD&As are poor, but my principal complaints are as follows:

  1. They don’t provide the “A” in MD&A – the analysis. Sales are up?  Great!  Why were they up?  Well, that’s anyone’s guess.  “Increased market acceptance of our product.”  Also great, but does “greater acceptance” mean that more units sold?  That customers were willing to pay more for each unit, so the company raised the price?  That the company expanded the markets in which the product is sold?  Beats me.
  2. Instead of discussing the “why’s,” companies do a cut and paste of key line items in their financial statements, sometimes with a “Percentage Change” column, indicating how much each line in, say, the P&L changed from period to period. In other words, they’re doing what any reader can do, which is precisely what prior SEC glosses on MD&A disclosure have said not to do.  And then they copy and paste sections of the notes to financial statements about how revenue is determined.  Again, no “why.”

I could rattle off a list of other weaknesses of many MD&As, but let’s move on.

Over the years, I’ve been surprised that the SEC has not been more vocal about MD&A disclosure.  There have been a few interpretive releases (here’s one) that have said “no, that’s not what we meant.”  And there were some enforcement actions, most notably one brought against Caterpillar for not disclosing problems with the company’s Brazilian operations even though concerns about those operations had been the subject of some serious boardroom discussions.   However, those actions were long ago and far away (Caterpillar in 1992 and the above interpretive release in 2003), and companies may have decided that the SEC wasn’t really interested in MD&A disclosure.

That’s changed recently.

First, in late January 2020, the SEC issued some rule proposals that would streamline the MD&A to make it more meaningful.  These proposals would eliminate some current requirements for MD&A disclosure and would also eliminate the need for “selected financial data” and “supplementary financial information.” So far so good – i.e., no bad news here.

The less good news came on February 19, when the SEC announced the conclusion of an enforcement action against Diageo plc, a purveyor of spirits, wine, and beer.  Diageo is a foreign private issuer, but the language in the SEC’s report could be equally applicable to any US issuer:

  • “Diageo failed to make required disclosures of known trends and uncertainties, thereby rendering its required periodic filings materially misleading…”.
  • “Diageo… said: ‘North America … again delivered top line growth, driven by 5% growth in Spirits and Wines…. Our strength in innovation has continued.’ This statement was rendered misleading by the fact that a significant portion of DNA’s top line growth was from overshipping, primarily of new innovation products.”
  • “Diageo failed to disclose the trends of shipping in excess of demand and the resulting inventory builds; the positive impact those trends had on sales and profits, and the negative impact they reasonably could be expected to have on future growth; and the fact that they caused Diageo and DNA’s reported financial information to not necessarily be indicative of future operating results or financial condition .”

One can argue that Diageo’s situation was less about disclosure than questionable business and accounting practices, that the SEC was concerned about Diageo’s disclosure controls, and so on.  However, the report certainly seems like a shot across the bow to issuers that the MD&A isn’t supposed to be a puff piece.

And then, just a few days later, the SEC issued an interpretive release containing “guidance” on disclosures of key performance indicators and metrics in the MD&A.  The release notes that “companies should identify and address those key variables and other… factors that are peculiar to and necessary for an understanding and evaluation of the individual company[, such as] key performance indicators and other metrics” and points out that some companies provide both financial and non-financial metrics.  It then goes on to

“remind companies that, when including metrics in their disclosure, they should consider existing MD&A requirements and the need to include such further material information, if any, as may be necessary in order to make the presentation of the metric, in light of the circumstances under which it is presented, not misleading…”.

And then states:

“We would generally expect…the following disclosures to accompany the metric:

    • A clear definition of the metric and how it is calculated;
    • A statement indicating the reasons why the metric provides useful information to investors; and
    • A statement indicating how management uses the metric in managing or monitoring the performance of the business.

“The company should also consider whether there are estimates or assumptions underlying the metric or its calculation, and whether disclosure of such items is necessary for the metric not to be materially misleading.”

The second bullet point above has long bugged me, as many companies give no reason why the metric provides useful information or give a non-reason (e.g., “some investors find it useful”). And the release points out that non-GAAP metrics call for the same information.

For calendar-year companies, there isn’t much time left to take into account the guidance conveyed in the Diageo matter and the interpretive release.  However, time spent thinking about and, as needed, improving your disclosures would seem to be time well spent.  The alternative may be a comment letter – or worse – from the SEC.