The New MD&A Rule: Part Four – Results of Operations Changes

By George Wilson

In this post, we overviewed the changes to MD&A in the SEC’s Management’s Discussion and Analysis, Selected Financial Data, and Supplementary Financial Information Final Rule. This rule was published in the Federal Register on January 11, 2021.  It is effective for filings on or after February 10, 2021.

The rule’s transition provisions include a mandatory transition date but also allow voluntary early compliance.  The mandatory transition date is each company’s first fiscal year that ends after August 9, 2021, 210 days after the effective date.  Companies may voluntarily apply the new rule, on an S-K item-by-item basis, in any filing made on or after the effective date of February 10, 2021.

This means a company that files a Form 10-K on or after February 10, 2021, has the option to early implement this new MD&A (S-K Item 303) guidance.  Even if a company does not implement the rule early, it is not too soon to start planning for any required changes.

In the second post and third post in this series, we reviewed and discussed the addition of an objective to S-K Item 303 and critical accounting estimate disclosures.

This fourth post addresses changes for the results of operations and known trend discussions.  While they are not momentous, these changes are great reminders that this part of MD&A is not just about what happened but why things happened.  As we explored in our discussion of the objective of MD&A, one of the goals of MD&A is to help readers assess whether past performance is predictive of future performance.  Understanding the causal factors behind changes helps a reader evaluate whether these causal factors and the related changes will continue in the future.

Results of Operations Discussion

One area that has always required a bit of extra thought in this section of MD&A is this S-K Item 303 guidance about changes in revenues:

Before the change:

(iii) To the extent that the financial statements disclose material increases in net sales or revenues, provide a narrative discussion of the extent to which such increases are attributable to increases in prices or to increases in the volume or amount of goods or services being sold or to the introduction of new products or services.

The fact that this paragraph refers only to increases in revenues leaves open the question about what should be discussed about decreases in revenues.  In our Workshops, we have referred to Instruction 4, which requires discussion of all material changes in line items to close this gap.  The Final Rule changes the wording to include all material changes in revenues:

From the Final Rule:

(iii) If the statement of comprehensive income presents material changes from period to period in net sales or revenue, if applicable, describe the extent to which such changes are attributable to changes in prices or to changes in the volume or amount of goods or services being sold or to the introduction of new products or services. 

The second change in the results of operations discussion is also related to Instruction 4.  In the existing S-K Item 303 this is Instruction 4:

Before the change:

4. Where the consolidated financial statements reveal material changes from year to year in one or more line items, the causes for the changes shall be described to the extent necessary (sic) to an understanding of the registrant's businesses as a whole; Provided, however, That if the causes for a change in one line item also relate to other line items, no repetition is required and a line-by-line analysis of the financial statements as a whole is not required or generally appropriate. Registrants need not recite the amounts of changes from year to year which are readily computable from the financial statements. The discussion shall not merely repeat numerical data contained in the consolidated financial statements.

The Final Rule adds language like the first part of this Instruction to the actual text of S-K Item 303 in new paragraph (b):

From the Final Rule:

Where the financial statements reflect material changes from period-to-period in one or more line items, including where material changes within a line item offset one another, describe the underlying reasons for these material changes in quantitative and qualitative terms. Where in the registrant’s judgment a discussion of segment information and/or of other subdivisions (e.g., geographic areas, product lines) of the registrant’s business would be necessary to an understanding of such business, the discussion must focus on each relevant reportable segment and/or other subdivision of the business and on the registrant as a whole. 

This language includes two new requirements:

Discuss issues even if they offset, and

Discuss changes in both qualitative and quantitative terms.  

As we have blogged about many times, the SEC issues many comments requiring a quantitative discussion of causal factors in MD&A.  

The second part of Instruction 4 dealing with not repeating information and making the important point that a line-by-line analysis is not generally appropriate is in new Instruction 2:

From the Final Rule:

2. If the reasons underlying a material change in one line item in the financial statements also relate to other line items, no repetition of such reasons in the discussion is required and a line-by-line analysis of the financial statements as a whole is neither required nor generally appropriate. Registrants need not recite the amounts of changes from period to period if they are readily computable from the financial statements. The discussion must not merely repeat numerical data contained in the financial statements. 

The Final Rule also deletes the following language in S-K Item 303 concerning the impact of inflation.

Before the change:

(iv) For the three most recent fiscal years of the registrant or for those fiscal years in which the registrant has been engaged in business, whichever period is shortest, discuss the impact of inflation and changing prices on the registrant's net sales and revenues and on income from continuing operations.

The SEC cites several reasons for removing this requirement, including that the current language may cause companies to focus “undue attention” on inflation.  In the related proposed rule, the SEC states that they believe the current known trend disclosure requirements require a discussion of inflation if management reasonably expects it to have a material impact on the finances of the company:

The precursors to Item 303(a)(3)(iv) and Instructions 8 and 9 were adopted in 1980, during a period of rapid domestic inflation.  At that time, the Commission was concerned with the adequacy of disclosures about the effect of inflation and changing prices on registrants. 

Although Instruction 8 to Item 303(a) specifies that a discussion of inflation and other changes in prices is required only when such matters are considered material, we believe that the reference to inflation and changing prices may give undue attention to the topic, even when such information is not necessary to an understanding of a registrant’s financial condition or results of operations. In order to encourage registrants to focus their MD&A on material information that is tailored to their respective facts and circumstances, we propose to eliminate Item 303(a)(3)(iv) and current Instruction 8 and Instruction 9 to Item 303(a). 

We do not believe that these proposed changes would result in a loss of material information. Despite these proposed deletions, registrants would still be expected to discuss the impact of inflation or changing prices if they are part of a known trend or uncertainty that has had, or the registrant reasonably expects to have, a material favorable or unfavorable impact on net sales, or revenue, or income from continuing operations.

Known Trend Discussion

The known trend disclosure requirements are not changed dramatically.  They are clarified and emphasized in the Final Rule.  This process starts with this part of the objective articulated in new paragraph S-K Item 303(a):

The discussion and analysis must focus specifically on material events and uncertainties known to management that are reasonably likely to cause reported financial information not to be necessarily indicative of future operating results or of future financial condition. This includes descriptions and amounts of matters that have had a material impact on reported operations, as well as matters that are reasonably likely based on management’s assessment to have a material impact on future operations

This direct language has been in various interpretive Releases, but never directly in S-K Item 303.  Including this language in S-K Item 303 provides greater clarity about this required disclosure of forward-looking information.

The second change here is another clarification.  The current language in S-K Item 303 about known trend disclosures includes this requirement:

Before the change:

(ii) …. If the registrant knows of events that will cause a material change in the relationship between costs and revenues (such as known future increases in costs of labor or materials or price increases or inventory adjustments), the change in the relationship shall be disclosed.

From the Final Rule:

(ii) …. If the registrant knows of events that are reasonably likely to cause a material change in the relationship between costs and revenues (such as known or reasonably likely future increases in costs of labor or materials or price increases or inventory adjustments), the reasonably likely change in the relationship must be disclosed. 

This change clarifies that the requirement to discuss changes in the relationships between line items that might occur in the future is subject to the same probability assessment as other known trends.

If you would like a refresher about this known trend probability level and a review of how misinterpreting it can result in big problems, you can read this post about the disclosure requirements and this post about a known trend related enforcement case.

As always, your thoughts and comments are welcome!

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