In 1989 the board of directors of Caterpillar was concerned about the company’s Brazilian subsidiary. The small unit was contributing disproportionately to the group’s overall earnings, a result of the combined effects of Brazil’s currency hyperinflation and international exchange rates.
Despite concerns, the global machinery maker’s first quarter 1990 10Q mentioned only ‘uncertainties’ in Brazil. That omission led to one of the SEC’s most notable enforcement actions for inadequate management discussion and analysis (MD&A) disclosure.
By not disclosing the size of its Brazilian subsidiary’s contribution to overall earnings, or the various factors that contributed to the earnings of the subsidiary itself, the SEC found that Caterpillar had failed to comply with reporting requirements. Regulators noted that, while not required under Gaap, further information about the subsidiary was needed under MD&A guidelines. The reason? The subsidiary’s earnings materially affected Caterpillar’s reported income from continuing operations.
Fast forward
That was more than a decade ago. Since then disclosure has become one of the hottest topics within investor relations, and the SEC has made no secret of its aim to improve and enhance MD&A disclosure. Its most recent release on the subject, issued in December 2003, again warns companies against disclosing ‘merely a recitation of financial statements in narrative form or an otherwise uninformative series of technical responses to MD&A requirements.’
‘The Caterpillar case shows that from a technical Gaap accounting disclosure standpoint, you can be 100 percent correct about what needs to be disclosed, but even under those circumstances, if the facts reflect a significant trend, it may be necessary to disclose that significant trend,’ says Karl Groskaufmanis, a partner at international law firm Fried, Frank, Harris, Shriver & Jacobson. ‘Another point in the Caterpillar case is that if the trend is being disclosed to senior management and the board, the MD&A should reflect those key trends.’
One way regulators are trying to improve MD&A is by analyzing the quality of disclosure in annual reports. The SEC reviewed the 2002-filed annual reports of Fortune 500 companies, and the Ontario Securities Commission (OSC), Canada’s largest regulator, recently looked at the 2003 MD&As of 47 Ontario-based companies – and found 72 percent showed deficiencies.
‘Despite the results, we are seeing improvement since 2002,’ says Viraf Nania, senior accountant in the OSC’s continuous disclosure group. ‘It’s just a question of time before people recognize there is guidance out there they should be using.’
Improving MD&A
One company that has raised the level of its disclosure in its MD&A is Toronto-based Four Seasons Hotels. Listed on both the New York and Toronto exchanges, the company is subject to securities laws in the US and Canada and has created a clear, comprehensive MD&A with both markets in mind. It duplicates the MD&A from its 10K in its annual report, something even certain US companies fail to do, and includes a table of contents and summary overview, which the SEC has asked for in its guidance.
‘We look at the MD&A and figure out what we need in it to achieve the objectives of all the regulations, both Canadian and US, where we’ve been listed since 1997,’ says Barbara Henderson, vice president of IR at Four Seasons Hotels. ‘We look at the US rules under the assumption the SEC wants things that investors want – therefore, we should be following those guidelines everywhere. We have always done an overview as part of the MD&A. Again, we look at it from how others would understand the section; they want to read about the business before they get to the specific line items.’
‘Four Seasons had its problems years ago in terms of disclosure and it has come a long way,’ says Len Racioppo, president of Toronto-based fund manager Jarislowsky Fraser. ‘It’s too bad more companies don’t use what they file with the SEC in their annual reports. Some may argue it’s too cluttered for regular investors, and I can understand that, but I don’t think it outweighs the benefits of doing so.’
Critics point out the emphasis on disclosure can go too far. Does a 40-page MD&A, complete with a section on critical accounting policies (which the SEC has suggested), inform or overwhelm your average investor? This is an especially touchy issue for foreign companies listing in the US.
‘What we have in the main report and accounts section of our annual report is put together based on the UK requirements,’ says George Stinnes, head of IR at British Airways. ‘What is included in the presentation should not simply be a matter of going to the lowest common denominator. There are items the SEC wants that, frankly, just aren’t done over here. People are looking at the US reporting issues, and some are thinking it’s not worth being involved in the US markets. The reporting review has existed in UK company law for a long time and, unlike the US, it’s not rule-based – it’s principle-based.’
John Hatherly, director of research for M&G Investment Management, a roughly $200 bn UK fund manger, finds the level of global disclosure has indeed improved. But he doesn’t view MD&A as a critical part of his decision-making process. ‘Companies are trying to put the best gloss on how they’re doing and giving it to all investors, both retail and professional,’ notes Hatherly. ‘We regard it as a bit of propaganda. It’s a shop-window approach, focused at individual investors, and it’s from the companies’ points of view. They set the agenda.’
For Racioppo, however, the MD&A is important, or at least an important starting point. ‘We definitely look at it, and if the disclosure is poor, we know where to look if it’s not in the annual report,’ he says. ‘We’ll go to the companies themselves, which retail investors can’t do. If a company won’t give it to us, we won’t invest.’
Putting it together
The investors’ perspective aside, no company wants to be at the wrong end of a regulatory action or fine, let alone a shareholder lawsuit due to faulty disclosure. As a result, a lot of companies are rethinking MD&A and disclosure in general.
‘We take a lot of pride in our disclosure policy,’ says Robert Powers, director of IR for White Plains, New York-based ITT Industries. ‘We feel it’s very important to be transparent and give investors the details. Multi-industry companies like ours have to go further in transparency, given the complexity of our businesses.’
Putting together a good MD&A is not easy, because of the broad collaboration that needs to occur. And it’s a process that will only become more difficult as the SEC phases in its new rule accelerating periodic filing dates.
‘The 10Ks are disseminated internally to multiple departments to make sure the normal checking process takes place,’ says Powers. ‘We have multiple meetings going through the 10K. I think the acceleration of the filing dates will mean we’ll have to put more bodies on the process. I’m part of the process from a review standpoint, and we will make sure the scheduling is on track to meet the new SEC timetables.’
ITT Industries, like many firms, pulls in multiple groups to insure the review and inputs are broad-based. The controllers’ organization receives inputs at the segment level, and then consolidates the information. The company includes an overview section in its MD&A, and is now including the same MD&A from its 10K in the annual report.
Powers, who is involved in the 10K and MD&A review process, says investors are paying close attention to disclosure these days. ‘We do hear back about our disclosure, including MD&A,’ he reports. ‘People read the 10K. It is a very important document.’
MD&A review
Karl Groskaufmanis offers US filers seven points to consider when preparing or reviewing MD&As. His advice is useful no matter where your company is listed, however.
1 Look at the SEC’s review of Fortune 500 company periodic reports.
2 Collect the transcripts of the most recent quarterly investor conference calls your company has conducted – most public companies address trends affecting their business during these calls.
3 Get hold of any information that has gone to the board during the last quarter or so, and any form of briefings to senior management, including flash reports or monthly summaries.
4 Review the industry publication for your relevant sector.
5 Get hold of competitors’ current filings, which can reveal industry-wide or macroeconomic trends that are probably affecting your company, too.
6 Assemble all documents relating to liquidity – primary credit documents, payment schedules and payment summaries – that provide a clear sense of the company’s current liquidity situation.
7 And – of course – double-check everything.
