Living Up to the Spirit of Narrative Reporting Guidance
Improving MD&A by Looking to Global Best Practices

By Judith Harris and Randall Rentfro

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JULY 2008 - Regulators often say financial reporting should tell a story about a company. As then–SEC Commissioner Cynthia Glassman remarked in a 2003 speech before the Northwestern University School of Law, “management can most effectively tell its story through the Management Discussion and Analysis, the MD&A.” Similarly, Sondra Stokes, an associate chief accountant of the SEC, stated at an AICPA conference in 2006, “The disclosures in MD&A should comply with both the spirit, as well as the letter of the law. This helps make the story being told complete, meaning more specific, transparent, and, ultimately, more informative.” Yet, the MD&A provided by some U.S. companies often presents reporting that falls short of the spirit of the MD&A regulations. Until now, the consequences of this have been limited. Nonetheless, in an increasingly global capital market, U.S. companies may find capital more expensive—and more difficult to attract—if their narrative reporting is less transparent than that provided by foreign competitors.

The recently formed SEC Advisory Committee on Improvements to Financial Reporting (Pozen Committee) would be well-served by examining the narrative reporting provided by non-U.S. firms. The Operating and Financial Review (OFR) that many U.K. companies voluntarily issue would be a good place to start. The U.K. Accounting Standards Board (ASB) has issued a statement of best practices to assist companies in preparing this narrative report (
). In 2006, the U.K. ASB reviewed OFRs issued by a sample of companies and concluded that companies are showing a willingness to go beyond legal requirements and toward best practices (“A Review of Narrative Reporting by UK Listed Companies in 2006,” U.K. ASB, January 2007,

Although the SEC provides guidance to U.S. companies in preparing MD&A, its guidance falls short of that provided by the U.K. ASB, which outlines basic principles to follow and provides a standard to which narrative reports can be compared. The following section compares the two sets of guidance.

MD&A Requirements and Guidance

The SEC began requiring listed companies to prepare MD&A in 1968; the current formulation began in 1980. The basic requirements are outlined in Regulation S-K, section 303, and the brevity of these requirements is striking. The section outlining the requirements, only four single-spaced pages, requires registrants to discuss financial condition, changes in financial condition, and results of operations, and to provide information necessary for understanding each of these. The section also specifies that MD&A must cover: 1) liquidity; 2) capital resources; 3) results of operations; 4) off–balance-sheet arrangements; and 5) tabular disclosure of contractual obligations. Under each topic, the requirements include disclosure of known trends or uncertainties.

Additional guidance in preparing MD&A can be found in other SEC statements and interpretative releases, notably:

  • 1989 Interpretative Release 33-6835, “SEC Interpretation: Management’s Discussion and Analysis of Financial Condition and Results of Operations; Certain Investment Company Disclosures”;
  • 2002 Commission Statement 33-
    8056, “Commission Statement about Management’s Discussion and Analysis of Financial Condition and Results of Operations”; and
  • 2003 Interpretative Release 33-8350, “Interpretation: Commission Guidance Regarding Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

The 1989 Interpretative Release 33-6835 states: “The MD&A requirements are intended to provide, in one section of a filing, material historical and prospective textual disclosure enabling investors and other users to assess the financial condition and results of operations of the registrant, with particular emphasis on the registrant’s prospects for the future.” Quoting SEC Concept Release 6711, the 1989 release also notes: “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 SEC staff prepared the 1989 release after reviewing filings of registrants in 24 industries. The document provides interpretative guidance, based on the staff’s evaluations of the disclosures it had reviewed. Guidance was provided on several topics, but some important discussion relates to prospective or forward-looking information.

The 1989 release notes that section 303 requires disclosure of forward-looking information, which it identifies as including known trends, uncertainties, and events “that would cause reported financial information not to be necessarily indicative of future operating results or financial condition.” Furthermore, it distinguishes between required and voluntary prospective information. The release notes that required disclosures are “based on currently known trends, events, and uncertainties,” while optional forward-looking information “involves anticipating a future trend or event or anticipating a less predictable impact of a known trend, event, or uncertainty.”

In 2002, the SEC released Commission Statement 33-8056 to outline the steps that management should take in preparing MD&A. The statement suggests that management begin the process by identifying information “including the potential effects of known trends, commitments, events, and uncertainties” that would help investors better understand the company’s financial position and operating results. The statement continues with suggestions for identifying and assessing trends, commitments, events, and uncertainties, and points out that MD&A must be understandable, stating that the most relevant information must be provided and that the information must be stated in a way that users will be able to understand.

The most recent 2003 Interpretative Release 33-8350 was spurred by a review of filings of Fortune 500 companies. The 2003 release begins by making three points about the presentation of information in MD&A:

  • The most important information should be presented in the most prominent manner;
  • Companies should avoid unnecessary duplication; and
  • The presentation could be enhanced by providing an executive overview outlining the context for the discussion.

The 2003 release then elaborates on each point at length, after which it discusses the focus and content of MD&A. The release states that companies should “focus on material information and eliminate immaterial information.” This section includes discussion of key performance indicators, materiality, material trends and uncertainties, and analysis. This is the first document that explicitly includes key performance indicators as an expected disclosure in MD&A. The release states:

[C]ompanies should consider whether disclosure of all key variables and other factors that management uses to manage the business would be material to investors, and therefore required. These key variables and other factors may be non-financial, and companies should consider whether that non-financial information should be disclosed.

OFR Guidance

The U.K. ASB originally issued the nonmandatory statement Operating and Financial Review, in July 1993. The statement provided “a framework within which directors could discuss the main factors underlying the company’s performance and financial position.” The U.K. ASB published its latest version of this OFR best practices statement, Reporting Statement: Operating and Financial Review (OFR), in January 2006. In announcing the statement, ASB Chairman Ian Mackintosh announced:

The Operating and Financial Review has for some years been an important feature of corporate reporting, providing an opportunity for directors to set out a clear and balanced analysis of the strategic position and direction of their business. … This reporting statement gives companies clear guidance and a framework within which they can achieve transparent and open communication with their shareholders.

Although issuing an OFR is voluntary, a 2003 Association of Chartered Certified Accountants research report noted that 80% of the largest quoted companies in the U.K. publish OFR material (“Half the Story: Progress and Prospects for the Operating and Financial Review,”
). Given the voluntary nature of the OFR, this finding might be surprising were it not for a statutory requirement that both quoted and unquoted companies provide an Enhanced Business Review (EBR) in their directors’ reports. The EBR is similar in nature to the OFR, but less extensive. In addition, the U.K. government briefly put in place a statutory requirement for quoted companies to prepare an OFR, but later rescinded the requirement. These factors may explain why many companies voluntarily prepare an OFR.

Reporting Statement: Operating and Financial Review (OFR) explains that the OFR should be a “balanced and comprehensive analysis” of the performance and the position of the entity. The OFR should identify main trends and factors underlying current performance and position, as well as those likely to affect future performance and position.

The reporting statement lists 22 principles that companies should follow in the preparation of the OFR. The first principle notes that the OFR should “set out an analysis of the business through the eyes of the board of directors.” Another principle states that the OFR should complement and supplement the financial statements. Other principles include: a forward-looking orientation in the OFR; investors’ needs for financial and nonfinancial information to evaluate past results and assess future prospects; consideration for the impact of omitted information on investors’ assessments; and comparability of OFRs over time.

A significant portion of Reporting Statement: Operating and Financial Review (OFR) is devoted to the disclosure framework, which outlines what the OFR should include and discuss. The major topics in this section are the nature, objectives, and strategies of the business; current and future development and performance of the business; resources; principal risks and uncertainties; relationships; financial position; cash flows; and liquidity. The reporting statement elaborates on each topic by providing guidance on items that should be discussed.

Much of the reporting statement’s content emphasizes key performance indicators (KPI) and investors’ understanding of each KPI. When disclosing a KPI, the company should, among other things, define the indicator, explain its calculation and purpose, identify the source of the underlying data, comment on future targets, and provide corresponding amounts for the prior year (where available).

The final section of Reporting Statement: Operating and Financial Review (OFR) provides implementation guidance and illustrates how to apply the framework to specific disclosures. This guidance includes 23 examples of disclosures that incorporate KPIs.

Comparing MD&A Guidance with OFR Guidance

The SEC and the U.K. ASB have similar expectations for their respective narrative reports. Both MD&A and the OFR are intended to give investors and others a view of the company through the eyes of management (or the board of directors). Both reports are supposed to focus on financial performance and financial condition with appropriate identification and analysis of trends, and both reports are supposed to be forward-looking.

Although the goals for the reporting are quite similar, the guidance in each has significant differences. One striking difference between the SEC’s MD&A guidance and the U.K. ASB’s OFR guidance is the nature of the guidance itself. The OFR guidance is more principles-based. Although some principles for preparing MD&A can be found in the aforementioned interpretative releases, Regulation S-K’s section 303 is devoid of principles.

Another difference is what might be described as the “accessibility” of the guidance. The U.K. ASB has placed all guidance in one reporting statement that outlines best practices. In contrast, the guidance for MD&A is contained in Regulation S-K and several additional releases, many of which contain important clarifying information. To fully comprehend the expectations for MD&A, one must read and assimilate guidance from many sources. Furthermore, the implementation guidance for MD&A is short on examples of required disclosures.

Finally, the OFR is more explicit in its discussion and illustration of reporting on KPIs. The SEC’s 2003 release introduces a call for reporting on KPIs, but provides no implementation guidance. In contrast, a significant portion of the Reporting Statement: Operating and Financial Review (OFR) discusses disclosure of KPIs.

Do Companies Comply with the Guidance?

Several reports have examined how well U.K. companies are complying with OFR guidance. Unfortunately, little comparable information is available for MD&A. In 2002, the SEC conducted a review of the filings of Fortune 500 companies. The report, “Summary by the Division of Corporate Finance of Significant Issues Addressed in the Review of the Periodic Reports of the Fortune 500 Companies” (, included a section commenting on MD&A. The SEC noted that it issued more comments on MD&A than any other topic in Fortune 500 filings. Exhibit 1 outlines conclusions in the report.

In 2007, the U.K. ASB released its Review of Narrative Reporting by UK Listed Companies in 2006. This report was based on a study conducted by the U.K. ASB, as well as external studies conducted by Black Sun Plc, Radley Yeldar, Deloitte & Touche, the Virtuous Circle, and PricewaterhouseCoopers. The review identified areas of good reporting, including descriptions of the business and markets, along with strategies and objectives; descriptions of current development and performance; and increases in reporting of environmental, employee, and social issues. Areas of reporting needing improvement included the disclosure of forward-looking information, descriptions of resources available, assessments of principal risks and uncertainties, and the identification of KPIs (although the report acknowledged that many companies provided a “good deal of information on measures and indicators”).

Once again, the different approaches taken by the SEC and the U.K. ASB are apparent. The U.K. ASB conducted a formal review of OFRs and published its findings and those of external organizations. This provides the U.K. ASB with an opportunity to educate companies about best practices and to clarify its expectations for OFRs. This report will likely spur improvements in future OFRs. In contrast, the SEC has not published or highlighted deficiencies in MD&A, other than as part of an overall report on filings by Fortune 500 companies, not taking an opportunity to improve future MD&As.

Comparing Examples of MD&A and OFR

In casual readings of U.S. and U.K. narrative reports, the authors have noticed differences in the substance and form of the reports. The authors conducted a side-by-side comparison of the MD&A provided by a U.S. telecommunications company (Verizon) with the OFR of a U.K. telecommunications company (Vodafone). The comparison showed that Vodafone’s annual report contains a significantly greater amount of textual content than Verizon’s annual report and 10-K. In the authors’ opinion, Vodafone’s OFR tells a much more informative story about the company’s activities than does Verizon’s MD&A.

While the narrative reports of the two companies have similarities, their differences are more telling. As expected, both companies present a business overview, but the information provided in Vodafone’s report is much more substantial. In addition, Vodafone emphasizes several topics that are discussed only cursorily by Verizon (Exhibit 2).

In fairness to Verizon and other U.S. companies, some information not included in the MD&A can be found in other documents, such as the proxy statement. The authors contend, however, that a more unified presentation of the information (as in Vodafone’s OFR) results in better transparency and makes it easier for investors to assimilate critical pieces of information.

Learning from Others

The easiest way to improve U.S. narrative reporting is to learn from what foreign standard-setters, regulators, and companies do. The OFR guidelines set a high standard for U.K. companies because the relevant reporting standard emphasizes best practices. By compiling all MD&A guidance into one document—a principles-based statement of MD&A best practices—the SEC could raise the expectations for MD&A. In turn, the SEC could make an improved MD&A an important and critical component of an improved financial reporting model. The Committee is the perfect vehicle for bringing this change about, and the authors believe the committee should strongly consider the role that narrative reporting plays in making financial reporting truly transparent.

The U.K. ASB noted that U.K. companies are moving toward best practices in their OFRs. Managers of U.S. companies could make a similar effort by living up to the spirit of the MD&A guidance, rather than adhering to the strict letter of the law. Managers should take to heart the words of SEC associate chief accountant Sondra Stokes, who stated at a December 2006 AICPA conference that MD&A is “management’s opportunity to provide some background color to the financial statements, as it gives them an opportunity to talk about the substance of transactions.” Providing narrative reports that go beyond mere discussion of what is obvious from the financial statements and that address some of the imperfections in GAAP will go a long way in helping investors truly see the company through the eyes of management.

As financial reporting becomes more transparent, the costs that investors incur in gathering information and trade in capital markets decrease. Therefore, to remain competitive in capital markets, U.S. companies must provide financial reporting that is as informative and useful to investors as that provided by foreign companies. If they fail to do that, investors may choose other investment alternatives or demand higher returns from U.S. companies. It is becoming increasingly more important for U.S. companies to meet global standards and expectations for narrative reports.

Judith Harris, CMA, DBA, is an associate professor of accounting, and Randall Rentfro, CPA, CMA, PhD, is an assistant professor of accounting; both are at the H. Wayne Huizenga School of Business and Entrepreneurship of Nova Southeastern University, Ft. Lauderdale, Fla.




















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