Up to the Spirit of Narrative Reporting Guidance
Improving MD&A by Looking to Global Best
By Judith Harris and Randall Rentfro
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 (www.frc.org.uk/images/uploaded/documents/Reporting%20
Statements%20OFR%20web.pdf). 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”;
- 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
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
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
research/research_archive/RR-080-002.pdf). 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
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” (www.sec.gov/divisions/corpfin/fortune500rep.htm),
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
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
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.