More Analysis in MD&A
One of the recurring issues in SEC comment letters that sometimes creates substantial discomfort for preparers of MD&A is how much detail to provide in the analysis of why financial statement line items have changed.
These comments are about building an MD&A that helps people understand quality of earnings and the extent to which past performance predicts future performance (part of the overall objective of MD&A as spelled out in FR 72). That said, the knife edge between what the SEC’s rules say we must tell investors and trying to keep competitively sensitive information private is never easy to walk.
As a brief reminder, S-K Item 303 Instruction 4 says:
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 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…….
The key issue of course is understanding causal factors, and the SEC emphasized this issue in FR72:
4. Focus on Analysis
MD&A requires not only a “discussion” but also an “analysis” of known material trends, events, demands, commitments and uncertainties. MD&A should not be merely a restatement of financial statement information in a narrative form. When a description of known material trends, events, demands, commitments and uncertainties is set forth, companies should consider including, and may be required to include, an analysis explaining the underlying reasons or implications, interrelationships between constituent elements, or the relative significance of those matters.
Identifying the intermediate effects of trends, events, demands, commitments and uncertainties alone, without describing the reasons underlying these effects, may not provide sufficient insight for a reader to see the business through the eyes of management. A thorough analysis often will involve discussing both the intermediate effects of those matters and the reasons underlying those intermediate effects. For example, if a company’s financial statements reflect materially lower revenues resulting from a decline in the volume of products sold when compared to a prior period, MD&A should not only identify the decline in sales volume, but also should analyze the reasons underlying the decline in sales when the reasons are also material and determinable. The analysis should reveal underlying material causes of the matters described, including for example, if applicable, difficulties in the manufacturing process, a decline in the quality of a product, loss in competitive position and market share, or a combination of conditions.
With those thoughts as starting points, here are some comments dealing with this issue:
1. We note that you do not quantify the impact of the various factors that affected your revenues from period to period. For example, on page 21, you state that the sales of precious metals were negatively impacted by the exit of solar pastes and lower sales in your North American and Asian metal powders product lines prior to being sold, but you do not quantify the impact. Similarly, you state on page 27 that gross profit in Pigments, Powders and Oxides increased in 2013 primarily due to favorable raw material costs, but do not indicate either the change in raw material costs or the impact of this change. These are just examples. In future filings please quantify the effects of such factors (emphasis added), and also discuss whether you believe these factors are the result of a trend, and, if so, whether you expect it to continue and how it may impact your financial condition and results of operations. See Item 303 of Regulation S-K and SEC Release No. 33-8350. Please also see comment 3 of our letter dated August 19, 2009.
This next comment goes even further, actually discussing issues the company addressed in earnings releases but not in MD&A:
1. We note your response to comment 6 in our letter dated August 8, 2013. We appreciate that you have made efforts to provide investors with an understanding of the material causes behind the factors impacting sales. However, your discussion and analysis as it relates to operating profit for each of your segments could be improved. For example, continuing with your use of the North America segment, you state the increase is driven by higher pricing and volumes without any further analysis. For volume, we note there was a shift in product mix from your discussion and analysis of sales. However, you do not explain how this shift in product mix impacted operating profit and operating margin. For example, do the sales to the energy, manufacturing and metals end-markets generally earn higher profit margins than the electronics and chemical end-markets? We further reviewed your fiscal year 2012 earnings call transcript in which you provide analysts with additional analysis of the material factors impacting your operating results that are not carried forward to MD&A in your periodic reports. Examples include the following:
Budget anxiety and deferral of capital spending resulting from poor business confidence was strongly evident in Europe, South America and the U.S. Demand for packaged gases, primarily from the metal fabrication and machinery industries, slowed markedly in December as customers took extended holiday shutdowns in the U.S., Canada and Mexico, Europe and particularly South America.
Our on-site and merchant customers maintained solid demand through the year end as production from efficient steel mills, chemical plants and refinery runs continued strong. Moreover, we’re clearly seeing a strong rebound in China now that the new Communist Party has taken hold and some delays in decision making that we have seen in 2012 have ended.
During 2012, for the fourth year in a row, we achieved more than 6% savings in our cost stack through productivity. This amount was higher than our ongoing targeted 5% per year as the Praxair businesses accelerated initiatives during the year in production, procurement and distribution. Approximately 25% of our savings came from sustainable productivity initiatives, with the largest being energy efficiency improvement in our plant.
This level of analysis was not provided in your MD&A but appears to provide material information that would be useful for investors. Please refer to Item 303(a)(3) of Regulation S-K and Sections 501.06.a and 501.12.b. of the Financial Reporting Codification for guidance.
As always, your comments and thoughts are welcome!