When reading the results of operations section in MD&A it is not unusual to experience a feeling of  déjà vu. When comparing the current year to last year companies will explain why financial statement line items changed with the goal of helping readers understand quality of earnings and the likelihood that past performance predicts future performance. (For a quick review of these objectives you could re-read the SEC’s 2003 MD&A release, FR 72.)

Unfortunately, when companies write the next part of this discussion and compare last year to the third year back, they frequently follow a sort of literal interpretation of the S-K Item 303 guidance and end up repeating this discussion but with the prior year numbers.

It is difficult to argue that this repetition does much to add to an investor’s understanding of earnings quality and predictability, and in fact this information is already available in prior year filings.

This was the issue that the SEC addressed in their March 20, 2019 Disclosure Modernization and Simplification rule in the one MD&A area they changed – S-K Item 303(a) instruction 1.  (As you likely have heard, most of the changes in this rule, including MD&A changes, are effective for filings after May 2, 2019.)

Here is the new language in this instruction, with changes bolded:

Instructions to paragraph 303(a): 1. The registrant’s discussion and analysis shall be of the financial statements and other statistical data that the registrant believes will enhance a reader’s understanding of its financial condition, changes in financial condition, and results of operations. Generally, the discussion shall cover the periods covered by the financial statementsincluded in the filing and the registrant may use any presentation that in the registrant’s judgment enhances a reader’s understanding. A smaller reporting company’s discussion shall cover the two-year period required in Article 8 of Regulation S-X and may use any presentation that in the registrant’s judgment enhances a reader’s understanding. For registrants providing financial statements covering three years in a filing, discussion about the earliest of the three years may be omitted if such discussion was already included in the registrant’s prior filings on EDGAR that required disclosure in compliance with Item 303 of Regulation S-K, provided that registrants electing not to include a discussion of the earliest year must include a statement that identifies the location in the prior filing where the omitted discussion may be found. An emerging growth company, as defined in Rule 405 of the Securities Act (§ 230.405 of this chapter) or Rule 12b-2 of the Exchange Act (§ 240.12b-2 of this chapter), may provide the discussion required in paragraph (a) of this Item for its two most recent fiscal years if, pursuant to Section 7(a) of the Securities Act of 1933 (15 U.S.C 77g(a)), it provides audited financial statements for two years in a Securities Act registration statement for the initial public offering of the emerging growth company’s common equity securities.

This instruction used to read:

Instructions to paragraph 303(a): 1. The registrant’s discussion and analysis shall be of the financial statements and other statistical data that the registrant believes will enhance a reader’s understanding of its financial condition, changes in financial condition and results of operations. Generally, the discussion shall cover the three-year periodcovered by the financial statementsand shall use year-to-year comparisons orany other formats that in the registrant’s judgment enhance a reader’s understanding. However, where trend information is relevant, reference to the five-year selected financial data appearing pursuant to Item 301 of Regulation S-K (§229.301) may be necessary. A smaller reporting company’s discussion shall cover the two-year period required in Article 8 of Regulation S-X and shall use year-to-year comparisonsor any other formats that in the registrant’s judgment enhance a reader’s understanding. An emerging growth company, as defined in Rule 405 of the Securities Act (§230.405 of this chapter) or Rule 12b-2 of the Exchange Act (§240.12b-2 of this chapter), may provide the discussion required in paragraph (a) of this Item for its two most recent fiscal years if, pursuant to Section 7(a) of the Securities Act of 1933 (15 U.S.C 77g(a)), it provides audited financial statements for two years in a Securities Act registration statement for the initial public offering of the emerging growth company’s common equity securities.

As you can see in the highlighted sections above, the key changes from the old instruction to the new instruction are:

1. Removing the language referring to “year-to-year” comparisons and replacing it with “registrants may use any presentation that in the registrant’s judgment enhances a reader’s understanding”.

2. Removing the reference to the five-year summary.

3. Allowing registrants who provide financial statements covering three years in a filing to omit discussion of the earliest of the three years if such discussion is already included in any other of the registrant’s prior filings on EDGAR. While the proposal had some limitations on this provision, companies can make this election with no limitations, but they must identify the location in the prior filing where the omitted discussion may be found.

As a point of interest, it is worth noting that the prior year MD&A does not have to be in a Form 10-K and in fact could be in any prior SEC filing.

Consistently with the other changes we have discussed so far and in alignment with CorpFin Director Hinman’s speech we reviewed in this post, these new requirements are not bright-line standards.  They are based on principles consistent with providing investors information they need to make investment and voting decisions and call on us to exercise judgment.

In the final rule release the SEC made these comments:

We believe the revisions to Item 303 that we are adopting give registrants the flexibility to tailor their presentation in MD&A in a manner that is most suitable for their varying circumstances, while at the same time continuing to require that they provide all of the information necessary to an understanding of their financial condition, changes in financial condition and results of operations. In that respect, we view the elimination of references to year-to-year comparisons and the new language in Instruction 1 of Item 303 allowing registrants to omit discussion of the earliest of the three years covered by the financial statements as complementary.

These amendments emphasize the flexibility available to registrantswith respect to the form of MD&A presentation. The major benefit of flexibility is that it allows registrants to frame the information in a way that emphasizes material information and allows registrants to omit information that is not material. One potential cost associated with this aspect of the amendment is that, to the extent the amendments lead to disclosure that varies more across firms and across a single firm’s filings, they also may make disclosure less comparable across registrants and over time.

The combined effects of these amendments will be to eliminate the burden on registrants to prepare and provide repetitive disclosure that is not material. The amendments are of particular significance because MD&A is typically one of the most labor-intensive sections of any form in which it is required. We anticipate that the amendments to simplify and clarify the MD&A requirements will reduce the paperwork burden associated with affected forms.

It will be interesting to see how companies use these new rules.

As always, your thoughts and comments are welcome!