United States: SEC Adopts Amendments To Modernize MD&A And Other Financial Disclosure Requirements (UPDATED)

[This post revises and updates my  earlier post  primarily to reflect the contents of the adopting  release.]

By a vote of three to two, the SEC has adopted new amendments to simplify, modernize and enhance Management's Discussion and Analysis of Financial Condition and Results of Operations and the other financial disclosure requirements of Regulation S-K. The amendments were adopted largely as proposed in January, with some modifications intended to address comments received. Once again, like other recent rulemakings, these amendments tilt toward a more principles-based, company-specific approach, highlighting the importance of materiality and trend disclosures. MD&A discussions have long been the subject of criticism as too mechanical, with companies sometimes chided for just "doing the math" without more. A new provision describes the objectives of MD&A with the goal of encouraging a more thoughtful, less rote MD&A and allowing investors a better view of the company from management's perspective. In some cases, the amendments eliminate prescriptive requirements in favor of more general disclosures that are integrated into the primary discussions. And some of the proposed changes are fairly dramatic—such as eliminating selected financial data and the Table of Contractual Obligations, and streamlining the requirement to disclose Supplementary Financial Information. Companies may also find the new explicit mandate to discuss critical accounting estimates to be a challenge. Whether the changes result in more nuanced, analytical disclosure remains to be seen. The amendments will become effective 30 days after publication in the Federal Register.

Included at the end of this post is a version of the SEC's table of changes.

Background

The amendments were initially proposed on January 30 (see this PubCo post), as part of the SEC's Disclosure Effectiveness Initiative and follow on the  2013 S-K Study, the Report on Review of Disclosure Requirements in Regulation S-K, required by Section 108 of the JOBS Act, and the 341-page 2016 concept release, which sought comment on modernizing certain business and financial disclosure requirements in Reg S-K (see  this PubCo post). The amendments take into account the comment letters received in response to the proposal, as well as the staff's experience with Reg S-K as part of Corp Fin's disclosure review program and changes in the regulatory and business landscape since the adoption of Reg S-K.

Commissioners Allison Lee and Caroline Crenshaw dissented. In their joint statement, Lee and Crenshaw are appreciative that some of the changes to Item 303 of Reg S-K—such as the statement of the objective of MD&A to provide a thoughtful narrative discussion and the new requirement to provide disclosure regarding critical accounting estimates—"should enhance the quality of MD&A disclosures," but take issue with two "significant aspects" of the final amendments that are once again rooted in the fundamental controversy over principles-based versus more prescriptive rulemaking, an issue that has pervaded the SEC's regulatory process almost throughout the term of SEC Chair Jay Clayton. (For a more detailed discussion, see this PubCo post.)

First, they object to the elimination of the Table of Contractual Obligations, which they believe "provides investors with critical insight into supply chain and risk management." While the proponents of the changes maintain that the Table is duplicative of information available elsewhere, the two commissioners contend that purchase obligations, required in the Table, are not always required by GAAP and not typically otherwise disclosed.  Yet they provide valuable information. Second, as with the SEC's recent effort to modernize the Reg S-K requirements for business, legal proceedings and risk factor disclosures (see  this PubCo post), on which Lee and Crenshaw similarly dissented, this rulemaking also fails to address climate risk, despite a significant proportion of public comments calling for the SEC to do so. Instead of taking "the opportunity to issue standardized disclosure requirements that would facilitate efficient comparisons of how companies manage these risks and assets," the SEC opted again for principles-based disclosure requirements. While some companies do provide climate disclosure in response to principles-based disclosure requirements, the "majority of U.S. based large companies have failed to acknowledge the financial risks of climate change in their filings." In addition, the information that is provided is "non-standardized, inconsistent, and incomparable disclosures," which does not "allow market participants to accurately price and compare the risks and opportunities associated with these risks." (See  this PubCo post.) Indeed, they cite a major study finding that "many institutional investors rank 'climate risk-disclosures' as being just as important as financial statements when predicting investment performance."

Nevertheless, they see a "silver lining." In their view, the opportunity remains to address climate, human capital and other ESG risks, with a new comprehensive rulemaking in the future.  They advocate that the SEC establish "an internal task force and ESG Advisory Committee that is dedicated to building upon the recommendations of leading organizations, such as the Task Force on Climate-Related Financial Disclosures, and defining a clear plan to address sustainable investing."

Elimination of selected financial data and revision of supplementary financial information (Items 301 and 302)

The final amendments eliminate the five-year table of selected financial data as proposed. With the ready availability of data on EDGAR and trend information already required in MD&A, the SEC views the table to no longer be necessary and the cost of preparation not justified. Nevertheless, the SEC encourages companies to consider including trend information for the earlier periods in MD&A if material as well as a tabular presentation of relevant financial or other information, as part of an introduction to MD&A.

The SEC had originally proposed to also eliminate the requirement to provide supplementary financial data, which comprises quarterly tabular operating data for two years, noting that, where fourth quarter results were material or there was a material retrospective change, that disclosure would still be elicited by existing requirements.  However, in response to comments critical of the change, the SEC instead elected to revise Item 302(a) to replace the current requirement for quarterly tabular disclosure with a principles-based requirement for disclosure regarding material retrospective changes, such as correction of an error, disposition of a business that is accounted for as discontinued operations, a reorganization of entities under common control or a change in an accounting principle. 

More specifically, the Item will be retained and streamlined to "require disclosure only when there are one or more retrospective changes that pertain to the statements of comprehensive income for any of the quarters within the two most recent fiscal years and any subsequent interim period for which financial statements are included or required to be included by Article 3 of Regulation S-X and that, individually or in the aggregate, are material." Companies will be required to explain the reasons for the material changes and "to disclose, for each affected quarterly period and the fourth quarter in the affected year, summarized financial information related to the statements of comprehensive income (as specified in Rule 1-02(bb)(ii) of Regulation S-X) and earnings per share reflecting such changes." "Affected quarters" could include a single quarter in which the material retrospective change applies, or subsequent quarters during the relevant period that were impacted by the earlier change. The SEC notes that not all changes in accounting principles would result in a retrospective change, depending on whether the standard will be applied retrospectively to interim periods. Other than requiring quarterly financial data when there have been material retrospective changes, the requirement to provide quarterly data, including for the fourth quarter, is being eliminated as duplicative or, for the most part, readily calculable (not to mention that the SEC expects that some companies will voluntarily provide fourth quarter disclosure.

In another change from the current rule, amended Item 302(a) will apply beginning with the first filing on Form 10-K after a company's initial Exchange Act registration. However, if a new Exchange Act filer has a material retrospective change to its year-to-date interim period information in its most recent registration statement, but has not yet disclosed that interim period information in quarterly increments, the company may present Item 302(a) disclosures for the same year-to-date interim period previously presented in the registration statement (rather than for each affected quarter during that time), along with the fourth quarter, in the affected year.

MD&A

The changes to MD&A are intended to streamline and clarify the rule and to elicit a more thoughtful and nuanced MD&A analysis.

Objectives of MD&A (new Item 303(a))

This new item, which has been adopted largely as proposed, collapses some of the prior instructions and prior guidance into a new paragraph designed to provide principles-based direction regarding the objectives of MD&A. The SEC advises that, in preparing MD&A, companies should "regularly revisit these objectives and consider ways to enhance the quality of the analysis provided." The objectives emphasize a company's "future prospects and highlight the importance of materiality and trend disclosures to a thoughtful MD&A," and are intended to remind companies "that MD&A should provide an analysis that encompasses short term results as well as future prospects." The SEC believes that a "discussion and analysis that meets these requirements is expected to better allow investors to view the registrant from management's perspective."

Under the new rule, the discussion should include:

• "Material information relevant to an assessment of the financial condition and results of operations of the registrant, including an evaluation of the amounts and certainty of cash flows from operations and from outside sources.
• Material events and uncertainties known to management that are reasonably likely to cause reported financial information not to be indicative of future operating results or of future financial condition. This includes descriptions and amounts of matters that have had a material impact on reported operations as well as matters that are reasonably likely based on management's assessment to have a material impact on future operations.
• The material financial and statistical data that the registrant believes will enhance a reader's understanding of the registrant's financial condition, cash flows and other changes in financial condition, and results of operations."

Discussion of full fiscal years (amended Item 303(b))

Overall, the SEC is seeking to elicit a less mechanical, more analytical discussion. To that end, the final amendments clarify that companies are required to disclose the "underlying reasons for material changes in quantitative and qualitative terms," highlighting "the importance of the analysis provided in MD&A." Discussion is required regarding material changes, including where material changes within a line item offset one another. Companies are also required to discuss, where, in the company's judgment, necessary to an understanding of the business, reportable segment information and/or information regarding other subdivisions (e.g., geographic areas, product lines) of the company's business.

Capital resources—material cash requirements (new Item 303(b)(1) and amended Item 303(b)(1)(ii))

The final amendments, as proposed, require companies to disclose the company's material cash requirements for known contractual and other obligations, including commitments for capital expenditures, instead of focusing only on disclosure of material commitments for capital expenditures, as the current rule provides.  Notwithstanding several comments expressing concern that the term "requirements" was too broad and could result in extensive new record keeping and controls, the SEC elected to adopt the provision as proposed, contending that the term "requirements" is "more consistent with the intended purpose of MD&A" and with prior SEC guidance emphasizing the need for attention to disclosure of cash requirements. Given that the amendments are limited to material cash requirements, the SEC did not believe that they reflected a new threshold for disclosure or would require new procedures. 

In addition, in response to comments received regarding the proposed elimination of the Table of Contractual Obligations (discussed below), the SEC adopted a major overhaul of Item 303(b), adopting amendments that were not originally proposed.  The amendments are "intended to clarify the requirements while continuing to emphasize a principles-based approach focused on material short- and long-term liquidity and capital resources needs, while also specifying that material cash requirements from known contractual and other obligations should be considered as part of these disclosures." These new amendments:

• provide the overarching requirements for liquidity and capital resources disclosures;
• define "liquidity" as the ability to generate amounts of cash adequate to meet the needs for cash and clarify its application to the liquidity and capital resources requirements more generally;
• require discussion of liquidity on a short- and long-term basis, codifying prior SEC guidance that short-term liquidity and capital resources covers cash needs up to 12 months into the future while long-term liquidity and capital resources covers items beyond 12 months;
• require an analysis of material cash requirements from known contractual and other obligations, including identification of the type of obligation and the relevant time period for the related cash requirements;
• indicate that known contractual obligations may include, for example, lease obligations, purchase obligations or other liabilities reflected on the company's balance sheet; and
• consistent with prior SEC guidance, state that the entire Item 303(b) analysis should be "in a format that facilitates easy understanding and does not duplicate disclosure already provided in the filing."

The amendments do not prescribe specific categories of contractual obligations, allowing companies flexibility in discussing material cash requirements.  However, to the extent that GAAP requires companies to assess currently prescribed categories of contractual obligations and those obligations are material, they will be required to be discussed in MD&A. As a general matter, unless otherwise clear from the discussion, companies are required to "discuss those balance sheet conditions or income or cash flow items which the registrant believes may be indicators of its liquidity condition."

Results of operations

• Known trends or uncertainties (amended Item 303(b)(2)(ii)).  The final amendments require disclosure of (i) any known trends or uncertainties that have had or that are reasonably likely to have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations and (ii) any known events that are reasonably likely to cause (as opposed to will cause) a material change in the relationship between costs and revenues, such as known or reasonably likely future increases in costs of labor or materials or price increases or inventory adjustments. Note that the "reasonably likely" threshold applies throughout Item 303 and requires application of a two-step test, based on objectively reasonable assessments by management of the "likelihood that an event will occur balanced with a materiality analysis regarding the need for disclosure." Companies applying the "reasonably likely" threshold will need to consider:

The express requirement to discuss the effects of inflation is being eliminated, but inflation and changing prices are still expected to be discussed if they are part of a known trend or uncertainty that had, or is reasonably likely to have, a material impact on net sales, revenue or income from continuing operations. (And note that, as discussed below, foreign private issuers will still be required to address hyperinflation.)

• Net sales and revenues (amended Item 303(b)(2)(iii)). As proposed, the final amendments provide that, to the extent there are material changes in net sales or revenues (not just increases, but also decreases), a narrative discussion is required of the extent to which the changes are attributable to changes in prices, the amount of goods or services being sold or to the introduction of new products or services. The narrative may also implicate a discussion of inflation. As noted above, the narrative must include a discussion of the "underlying reasons" for these material changes in quantitative and qualitative terms.

Off-balance sheet arrangements (new Instruction 8 to Item 303(b))

In light of changes to U.S. GAAP that require overlapping information, the final amendments eliminate, as proposed, the current prescriptive definition of off-balance sheet arrangement (incorporating a definition instead in Form 8-K) and the related requirement for disclosure under a separately captioned section. That requirement is replaced with a principles-based instruction to Item 303 requiring a discussion of off-balance sheet arrangements that have or are reasonably likely to have a material current or future effect on a company's financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, cash requirements or capital resources. The SEC expects companies to incorporate their discussions of off-balance sheet arrangements into their broader discussions of liquidity and capital resources.

The instruction identifies a number of off-balance sheet arrangements, including "guarantees; retained or contingent interests in assets transferred; contractual arrangements that support the credit, liquidity or market risk for transferred assets; obligations that arise or could arise from variable interests held in an unconsolidated entity; or obligations related to derivative instruments that are both indexed to and classified in a registrant's own equity under U. S. GAAP." As an example offered in support of its principles-based approach, the SEC explains that the current prescriptive definition was deficient in that it did not include certain types of off-balance sheet arrangements, such as contingent obligations of some pharma companies to make milestone payments to licensors of drug compounds. Nevertheless, companies have often disclosed these obligations in MD&A, supporting the SEC's belief that a principles-based instruction will better elicit information "useful to a broader understanding of the impact of off-balance sheet arrangements to a registrant's financial condition, and the nature and purpose of such arrangements."

Contractual obligations table (current Item 303(a)(5)) and amended Item 303(b)(1)—liquidity and capital resources)

The SEC is eliminating the prescriptive contractual obligations table, as proposed, and focusing instead on a principles-based requirement to provide, as discussed above, "a robust discussion of liquidity and capital resources, including a discussion of contractual obligations." The SEC's  intent is to eliminate the burdens associated with preparation of the table while continuing to provide investors with material information.

Critical accounting estimates (new Item 303(b)(3))

In prior guidance, the SEC has said that, in addition to discussing critical accounting policies in MD&A, companies should address the material implications of uncertainties associated with critical accounting estimates. The disclosure was supposed to supplement the policies discussion, but often just duplicated it. To eliminate this duplication and promote enhanced analysis of estimation uncertainties, the SEC is amending Item 303(a) to explicitly require disclosure regarding critical accounting estimates, including changes in estimates and the sensitivity of the reported amounts to the underlying estimates. As the SEC stated in the proposal, the intent of the requirement is to further understanding of amounts reported in the financials “by providing greater insight on the uncertainties involved in creating and applying an accounting policy and how significant accounting policies of registrants faced with similar facts and circumstances may differ.”

Many commenters on the proposal had expressed concerns regarding the need to provide a sensitivity analysis, noting the challenging and costly nature of the requirement for some companies and the possibility that it might elicit immaterial information. Some also objected that "this requirement—by virtue of the nature of some critical accounting estimates, the potential interrelatedness of assumptions, and the degree of inputs used to arrive at the estimate—would result in investor confusion, disclosure that is not useful to investors, unwarranted questioning of past judgments, or heightened liability exposure." Some commenters also asked the SEC to clarify the applicable period for changes in estimates. Some also opposed the requirement to disclose changes in estimates, contending that the disclosure either could "result in confusion and unwarranted questioning of past judgments or would be reflected in amounts that are reported in the financial statements" and discussed in MD&A.

In response, the SEC is modifying the final rule to to make clear that: "(i) the application of the material and reasonably available qualifier applies to all parts of the disclosure, not just to quantitative information; (ii) the discussion on how much each estimate has changed may also be met through a discussion of changes in the assumptions during the period; and (iii) the disclosure of changes in the estimate/assumption will cover a "relevant period," rather than a "reporting period."

The final amendments define "critical accounting estimates" as estimates made in accordance with GAAP "that involve a significant level of estimation uncertainty and have had or are reasonably likely to have a material impact on the financial condition or results of operations of the registrant." Companies will be required to provide "qualitative and quantitative information necessary to understand the estimation uncertainty and the impact the critical accounting estimate has had or is reasonably likely to have on financial condition or results of operations to the extent the information is material and reasonably available." Companies will need to discuss "why each critical accounting estimate is subject to uncertainty and, to the extent the information is material and reasonably available, how much each estimate and/or assumption has changed over a relevant period, and the sensitivity of the reported amount to the methods, assumptions and estimates underlying its calculation." (Emphasis added.)

According to the SEC, the requirement to disclose how much an estimate and/or assumption has changed over a relevant period is "intended to allow an investor to better evaluate the uncertainty associated with the critical accounting estimate by observing changes in estimates or assumptions over time." The new reference to "assumptions" in addition to estimates is intended to make clear that companies "have flexibility to provide appropriate context in the discussion of changes underlying a critical accounting estimate." And the SEC also makes the point that "disclosure of changes in an estimate/assumption should not be implied to mean that the earlier estimate was made in error. Rather, the disclosure provides insight into the estimation uncertainty and the variability that could result over time." Notably, the requirement to disclose changes, as well as the sensitivity disclosure, are "not intended to yield discussions of quantitative changes to reported amounts," but rather "to provide investors with a greater understanding of the variability that is reasonably likely to affect the financial condition or results of operations so investors can adequately evaluate the estimation uncertainty of a critical accounting estimate." An instruction specifies that critical accounting estimates should supplement, not duplicate, the description in the notes to the financial statements.

Discussion of interim periods (amended Item 303(c))

The final amendments are intended to provide companies with more flexibility in their discussions of interim periods by permitting comparison of the most recently completed quarter to either the corresponding quarter of the prior year (as is currently required) or  to the immediately preceding quarter. The objective is to allow companies to provide a "more tailored and meaningful analysis that is relevant to their specific business cycles while also providing investors with material information to assess quarterly performance." For example, businesses that are not seasonal may find a sequential quarter analysis to be more relevant than a comparison to the corresponding quarter of the prior year. Under the final amendments, if the company opts to provide a sequential quarter analysis, the company must provide summary financial information for that preceding quarter or identify the relevant prior EDGAR filing. In addition, if a company changes the comparison from the prior interim period comparison (e.g., provides sequential quarter analysis after previously providing analysis of the corresponding quarter of the prior year), the company would be required to explain the reason for the change and present both comparisons in the filing. The SEC believes that this requirement will provide investors greater insight into the company's decision-making. The final amendments will continue to require a discussion of the material changes in items specified in the full fiscal year requirements in amended Item 303(b), including critical accounting estimates.

Smaller reporting companies

Smaller reporting companies are currently not required to provide the Table of Contractual Obligations and, as the Table is being eliminated, the SEC is also eliminating the specific exclusion for SRCs.  However, new Item 303(b) specifically requires disclosure of material cash requirements from known contractual and other obligations as part of a liquidity and capital resources discussion, and the SEC emphasizes that SRCs should comply with the amended MD&A disclosure requirement.

Application to foreign private issuers

The SEC is adopting parallel amendments applicable to financial disclosures provided by foreign private issuers largely as proposed (with some conforming changes). The corresponding amendments apply to FPIs using Form 20-F or Form 40-F, as well as to current Instruction 11 to Item 303, which specifically applies to FPIs that choose to file on domestic forms. Instruction 11 is being amended to incorporate the requirement for FPIs to discuss hyperinflation in a hyperinflationary economy.

Additional conforming amendments

There are also a number of additional conforming amendments, not discussed in this post, that affect roll-up transactions, Reg AB, summary prospectuses in Forms S-1 and F-1, and to business combinations in Form S-4, Form F-4 and Schedule 14A (eliminating references to Item 301, as well as some duplicative requirements)

Compliance date

As noted above, the final amendments will become effective 30 days after publication in the Federal Register. Companies will be required to comply for "their first fiscal year ending on or after... the 'mandatory compliance date,'" which is the date that is 210 days after publication in the Federal Register.  The SEC staff has separately confirmed to us that the reference is intended to apply to the first annual report on Form 10-K for the first fiscal year ending on or after the mandatory compliance date.  Assuming publication of the new rules this year, companies with calendar-year fiscal years will be required to comply beginning with their Forms 10-K for 2021 to be filed in 2022. In addition, companies "will be required to apply the amended rules in a registration statement and prospectus that, on its initial filing date, is required to contain financial statements for a period on or after the mandatory compliance date. " Although companies will not be required to apply the amended rules until the mandatory compliance date, the final amendments permit early compliance any time after the effective date, so long as the disclosure is responsive to an amended item in its entirety and the company provides disclosure responsive to that entire amended item in any applicable filings going forward.

Table of Changes

Below is a slightly modified version of the SEC's table of changes

Originally Published by Cooley, November 2020

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.