2.7 Item 7: Management Discussion and Analysis (MD&A)

2.7 Item 7: Management Discussion and Analysis (MD&A)

Another important item for a financial analyst is Item 7 which contains information that cannot be found in the financial statements. This item is intended to cover favorable and unfavorable trends or events relating to liquidity, capital expenditures, financing and operations. However it is relatively open ended and as such this item has always had questions raised in relation to its usefulness in practice. For example in an early study by M. L. Parva and M. J Epstein, Journal of Accountancy March 1993 it was noted that although historical information was summarized many companies provided no forward looking information. In a recent extensive study by the SEC of this item they reported (source http://www.journalofaccountancy.com/Issues/2006/Aug/MdAReportCard.htm):

MD&A Report Card

August 2006

ON THE RECORD

What is the state of MD&A disclosure? The staff in the SEC’s Division of Corporation Finance reviewed over 6,000 public companies’ filings last year. They tell me that generally, MD&A has improved. In many instances companies are better explaining their financial statements, providing and clarifying context and using MD&A to fill in some of those gaps in GAAP. ”

“ Despite this progress, there is still room for improvement. Some companies are doing an ‘elevator analysis’ without ample explanation. And some companies’ MD&A is still unnecessarily lengthy and not focused on telling the story clearly. ”

“ Management’s story would be more complete if it contained more forward-looking information, better explained trends and uncertainties that affect the business and discussed in more detail the business’ key drivers. ”

—SEC Commissioner Cynthia A. Glassman,

remarks at the 10th Annual Corporate Counsel Institute,

Washington, D.C., March 2006.

Thus even today there are still questions about forward looking information in this item. Companies do seem to be improving however, and as such this is a useful item for analysts to read in conjunction with the Financial Statements.

Finally, the SEC EDGAR Database also contains filings from non-US companies that choose to list their stocks on US exchanges. These stocks are known as American Depository Receipts (ADR’s). Formally, these are "receipts" for shares of stocks of non-US companies held by US banks and traded by investors in the US. There are three levels of ADR’s. Level I is the lowest level, traded over-the-counter with minimal reporting requirements to the SEC. Level II is listed and traded in the secondary stock markets. A level II firm must file the equivalent of a 10-K and 10-Q with the SEC. The equivalent forms for ADR’s are 20-F and 6-K respectively for the 10-K and 10-Q forms. Level III is the highest level and carries additional SEC reporting requirements because such a firm can issue stock in the US primary stock markets.

MD&A also contains a section of Critical Accounting Judgments. This is useful to read in an attempt to gauge the quality of the financial reports. Unfortunately omissions of discussion may be more important than actual discussions in this section as well as reporting in other parts of the 10-K. You can read about this further in the latter part of the chapter Krispy Kreme mini case study.