Yesterday, once again without an open meeting, the SEC voted (with a dissent from Commissioner Allison Lee) to adopt amendments to the requirements for financial statements relating to acquisitions and dispositions of businesses. According to the press release, the amendments are intended to improve disclosure of financial information, facilitate more timely access to capital and reduce the complexity and costs to prepare the disclosure. The final amendments were adopted largely as proposed, but with some modifications to virtually every component of the proposal. Notably, as adopted, the final amendments modify the rules for determining whether an acquisition or disposition is significant and require companies to file the financial statements of acquired businesses for only up to the two most recent fiscal years, instead of the current three. In addition, the existing adjustment criteria for pro forma financial statements will be replaced with simplified requirements to depict the accounting for the transaction and, in response to some controversy over the proposal, provide the option to “depict synergies and dis-synergies of the acquisitions and dispositions for which pro forma effect is being given.” The final amendments will become effective on January 1, 2021. Companies may early adopt the final amendments, but only in their entirety.
The final amendments affect Rules 3-05 and Article 11 of Reg S-X, as well as related rules and forms. Under Rule 3-05, acquiring companies must provide separate audited annual and unaudited interim pre-acquisition financial statements of a “significant” acquired business, with the number of years required determined on the basis of the relative significance of the acquisition. Article 11 applies to pro forma financial statements, and requires the company to file unaudited pro forma financial information with regard to the acquisition or disposition, including adjustments that show how the acquisition or disposition might have affected the historic financial statements.
(The final amendments also affect the rules and forms related to real estate businesses and investment companies, not discussed in this post.)
As summarized by the SEC, the amendments will:
- “Update the significance tests used under these and other rules to generally improve their application and assist registrants in making more meaningful significance determinations;
- Expand the use of pro forma financial information in measuring significance;
- Conform, to the extent applicable, the significance threshold and tests for a disposed business to those used for an acquired business;
- Require the financial statements of the acquired business to cover only up to the two most recent fiscal years;
- Permit disclosure of abbreviated financial statements for certain acquisitions of a component of an entity;
- Permit the use of, or reconciliation to, International Financial Reporting Standards as issued by the International Accounting Standards Board (“IFRS-IASB”) in certain circumstances;
- No longer require separate acquired business financial statements once the business has been included in the registrant’s post-acquisition audited annual financial statements for either nine months or a complete fiscal year, depending on significance;
- Modify and enhance the required disclosure for the aggregate effect of acquisitions for which financial statements are not required or are not yet required;
- Align Rule 3-14 with Rule 3-05 where no unique industry considerations exist;
- Clarify the application of Rule 3-14 regarding the determination of significance, the need for interim income statements, special provisions for blind pool offerings, and the scope of the rule’s requirements;
- Amend the pro forma financial information requirements to improve the content and relevance of such information;
- Clarify when financial statements and pro forma financial information are required, and update the language used in our rules to take into account concepts that have developed since adoption of the rules over 30 years ago; and
- Make corresponding changes to the smaller reporting company requirements in Article 8 of Regulation S-X.”
More specifically, the final amendments provide the following:
Significance test. Currently, to determine the significance of an acquisition (and therefore the extent of the required financial disclosure), under Rule 3-05, companies apply prescribed investment, asset and income tests set forth in the “significant subsidiary” definition in Rule 1-02(w). The final amendments revise the significance tests by modifying the investment test and the income test.
The new investment test will compare the company’s (and its other subsidiaries’) investments in and advances to the tested subsidiary to the aggregate worldwide market value of the company’s voting and non-voting common equity, when available; however, this amendment will be limited to acquisitions and dispositions (excluding, for example, use in evaluating equity method investments). Aggregate worldwide market value will be calculated daily for the last five trading days of the company’s most recently completed month ending prior to the earlier of the company’s announcement date or agreement date of the acquisition or disposition. The existing test will continue to apply if the company does not have an aggregate worldwide market value and for any additional purposes for which the Rule 1-02(w) definition is applicable. There are additional changes clarifying the meaning of “investments in” the tested subsidiary and providing for inclusion of the fair value of contingent consideration in certain circumstances.
The new income test adds a revenue component. The intent of the addition is to reduce the frequency of immaterial acquisitions being deemed significant and other anomalous results that occur from relying solely on the net income component. The new revenue component compares the company’s (and its other subsidiaries’) share of the tested subsidiary’s consolidated total revenues (after intercompany eliminations) to the company’s consolidated total revenues for the most recently completed fiscal year. The new test will require that “the tested subsidiary meet both the revenue component and the net income component when the revenue component applies, and for purposes of the application of Rule 3-05, [companies] may use the lower of the revenue component and the net income component to determine the number of periods for which Rule 3-05 Financial Statements are required.” The revenue component will not apply if either the company and its consolidated subsidiaries or the tested subsidiary did not have material revenue in each of the two most recently completed fiscal years. The final amendments retain the current requirement to use pre-tax income from continuing operations. Additional changes also relate to the use of absolute values in calculating income, as well as other clarifications and simplifications.
The SEC did not propose to amend the assets test; however, the final amendments provide that, when computing the assets test for acquisitions, intercompany transactions with the acquired business must be eliminated from the company’s consolidated total assets.
The changes also expand the use of pro forma financial information in measuring significance, as discussed below, and conform the significance threshold and tests for a disposed business, including raising the significance threshold from 10% to 20%.
Number of years. Currently, if none of the significance tests exceeds 20%, no Rule 3-05 financial statements are required. Between 20% and 40%, financial statements are required for the most recent fiscal year and any required interim periods; between 40% and 50%, a second fiscal year is required, and over 50%, a third fiscal year is required (unless net revenues of the acquired business were less than $100 million in its most recent fiscal year).
The final amendments reduce the number of years of required financial statements for the acquired business from three years to two years for an acquisition that exceeds 50% significance. As a result, if any of the tests exceeds 40%, financial statements are required for at least the two most recent fiscal years and any interim periods specified in Rules 3-01 and 3-02. In addition, where a significance test measures 20%, but none exceeds 40%, Rule 3-05 will now require “financial statements for the ‘most recent’ interim period specified in Rule 3-01 and 3-02 rather than ‘any’ interim period.” The change eliminates the need to provide a comparative interim period when only one year of audited financial statements is required. The adopting release includes a reminder that if trends depicted in Rule 3-05 financial statements “are not indicative or are otherwise incomplete,” companies are required by Rule 4-01(a) to provide “such further material information as is necessary to make the required statements, in light of the circumstances under which they are made, not misleading.”
Pro forma financial information. Currently, pro forma financial information typically includes a pro forma balance sheet and pro forma income statement based on the historical financial statements of the acquiring company and the acquired or disposed business. Pro formas generally include adjustments that are designed to show how those financial statements might have been affected by the acquisition or disposition had the transaction occurred at an earlier time. In addition, the existing pro forma adjustment criteria “preclude the inclusion of adjustments for the potential effects of post-acquisition actions expected to be taken by management.”
Under the proposal, the existing pro forma adjustment criteria would have been replaced with simplified requirements to include disclosure of transaction accounting adjustments, which would “reflect the accounting for the transaction”; and management’s adjustments, which would “reflect reasonably estimable synergies and transaction effects,” such as “closing facilities, discontinuing product lines, terminating employees, and executing new or modifying existing agreements, that are both reasonably estimable and have occurred or are reasonably expected to occur.”
The requirement to apply “management’s adjustments” turned out to be the most controversial component of the proposal. In particular, many commenters opposed inclusion of management’s adjustments as too subjective, uncertain, inapt and burdensome and expressed concern regarding potential liability for the disclosure. Other commenters favored inclusion because the adjustments would provide provide greater flexibility for inclusion of forward-looking information and offer insight into the potential effects of the acquisition and post-acquisition plans as well as management’s rationale for the transaction.
In response to these comments, the SEC made the inclusion of management adjustments optional. The final amendments replace the existing pro forma adjustment criteria with simplified requirements to depict the accounting for the transaction and provide the option “to depict synergies and dis-synergies of the acquisitions and dispositions for which pro forma effect is being given.” As adopted, there will be three categories of pro forma adjustment criteria: “Transaction Accounting Adjustments;” “Autonomous Entity Adjustments;” and “Management’s Adjustments.” As described,
“Transaction Accounting Adjustments reflect only the application of required accounting to the acquisition, disposition, or other transaction linking the effects of the acquired business to the registrant’s audited historical financial statements.
Autonomous Entity Adjustments are adjustments necessary to reflect the operations and financial position of the registrant as an autonomous entity when the registrant was previously part of another entity.
Management’s Adjustments provide both flexibility to registrants to include forward-looking information that depicts the synergies and dis-synergies identified by management in determining to consummate or integrate the transaction for which pro forma effect is being given and insight to investors into the potential effects of the acquisition and the post-acquisition plans expected to be taken by management.”
Transaction Accounting Adjustments and Autonomous Entity Adjustments will be mandatory; however, Management’s Adjustments “may, in the registrant’s discretion, be presented if in its management’s opinion, such adjustments would enhance an understanding of the pro forma effects of the transaction.”
Moreover, to present Management’s Adjustments, the company must satisfy new conditions related to the basis for Management’s Adjustments and the form of presentation intended to ensure that “if Management’s Adjustments are presented, they are done so consistently and in a manner that would not be misleading to investors.” For example, each adjustment must have a reasonable basis, the pro forma financial information must reflect all Management’s Adjustments necessary to a fair statement of the pro forma financial information presented, and the explanatory notes must disclose “the basis for and material limitations of each Management’s Adjustment, including any material assumptions or uncertainties of such adjustment, an explanation of the method of the calculation of the adjustment, if material, and the estimated time frame for achieving the synergies and dis-synergies of such adjustment.”
In addition, the amended rules require Management’s Adjustments to be presented in the explanatory notes to the pro forma financial information in the form of reconciliations. Any forward-looking information will be expressly covered by the safe harbors under Rules 175 and 3b-6.
Acquisition of component of entity. Where the acquisition is of a component, such as a product line or a line of business spread across more than one subsidiary or division, but constitutes a “business” as defined in Rule 11-01(d), the final amendments allow companies to provide audited abbreviated financial statements and eliminate the need to make some allocations of specified expenses by permitting the omission of certain corporate overhead, interest and income tax expenses for these types of acquisitions if required conditions are satisfied. Among the conditions are that separate financials have not previously been prepared, that the seller has not maintained separate accounts for the business including these expenses (making it impracticable to prepare separate financials) and that the acquired assets and revenues are 20% or less of the corresponding amounts of the seller and its subsidiaries for the most recent fiscal year.
Individually insignificant acquisitions. Currently, if the aggregate impact of “individually insignificant businesses” acquired since the date of the most recent audited balance sheet exceeds 50%, the company must include in a registration statement or proxy statement audited historical pre-acquisition financial statements covering at least the substantial majority of the businesses acquired, as well as related pro forma financial information required by Article 11.
The final amendments clarify that “individually insignificant businesses” include:
“(a) Any acquisition consummated after the registrant’s audited balance sheet date whose significance does not exceed 20 percent;
(b) Any probable acquisition whose significance does not exceed 50 percent; and
(c) Any consummated acquisition whose significance exceeds 20 percent, but does not exceed 50 percent, for which financial statements are not yet required by Rule 3-05(b)(4) because of the 75-day filing period.”
The amended rule will require companies to provide pre-acquisition historical financial statements only for those businesses whose individual significance exceeds 20%. Instead of historical financials for a majority of the acquired businesses, companies will be required to provide pro forma financial information depicting the aggregate effects of all “individually insignificant businesses” in all material respects.
In applying the 50% income test, businesses with losses must be aggregated separately, and, “if either group exceeds 50 percent, the disclosure requirements apply to all of the businesses subject to the aggregate test and must not be limited to either the businesses with losses or those with income.”
The SEC acknowledges that, where historical financial statements included in the pro forma financial information for individually insignificant acquisitions have not been reviewed or audited, accountants providing negative assurance to underwriters on the combined pro forma financial information may be required to perform additional steps, but the SEC concluded that the benefit of the information outweighs those concerns.
Omission of financial statements. Currently, Rule 3-05 financial statements are not required in registration and proxy statements once the operating results of the acquired business have been reflected in the audited consolidated financial statements of the acquiring company for a complete fiscal year, unless the financial statements have not been previously filed or, when previously filed, the acquired business is of major significance.
Under the final amendments, financial statements will no longer be required in registration statements and proxy statements for businesses that exceed 20% but do not exceed 40% significance once they are included in the company’s audited post-acquisition results for nine months (rather than the proposed complete fiscal year). For businesses that exceed 40% significance, omission of pre-acquisition financial statements is permitted once they have been included in the company’s post-acquisition results for a complete fiscal year. The final amendments also eliminate the requirement to provide financial statements when they have not been previously filed or when they have been previously filed but the acquired business is of major significance.
Use of pro formas for significance test. Currently, a company may use pro forma, rather than historical, financial information for significance testing if the company “made a significant acquisition subsequent to the latest fiscal year-end and filed its Rule 3-05 Financial Statements and pro forma financial information on Form 8-K.” The final amendments expand the circumstances in which a company can use pro forma financial information for significance testing, allowing companies, for filings that require Rule 3-05 Financial Statements, to “measure significance using filed pro forma financial information that only depicts significant business acquisitions and dispositions consummated after the latest fiscal year-end for which the registrant’s financial statements are required to be filed.” Conditions apply, including that the company has filed the Rule 3-05 Financial Statements for the acquired business and filed the pro formas for the acquired or disposed business. Once a company uses pro forma financial information to measure significance, it must continue to do so until its next annual report on Form 10-K or Form 20-F.
International acquisitions. The final amendments modify “Rule 3-05(c) to permit foreign private issuers that prepare their financial statements using IFRS-IASB to reconcile Rule 3-05 Financial Statements of foreign businesses prepared using home country GAAP to IFRS-IASB rather than U.S. GAAP because this will provide more comparable information and better facilitate analysis of the financial statements.” In addition, Rule 3-05(d)will now permit “Rule 3-05 Financial Statements to be prepared in accordance with IFRS-IASB without reconciliation to U.S. GAAP if the acquired business would qualify as a foreign private issuer if it were a registrant.”
Smaller reporting companies. The final amendments make corresponding changes, other than for form and content requirements for the financial statements, to the smaller reporting company requirements in Article 8 of Reg S-X. A new paragraph is being added to Rule 8-01 expressly permitting application of Rule 3-06, which generally permits financials covering a period of nine months to satisfy the Rule 3-05 requirement for filing financial statements for a period of one year. Rule 8-04 will continue to require up to two years of acquired business historical financial statements and permit smaller reporting companies to omit the financial statements if the acquired business has been included in the company’s results for a complete fiscal year. Form 8-K and Article 8 are being amended to require smaller reporting companies to provide pro forma financial information for disposition of a significant business in Form 8-K and in certain registration statements and proxy statements when the disposition occurs during or after the most recently completed fiscal year. In addition, the SEC is amending Rule 8-05 to require that the preparation, presentation and disclosure of pro forma financial information by smaller reporting companies substantially comply with Article 11.
Conforming and clarifying changes. The final amendments provide conformity across the “significant subsidiary” definitions (except as noted above with regard to the investment test and testing significance of equity method investees, as well as for the additional purposes for which the definition is used). The final amendments also revise Rule 3-05 and Article 11 to clarify when financial statements and pro forma financial information are required, and to update the language to take new concepts into account. For example, the amendments specify that “financial statements are required if a business acquisition has occurred during the most recent fiscal year or subsequent interim period for which a balance sheet is required by [Rule 3-01], or if a business acquisition has occurred or is probable after the date that the most recent balance sheet has been filed.” There are also a number of changes in terminology, such as replacing the term “furnish” with “file” to clarify that Rule 3-05 and Article 11 information must be filed with the SEC.
Transition. Companies will not be required to apply the final amendments until the beginning of the company’s fiscal year beginning after December 31, 2020 (the “mandatory compliance date”). Acquisitions and dispositions that are probable or consummated after the mandatory compliance date must be evaluated for significance using the final amendments. For initial registration statements, companies are not required to apply the final amendments until the initial registration statement is first filed on or after the mandatory compliance date, at which point, “all probable or consummated acquisitions and dispositions, including those consummated prior to the mandatory compliance date, must be evaluated for significance using the final amendments.”
Voluntary early compliance is permitted in advance of the company’s mandatory compliance date provided that the final amendments are applied in their entirety from the date of early compliance.