SEC Proposes to Relax Certain Historical and Pro Forma Financial Statement Requirements Relating to Acquisitions and Dispositions
Under existing SEC rules, an acquiring company must generally provide separate audited annual and unaudited interim pre-acquisition financial statements of an acquired business if it is “significant” to the acquiring company. The significance of an acquisition is determined by comparing (1) the assets of the target with the assets of the acquiring company, (2) the pre-tax income of the target with the pre-tax income of the acquiring company, and (3) the purchase price for the target (the investment in the target) with the assets of the acquiring company. If none of the significance tests exceeds 20%, no financial statements of the acquired business are required. If any of the three significance tests exceeds 20%, but none exceeds 40%, the acquiring company is required to provide financial statements of the acquired business for the most recent fiscal year and any required interim periods. If any of the tests exceeds 40%, but none exceeds 50%, two years of audited financial statements of the acquired business are required. When at least one of the three tests exceeds 50%, three years of audited financial statements are required (unless net revenues of the acquired business were less than $100 million in its most recent fiscal year).
Number of Audited Years Required for Significant
Acquisitions: Elimination of Third Year
Under existing rules, audited financial statements of the acquired business may be required for up to three years if any of the significance tests is exceeded at the 50% level. In many cases, the third year of financial statements may be too old to be material to investors.
The SEC proposes to eliminate the requirement to file the third year of the acquired company’s financial statements for acquisitions exceeding 50% significance.
Income Test: Addition of Revenue Test
Under existing rules, the income test for determining significance is based on comparing the target company’s pre-tax income to the pre-tax income of the acquiring company reflected in its most recent annual financial statements prior to the acquisition date. Focusing on income as a single component of the income test occasionally has anomalous results where companies are required to provide financial statements for acquisitions that otherwise would not be material to investors. In order to address this issue, the SEC proposes to add a new revenue component to the income test and to simplify the calculation of income by using income or loss from continuing operations after income taxes.
Under the proposed rules, if the acquiring company and the acquired business have recurring annual revenue, the acquiring company would compare its revenue to the target’s revenue, and its after-tax income to the target’s after-tax income. Target company financial statements would be required only if both the revenue and income tests were met, and the number of years of financial statements would be determined by using the lower of the revenue test and the income test (for example, if the income test is met at 44%, but the revenue test is only 15%, no financial statements for the acquired entity would be required).
Investment Test: Compare Investment in Target to Acquiring
Company’s Worldwide Common Equity Market Value
Under existing rules, the investment test is based on comparing the purchase price for the acquisition (the acquiring company’s investment and advances to the acquired business) to the acquiring company’s total assets as of its most recent fiscal year prior to the acquisition date.
The SEC proposes to amend the investment test so that the acquiring company’s investment and advances to the acquired business will be compared to the aggregate worldwide market value of its voting and non-voting common equity instead of its total assets. For purposes of this test, the market value will be determined as of the last business day of the most recently completed fiscal year prior to the acquisition date and would include all common equity whether or not held by affiliates of the company.
Broadening of Permitted Pro Forma Adjustments
Under existing rules, in addition to presenting the financial statements of an acquired business in accordance with Rule 3-05, acquiring companies are also required to file unaudited pro forma financial information (typically comprised of the most recent balance sheet and the most recent annual and interim income statements). Pro forma financial information for a business combination combines the historical financial statements of the acquiring company and the acquired business and is adjusted for certain items which meet specified criteria.
Article 11 of Regulation S-X currently only allows pro forma adjustments that are directly attributable to the transaction, factually supportable and, with respect to the pro forma income statement, expected to have a continuing impact on the company. The SEC’s proposing release states that these existing criteria for pro forma adjustments “are not clearly defined nor easily applied and, in practice, can yield inconsistent presentations for similar fact patterns.” Significantly, the existing SEC rules also do not permit the inclusion of adjustments for the potential effects of post-acquisition actions expected to be taken by management.
The SEC proposes to replace the existing pro forma adjustment criteria with “Transaction Accounting Adjustments” and “Management’s Adjustments.”
- Transaction Accounting Adjustments would reflect the application of required accounting for the acquisition or disposition under U.S. GAAP or IASB/IFRS.
- Management’s Adjustments would reflect synergies and other effects of the transaction (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 SEC proposal provides that, for each Management’s Adjustment, the company must include (1) a description, including the material uncertainties, of the synergy or other transaction effects, (2) disclosure of the underlying material assumptions, the method of calculation and the estimated time frame for completion, (3) qualitative information necessary to give a fair and balanced presentation of the pro forma financial information and (4) to the extent known, the reportable segments, products, services and processes involved, the material resources required, if any, and the anticipated timing. For synergies and other transaction effects that are not reasonably estimable and will not be included in Management’s Adjustments, the SEC proposes to require that qualitative information necessary for a fair and balanced presentation of the pro forma financial information must be provided. As proposed, the notes to the pro forma financial statements would also be required to disclose (1) revenues, expenses, gains and losses, and related tax effects which will not recur in the income of the company beyond 12 months after the transaction, (2) the total consideration transferred or received, including its components and how they were measured, (3) if total consideration includes contingent consideration, the arrangement, the basis for determining the amount of payment or receipt and an estimate of the range of outcomes (undiscounted) or, if a range cannot be estimated, that fact and the reasons why, and (4) information about Transaction Accounting Adjustments when the initial accounting is incomplete. The SEC proposal provides that “Management’s Adjustments” must be presented through a separate column in the pro forma financial information after the presentation of the combined historical financial statements and Transaction Accounting Adjustments. In addition, the SEC proposes that per share data be presented in two separate columns – one column would present the pro forma total depicting the combined historical statements with only Transaction Accounting Adjustments, and the second column would show the combined historical statements with both Transaction Accounting Adjustments as well as Management’s Adjustments.
As proposed, pro forma financial information must be appropriately labeled and presented as required by Article 11 of Regulation S-X. Each transaction for which pro forma effect is required to be given must be presented in a separate column. Finally, if pro forma financial information includes another entity’s statement of comprehensive income, such as that of an acquired business, it must be brought up to within one fiscal quarter, if practicable.
Because Management’s Adjustments might contain forward-looking information, the SEC proposes to clarify that the safe harbor provisions in the SEC rules for forward-looking information would be available with respect to Management’s Adjustments.
Financial Statements of Individually Insignificant Acquisitions
Under existing rules, if individually insignificant completed and probable acquisitions since the date of the most recent audited balance sheet collectively exceed the 50% significance test, the acquiring company is required to include audited financial statements and unaudited pro forma financial information for the substantial majority of such individually insignificant acquisitions in most of its registration statements and proxy statements. The result of this rule is that companies may be required to provide separate audited financial statements for acquired businesses that are individually not material, and they provide pro forma financial information that does not fully depict the aggregate effect of all of the individually insignificant businesses. The proposed rules modify Rule 3-05 to require (1) pro forma financial information depicting the aggregate effects of all of the insignificant businesses in all material respects and (2) pre-acquisition historical financial statements only for those businesses whose individual significance exceeds 20% but whose financial statements have not yet been required to be filed.
Increase the Significance Threshold for Dispositions
Under existing rules, pro forma financial statements are required to be presented for significant dispositions which are significant at the 10% level.
The proposed changes would raise the significance threshold for business dispositions from 10% to 20% to conform to the threshold used for business acquisitions.
- Acquisition of a Component of an Entity: Elimination of Need to Allocate Overhead, Interest and Income Tax. With respect to acquisitions of a component of an entity (for example, a product or business line) that involves a “business,” as defined in SEC rules, but does not constitute a separate entity, the SEC proposal would eliminate the requirement that the selling entity make an appropriate allocation of corporate overhead, interest and income tax expenses to the assets sold in preparing the required financial statements, if certain conditions are satisfied. These conditions include (1) the business constitutes less than substantially all of the assets and liabilities of the seller and was not a separate entity, subsidiary, segment or division of the seller, (2) separate financial statements for the business have not previously been prepared, (3) the seller has not maintained distinct and separate accounts for the business and it is impracticable to prepare them, (4) interest expense can be excluded only if the related debt will not be assumed by the registrant, (5) the statements of revenue and expenses may not omit selling, distribution, marketing, general and administrative and R&D expenses incurred by the acquired business, and (6) the notes to the financial statements disclose the type of omitted expenses and the reasons why they are excluded, information about the business’s operating, investing and financing cash flows, an explanation of the impracticability of preparing financial statements that include the omitted expenses, and a description that the financial statements are not indicative of the financial condition or results of operations of the acquired business.
- Acquisition of Oil and Gas Businesses: Ability to Exclude Depletion, Depreciation, Amortization, Corporate Overhead Expense, Income Taxes and Interest Expense. For significant acquired businesses that include significant oil-and-gas-producing activities, the SEC proposal would allow the target financial statements to exclude depletion, depreciation, amortization expense, corporate overhead expense, income taxes and interest expense that are not comparable to the proposed future operation, subject to certain conditions. These conditions include that (1) substantially all of the revenues of the business are generated form oil and gas producing activities and (2) all of the conditions described in the immediately preceding bullet are satisfied (other than item 5 which need not be satisfied). The financial statements would also be required to include industry-specific supplemental information.
- Interim Financials When Only One Year of Audits is Required. For acquisitions with significance exceeding 20%, but not exceeding 40%, the SEC proposes to allow companies to file interim financial statements for just the “most recent” interim period (rather than for “any” interim period, as required under existing rules)—this eliminates the need to provide a comparative interim period when only one year of audited financial statements of the acquired business is required.
Omission of Acquired Company’s Financial Statements If the Acquired Entity Is Already Reflected in the Acquiring Company’s Financial Statements for a Full Fiscal Year. Currently, financial statements of an acquired business that are otherwise required under Rule 3-05 may be omitted 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 (1) the financial statements have not been previously filed (for example, if a significant acquisition was made in the earliest of the three years for which the company provides financial statements in its IPO prospectus but financial statements for the target were never previously filed) or (2) the acquisition is of major significance to the acquiring company and the omission of the financial statements of the acquired business would materially impair the investors’ ability to understand historical financial results of the acquiring company (for example, if the target’s significance level was 80% or higher at the time of acquisition).
Under the proposed rules, the exceptions listed above will be eliminated and the financial statements of an acquired business will no longer be required in registration statements and proxy statements of the acquiring company in any circumstance once the acquired business is reflected in its post-acquisition financial statements for a complete fiscal year.
Additional Accommodations for Financial Statements of Foreign Businesses. Regulation S-X currently permits “foreign private issuers” to utilize financial statements prepared in accordance with International Financial Reporting Standards, as adopted by the International Accounting Standards Board (IASB/IFRS), without reconciliation to U.S. GAAP. However, acquired entities can use IASB/IFRS financial statements only if the acquired entity is a “foreign business” which is a narrower definition than “foreign private issuer.” This has resulted in acquired entities which qualify as a “foreign private issuer” but not a “foreign business” not being permitted to utilize IASB/IFRS financial statements, even if they are available. The SEC proposes to modify Rule 3-05 of Regulation S-X to permit the financial statements of an acquired foreign business to be prepared in accordance with IASB/IFRS (without reconciliation to U.S. GAAP) if the acquired business would qualify to use IASB/IFRS if it were an SEC registrant. Notwithstanding this change, if the acquiring company presents its financial statements in U.S. GAAP, the pro forma financial information reflecting the acquisition will still be required to be presented in U.S. GAAP.
In addition, the proposed rules will also permit foreign private issuers that prepare their financial statements in accordance with IASB/IFRS to provide an acquired company’s financial information prepared using home county GAAP with a reconciliation to IASB/IFRS rather than to U.S. GAAP (under existing rules, it is required to be reconciled to U.S. GAAP even if the acquiring company is a foreign private issuer that prepares its financial statements under IASB/IFRS).
Use of Pro Forma Financial Information to Measure Significance. Under existing rules, significance determinations are made by comparing the most recent annual consolidated financial statements of the acquired business to those of the acquiring company filed at or prior to the date of acquisition. However, an acquiring company is permitted to use pro forma, rather than historical, financial information to determine the significance of acquisitions and dispositions if it made a significant acquisition after the latest fiscal year end and filed the required financial statements of the acquired business and pro forma financial statements on Form 8-K with the SEC. The existing rule does not allow the use of pro forma financial statements filed with respect to a significant disposition and is not available for companies filing initial registration statements.
The proposed changes eliminate these restrictions and would, for all filings where Rule 3-05 financial statements are required, allow the acquiring company 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, provided that the company has filed (1) the financial statements of the acquired or disposed business as required under Rule 3-05 and (2) the required Article 11 pro forma financial information for any such acquired or disposed business.
* The authors wish to thank Evgeniya Berezkina for her assistance in the preparation of this client alert.