Insights

SEC Proposes Amendments to M&A Financial Disclosures

Firm Thought Leadership

On May 3, 2019, the U.S. Securities and Exchange Commission proposed extensive amendments to disclosure requirements for financial reporting for acquisitions and dispositions of businesses. As indicated in its press release, the SEC intends for these changes to improve financial information about acquired and disposed businesses, facilitate more timely access to capital and reduce the complexity and cost to prepare disclosures.

The proposed amendments are the result of the SEC's ongoing comprehensive evaluation of disclosure requirements and primarily cover financial disclosure requirements in Rules 3-05 and Article 11 of Regulation S-X relating to registration statements and Exchange Act reports.

Background
When a registrant acquires a significant business, Rule 3-05 of Regulation S-X requires disclosure of separate audited annual and unaudited interim pre-acquisition financial statements of that business. The number of years of audited financial statements that must be provided depends on the relative significance of the acquired business to the registrant. In addition, Article 11 of Regulation S-X requires registrants to file unaudited pro forma financial information relating to certain significant acquisitions and dispositions.

Whether a transaction is significant, and therefore what historical financial statements and pro forma financial information are required to be provided in connection with that transaction, is determined by applying three tests set forth in Rule 1-02(w) of Regulation S-X:

  • an investment test, which compares the registrant's investment in and advances to the acquired business to the carrying value of the registrant's total assets;
  • an income test, which compares the income of the acquired business to the income of the registrant; and
  • an asset test, which compares the total assets of the acquired business to the total assets of the registrant;
in each case, based on the registrant's and the target's most recent annual financial statements (subject to limited exceptions).    

This alert covers the following proposed amendments:

  • updates to the investment test and the income test;
  • expansion of the use of pro forma financial information in measuring significance;
  • changes to required financial statements at various significance levels;
  • changes to the significance threshold and tests for a disposed business;
  • updates to financial statements required in carve-out transactions;
  • when financial statements not previously filed or those relating to an acquisition of major significance may be omitted;
  • changes to the treatment of individually insignificant acquisitions;
  • revisions to adjustments that may be made to pro forma financial information; and
  • codification of historical reporting practices for financial statements of oil and gas producers.

Proposed Amendments to Significance Tests
The SEC has proposed amendments to the investment and income tests as described below. Apart from certain clarifying changes, the asset test would remain substantially unchanged under the proposed amendments.

Investment Test
Proposed changes to the investment test include:

  CURRENT INVESTMENT TEST PROPOSED INVESTMENT TEST
Comparison Metric

A registrant’s investment in and advances to the acquired business is compared to the carrying value of the registrant’s total assets.

A registrant’s investment in and advances to the acquired business is compared to the aggregate worldwide market value of the registrant’s voting and non-voting common equity (including equity held by affiliates), determined as of the last business day of the registrant’s most recently completed fiscal year prior to closing the transaction.

If the registrant does not have an aggregate worldwide market value, the carrying value of the registrant’s total assets would continue to be used.

Contingent Consideration

A registrant’s “investment in” a tested target includes the gross amount of contingent consideration if likelihood of payment is more than remote.1

A registrant’s “investment in” a tested target includes the fair value of contingent consideration required to be recognized at fair value by the registrant at the acquisition date under U.S. GAAP or IFRS-IASB, as applicable.

If recognition at fair value is not required, the proposed amendment would require all contingent consideration to be included, except sales-based milestones and royalties, unless the likelihood of payment is remote.

1 The inclusion of contingent consideration is based on SEC guidance and not based on the language of Rule 1-02(w).

The SEC states that using the registrant's aggregate worldwide market value would align the investment test more closely with the economic significance of the acquisition to the registrant and that measuring against total assets may not fully reflect the registrant's current fair value.

Note that, because the aggregate worldwide market value is proposed to be measured at the registrant's most recently completed fiscal year end, without any alternative measurement or lookback period to address fluctuations in equity prices, the aggregate worldwide market value may not reflect the market's reaction to a transaction's announcement.

Income Test
Proposed changes to the income test include:

  CURRENT INVESTMENT TEST PROPOSED INVESTMENT TEST
Comparison Metric

A target’s income from continuing operations before taxes is compared to the registrant’s income from continuing operations before taxes.

Two tests must be met in order to exceed the applicable significance threshold:

  1. The target’s income from continuing operations after taxes compared to the registrant’s income from continuing operations after taxes; and
  2. The target’s revenue compared to the registrant’s revenue.

The lower of the two tests is used to determine significance.

Where a registrant or target does not have recurring annual revenues, only the net income component would apply.

Low Income Year

If the registrant’s income for the most recent fiscal year is at least 10% lower than the average income for the last five fiscal years:

  • use the five-year average for purposes of the income test instead of prior year; and
  • use zero for any loss years for purposes of computing five-year average income.2

 

In these circumstances, the SEC has clarified that, instead of using zero for loss years, the registrant may use the absolute value of any loss in determining the average.

2 The use of zero for loss years is based on SEC guidance and not based on the language of Rule 1-02(w).

By revising the income test to require that the registrant exceed both revenue and net income components when the registrant and the target have recurring annual revenue, the SEC believes the income test would more accurately determine whether a business is significant to the registrant and would reduce the frequency of the anomalous result of immaterial acquisitions being deemed significant.

Use of Pro Forma Financial Information for Testing
Significance is generally determined by comparing the most recent annual consolidated financial statements of the target to those of the registrant filed at or prior to the date of acquisition. However, in certain circumstances, registrants are permitted to use pro forma financial information to measure significance. Under the proposed rules, the SEC would expand the use of pro forma financial statements as follows:

CURRENT RULE PROPOSED RULE

Pro forma financial information can be used if the registrant made a significant acquisition subsequent to the latest fiscal year and previously filed the required pro forma financial information.

Pro forma financial information can be used if the registrant made a significant acquisition or disposition subsequent to the latest fiscal year-end and previously filed the required pro forma financial information.

Note that under the proposed rules registrants may not include “management’s adjustments” (as described below) when using pro forma financial information to determine significance. Rather, the pro forma financial information must be limited to the applicable subtotals that combine the historical financial information of the registrant and the acquired business and “transaction accounting adjustments” (as described below).

Other Considerations
Although the proposed changes clearly impact registrants engaged in M&A activities, if adopted, these changes will also impact other disclosure related to “significant subsidiaries” or that otherwise rely on the significance tests in Rule 1-02(w) to determine the disclosure requirements, including the determination of a registrant’s significant subsidiaries for Exhibit 21 to Form 10-K. In addition, if the proposed amendments are adopted, companies should review any representations regarding significant subsidiaries made by the company in both acquisition and financing agreements, including underwriting agreements and credit documents, with the new tests in mind, to ensure that the representations may be given without qualification with respect to any additional subsidiaries covered under the new tests.

Proposed Amendments to Required Financial Statements
The current requirements for acquisition financials, as well as the proposed changes, are summarized below.

CURRENT FINANCIAL STATEMENT REPORTING REQUIREMENTS

 

Audited

Unaudited

At or below 20%

None

None

Above 20% but below 40%

One Year

Most recent interim period and corresponding prior year period

Above 40% but below 50%

Two Years

Most recent interim period and corresponding prior year period

Above 50%

Three Years

Most recent interim period and corresponding prior year period



PROPOSED FINANCIAL STATEMENT REPORTING REQUIREMENTS

 

Audited

Unaudited

At or below 20%

No change (none)

No change (none)

Above 20% but below 40%

No change (one year)

Most recent interim period (eliminates corresponding prior year period)

Above 40% but below 50%

No change (two years)

No change

Above 50%

Two Years

No change

Most notably, the proposed rules would require the financial statements of the acquired business above 50% significance to cover only the two most recent fiscal years rather than three. The SEC believes that two years of pre-acquisition financial statements would be sufficient to allow investors to understand the possible effects of the acquired business on the registrant. Older financial statements, such as the third year of Rule 3-05 financial statements, are less likely to be indicative of the current financial condition and results of operations of the acquired business.

Note that, should the proposed amendments be adopted, registrants wishing to access the capital markets and needing to reflect an acquisition above 20% but below 40% should consult with their underwriters to determine whether continued inclusion of prior year and interim period financials would be desirable from a marketing point of view and should consult with their auditors to determine whether the elimination of a prior period will have any effect on the comfort letter provided to the underwriters.

Other Proposed Amendments
Proposed Conforming Amendments for Dispositions
The proposed amendments provide certain conforming changes for dispositions, which currently have different rules relative to acquisitions, including:

  • Raising the significance threshold for the disposition of a business from 10% to 20%, the lowest significance threshold for an acquisition; and
  • Conforming the tests used to determine significance of a disposed business to those used to determine significance of an acquired business, as described above.

Carve-Out Financials
Registrants frequently acquire a component of an entity, such as a product line or a line of business that does not constitute a separate entity, subsidiary or division. These businesses may not have separate financial statements or maintain separate and distinct accounts necessary to prepare Rule 3-05 financial statements, and making relevant allocations of the selling entity’s corporate overhead, interest and income tax expenses necessary to provide Rule 3-05 financial statements for the business may be impracticable.

The proposed amendments would allow registrants to provide audited financial statements of assets acquired and liabilities assumed, and statements of revenues and expenses (exclusive of corporate overhead, interest and income tax expenses) if certain requirements are met.

Omission of “Not Previously Filed” and Major Significance Financial Statements

CURRENT RULE PROPOSED RULE

Rule 3-05 financial statements may be omitted once the operating results of the acquired business have been reflected in the financial statements of the registrant for a complete fiscal year, unless the financial statements have not been previously filed or the acquisition is of major significance (i.e., 80%) to the registrant.

Rule 3-05 financial statements may be omitted once the operating results of the acquired business have been reflected in the financial statements of the registrant for a complete fiscal year (eliminates the requirement that Rule 3-05 financial statements be provided when they have not been previously filed or the acquired business is of major significance).

This proposed amendment will be of interest to companies filing IPO registration statements. The “not previously filed” exception requires those registrants to test the significance of acquisitions that occurred during the earliest years for which the registrant is required to provide its historical financial statements and, if significant, to provide pre-acquisition financial statements of the acquired business, regardless of whether the acquired business has been reflected in the registrant’s financial statements for a complete fiscal year. This requirement can often delay a registrant’s offering while providing information that is often less meaningful to investors.

Individually Insignificant Acquisitions
Generally, audited historical financial statements are not required if an acquired business does not exceed 20% significance. However, if the aggregate impact of “individually insignificant businesses” acquired exceeds 50%, certain audited historical financial statements (and related pro forma information) must be filed. The SEC proposes changing the requirements as follows:

CURRENT RULE PROPOSED RULE

Registrants must file audited historical financial statements (and related pro forma information) covering at least the substantial majorityof the businesses acquired.

Registrants must provide audited historical financial statements only for those businesses whose individual significance exceeds 20%.

However, pro forma financial information depicting the aggregate effects of all such acquisitions must be provided.

The SEC believes the proposed amendments would both improve the information provided to investors and reduce burdens on registrants of providing audited historical financial statements for immaterial acquisitions. Preparing disclosure about immaterial acquisitions and negotiating with sellers to timely provide historical financial statements for them can increase the cost of registration and delay access to capital. In addition, requiring pro forma financial information that shows the aggregate effect of the acquired businesses for which financial statements are either not required or not yet required in all material respects rather than only giving effect to a mathematical majority of such businesses, would make it easier for investors to understand the overall effect of those acquisitions on the registrant.

Adjustments Made in Pro Forma Financial Information
The SEC proposes to replace the existing pro forma adjustment criteria because they are not clearly defined nor easily applied and, in practice, can yield inconsistent presentations for similar fact patterns. The existing adjustments also preclude the inclusion of adjustments for the potential effects of post-acquisition actions expected to be taken by management, which can be important to investors. The current requirements for pro forma adjustments, as well as the proposed changes, are summarized below.

CURRENT RULE PROPOSED RULE

Income Statement.
Registrants may only make adjustments to income statements that are:

  • directly attributable to the transaction;
  • expected to have a continuing impact on the registrant; and
  • factually supportable.

 

Balance Sheet.
Registrants may only make adjustments to balance sheets that are directly attributable to the transaction and factually supportable, regardless of whether the impact is expected to be continuing or nonrecurring.

Registrants would be permitted to make adjustments based on two categories, which categories must be presented in separate columns:

Transaction Accounting Adjustments:

  • Income Statement.
    Adjustments to depict the effects of pro forma balance sheet adjustments assuming the adjustments were made as of the beginning of the fiscal year presented; and
  • Balance Sheet.
    Adjustments to depict the required accounting for the transaction required by GAAP (or IFRS-IASB, if applicable).

 

Management’s Adjustments:
Registrants are permitted to reflect adjustments which depict 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.

For each Management’s Adjustment, registrants will be required to disclose:

  • a description, including the material uncertainties, of the synergy or other transaction effects;
  • the underlying material assumptions, the method of calculation, and the estimated time frame for completion;
  • qualitative information necessary to give a fair and balanced presentation of the pro forma financial information;
  • to the extent known, the reportable segments, products, services, and processes involved;
  • the material resources required, if any; and
  • the anticipated timing.

 

Financial Statements for Oil and Gas Producers
The proposed amendments would codify reporting practices historically used in relation to financial statements for acquisitions of a significant business that includes oil and gas producing activities. Specifically, under the proposed amendments:

  • Rule 3-05 financial statements would include the industry-specific disclosures specified in FASB ASC Topic 932 Extractive Activities – Oil and Gas on an unaudited basis for each full year of operations presented for the acquired business; and
  • Rule 3-05 financial statements may be audited statements of revenues and expenses that exclude depletion, depreciation, and amortization expense, corporate overhead expense, income taxes, and interest expense that are not comparable to the proposed future operations if certain conditions are met.

Public Comment Period
The SEC will accept comments on the proposed amendments for 60 days after the proposal is published in the Federal Register.

 

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