In May 2019, the Securities and Exchange Commission (“SEC”) issued proposed amendments to financial disclosure requirements relating to the financial statements of acquired businesses (or business that will be acquired) and business dispositions. Through proposed amendments to Rules 3-05, 3-14 and Article 11 of Regulation S-X, the SEC intends to (i) improve the financial information provided to investors relating to acquired and disposed businesses, (ii) facilitate more timely access to capital and (iii) reduce the complexity and costs of preparing the disclosures. The proposed amendments are subject to a 60-day public comment period, with all comments due to the SEC on or before July 29, 2019.
The proposed amendments are complex and contain numerous specific features that merit careful study if relevant to your situation. We have narrowed the scope of this article to a review of changes relevant to determining if pro forma financial statements are required in connection with a potential transaction.
When a registrant is acquiring a business, both (i) historical financial information about the target and (ii) pro forma financial information about the combined business, may be relevant to the public. Likewise, when a registrant is selling a business, pro forma financial information showing the effects of the sale may be relevant to the public. Regulation S-X sets forth the rules relevant to the disclosure of historical financial information of a target company and the pro forma financial information of the combined business for all registered security offerings. Regulation S-X is also commonly used for an issuer’s financial presentation when selling privately-placed securities, including in Rule 144A offerings.
In order to determine the financial information that must be disclosed under Regulation S-X, a registrant must initially determine if the potential transaction involves the acquisition of a “significant” business. To determine if the acquired business (the “Target Business”) is significant, Regulation S-X Rule 1-02(w) provides three tests: the Asset Test, the Investment Test and the Income Test (the “Significance Tests”).
Generally, the Asset Test is calculated by dividing the issuer’s proportionate interest in the total assets of the Target Business by the issuer’s total assets as of the end of the most recent fiscal year. The Investment Test generally measures the issuer’s investments in, and advances to, the Target Business (e.g. the purchase price) divided by the sum of the issuer’s total assets as of the end of the most recent completed fiscal year. The Income Test generally measures the issuer’s proportionate interest in the total income from continuing operations of the Target Business divided by the issuer’s total income from continuing operations as of the end of its most recent fiscal year.
Historical Financial Statements
Under Rule 3-05 of Regulation S-X, the historical financial statements of the Target Business that must be presented will vary depending of the level significance resulting from the Significance Tests. At best, no historical financial statements of the Target Business may be required. At worst, three years of audited income and cash flow statements and two years of audited balance sheets, together with unaudited interim financial statements may be required.
Pro-forma Financial Statements
Under Article 11 of Regulation S-X, a reporting company must also file unaudited pro forma financial statements for business acquisitions and dispositions based on historical financial statements of the registrant and the acquired or disposed business, which is intended to show how the acquisition or disposition will affect the registrant. The pro forma financial statements generally include a pro forma balance sheet as of the most recent balance sheet date and a pro forma income statement as of the most recent fiscal year and any subsequent interim period.
The proposed amendments would:
- Revise the Investment Test to compare the issuer’s investments in, and advances to, the acquired business to the aggregate worldwide market value of the issuer’s voting and non-voting common equity, instead of its total assets;
- Revise the Income Test by adding a new revenue component to the income component, and the calculation of income would be simplified by using income or loss from continuing operations after income taxes;
- Expand the use of pro forma financial information to determine significance to allow issuers to measure significance using filed pro forma financial information that depicts significant business acquisitions consummated after the prior fiscal year end;
- Increase the significance threshold for dispositions from 10% to 20%;
- Shorten the period of financial statements presentation of a Target Business to a maximum of two years; and
- Eliminate any requirement for financial statements of a Target Business after the acquisition has been reflected for a complete fiscal year regardless of significance.
The chart below compares some of the key differences between the current reporting obligations under Rule 3-05 and Article 11 of Regulation S-X and the SEC’s proposed amendments.
Current Rules and Proposed Rules