On May 21, 2020, the Securities and Exchange Commission announced it has adopted amendments to the rules for financial statement disclosure requirements in connection with the acquisition or disposition of a business.
The new rules change two of the three significance tests used to determine whether a company is required to disclose financial statements of an acquired business (which we refer to as a target) and the related pro forma financial statements and whether a company is required to disclose pro forma financial statements in connection with a disposition, reduce the maximum number of years of target financial statements to two years from three years and raise the significance threshold for dispositions, among other changes. These amendments are expected to improve the information that investors receive regarding the acquisition and disposition of businesses and to reduce complexity and compliance costs.
While the new rules are mandatory only for fiscal years beginning after December 31, 2020, companies are permitted to immediately elect voluntary early compliance with the new rules, provided that the new rules are applied in their entirety. We expect most companies to elect voluntary early compliance. We also expect market participants to apply the new rules to unregistered securities offerings made pursuant to Rule 144A that are not technically subject to these financial statement disclosure requirements.
Significance Tests. Target financial statements and related pro forma financial statements are required to be filed with the SEC in connection with an acquisition depending on the significance of the target acquisition to the acquiring company. Significance is measured using the following three tests: the investment test, the asset test and the income test. Target and pro forma financial statements are required if any one of these three tests is triggered. Each of the tests is calculated as a percentage based on the fractions presented below using the relevant amounts in the most recent annual financial statements. These tests are also used for evaluating the significance of dispositions. See “Dispositions” below.
As amended, the three tests operate as follows:
- Periods Required. The financial periods for which target financial statements will be required to be included in an SEC filing depends on the highest significance level determined under any one of the three tests described above, with the lower of the pre-tax earnings and revenue components of the income test used for this purpose in the case of the income test.Investment Test. The worldwide market value of common equity of the acquiring company is determined by averaging the last five trading days of the acquiring company’s most recently completed month prior to the earlier of the announcement date or agreement date of the acquisition or disposition. The acquiring company’s aggregate worldwide market value of common equity includes the value of common equity held by affiliates, which is different from the “public float” tests used to determine large accelerated filer or WKSI status. If the acquiring company has no publicly traded common equity anywhere in the world, total assets of the acquiring company is used instead for the denominator in the investment test.
- Asset Test. The asset test is unchanged by the new rules.
- Income Test. The income test includes two components – one that compares income from continuing operations before income taxes attributable to the controlling interests (so after amounts attributable to minority interests in subsidiaries), or pre-tax earnings, and one that compares total revenue. The acquisition or disposition has to meet both the pre-tax earnings and revenue components of the test, and the lower of the percentages resulting from the components is used to determine the number of financial periods for which financial statements are required. If either the acquiring company or the target did not have material revenue in each of the two most recent fiscal years, the revenue component does not apply. When only the pre-tax earnings component is used for the income test, the average of the absolute values of the acquiring company’s pre-tax earnings or loss over the last five fiscal years may have to be used in the denominator. This is the case where the absolute value of the acquiring company’s pre-tax earnings or loss for the latest fiscal year is at least 10% lower than that average.
In addition, if target financial statements are required then the following are also required:
- a pro forma balance sheet as of the end of the acquiring company’s most recently completed fiscal period for which a balance sheet is required (unless the transaction is already included in the historical balance sheet), and
- a pro forma income statement for the last audited fiscal year and most recent interim period.
See “Pro Forma Financial Statements” below.
50% Significance. Significance in excess of 50% no longer requires the inclusion of three years of audited target financial statements, as it did under the prior rules. The 50% threshold, however, remains relevant for other purposes. A significant acquisition by a U.S. domestic issuer typically triggers a Form 8-K to be filed with the target and pro forma financial statements within approximately 74 days of closing. Technically, securities offerings within this 74-day period are not required to include such financial statements, but they often are included due to materiality considerations. If, however, significance exceeds 50% under any one of the three tests, then target and pro forma financial statements must be included in a registration statement even if the acquisition has not yet closed but is probable or if the acquisition closed only within the 74-day period prior to the date of the required Form 8-K filing. In addition, after an acquisition with greater than 50% significance has closed, securities cannot be offered under already effective shelf registration statements unless target and pro forma financial statements are included, except for secondary offerings or the issuance of securities under outstanding convertible securities or warrants.
Individually Insignificant Acquisitions. The new rules, largely similar to the prior ones, require that the following acquisitions be aggregated:
- separate acquisitions after the date of the most recent audited balance sheet that do not exceed 20% significance individually and therefore do not trigger financial statements, and
- any acquisitions that are significant in excess of 20% but are only probable or which only closed during the past 74 days but do not exceed 50% significance and therefore do not trigger financial statements yet.
The new rules aggregate as “individually insignificant acquisitions” all transactions that are below the 20% significance threshold and to transactions that exceed the 20% threshold, but do not trigger the need to file target financial statements because they have not yet closed, or have closed only recently within the 74-day period prior to the filing. Under the new rules, if all of the “individually insignificant acquisitions” taken together exceed 50% significance, audited historical financial statements are only required for those target businesses whose individual significance exceeds 20%.
In addition, the new rules mandate that the pro forma financial statements reflect the aggregate effects of all “individually insignificant acquisitions” in all material respects. Pro forma financial statements for “individually insignificant acquisitions” may therefore be required even if none of the underlying target financial statements must be audited and filed. It is unclear what additional procedures a company’s auditors will need to perform on the underlying unaudited and unreviewed target financial statements when they prepare pro forma financial statements that rely on this information, particularly when they will be asked to cover these pro forma financial statements in a comfort letter when used in a securities offering.
Use of Pro Forma Financial Statements to Determine Significance. As an alternative to using the annual financial statements in their most recent Form 10-K or Form 20-F for the three tests, acquiring companies that have completed significant acquisitions and dispositions after the latest fiscal year-end for which pro forma financial statements have been filed may now use such pro forma financial statements as the basis to determine significance of a new transaction provided that the company continues to use such pro forma financial statements to measure significance until its next annual report. In this respect the new rules largely codify existing SEC staff guidance on the topic but provide some incremental flexibility.
Net Assets and Revenues That Constitute a “Business”. It can be difficult to produce full financial statements for a target component of a selling entity, such as a target product line or a line of business contained in more than one subsidiary of the selling entity, which does not constitute a separate entity, subsidiary, operating segment or division and for which the seller has not maintained separate and distinct accounts. In these situations, the new rules permit acquiring companies to present abbreviated statements of assets acquired and liabilities assumed and statements of comprehensive income that reflect revenues and certain expenses, together with certain additional disclosures. The conditions include that the total assets and total revenues of the target product line or line of business constitute 20% or less of such corresponding amounts of the seller as of and for the most recent fiscal year. The statement of comprehensive income must include expenses incurred by or on behalf of the target product line or line of business during the pre-acquisition periods (including costs of sales, SG&A, depreciation and amortization and R&D), but may otherwise omit corporate overhead expense. It may also omit interest expense on debt that will not be assumed and income tax expense. If the target product line or business exceeds the 20% threshold, the acquiring company is expected to produce full “carve-out” target financial statements that, among other things, allocate corporate overhead expense, but may seek relief from the SEC staff if doing so would present unique challenges.
Omission of Target Financial Statements. Under the new rules, target financial statements are no longer required to be included once the results of the target have been included in the acquiring company’s audited financial statements for a complete fiscal year (at significance in excess of 40%) or for at least nine months (at significance greater than 20% but not in excess of 40%). The ability to omit target financial statements no longer depends on whether such statements have previously been filed or on whether the acquisition is not of “major significance.” The 80% significance threshold previously used to determine “major significance” is therefore no longer relevant.
Pro Forma Financial Statements
Pro forma financial statements reflect the impact of an acquisition or disposition on the historical financial statements of the acquiring company (in the case of an acquisition) or disposing company (in the case of a disposition) as if the relevant transaction had occurred as of the most recent balance sheet date (in the case of the balance sheet) or at the beginning of the earliest period(s) covered by the pro forma income statement (in the case of the income statement).
The new rules replace the existing pro forma adjustment criteria with simplified requirements. Specifically, the new rules contemplate three categories of adjustments that are made to the historical amounts:
- “Transaction Accounting Adjustments,” which are adjustments to reflect the accounting for the transaction,
- “Autonomous Entity Adjustments,” which are adjustments to reflect the operations and financial position of the target entity as an autonomous entity when such entity was previously part of another entity (as in the case of a carve-out), and
- “Management’s Adjustments,” which are adjustments to reflect reasonably estimable synergies and dis-synergies of the transaction.
Management’s Adjustments can be used in the company’s discretion if, in management’s opinion, such adjustments would enhance an understanding of the pro forma effects of the transaction. If Management’s Adjustments are used, they must be presented in a separate column in the pro forma financial statements to the right of the column that presents Transaction Accounting Adjustments and Autonomous Entity Adjustments (if any). Each Management’s Adjustment must have a reasonable basis must be limited to the effect of synergies and dis-synergies on the existing financial statements that form the basis for the pro forma income statement as if the synergies and dis-synergies existed as of the beginning of the fiscal year presented. If Management’s Adjustments are being used, the pro forma financial statements must reflect all Management’s Adjustments that are, in the opinion of management, necessary to a fair statement of the pro forma financial statements presented and a statement to that effect must be disclosed. In addition, when synergies are presented, any related dis-synergies must also be presented. The new rules also contain detailed requirements for the presentation format to be used for Management’s Adjustments, including explanatory notes and reconciliations and the disclosure of material limitations, assumptions and uncertainties as well as the timeframe for achieving the synergies.
It will be interesting to see to what extent companies will avail themselves of the increased flexibility in the presentation of synergies in pro forma financial statements. Following a number of comments on the original rule proposal from last year, the SEC decided to make the use of Management’s Adjustments optional rather than mandatory. The SEC declined to create a new safe harbor for forward-looking information used in Management’s Adjustments (such as synergies), but did expressly bring those adjustments within the scope of certain (but not all) existing safe harbors for forward-looking statements. Companies electing to present estimated synergies in the pro forma financial statements through Management’s Adjustments, rather than in MD&A or in press releases or other non-filed communications will need to keep mind that the new rules expressly require those estimates to be updated when the relevant pro forma financial statements are subsequently incorporated into a registration statement or other filing. Also, when companies rely on pro forma financial statements for the significance tests described above, Autonomous Entity Adjustments and Management’s Adjustments must be excluded.
The SEC’s rules require the presentation of pro forma financial statements for significant dispositions that are probable or have been consummated but have not yet been reflected in the disposing company’s audited annual financial statements as discontinued operations. The amendments raise the significance threshold for dispositions to 20% from 10%, which brings it in line with the significance threshold for acquisitions.
As a reminder, U.S. domestic issuers must file pro forma financial statements in connection with significant dispositions on a Form 8-K within four business days of the consummation of the significant disposition. A requirement to file pro forma financial statements is also triggered by the filing of a registration statement when such a disposition has closed or becomes probable. As a matter of market practice, pro forma financial statements may also be included in connection with an offering under an already effective shelf registration statement.
What remains unchanged by the amendments is the number of periods that need to be presented in the pro forma income statement for a significant disposition. If the disposition is required to be accounted for as discontinued operations, as is often the case, the pro forma income statement generally needs to be presented for the past three years (two years in the case of emerging growth companies or smaller reporting companies) and the most recent interim period. This has long been an SEC staff position, and the amendments codify this into the text of the new rules.
For smaller reporting companies, the amendments require that the preparation, presentation and disclosure of pro forma financial statements substantially comply with the rules applicable to other public companies. This will require smaller reporting companies to provide pro forma financial statements not only for significant acquisitions, as was the case under the prior rules, but also for significant dispositions and certain other transactions.
The new rules also effect a number of other changes. They codify existing SEC guidance applicable to acquisitions of a business that includes significant oil and gas producing activities. With respect to real estate operations, the new rules align the corresponding special requirements with those governing target financial statements for other companies where no unique industry considerations exist and also make certain other changes. In connection with foreign acquisitions, the new rules allow target financial statements to be prepared in accordance with IFRS-IASB without any reconciliations not only if the target meets the definition of “foreign business,” but also if the target would qualify to use IFRS-IASB if it were itself an SEC reporting company. Foreign private issuers that use IFRS-IASB would be able to reconcile home country GAAP target financial statements to IFRS-IASB rather than U.S. GAAP.
Many of the changes effected by the amendments apply not only to financial statements required in connection with significant acquisitions and dispositions, but also to the definition of “significant subsidiary” and to the financial statement requirements for significant equity investees. For those purposes, however, the new rules retain the use of total assets in the denominator of the investment test and do not apply the worldwide market value of the registrant’s common equity. This was done to avoid a mismatch when evaluating the significance of subsidiaries and equity method investees because the company’s investments may not be equivalent to fair value when the investment is not newly acquired.
Companies will not be required to apply the new rules until the beginning of their fiscal years beginning after December 31, 2020. Acquisitions or dispositions that are probable or consummated after this mandatory compliance date must be evaluated for significance using the new rules. IPO companies are not required to apply the new rules until an initial registration statement is first filed on or after the mandatory compliance date. For initial registration statements first filed on or after the mandatory compliance date, all probable or consummated acquisitions and dispositions, include those consummated prior to the mandatory compliance date, must be evaluated for significance using the final amendments.
Voluntary early compliance with the new rules is expressly permitted in advance of the mandatory compliance date provided that the new rules are applied in their entirety from the date of early compliance. For an acquisition or disposition for which a company has filed (or was required to file) a Form 8-K under Item 2.01 in connection with the closing of the transaction prior to the mandatory compliance date (or voluntary early compliance date, if applicable), but for which the target and pro forma financial statements are not required to be filed in an amendment to the initial Form 8-K until after the mandatory or early compliance date, as the case may be, the required target and pro forma financial statements will be governed by the rules in effect when the closing Form 8-K was required to be filed.
We expect that most companies will elect voluntary early compliance with the new rules. The ability to use the worldwide market value of common equity of an acquiring company as the denominator in the investment test and to rely on total revenue as an additional component of the income test should enable companies to avoid having to file target and pro forma financial statements for acquisitions that are not truly significant to their business.
There could be special circumstances, however, where companies decide that continuing to use the prior rules until the mandatory compliance date is advantageous, such as in the case of individually significant acquisitions or in the case of significant dispositions by smaller reporting companies.