Final Amendments to M&A Financial Statement Disclosures Adopted by SEC

June.08.2020

Executive Summary. On May 21, 2020, the Securities and Exchange Commission (SEC) adopted amendments to the current rules that require public companies to disclose financial information on significant acquisitions and divestitures of businesses. The final amendments take effect on January 1, 2021 and include:

  • Updates to the significance tests used under Rule 1-02(w) and other SEC rules by:

    • revising the investment test, as applied to acquisitions and dispositions, to compare the registrant’s investments in and advances to the acquired or disposed business to the registrant’s aggregate worldwide market value;
    • adding a revenue element to the income test that also must be met if the registrant and the target business have “material revenue”;
    • expanding the use of pro forma financial information in measuring significance; and
    • conforming, to the extent applicable, the significance tests and thresholds for disposed businesses to those used for acquired businesses.

  • Changing filing requirements for acquired business financial statements to cover no more than the two most recent fiscal years (instead of the current three).
  • Permitting “abbreviated” financial statements that omit certain expenses for certain acquisitions of a component of an entity.
  • Amending the pro forma financial information requirements to enhance the content and relevance of information, including the inclusion of additional columns for “Transaction Accounting Adjustments,” “Autonomous Entity Adjustments” (if the registrant was previously part of another entity) and an optional “Management Adjustments” column to show synergies (or dis-synergies).

Registrants will not be required to apply the final amendments until the beginning of their fiscal year beginning after December 31, 2020. Acquisitions and dispositions that are probable or consummated after December 31, 2020 must be evaluated for significance using the final amendments. For IPO companies and other first-time registrants, companies are not required to apply the final amendments until the initial registration statement is first filed on or after December 31, 2020, at which point all probable or consummated acquisitions and dispositions, including those consummated prior to December 31, 2020, must be evaluated for significance in accordance with the final amendments.

Voluntary early compliance is permitted in advance of the registrant’s mandatory compliance date but only if the final amendments are applied in their entirety from the date of early compliance.

Introduction. The new amendments were adopted to improve the financial information about acquired or disposed businesses for investors, facilitate more timely access to capital, and reduce the complexity and costs to prepare the disclosure. They also provide clarity on when and how M&A-related financial statement disclosure is required.

Background. Under Rule 3-05 of Regulation S-X, acquiring companies currently must provide separate audited annual and unaudited interim pre-acquisition historical financial statements of a “significant” acquired business, with the number of years required determined by the relative significance of the acquisition above a 20% threshold. Significance is measured under the framework provided by Rule 1-02(w), which includes 1) an “investment test,” comparing the total GAAP sale or purchase price of the acquired business (as adjusted) to the registrant’s consolidated total assets, and 2) an “income test,” comparing equity in the acquired or disposed business’ income from continuing operations before taxes, extraordinary items and the cumulative effect of a change in accounting principle to that of the registrant. Article 11 of Regulation S-X applies to pro forma financial statements and requires the registrant to file unaudited pro forma financial information regarding the acquisition or disposition, including adjustments that show how the acquisition or disposition might have affected the historical financial statements.

Significance Tests. The final amendments revise two of the three significance tests (the investment test and the income test) under Rule 1-02(w).[1] Below is a comparison of the current tests and the impact of the final amendments. Note that the final amendments to the “significance” test in Rule 1-02(w) have relevance outside of the M&A context, such as to the determination of whether a registrant’s subsidiary is a “significant subsidiary.”

Significance Test Current Rule New Rule (effective Jan. 2021)

Investment Test

Compares (i) the registrant’s investments in, and advances to, the acquired business with (ii) the total assets of the registrant reflected in its most recent annual financial statements required to be filed at or prior to the acquisition date.

Compares, with respect to acquisitions or dispositions, (i) the registrant’s investments in and advances to the target business with (ii) the aggregate worldwide market value of the registrant’s voting and non-voting common equity securities, when available.

The worldwide market value of common equity of the registrant is determined by averaging the last five trading days of the registrant’s most recently completed month prior to the earlier of the announcement date or agreement date of the acquisition or disposition.[2]

Income Test

Compares (i) the registrant’s equity in the income from continuing operations of the acquired business before income taxes (excluding amounts attributable to any noncontrolling interests), as reflected in the registrant’s most recent annual pre-acquisition financial statements, with (ii) the same measure reflected in the registrant’s most recent annual financial statements required to be filed at or prior to the acquisition date.

Addition of revenue component. The target business must meet both the revenue component (when the revenue component applies) and the net income component. For purposes of application of Rule 3-05, the registrant 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 apply unless either the registrant (with its consolidated subsidiaries ) or the target business did not have material revenues in each of the two most recently completed fiscal years. If the revenue component does not apply, then only the net income component is used to determine significance.


Number of Years Required to Be Presented.

Significance Level Financial Information Requirement

<20%

Rule 3-05 financial statements are not required.

Between 20% and 40%

One year of audited financial statements and unaudited financial statements for the most recent interim period without the need to provide interim financial statements for the corresponding prior year interim period.[3]

>40%

Two years of audited financial statements and unaudited financial statements for the most recent interim period and the corresponding prior year interim period (reduced from three years under the current rule for acquisitions exceeding the 50% significance level).

 

Registrants also may omit historical financial statements from registration statements and proxy statements for businesses that (i) are between 20% and 40% significance after results from the target business have been included in at least nine months of reported financial results and (ii) exceed 40% significance, once the business has been included in the registrant’s post-acquisition results for a complete fiscal year.

“Carve-out” Acquisitions. Where the acquisition is of a “component,” such as a product line or a line of business crossing more than one subsidiary or division, but constitutes a “business” as defined in Rule 11-01(d), sometimes referred to as a “carve-out” transaction, the final amendments allow companies to provide audited (unaudited for interim periods), 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. To provide the audited abbreviated financial statements:

  • the target business must constitute less than substantially all of the assets and liabilities of the target and should not have been a separate entity, subsidiary, segment or division of the target during the periods for which the acquired business’ financial statements would be required;
  • separate financial statements for the target business were not previously prepared; and
  • the target has not maintained distinct and separate accounts necessary to present financial statements that include the omitted expenses and it is otherwise impracticable to prepare such financial statements.

Omission of Financial Statements. Currently, financial statements under Rule 3-05 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 registrant for a complete fiscal year, unless the financial statements have not been previously filed or, when previously filed, the acquired business exceeds the 50% significance level.

Under the final amendments, financial statements will no longer be required in registration statements and proxy statements for businesses at the 20-40% significance level once they are included in the registrant’s audited post-acquisition results for nine months. For businesses that exceed the 40% significance level, omission of pre-acquisition financial statements is permitted once they have been included in the registrant’s post-acquisition results for a complete fiscal year. 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 has been eliminated.

Use of Pro Formas for Significance Test. Currently, a registrant may use pro forma (rather than historical) financial information for significance testing if the registrant has made a significant acquisition subsequent to the last completed fiscal year-end and filed the financial statements required by Rule 3-05 and pro forma financial information on a current report on Form 8-K. The final amendments expand the circumstances in which a registrant can use pro forma financial information for significance testing, allowing companies, for filings that require financial statements under Rule 3-05, to measure significance using filed pro forma financial information that only depicts significant business acquisitions and dispositions consummated after the most recently completed fiscal year-end for which the registrant’s financial statements are required to be filed. Certain conditions apply, including that the registrant filed the financial statements required by Rule 3-05 for the acquired business and filed the pro formas for the acquired or disposed business. Once a registrant uses pro forma financial information to measure significance, it must continue to do so until the filing of its next annual report on Form 10-K or Form 20-F.

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 registrant and the acquired or disposed business. These pro forma statements 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 point in time. In addition, the existing pro forma adjustment criteria preclude the inclusion of most adjustments for the potential effects of post-acquisition actions expected to be taken by management (i.e., potential synergies or dis-synergies).

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 reflect synergies and dis-synergies. There are three categories of pro forma adjustment criteria:

Transaction Accounting Adjustments. These mandatory adjustments apply 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. These mandatory adjustments 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. These optional adjustments can be used in the registrant’s discretion if, in management’s opinion, such adjustments would enhance an investor’s understanding of the pro forma effects of the transaction. If used, such Management’s Adjustments must:

  • be presented in the explanatory notes to the pro forma financial statements;
  • have a reasonable basis;
  • 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;
  • with regard to pro forma financial statements, 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; and
  • when synergies are presented, any related dis-synergies must also be presented.

The new rules also contain detailed requirements for the presentation format of Management’s Adjustments, including explanatory notes and reconciliations, the disclosure of material limitations, assumptions and uncertainties, as well as the timeframe for achieving the synergies. Registrants may hesitate to provide optional Management’s Adjustments however, given the sensitivity and uncertainty of their forward-looking nature, unless they are important in gaining investor support for a transaction.

Other. The following are summaries of certain additional provisions updated by the final amendments:

  • Enhance required disclosure for the aggregate effect of acquisitions for which financial statements are not required or not yet required by eliminating the disclosure of historical financial statements for insignificant businesses and expanding the pro forma financial information to depict the aggregate effect of acquisitions.
  • Permit the use of (or reconciliation to) International Financial Reporting Standards issued by the International Accounting Standards Board (IFRS-IASB) for the financial statements presented in certain limited circumstances.
  • No longer require presentation of separate acquired business financial statements once the business has been included in the registrant’s post-acquisition financial statements for nine months or a complete fiscal year, depending on the level of significance. This change is particularly helpful to foreign private issuers and IPO companies.
  • For smaller reporting companies, the preparation, presentation and disclosure of pro forma financial statements must 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.

[1] While the SEC did not propose to amend the third test under Rule 1-02(w), the assets test, the final amendments provide that, when computing the assets test for acquisitions, intercompany transactions with the acquired business must be eliminated from the registrant’s consolidated total assets.

[2] The registrant’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.

[3] The adopting release includes a reminder that if trends depicted in Rule 3-05 financial statements are not indicative or are otherwise incomplete, registrants are required by Rule 4-01(a) to provide additional material information as necessary to make the required statements, in light of the circumstances under which they are made, not misleading.