The SEC has proposed rule amendments that revise required financial disclosure upon the acquisition and disposition of businesses in M&A transactions. The proposed changes would, among other things:
- update the significance tests under these rules by revising the investment test and the income test, and conforming the significance threshold and tests for a disposed business;
- require the financial statements of the acquired business to cover up to the two most recent fiscal years rather than up to the three most recent fiscal years;
- permit disclosure of financial statements that omit certain expenses for certain carve-out transactions;
- clarify when financial statements and pro forma financial information are required;
- no longer require separate acquired business financial statements once the business has been included in the registrant’s post-acquisition financial statements for a complete fiscal year; and
- amend the pro forma financial information requirements to improve the content and relevance of such information; more specifically, these improvements would include disclosure of “Transaction Accounting Adjustments,” reflecting the accounting for the transaction; and “Management’s Adjustments,” reflecting reasonably estimable synergies and transaction effects.
When a registrant acquires a business, Rule 3-05 of Regulation S-X generally requires a registrant to provide separate audited annual and unaudited interim pre-acquisition financial statements of the business if it is significant to the registrant (“Rule 3-05 Financial Statements”). Whether an acquisition is significant under Rule 3-05 is determined by applying the investment, asset, and income tests provided in the “significant subsidiary” definition in Rule 1-02(w).
Under the current formulation of the rule, if none of the Rule 3-05 significance tests exceeds 20%, a registrant is not required to file Rule 3-05 Financial Statements. If any of the Rule 3-05 significance tests exceeds 20%, but none exceeds 40%, Rule 3-05 Financial Statements are required for the most recent fiscal year and any required interim periods. If any Rule 3-05 significance test exceeds 40%, but none exceeds 50%, a second fiscal year of Rule 3-05 Financial Statements is required. When at least one Rule 3-05 significance test exceeds 50%, a third fiscal year of Rule 3-05 Financial Statements is required unless net revenues of the acquired business were less than $100 million in its most recent fiscal year. Rule 3-05 Financial Statements are not required 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 the acquisition is of major significance.
An acquisition is considered to be of major significance when the acquired business is of such significance to the registrant that omission of Rule 3-05 Financial Statements would materially impair an investor’s ability to understand the historical financial results of the registrant; for example, if, at the date of acquisition, the acquired business met at least one of the conditions in the significance tests at the 80% level.
Proposed Amendments to Generally Applicable Financial Statement Requirements for Acquired Businesses
The SEC proposes to revise the significance tests related to investments and income to improve their application. The investment test compares the registrant’s investment in and advances to the acquired business to the carrying value of the registrant’s total assets. The SEC proposes to revise the investment test to compare the registrant’s investment in and advances to the acquired business to the aggregate worldwide market value of the registrant’s voting and non-voting common equity (“aggregate worldwide market value”), when available. If the registrant does not have an aggregate worldwide market value, the SEC proposes to retain the existing test.
Currently, the income test focuses on a single component, net income, which can include infrequent expenses, gains, or losses that can distort the determination of relative significance. For registrants with marginal or break-even net income or loss in a recent fiscal year, the use of a net income component by itself can also have the effect of requiring financial statements for acquisitions that otherwise would not be considered material to investors. In these circumstances comparatively small entities may trigger the requirement for Rule 3-05 Financial Statements, which can be costly to prepare.
The SEC proposes to revise the income test by adding a new revenue component and to simplify the calculation of the net income component by using income or loss from continuing operations after income taxes. The SEC expects adding a revenue component would reduce the anomalous results that may occur by relying solely on net income. The SEC believes that this change, along with simplifying these calculations, would reduce complexity and preparation costs without sacrificing material information that investors may need to evaluate these transactions.
Under the proposed amendments, the income test would require that, where the registrant and its consolidated subsidiaries and the tested subsidiary have recurring annual revenue, the tested subsidiary must meet both the new revenue component and the net income component. In this case, the registrant would 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.
Where a registrant or tested subsidiary does not have recurring annual revenues, the revenue component is less likely to produce a meaningful assessment and therefore only the net income component would apply. To reduce inconsistent results in these circumstances, the SEC also proposes revising the income test to use the average of the absolute value of net income when the existing 10% threshold in Computational Note 2 to Rule 1-02(w) is met and the proposed revenue component of the income test does not apply.
The SEC also proposes to revise the net income component calculation so that it is based on income or loss from continuing operations after income taxes. Income tax is a recurring and often material line item. Further, the current calculation, which is based on income from continuing operations before income taxes, may require additional calculations for components of net income that are presented on a post-tax basis with the result that a registrant may not be able to use amounts directly from the financial statements. Instead, the proposed amendments refer to income or loss from continuing operations after income taxes, which would permit a registrant to use line item disclosure from its financial statements, simplifying the determination. The SEC is also proposing to clarify the net income component by inserting a reference to the absolute value of equity in the tested subsidiary’s consolidated income or loss from continuing operations, which the SEC believes will mitigate the potential for misinterpretation that may result from inclusion of a negative amount in the computation.
The SEC proposes to calculate net income and average net income using absolute values. For net income, the SEC believes this modification would serve to clarify that the test applies when a net loss exists, and is to be used when either the tested subsidiary or the registrant, but not both, has a net loss. For average income, the SEC proposal differs from current staff interpretation, which indicates that “zero” should be used for loss years in computing the average. The SEC believes calculating average net income using the absolute value of the loss or income amounts for each year and then calculating the average would make the average income test more indicative of relative significance.
In addition, proposed Rules 3-05(b)(3) and 11-01(b)(3) will also clarify that the Income Test may be determined using the acquired business’s revenues less the expenses permitted to be omitted by proposed Rules 3-05(e) and 3-05(f) if the business meets the conditions in those proposed rules.
Audited Financial Statements for Significant Acquisitions
Currently Rule 3-05 Financial Statements may be required for up to three years depending on the relative significance of the acquired or to be acquired business. The SEC proposes to revise Rule 3-05 to require up to two years depending on the relative significance. Accordingly, the SEC proposes eliminating the requirement to file the third year of Rule 3-05 Financial Statements for an acquisition that exceeds 50% significance.
The SEC also proposes to revise Rule 3-05 for acquisitions where a significance test exceeds 20%, but none exceeds 40%, to require financial statements for the “most recent” interim period specified in Rule 3-01 and 3-02 rather than “any” interim period. This proposed revision would eliminate the need to provide a comparative interim period when only one year of audited Rule 3-05 Financial Statements is required.
Financial Statements for Carve-Out Transactions
Registrants frequently acquire a component of an entity, such as a product line or a line of business contained in more than one subsidiary of the selling entity that is a business as defined in Rule 11-01(d) but 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 because they often represent only a small portion of the selling entity. In these circumstances, 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 SEC proposes to permit 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 conditions are met.
Timing and Terminology of Financial Statement Requirements
The SEC proposes revising Rule 3-05 and Article 11 to clarify when financial statements and pro forma financial information are required, and to update the language to take into account concepts that have developed since adoption of the rules over 30 years ago. Specifically, the proposed amendments would specify that financial statements are required if a business acquisition has occurred during the most recent fiscal year or subsequent interim period for which a balance sheet is required by Rule 3-01 of Regulation S-X, or if a business acquisition has occurred or is probable after the date that the most recent balance sheet has been filed. The SEC also proposes to clarify that Rule 3-05 applies when the fair value option is used in lieu of the equity method to account for an acquisition because the disclosure required by U.S. GAAP on a post-acquisition basis, and related requirements in Rules 4-08(g) and 3-09, includes summarized financial information or separate financial statements of the business after the acquisition.
The SEC further proposes replacing the term “furnish” with “file” throughout Rule 3-05 and Article 11 to make clear that the information required by Rule 3-05 and Article 11 must be filed with the SEC, as the SEC believes that, at the time of adoption, the use of the term “furnished” in Rule 3-05 and Article 11 was not intended to mean that those disclosures were “not filed.”
In addition, Rule 3-05 requires “financial statements prepared and audited in accordance with this regulation.” Consistent with current practice, the proposed amendments to Rule 3-05 would clarify that references to “this regulation” include the independence standards in Rule 2-01 unless the business is not a registrant, in which case the applicable independence standards would apply.
As another clarification, the SEC proposes to replace references to “business combination” with the term “business acquisition” to make clear that Rule 3-05 and Article 11 are not limited to “business combinations” as that term is used in U.S. GAAP and IFRS-IASB. The term “business combination” is defined by reference to the term “business,” which has developed differently under U.S. GAAP and IFRS-IASB from that term as defined in Rule 11-01(d). Because “business acquisition” also encompasses a “combination between entities under common control,” the proposed amendments would also replace this term in Rule 3-05 and Article 11.
Consistent with current practice, the proposed amendments would further provide that a registrant may continue to determine significance using amounts reported in its Form 10-K for the most recent fiscal year when the registrant has filed its Form 10-K after the acquisition consummation date, but before the date the registrant is required to file financial statements of the acquired business on Form 8-K. The SEC proposes to permit rather than require use of the more recent Form 10-K in this circumstance to avoid creating an incentive for registrants to delay the filing of their Form 10-K.
The proposed amendments would also replace the term “majority-owned” as used in Item 2.01 of Form 8-K with the term “subsidiaries consolidated,” as that term more accurately conveys which subsidiaries are required to be included in the registrant’s financial statements.
Omission of Rule 3-05 Financial Statements for Businesses That Have Been Included in the Registrant’s Financial Statements
Current Rule 3-05(b)(4)(iii) generally permits Rule 3-05 Financial Statements to be omitted 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. However, Rule 3-05 Financial Statements are required to be included when they have not been previously filed or when the Rule 3-05 Financial Statements have been previously filed, but the acquired business is of major significance to the registrant.
The SEC is proposing to no longer require Rule 3-05 Financial Statements in registration statements and proxy statements once the acquired business is reflected in filed post-acquisition registrant financial statements for a complete fiscal year. This change would eliminate the requirement that Rule 3-05 Financial Statements be provided when they have not been previously filed or when they have been previously filed but the acquired business is of major significance.
Pro Forma Financial Information
Adjustment Criteria and Presentation Requirements
The pro forma financial information described in Article 11 of Regulation S-X must accompany Rule 3-05 Financial Statements. Pro forma financial information for an acquired business is required at the 20% and 10% significance thresholds under Rule 3-05. The rules also require pro forma financial information for a significant disposed business at a 10% significance threshold for all registrants.
Article 11 provides that the only adjustments that are appropriate in the presentation of the pro forma condensed statement of comprehensive income are those that are:
- directly attributable to the transaction,
- expected to have a continuing impact on the registrant, and
- factually supportable.
The pro forma condensed balance sheet, on the other hand, reflects pro forma adjustments that are directly attributable to the transaction and factually supportable, regardless of whether the impact is expected to be continuing or nonrecurring because the objective of the pro forma balance sheet is to reflect the impact of the transaction on the financial position of the registrant as of the balance sheet date.
The SEC proposes to revise Article 11 by replacing the existing pro forma adjustment criteria with simplified requirements to depict the accounting for the transaction and present the reasonably estimable synergies and other transaction effects that have occurred or are reasonably expected to occur. The proposed adjustments would be broken out into two categories:
- “Transaction Accounting Adjustments”; and
- “Management’s Adjustments.”
Transaction Accounting Adjustments would depict:
- in the pro forma condensed balance sheet, the accounting for the transaction required by U.S. GAAP or IFRS-IASB; and
- in the pro forma condensed income statements, the effects of those pro forma balance sheet adjustments, assuming the adjustments were made as of the beginning of the fiscal year presented.
The Transaction Accounting Adjustments are intended to reflect only the application of required accounting to the acquisition, disposition, or other transaction. The SEC believes the Transaction Accounting Adjustments would link the effects of the acquired business to the registrant’s audited historical financial statements while the Management’s Adjustments would provide flexibility to include forward-looking information that depicts the synergies and other transaction effects identified by management in determining to consummate or integrate the transaction for which pro forma effect is being given.
Management’s Adjustments would be required for and limited to 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 believes it is appropriate to require disclosure of synergies and other transaction effects in these circumstances in order to provide investors insight into the potential effects of the acquisition and the post-acquisition plans expected to be taken by management. Limiting Management’s Adjustments to those that are reasonably estimable and that have occurred or are reasonably expected to occur will serve to define the population of effects subject to inclusion in pro forma financial information. While not all information is appropriate for reflecting an adjustment in the pro forma financial information, some information where the synergies and other transaction effects are not reasonably estimable would still be important to investors. The SEC believes that any information necessary to give a fair and balanced presentation of the pro forma financial information should be provided to investors. Thus, the SEC proposes to require registrants to additionally provide qualitative disclosure of such information in the explanatory notes to the pro forma financial information to further elicit appropriately balanced disclosure.
The SEC also proposes to include presentation requirements for Management’s Adjustments. The presentation requirements would provide that Management’s Adjustments be presented through a separate column in the pro forma financial information after the presentation of the combined historical statements and Transaction Accounting Adjustments. Similarly, 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 the Transaction Accounting Adjustments, and the second column would present the combined historical statements with both the Transaction Accounting Adjustments and Management’s Adjustments.
To clarify the required disclosure in the explanatory notes accompanying the pro forma financial information, the SEC proposes to add requirements based on existing rules, practice, and staff interpretation that would require disclosure of:
- revenues, expenses, gains, and losses, and related tax effects which will not recur in the income of the registrant beyond 12 months after the transaction;
- total consideration transferred or received, including its components and how they were measured. If total consideration includes contingent consideration, the proposed amendments would require disclosure of the arrangement(s), the basis for determining the amount of payment(s) or receipt(s), and an estimate of the range of outcomes (undiscounted) or, if a range cannot be estimated, that fact and the reasons why; and
- information about Transaction Accounting Adjustments when the initial accounting is incomplete.
For each Management’s Adjustment, the SEC proposes to require:
- a description, including the material uncertainties, of the synergy or other transaction effects;
- disclosure of 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; and
- 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 additionally proposes to require that qualitative information necessary for a fair and balanced presentation of the pro forma financial information also be provided.
Significance and Business Dispositions
Rule 11-01(a)(4) provides that pro forma financial information is required upon the disposition or probable disposition of a significant portion of a business either by sale, abandonment, or distribution to shareholders by means of a spin-off, split-up, or split-off, if that disposition is not fully reflected in the financial statements of the registrant. Rule 1-02(w) uses a 10% significance threshold, not the 20% threshold used for business acquisitions under Rules 3-05 and 11-01(b). When a registrant determines that it has an acquisition or disposition of a significant amount of assets that do not constitute a business, Item 2.01 of Form 8-K uses a 10% threshold for both acquisitions and dispositions to require disclosure of certain details of the transaction.
The SEC proposes revising Rule 11-01(b) to raise the significance threshold for the disposition of a business from 10% to 20%, to conform to the threshold at which an acquired business is significant under Rule 3-05. The SEC also proposes conforming, to the extent applicable, the tests used to determine significance of a disposed business to those used to determine significance of an acquired business. This change would be consistent with the symmetrical treatment in Form 8-K provided to acquisitions and dispositions of assets that do not constitute a business.