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    Locke Lord QuickStudy: SEC Streamlines Financial Statement Requirements for Acquired and Disposed Businesses

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    The SEC has revised its rules that require public companies to disclose financial statements of acquired businesses and to show the pro forma effect of acquired and disposed businesses. The adopting release is available here. The revised rules reflect an effort to make the information presented more useful and less burdensome. Our summary of the SEC’s initial proposal in May 2019 can be found here. Many of the changes, including a reduction in the number of years covered by required financial disclosures and changes to the significance tests, will certainly be welcome. The rules also offer companies an option to present expected synergies in pro forma financial information, but companies that take advantage of this option will want to do so carefully.

    Existing Rules

    Before the amendments, three years of historical audited financial statements of acquired businesses, plus interim periods, were required if any of three significance tests was met at a 50% or greater significance level and if the acquired business had over $100 million in revenue in the prior year. Two years plus interim periods were required at significance levels between 40% and 50%, with one year and interim periods required at significance levels over 20%. The significance tests are sometimes met even though the acquired business was immaterial to investors. The SEC accounting staff has been using its discretion to grant waivers under Rule 3-13 of Regulation S-X where required financial statements are demonstrably immaterial. Under the new rules, the number of years of historical financial statements has been reduced and the significance tests have been changed in ways that are likely to reduce anomalous results.

    Under current rules, pro forma financial information shows adjustments for the application of accounting rules to the specific transaction and for its financing, for example, but is limited to the isolated and objectively measurable effects of the transaction. It may not include estimates of how management decisions may have changed as a result of the transaction and the impact of management actions taken in response to the transaction. (See Section 3210.2 of the Financial Reporting Manual available here.) It thus omits a number of items an investor may want to see in order to understand how the combined company may perform going forward.

    Financial statements may be omitted from registration statements and proxy statements under current rules once they have been reflected in the audited financial statements of a registrant for a complete fiscal year, but only if they have previously been filed and if the acquired business is not of “major significance” to the registrant.

    Significance Tests

    The rules amend the significance tests that are used to determine whether financial statements and/or pro forma financial statements of acquired or disposed businesses are necessary.  Specifically, in the definition of a “significant subsidiary” under Rule 1-02(w) of Regulation S‑K:

    • The “investment test” will now compare investments in and advances to the tested business to the aggregate worldwide market value of the acquiring or disposing company, rather than to its total assets. This addresses the mismatch arising because a business’s purchase price as a reflection of its fair value does not necessarily correspond to the book value of its assets. In the case of a disposition, the “investments in” the business will equal the fair value of the consideration received. Contingent consideration is valued at fair value to the extent it is required to be recognized by US GAAP or IFRS as adopted by the IASB; otherwise, all contingent consideration is included unless the likelihood of payment is remote. The  existing test will remain for contexts other than acquisitions and dispositions, or where an aggregate worldwide market value is not available. 

    • The “income test” will have a new revenue component in order to address anomalous results under the existing rules that often cause financial statements of an otherwise non-material subsidiary to be required because the acquiring or selling company has a near break-even year. The revised income test is met where both the existing income component and the new revenue component exceed the applicable percentage threshold. The rules also clarify that the absolute value of income or loss is used in the calculation, when losses at the parent are compared to profits at the tested subsidiary or vice versa.

    Periods Presented

    No more than two years of audited financial statements will now be required under Rule 3-05 of Regulation S-X. If any of the significance tests exceeds 20%, but none exceeds 40%, then financial statements for only the most recent fiscal year and the most recent interim period are required. In that case, a comparative interim period in the prior year will not be needed. If any of the significance tests exceeds 40%, two years and comparative interim periods are required. For purposes of determining the periods to be presented, the lower of the income component or the revenue component under the income test is used.

    Net Assets that Constitute a Business

    Abbreviated financial statements will be permitted in some circumstances where a company acquires a “business” as defined in Rule 11-01(d) that is not a separate entity, subsidiary, operating segment or division of the selling entity. This can arise with a product line or with a business contained in one or more subsidiaries of the selling entity. Abbreviated financial statements are permitted where such a business constitutes less than 20% of the total assets and total revenues of the selling company and its consolidated subsidiaries, and where the selling entity has not previously prepared financial statements for the business and has not maintained the separate accounts necessary to prepare financial statements for the business. Among other accommodations, (a) the balance sheet may be a statement of assets acquired and liabilities assumed, (b) the income statement may be a statement of revenues and expenses, and (c) corporate overhead, interest expense and income tax expense may be excluded from the income statements under some circumstances.

    Registration Statements and Proxy Statements

    Rule 3-05 financial statements may be omitted from registration statements and proxy statements once the acquired business is reflected in filed post-acquisition financial statements for either nine months (for acquisitions that are at least 20%, but not more than 40%, significant) or for one year (for acquisitions exceeding 40% significance). This is regardless of whether the separate financial statements have been previously filed or whether the acquired company is of major significance.

    Individually Insignificant Businesses

    Acquisitions that are individually insignificant but that exceed 50% significance in the aggregate will no longer require separate audited financial statements for a substantial majority of the acquired businesses. Instead, the acquiring company will need to provide pro forma financial statements showing the aggregate effects of all such individually insignificant businesses in all material respects. In measuring significance under the income test, acquired businesses with profits are measured separately from those with losses, and if either exceed 50% significance, the disclosure requirements apply to all the acquired businesses. The SEC acknowledges that this requirement may require additional work by auditors who are requested to provide negative assurance “comfort letters” to underwriters covering the required pro forma information, where separate financial statements for the businesses have not been reviewed or audited. How audit firms and underwriters will address these issues remains to be seen.

    Pro Forma Financial Statements

    Pro forma balance sheets and income statements prepared under Rule 11-01 of Regulation S-X must be limited to two categories of required adjustments and one category of optional adjustments:

    • Transaction Accounting Adjustments, which are required and which reflect the application of accounting rules to the balance sheet and the effect of those balance sheet adjustments on the income statement assuming the adjustments were made as of the beginning of the fiscal year presented,

    • Autonomous Entity Adjustments, which are required if the registrant was previously part of another entity and which reflect the operations and financial position of the registrant as an autonomous entity, and

    • Management’s Adjustments, which is an optional presentation of the net synergies of the transaction contemplated by the board or management in deciding to make the acquisition or disposition.

    Management’s Adjustments, if any, should be presented in the explanatory notes to the pro forma financial information as a reconciliation of the pro forma net income from continuing operations and the related pro forma earnings per share to the same amounts after giving effect to Management’s Adjustments. Line item specificity is not required. If presented, Management’s Adjustments must present all adjustments necessary in the opinion of management to a fair statement of the pro forma financial information, suggesting that cherry-picking is not permitted. (However, the adopting release does suggest that a company might present cost synergies without revenue synergies with appropriate disclosure.) If positive synergies are presented, any negative synergies such as the expected loss of customers or additional expenses of the combined entity must also be presented. The explanatory notes will need to include a description of material assumptions or uncertainties of each adjustment, how it was calculated, and the estimated time frame for achieving the synergies reflected in the adjustment.

    The inclusion of Management’s Adjustments will require careful thought. These adjustments may provide investors a better understanding of the expected pro forma effect of the transaction, but they are by their nature forward-looking and speculative, even if they should fall within applicable safe harbor rules. Management’s Adjustments that are included in or incorporated by reference into a registration statement, proxy statement or other filing will need to be presented as of the most recent practicable date before the filing’s effective date, mailing date or filing date, as applicable, and so may need to be updated if the information has previously been provided in a Form 8-K that is incorporated by reference. The requirement to include all adjustments necessary to a fair statement of the pro forma financial information, and to include a statement to that effect, combined with the inherently uncertain and speculative nature of synergies expected to be achieved, may cause many companies to approach including these adjustments cautiously.

    The new rules are complex and will require careful attention when public companies acquire or dispose of significant operations and evaluate their related disclosure requirements. In addition to the matters mentioned above, the changes include specific provisions applicable to investment companies, smaller reporting companies, companies relying on Regulation A, acquired real estate operations and businesses that include oil and gas producing activities. In addition, they modify the reconciliation requirements for foreign private issuers and issuers acquiring certain foreign businesses. They also address when pro forma financial information reflecting prior acquisitions or dispositions may be used in applying the significance tests. 

    The changes are effective January 1, 2021, but voluntary adoption before then is permitted.

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