SEC Updates Financial Disclosure Requirements for Acquisitions and Dispositions
On May 21, the SEC amended the disclosures required for business acquisitions and dispositions. The new amendments will be effective January 1, 2021; however, companies are permitted to comply with the changes earlier. The changes are intended to improve the financial information related to acquired or disposed businesses, facilitate more timely access to capital, and reduce the complexity and costs to prepare the required disclosures. The changes outlined below will affect reporting for a broad range of transactions.
These sweeping changes to SEC rules that have been in place for decades are intended to reduce a transaction-active organization’s financial reporting burdens going forward. The changes have clarified guidance across industries to add consistency in what is determined to be significant with less SEC pre-clearance. Pro forma financial statements will increase transparency of the acquired businesses and afford companies additional flexibility in what and how to disclose possibly synergies that will add insight to investors on the future outlook on the combined business.
What changed and why it matters
Modification of the significance test
When a registrant acquires a business, Rule 3-05 of Regulation S-X generally requires the disclosure of separate audited annual and unaudited interim pre-acquisition financial statements if the business is significant to the registrant. Significance is evaluated by applying three tests: an investment test, an income test and an asset test. Here is how the approved Rule modifies each test.
- Income test: The previous formula evaluates significance by comparing the income from continuing operations before taxes, extraordinary items, and cumulative effects of changes in accounting principles of the target and the registrant. The new income test allows for an assessment of significance using the lower of two components: one based on consolidated total revenue and one based on pre-tax income or loss from continuing operations attributable to controlling interests.
- Investment test: The new test compares the investment in the acquired business to the aggregate worldwide market value (AWMV) of the registrant instead of the registrant’s total assets. If aggregate market value is not available, the calculation will revert to total assets, which is consistent to the previous test.
- Asset test: No change; the test continues to be total assets of the target divided by the total assets of the registrant.
RIVERON POINT OF VIEW
The change to the investment test could lower the amount of significant acquisitions. Companies with significant assets, however, whose market cap might be smaller relative to the acquired assets, such as highly levered companies, might have additional reporting requirements. The changes to the income test could also lower the amount of significant acquisitions, particularly in break-even scenarios. The addition of a revenue component to the income test will reduce the need to request relief under Rule 3-13 caused by situations when the current income test results in a significance determination that would not be material to investors due to the variability of expenses in a given period.
Changes to financial statements required to be included
The SEC has made several changes to the financial statements required to be included under Rule 3-05. The changes are intended to refresh decades old guidance and facilitate more efficient capital markets activity. Here is how the approved Rule will modify the financial statements to be included.
RIVERON POINT OF VIEW
These changes will likely soften the reporting burden by reducing the required financial information to be disclosed and will eliminate information that is no longer relevant, allowing investors to focus on the most relevant and material results. The common challenge to prepare Rule 3-05 financial information for earlier years will be reduced as a result of this change. The combination of the amended guidance may simplify the IPO track for registrants that have previously acquired a company in preparation for their IPO.
- Reduction in required years of financial statements: Historically, three years of audited financial statements and the associated interim periods were required for acquisitions where any of the three significance tests produced a result greater than 50%. Under the new rules, a maximum of two years of audited financial statements will be required.
- Reduction in unaudited interim financial statements: Unaudited financial statements will only be required for the most recent interim period when only one year of audited Rule 3-05 financial statements are required. A corresponding comparative period will only be needed when two years of financial statements are needed.
- Registration statement relief: When an acquired business has been included in the post-acquisition financial statements of a registrant for nine months and the acquired business exceeds 20% but less than 40% significance, the pre-acquisition financial statements may be omitted. For acquisitions exceeding 40% significance, the registrant may omit the pre-acquisition financial statements when included in the registrant’s post-acquisition financial statements for a complete fiscal year.
- Increase to disposal significance: The new rules increase the significance threshold to 20% percent (previously 10 percent) to mirror the acquisition rules.
- Additional criteria to utilize abbreviated financial statements: Registrants who meet certain qualifications may file abbreviated financial statements. Abreviated financial statements allow the registrant to issue abridged versions of the balance sheet, income statement, statement of comprehensive income as well as certain expanded disclosures explaining the abbreviated components of the business if the following criteria are met:
- The total assets and total revenues (both after intercompany eliminations) of the acquired or to-be acquired business constitute 20 percent or less of such corresponding amounts of the seller and its subsidiaries consolidated as of and for the most recently completed fiscal year.
- The acquired business was not a separate entity, subsidiary, operating segment (as defined in US GAAP or IFRS-IASB, as applicable), or division during the periods for which the acquired business financial statements would be required
- Separate financial statements for the business have not previously been prepared; and
- The seller has not maintained the separate accounts necessary to present financial statements that include the omitted expenses, and it is impracticable to prepare such financial statements.
RIVERON POINT OF VIEW
This accommodation was, at times, applied in oil and gas producing activities historically, but is now expected to be applied in many industries if the criteria are met. It will be interesting to see how management teams interpret the impracticability aspect that could be viewed as a high bar to get around in practice as carve-out Rule 3-05 financial statements are possible in many cases, but are time consuming and expensive to produce.
Changes to pro forma financial information
Pro forma financial information is required in connection with a significant acquisition or divestiture and is intended to provide stakeholders with the impact of the transaction on historical financial data. The SEC has revised the existing pro forma adjstument criteria with more simplified requirements to depict the accounting for the transaction and to provide the option to depict synergies or dis-synergies. Pro forma adjustments will now be classified into three categories: transaction accounting adjustments, autonomous entity adjustments, and management adjustments.
- Transaction Accounting Adjustments (required): These reflect only the application of required accounting to the acquisition, disposition, or other transaction linking the effects of the acquired business to the registrant’s audited historical financial statements. These adjustments require the registrant to include (i) a pro forma condensed balance sheet accounting for the transaction required by US GAAP or IFRS-IASB and (ii) a pro forma condensed income statement considering the effects of pro forma balance sheet adjustments as if they were made as of the beginning of the fiscal year presented as well as any additional adjustments required to depict the accounting for the transaction required by US GAAP or IFRS-IASB.
- Autonomous Entity Adjustments (required): These reflect the operations and financial position of the registrant as an autonomous entity when the registrant was previously part of another entity. These adjustments must be presented separately from Transaction Accounting Adjustments and should be reflected whether recurring or nonrecurring.
- Management’s Adjustments (optional): These provide both flexibility to registrants to include forward-looking information that depicts the synergies and dis-synergies identified by management in determining to consummate or integrate the transaction for which pro forma effect is being given and insight to investors into the potential effects of the acquisition and the post-acquisition plans expected to be taken by management. These adjustments are optional; however, certain criteria are required in order to present synergies and dis-synergies including:
- There is a reasonable basis for each such adjustment;
- The adjustments are limited to the effect of such synergies and dis-synergies on the historical financial statements that form the basis for the pro forma statement of comprehensive income as if the synergies and dis-synergies existed as of the beginning of the fiscal year presented. If such adjustments reduce expenses, the reduction shall not exceed the amount of the related expense historically incurred during the pro forma period presented; and
- The pro forma financial information reflects all management’s adjustments that are, in the opinion of management, necessary to a fair statement of the pro forma financial information presented and a statement to that effect is disclosed. When synergies are presented, any related dis-synergies shall also be presented.
RIVERON POINT OF VIEW
The change to allow synergy adjustments is a significant departure from the current requirements and could result in wider-ranging pro forma results with expanded disclosure around the assumptions and judgements. Management will need to consider the accounting for those judgements as well as the potential financial impact of not meeting those synergies within a year from the acquisition date. The presentational changes are likely to improve consistency between various filings. Elimination of the nonrecurring concept in the pro forma statement of operations could provide more confusion to readers regarding the ongoing nature of the combined business.