The SEC has issued rules amending the disclosure requirements for providing historical and pro forma financial statements in connection with material acquisitions and dispositions. The final amendments, issued on May 21, 2020, are largely consistent with the amendments as proposed by the SEC on May 3, 2019.
We regard the following as the most significant changes effected by the amendments for technology and life science companies:
- The significance tests used to determine if a transaction is of sufficient materiality to require historical and pro forma financial statements have been tightened—most notably by measuring the size of the acquisition or disposition against the company’s market capitalization rather than its total assets for the investment test and by adding a revenue component to the income test.
- Transactions that meet the 50% significance threshold will no longer require the filing of three full years of historical financial statements (the limit will be two years).
- For asset acquisitions, the company will be allowed to provide abbreviated financial statements of the acquired business rather than the complete financials that are currently required.
- Pro forma adjustment criteria have been revised to allow adjustments depicting synergies and dis-synergies of the acquisition or disposition.
Companies will not be required to comply with the amendments until the beginning of their first fiscal year commencing after December 31, 2020. Importantly, voluntary compliance in advance of the date that the amendments otherwise become applicable is allowed, provided the amendments are complied with in their entirety.
Regulation S-X contains rules regarding financial statements that must be included in SEC filings. It includes Section 3-05, which addresses historical financial statements that must be filed for material acquisitions, and Article 11, which governs the pro forma financial statements that must be provided for material acquisitions and dispositions. The number of years of historical financial statements that must be provided for material acquisitions is phased, based on the relative size of the transaction, with one year of historical financials required for the smallest transactions that meet the materiality threshold and up to a maximum of three years for the relatively largest transactions.
The materiality thresholds for these determinations are based on the definition of “significant subsidiary” contained in Rule 1-02(w) of Regulation S-X. That definition includes alternative tests, an investment test (in most cases based on the purchase price paid in an acquisition or received in a disposition), an asset test (which measures the value of the assets acquired/disposed of against the company’s total assets) and an income test (which, generally speaking, measures the operating income of the acquired/disposed of business against the company’s aggregate operating income). Under Regulation S-X, if any of the tests is tripped at or above the 20% level, but below the 40% level, one year of financial statements of the acquired business must be provided; if any test exceeds 40% but is less than 50%, two years of historical financial statements are required; and if any exceeds the 50% level, three years of historical financials are typically required. In each case where historical financials are required, pro forma financial statements showing the combined assets and operating results of the acquired business must be provided. If a disposition of a significant portion of the company’s business has occurred (which consists of a disposition that exceeds any of the significant subsidiary tests at the 10% level), pro forma financial statements must also be provided.
The amendments modify the Investment Test to compare, in the case of acquisitions, the company’s consolidated investments in and advances to the target company (once again, in most cases this is the purchase price) and, in the case of dispositions, the consideration received in the sale, to the aggregate worldwide market value of the company’s voting and non-voting common equity (the market cap). Market cap is to be determined using the average of the last five trading days of the most recently completed month ending prior to the earlier of the announcement date or agreement date of the transaction and includes the value of all of the company’s outstanding equity. This test is different than the test for measuring accelerated filer status, which excludes the value of shares held by affiliates and is calculated as of the last day of the second fiscal quarter. If the company has no market cap (as would be the case for a company filing a registration statement for an IPO), the measurement base would continue to be the total assets of the company.
The Income Test compares the acquired/disposed of business’s income or loss from continuing operations before income taxes to those of the company, in each case for the most recently completed fiscal year. The amendments add a revenue component to the Income Test, meaning that both the operating income and revenue tests must cross the 20% threshold for an acquisition to require the filing of the acquired company’s financial statements and pro formas, and for a disposition to require the filing of pro formas. If both tests cross the 20% threshold for an acquisition, the lower of the two percentages will be used to determine the number of years of financial statements that must be provided. The revenue component does not apply if either the company or the target company did not have material revenue in each of the two most recent fiscal years. The amendments further provide that if the current year income is more than 10% lower than the five-year average, the company may not use the five-year-average test allowed under the current rules if the revenue component is applicable.
Lastly, the amendments modify the use of pro forma financial statements in measuring significance in the context of an IPO. If the company has completed an acquisition in, or after the end of, a fiscal year and then completes another acquisition before the results of the first to occur have been reflected for a full year, the amendments permit, subject to certain conditions, the company to measure the significance of the second transaction based on pro forma financial statements if the company has already filed historical and pro forma financial statements reflecting the first transaction.
Other technical changes have been made to the application of the significance standards, including the extent to which contingent consideration is to be included as part of the purchase price for the Investment Test and disclosures required when the aggregate impact of individually insignificant acquisitions exceeds the 50% level on any of the significance tests. Additionally, companies are still permitted to measure significance using the alternative method specified in Staff Accounting Bulletin No. 80, which provides a method similar to that in Rule 3-05.
Number of Fiscal Years to be Presented
As noted above, Regulation S-X requires the filing of one, two or three years of historical financial statements of an acquired company, based on exceeding any of the significance measures at the 20%, 40% or 50% levels. Under the amendments, the 20% and 40% thresholds for filing one or two years of historical statements remain intact, but the requirement to provide three years of statements for transactions at the 50% threshold has been eliminated.
In addition, for an acquisition where any significance threshold is greater than 20% but less than 40%, Regulation S-X requires the presentation of target interim period financial information (i.e., since the end of the most recent fiscal year) for the most recent current period and the comparative interim period in the prior year. The amendments eliminate the requirement to provide the comparative prior year interim period for acquisitions at this level of significance.
Certain Target Financial Statements No Longer Required
Regulation S-X permits acquired company financial statements to be omitted from registration statements and proxy statements once the operating results of the acquired company have been included in the company’s results for a full year, provided the acquired company financial statements were previously filed (most likely under a Form 8-K) and provided that the acquisition was not of “major significance” (which, essentially, is a transaction where any of the significance thresholds exceeds 80%).
The amendments provide relief from the requirement to file the historical financial statements of an acquired business after the results of that business have been included in the financial statements of the company for specified periods of time, regardless of whether the financial statements of the acquired company have been previously filed. This modification does not have a significant impact on reporting companies, as they are required to file the target company’s financial statements with a Form 8-K well before the one-year mark. However, a company preparing for its initial public offering will no longer need to provide such historical financial statements of the acquired business if the acquired business has been reflected in the company’s financial statements for a specified period. More specifically, such financial statements need not be included in a registration statement or proxy statement in either of the following circumstances:
- If the acquisition is of greater than 20% significance but less than 40% significance and has been reflected in the company’s financial statements for nine months
- If the acquisition is of greater than 40% significance and has been reflected in the company’s financial statements for one year
The amendments also remove the requirement to include in a registration statement or proxy statement acquired-company financial statements if the results have been included in the company’s financial statements for a full year, even if the transaction was of major significance.
Companies may acquire product lines or other assets that are not maintained and accounted for as a separate business by the seller, but constitute an acquired business under Regulation S-X. In these scenarios, it can be very time-consuming and expensive to prepare the required financial statements, especially given that sellers often have very little motivation to assist. The amendments significantly reduce the burden of these requirements by permitting companies acquiring assets to provide audited abbreviated financial statements of the acquired business in the form of statements of assets acquired and liabilities assumed and statements of revenues and expenses, exclusive of specified indirect expenses.
The streamlined disclosure requirements are available if all the following conditions are met:
- The total assets and total revenues (both after intercompany eliminations, if applicable) of the acquired or to be acquired business constitute 20% 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 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.
- The seller has not maintained the distinct and separate accounts necessary to present financial statements that include the omitted expenses and it is impracticable to prepare such financial statements.
Pro Forma Adjustments
As noted above, Article 11 of Regulation S-X requires the filing of pro forma financial statements to give effect to acquisitions and dispositions that exceed the relevant significance thresholds. The pro forma financial statements combine the operating results and the assets and liabilities of the company and the acquired company or depict the operating results and assets and liabilities of the disposing company after giving effect to the disposition. Article 11 provides that the only adjustments that are allowed in the presentation of operating results are those that are directly attributable to the transaction, are expected to have a continuing impact on the company and are factually supportable. The allowed adjustments to the combined balance sheet are those that are directly attributable to the transaction and factually supportable, regardless of whether the impact is expected to be continuing or nonrecurring. The amendments address these pro forma adjustment criteria by establishing three classes of adjustments:
- Transaction Accounting Adjustments – adjustments that reflect the application of required accounting to the acquisition or disposition
- Autonomous Entity Adjustments – adjustments necessary to reflect the operations and financial position of the company as an autonomous entity when the company was previously part of another entity
- Management’s Adjustments – adjustments that provide flexibility to companies to include forward-looking information that depicts the synergies and dis-synergies identified by management in connection with the transaction and also provide insight to investors on the potential effects of the transaction
Pro forma financial statements must include the Transaction Accounting and Autonomous Entity Adjustments, but the use of Management’s Adjustments is optional. To encourage forward-looking statements about the possible effects of a transaction, Management’s Adjustments would be covered by the forward-looking statement safe harbor.
As noted above, Regulation S-X requires the filing of pro forma financial statements for a disposition when the transaction exceeds any of the significance thresholds at the 10% level. In order to align the acquisition and disposition disclosure rules, the amendments have raised the disposition threshold to 20%.
The amendments also make a number of other less significant technical and conforming changes to Regulation S-X and to certain 1933 Act and 1934 Act Rules and forms. Further, they include specific provisions for real estate and investment companies.