As part of its overall initiative to improve and streamline disclosure, the U.S. Securities and Exchange Commission recently proposed amendments to the requirements of Regulation S-X for financial statements relating to acquisitions and dispositions of businesses, including the requirements to disclose “target company” financial statements and pro forma financial statements reflecting the transaction. The SEC proposal will be subject to a 60-day public comment period following its publication in the Federal Register, with comments due likely by mid-July.
The proposed changes to the rules would, among other things:
- revise the “investment test” and “income test” used to determine the “significance” of an acquisition or disposition and expand the use of pro forma financial information in measuring significance;
- shorten the maximum period for which historical financial statements for an acquired business are required from three fiscal years to two fiscal years (in addition to any interim period disclosure);
- eliminate any requirement for financial statements of an acquired business once the results of the acquired business have been reflected in the acquiring company’s financial statements for a complete fiscal year, regardless of the significance of the acquisition;
- reduce the disclosure requirements for individually insignificant acquisitions;
- increase the significance threshold for dispositions from 10% to 20%, to conform with the minimum significance threshold for acquisitions, and to otherwise conform the disposition tests with the acquisition tests;
- align the target company financial statement rules for real estate companies with the general target company financial statement rules, where no unique industry considerations exist;
- formally codify existing practices relating to aspects of target company financial statements that are unique to oil and gas acquisitions;
- permit the use in certain circumstances of, or reconciliation to, International Financial Reporting Standards (IFRS) as issued by the International Accounting Standards Board (IASB); and
- amend the pro forma financial information requirements to permit, in addition to customary transaction adjustments, “management adjustments” reflecting reasonably estimable synergies and efficiencies resulting from the transaction.
All of these proposed changes are welcome and, in our view, would move the relevant U.S. disclosure requirements toward a more principles-based regime. In particular, the change allowing pro forma financial statements to reflect future synergies and efficiencies from a business combination is a significant liberalization of the current rules, and would provide management with considerable latitude in incorporating its estimate of the anticipated impact of the transaction on pro forma operating results.
The proposal also includes changes specific to investment companies and companies that qualify as smaller reporting companies, which we do not discuss in this Sidley Update.
Current Regulation S-X Significance Test for Acquisitions and Dispositions
Where an issuer has entered or is proposing to enter into an acquisition of a business, information relating to the business that has been (or is being) acquired — in addition to pro forma financial information giving effect to the transaction and any related financing — may be relevant to an investor’s investment decision. Similarly, when a company is seeking to dispose of a business or a portion of the business, pro forma financial information showing the effects of the disposition may be relevant to investors. Regulation S-X sets out rules that apply in relation to the preparation and disclosure of target company financial statements and pro forma financial information in connection with significant acquisitions and dispositions. While these Regulation S-X requirements expressly apply to securities offerings that are registered with the SEC under the U.S. Securities Act of 1933, as amended, the requirements are generally applied to Rule 144A offerings and other U.S. private placements as a matter of market practice.
In relation to acquisitions, the current requirements for presentation of historical financial statements of the target company vary — from no financial statements to three years of audited income and cash flow statements and two years of audited balance sheets, together with unaudited interim financial statements, if any — depending on the level of significance (within the meaning of Regulation S-X) of the acquisition. In addition, where historical target company financial statements are required to be included in the offering document, pro forma financial information showing the effects of the transaction is also required, but just for the last fiscal year and, if applicable, any subsequent interim fiscal period. General 10b-5 considerations also inform the manner in which target company disclosure is provided and will continue to do so, whether or not the proposed rules are adopted.
Under the current rules, Regulation S-X provides that historical target company financial statements are required depending on the significance of the acquired business, measured using three tests: the investment test, the income test and the asset test. If any one of the three tests exceeds the minimum 20% threshold (as set out below), then audited financial statements for the target company (for varying periods depending on the size of the acquisition as described below) must be included in the offering document.
The three tests1 are:
- Investment test: The issuer’s investments in, and advances to, the target exceed 20% of the issuer’s total assets as of the end of the most recently completed fiscal year. The investment test is calculated by dividing the sum of the issuer’s investments in, and advances to, the acquired business by the issuer’s total assets as of the end of the most recently completed fiscal year for which the issuer’s audited financial statements have been filed. As a general rule, the investment in an acquired business is equal to the total purchase price of the acquisition.
- Income test: The issuer’s equity in the target company’s income from continuing operations before income taxes (calculated as described below) exceeds 20% of such income of the issuer for the most recently completed fiscal year. The income test is calculated by dividing (x) the issuer’s proportionate interest in the total income from continuing operations of the acquired business after inter-company eliminations by (y) the issuer’s total income from continuing operations as of the end of its most recently completed fiscal year. The issuer’s proportionate interest includes direct and indirect ownership. Income from continuing operations is defined as income before income taxes, extraordinary items and cumulative effects of changes in accounting principles. Income may not be adjusted for nonrecurring or special charges or credits. If the issuer’s income from continuing operations for the most recent fiscal year is at least 10% lower than the average of its income from continuing operations for the last five years, then the five-year average income may be used. When a business is being acquired, the issuer’s total income excludes the income of the acquired business.
- Asset test: The issuer’s proportionate share of the total assets (after inter-company eliminations) of the target exceeds 20% of the total assets of the issuer as of the end of the issuer’s most recently completed fiscal year. The asset test is calculated by dividing the issuer’s proportionate interest in the total assets of the acquired business before purchase adjustments and after inter-company eliminations by the issuer’s total assets as of the end of its most recently completed fiscal year. The issuer’s proportionate interest includes direct and indirect ownership. When a business is being acquired, the issuer’s total assets exclude the assets of the acquired business.
In terms of the number of years of historical target company financial statements required, if any of the above tests is above 20% but below 40%, then audited target company financial statements for only the most recent fiscal year and unaudited financial statements for any subsequent interim period would generally be required. If any test is above 40% but below 50%, then audited target company financial statements for the two most recent fiscal years (plus unaudited financial statements for any subsequent interim period) would generally be required. If any test is above 50%, then three years of audited income and cash flow statements and two years of audited balance sheets (plus unaudited financial statements for any subsequent interim period) would generally be required.
In addition to historical target company financial statements, where an acquisition of a significant business has occurred or is probable, pro forma financial information — i.e., a pro forma condensed balance sheet and a pro forma condensed income statement — showing the impact of the acquisition is required for the most recent fiscal year and any subsequent interim period (for the pro forma income statement) and for the most recent balance sheet date (for the pro forma balance sheet). A pro forma balance sheet for the most recent fiscal year or interim period is not required if the transaction is already reflected in such balance sheet.
In relation to dispositions, the current rules provide that pro forma financial information (a balance sheet and income statement) is required for dispositions of a significant portion of a business, where such disposition has occurred or is probable and is not fully reflected in the financial statements of the issuer. Note that the current significance threshold for dispositions, using the same three tests described above, is 10% (as opposed to 20% for acquisitions). In terms of the balance sheet, a pro forma condensed balance sheet is required as of the end of the most recent balance sheet date of the issuer, unless the transaction is already reflected in such balance sheet. In terms of the income statement, a pro forma condensed income statement is required for the most recent fiscal year and any subsequent interim period.
Modifications to the Investment Test and the Income Test to Measure Significance
Under the proposed rules, the investment test would be revised to compare the issuer’s investments in, and advances to, the acquired business to the aggregate worldwide market value of the issuer’s voting and non-voting common equity, instead of its total assets. The rationale for this change is because, while the purchase price for a recent or probable acquisition presumably reflects the current market value of the target, the measure against which the purchase price is compared under the existing test (i.e., total assets) reflects historical (and in some cases depreciated) asset values, which may substantially understate the true enterprise value of the issuer. Using the aggregate worldwide market value, in contrast, would align the investment test more closely with the current economic significance of the acquisition to the issuer, and aggregate worldwide market value is readily available information which can be objectively determined by the market.
The proposed rules would also revise the income test. Currently, the income test consists of a single component, based on income from continuing operations before income taxes. For early-stage issuers that do not anticipate positive net income for several years, or issuers with marginal or break-even net income or loss in a recent fiscal year, the use of the income component by itself can have the effect of requiring financial statements for otherwise immaterial acquisitions.
Under the proposed rules, the income test would be revised by adding a new revenue component2 to the income component, and the calculation of the income component would be simplified by using income or loss from continuing operations after income taxes.
Where the issuer, its consolidated subsidiaries and the target company have recurring annual revenue, the target company must meet both the new revenue component and the income component, and the issuer would use the lower of the revenue component and the income component to determine the number of periods for which target company financial statements are required. If the target company does not exceed both of these components, the acquisition would not be considered significant for purposes of the income test.
Under the proposed rules, the income component would be determined by comparing the absolute value of the consolidated income or loss from continuing operations after income taxes of the target company with that of the issuer. The revenue component would be calculated by comparing the issuer’s proportionate share of the consolidated revenue of the target company with the issuer’s consolidated revenue.
Where an issuer or target company does not have recurring annual revenues, the revenue component is less likely to produce a meaningful assessment and, therefore, only the income component would apply. If the revenue component does not apply and the absolute value of the issuer’s consolidated income or loss from continuing operations is at least 10% lower than the average of absolute value of such amounts for the last five years, then, similar to the approach under the existing rules, the five-year average of the absolute value of consolidated income may be used.3
The Use of Pro Forma Financial Information to Measure Significance
Under the current rules, significance determinations are generally required to be made by comparing the most recent annual consolidated financial statements of the target company to those of the issuer prior to the date of acquisition. In applying the significance tests, an issuer is permitted to use pro forma, rather than historical, financial information in limited circumstances — that is, where the issuer made a significant acquisition subsequent to its latest fiscal year end and filed with the SEC target company financial statements and pro forma financial information relating to the acquisition. Under the proposed rules, the SEC proposes to expand the circumstances in which an issuer can use pro forma financial information for significance testing, to allow issuers to measure significance using filed pro forma financial information that depicts significant business acquisitions and dispositions consummated after the latest fiscal year end for which the issuer’s financial statements are required to be filed, provided target company financial statements for any such acquisitions and pro forma financial information relating to such acquisitions and dispositions have been filed with the SEC.
In addition, when using pro forma financial information to determine significance, issuers would not be permitted to include any “management’s adjustments” (as discussed below), but they would be required to make “transaction accounting adjustments” (as discussed below).
Target Company Financial Statements for Significant Acquisitions
As noted above, under the existing rules, target company financial statements may be required for up to three years depending on the relative significance of the acquired or to be acquired business. The proposed rules seek to reduce the requirement to a maximum of two years for even the most significant acquisitions (i.e., acquisitions exceeding the 50% significance level).
In addition, where a significance test exceeds 20% but none exceeds 40%, the proposed rules would require financial statements only for the “most recent” interim period rather than “any” interim period. This proposed revision would eliminate the need to provide a comparative interim period when only one year of audited target company financial statements is required. In the SEC’s view, providing a comparative interim period when there is no requirement for a corresponding comparative annual period may have limited utility for investors and creates an additional burden on registrants to prepare such information. Focusing on the most recent interim period would provide the most relevant and material information to investors.
Omission of Target Company Financial Statements for Major Significant Transactions
The proposed rules would eliminate the current requirement to provide target company financial statements when the target company has been reflected in the issuer’s post-acquisition financial statements for a complete fiscal year, even when the target company exceeds the 80% significance level.
Disclosure Requirements for Individually Insignificant Acquisitions
Under the existing rules, audited historical pre-acquisition financial statements are generally not required if an acquired or to be acquired business does not exceed 20% significance (or does not exceed higher significance levels, in other prescribed circumstances). However, if the aggregate impact of “individually insignificant businesses” acquired since the date of the most recent audited balance sheet of the issuer exceeds 50%, audited pre-acquisition financial statements covering at least the substantial majority of the businesses acquired must be included in the offering document. Issuers must also provide related pro forma financial information reflecting such acquisitions. Under the proposed rules, issuers would still be required to provide pro forma financial information depicting the aggregate effects of all such businesses in all material respects, but target company financial statements would be required only for those businesses whose individual significance exceeds 20%.
Significance Thresholds for Dispositions
As noted above, under the current rules pro forma financial statements are required if the significance of a disposition exceeds 10% (as opposed to 20% for acquisitions). The proposed amendments would raise the significance threshold for dispositions from 10% to 20%. The tests used to determine significance would be conformed to those relating to acquisitions.
Financial Statements for Real Estate Operations
The existing rules relating to financial statements for real estate operations (under Rule 3-14 of Regulation S-X) have historically differed from the target company financial statement rules for other businesses (under Rule 3-05 of Regulation S-X). For example, the SEC generally requires only one year of financial statements for real estate operations to be provided in most circumstances because, according to the proposing release, audited financial statements for a real estate operation are rarely available from the seller without additional effort and expense because most real estate managers do not maintain their books on a U.S. GAAP basis or obtain audits. In addition, historical financial statements for real property do not usually provide significant information about the trends and factors that are most likely to affect future operations.
The proposed rules seek to align the target company financial statement requirements for real estate operations under Rule 3-14 with those for other businesses under Rule 3-05, consistent with the proposed amendments discussed herein, where no unique industry considerations exist.
Financial Statements for Businesses that Include Significant Oil and Gas Producing Activities
Oil and gas acquisitions raise unique accounting issues that are not currently addressed in Regulation
S-X. As a result, issuers have historically adopted a practice of relying instead on Financial Accounting Standards Board (FASB) oil and gas guidelines and case-by-case dispensation from the SEC staff in order to comply with Rule 3-05’s target company financial statement requirements. The proposed amendments would formally codify these practices in new Rule 3-05(f) of Regulation S-X.
It is not uncommon for an acquisition of oil and gas properties to be large enough to meet the significance tests of Regulation S-X, but without any historical audited financial statements because those properties are not held in a separate subsidiary or division. Rule 3-05(f) would formally permit issuers to provide an audited statement of revenues and direct operating expenses (i.e., excluding corporate overhead, depreciation, depletion, amortization, income tax and interest expenses) instead of a full income statement and balance sheet, as long as certain conditions are met. This has been the SEC staff’s practice for some time, but issuers were still required to submit a formal request similar to a no-action letter request. If the proposed amendments are adopted, that step will no longer be necessary.
In addition, Rule 3-05(f) would expressly require issuers to include the FASB proved reserve and standardized measure disclosures4 along with the non-industry specific historical target company financial statements.
Financial Statements for Foreign Businesses
Regulation S-X currently permits the use of IFRS financial statements (that comply with IASB) for foreign businesses. The proposed rules would permit target company financial statements to be prepared in accordance with IFRS without reconciliation to U.S. GAAP if the target company would qualify to use IFRS if it were an SEC registrant, and to permit foreign private issuers that prepare their financial statements using IFRS to provide target company financial statements prepared using home country GAAP to be reconciled to IFRS rather than U.S. GAAP.
Pro Forma Financial Information
Under the current rules, where an acquisition of a significant business has occurred or is probable, pro forma financial information — i.e., a pro forma condensed income statement and a pro forma condensed balance sheet — showing the impact of the acquisition is required for the most recent fiscal year and any subsequent interim period (for the pro forma income statement) and for the most recent balance sheet date (for the pro forma balance sheet). Pro forma financial information (a balance sheet and income statement) is required for dispositions of a significant portion of a business, where such disposition has occurred or is probable and is not fully reflected in the financial statements of the issuer.
The current rules provide that the only adjustments that are appropriate in the presentation of the pro forma income statement are those that are directly attributable to the transaction, expected to have a continuing impact on the registrant and factually supportable. The pro forma 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 issuer as of a single point in time (i.e., the balance sheet date).
Under the proposed rules, the existing pro forma adjustment criteria would be replaced with two categories of adjustments: “transaction accounting adjustments” and “management’s adjustments.” In particular, “management’s adjustments” would permit pro forma income statements to reflect certain anticipated post-transaction synergies or efficiencies, which may be important to investors but are impermissible under the current rules. In addition, because “transaction accounting adjustments” must be presented in a separate column from “management’s adjustments,” the familiar four-column format of pro forma financial statements would be expanded to five columns.5
“Transaction accounting adjustments” are intended to depict adjustments relating to the accounting for the transaction required by U.S. GAAP or IFRS. The “transaction accounting adjustments” are intended to reflect only the application of required accounting to the acquisition, disposition or other transaction. These are effectively the pro forma adjustments that are permitted under the current rules.
“Management’s adjustments” would be 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. “Management’s adjustments” would be presented through a separate column in the pro forma financial information after the presentation of the historical statements and “transaction accounting adjustments.” This presentation would permit investors to distinguish the objective accounting effects of the transaction from the projected results of management’s plans.
In a significant departure from past practice, the inclusion of “management’s adjustments” would provide flexibility to include forward-looking information that depicts certain anticipated synergies, efficiencies and other transaction effects identified by management. On the other hand, this information would allow the inclusion of projections and forward-looking information, in some cases for events that have yet to occur and that are subject to various assumptions, risks and uncertainties — in short, the type of information that lawyers and, to some degree, issuers and bankers have sought to exclude from offering documents for liability reasons. To the extent that information of this nature is included, underwriters and their counsel will need to conduct a heightened level of due diligence with respect to the pro forma financial information and, in particular, the forward-looking information.
The proposing release provides that for synergies and other transaction effects that are not reasonably estimable and therefore cannot be included in “management’s adjustments,” qualitative narrative disclosure should be included to give a fair and balanced presentation of the pro forma financial information.
1 For purposes of these tests, the issuer’s financial metrics are generally calculated on a consolidated basis for the issuer and its consolidated subsidiaries, excluding the target company.
2 Revenue is considered an important indicator of the operations of a business and generally has less variability than income from continuing operations, which can include expenses related to historical capitalization (e.g., interest expense) as well as certain other infrequent or nonrecurring expenses. The SEC believes that adding a revenue component will reduce the anomalous results that may occur by relying solely on income, such as where the issuer has marginal or break-even income in a recent fiscal period. It is interesting to note that prior to 1981, the significance test included a revenue test, and the SEC eliminated the revenue test in favor of an income test because it considered that the presentation of additional financial disclosure for a target company may not be meaningful if, for example, the target company had high sales volumes but a relatively low profit margin.
3 Note that for calculating average income, the SEC proposal differs from current SEC staff interpretation, which indicates that zero should be used for loss years in computing the average. Under the proposed rules, average income should be calculated using the absolute value of the loss or income amounts for each year and then calculating the average.
4 See FASB ASC Topic 932 Extractive Activities — Oil and Gas 932-235-50-3 through 50-11 and 932-235-50-29 through 50-36.
5 The four columns are typically historical acquirer, historical target, adjustments and pro forma. Under the proposed rules, “transaction accounting adjustments” and “management’s adjustments” would be presented in separate columns.
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