SEC’s Modernization and Simplification Efforts Continue: Changes Coming to Disclosures for Acquisitions and Dispositions by Public Companies
The efforts of the U.S. Securities and Exchange Commission (SEC) to modernize and simplify public company disclosure rules continue, with the latest round of changes including a final order adopted on May 21, 2020 addressing financial disclosures required for acquired or divested businesses. Although the effective date for the revised rules is January 1, 2021, companies may voluntarily comply with them now.
This update focuses on the most broadly relevant changes — those that are generally applicable to any public company that engages in M&A activity that includes significant acquisitions or dispositions. These changes include (1) revised tests for determining the “significance” of an acquisition or disposition and (2) paring back some of the requirements for separate financial statements of an acquired or divested business. Like most of the SEC’s recent modernization and simplification efforts, the changes are incremental improvements rather than fundamental changes.
The new rules include a variety of other changes, including changes to Rules 1-02(w), 3-05, 3-14, 8-04, 8-06 and Article 11 of Regulation S-X (the principal set of SEC rules governing financial disclosures), Rule 405 under the Securities Act of 1933 and Rule 12b-2 under the Securities Exchange Act of 1934. These amendments include specific provisions applicable to registered investment companies, business development companies, real estate operations and smaller reporting companies that are beyond the scope of this summary.
Significance Tests
The threshold issue for a public company considering the disclosure implications of a potential acquisition or disposition is its “significance.” Significance of an acquired or disposed business (target) is determined by using the highest degree of significance among the results of three separate tests (described in Rule 1-02(w) of Regulation S-X): (1) the “investment test,” (2) the “income test” and (3) the “asset test.” Each of these tests calculates a percentage by comparing certain financial metrics of the target to those of the registrant.
That’s still the case under the new rules, but each of the three significance tests has been revised, as summarized in the following table:
| Significance Test | Prior Standard | Amended Standard |
|---|---|---|
| Investment Test | Compare (x) the registrant’s investments in and advances to the target to (y) the registrant’s total assets. | Compare (x) the registrant’s investments in and advances to the target to (y) the average aggregate worldwide market value of the registrant’s voting and non-voting common equity.
If the registrant does not have an aggregate worldwide market value, then the prior standard would be used. |
| Income Test | Compare (x) the registrant’s equity in the target’s pre-tax income from continuing operations to (y) the registrant’s pre-tax income from continuing operations. | The new income test adds an additional component if both the registrant and target have “material revenue.” In that case, significance under the income test would be the lower of the significance determined using the prior income test and the significance determined using the following new revenue test: compare (x) the registrant’s proportionate share of the target’s total revenues (after intercompany eliminations) to (y) the registrant’s total revenues (after intercompany eliminations).
If either the registrant or the target did not have material revenue in each of the two most recently completed fiscal years, only the prior standard would be used. The SEC did not define “material” for purposes of the new income test. |
| Asset Test | Compare (x) the registrant’s proportionate share of the total assets (after intercompany eliminations) of the target to (y) the total assets of the registrant. | Same as prior standard, but excludes intercompany transactions with the target from the registrant’s consolidated total assets. |
In addition to the changes summarized above, serial acquirers will also appreciate that the new rules permit the tests to be completed using pro forma financial information reflecting a prior significant acquisition that has been filed with the SEC when measuring the significance of subsequent acquisitions.
These changes to the significance tests are not earth-shattering and, in most cases, won’t change the results. They are, however, incremental improvements that will simplify calculation for public companies and reduce some counter-intuitive results that the prior rules have produced. For example:
- The prior investment test has looked at the carrying value of the target company’s assets. Under standard accounting principles, carrying value would reflect fair market value of certain assets (such as financial instruments) but only historical cost for many other assets (property, plant, equipment and acquired intangibles) and would include no value for certain other assets (including certain internally developed intangibles). And of course, the value of assets alone would not take into account any liabilities. By substituting market capitalization (if available) for the value of the registrant’s assets, the new test should give a more accurate picture of how the registrant’s investment in the target compares to the registrant’s value as a going concern.
- The prior income test produced results that may not make sense for companies that, for whatever reason, operate close to break-even. By adding a revenue test as an additional layer, the new rules will limit the circumstances in which financial statements could be required for a relatively small acquisition solely due to differences in profitability. Revenue can also be easier to calculate, so the rule’s provision to use the lower of the income and revenue test figures may allow public companies to rule out significance without needing to calculate income.
Significance Threshold
Under the prior rules, financial statements have generally been required for acquisitions for which the significance exceeds 20% and dispositions for which the significance exceeds 10%. The new rules increase the threshold for dispositions to 20%, aligning the significance requirements for dispositions with that of acquisitions and reducing the scope of dispositions for which financial statements will be required.
Financial Statement Requirements for Significant Acquisitions
For an acquired business that is determined to be “significant,” either individually or in the aggregate, the amendments reduce disclosure requirements related to separate financial statements in the following ways:
| Topic | Prior Requirement | Amended Requirement |
|---|---|---|
| Historical Periods Covered | One, two or three years of audited financial statements (plus unaudited financial statements for the most recent interim period and the prior comparison period) for the target are generally required, depending on whether the significance reaches the 20%, 40% or 50% level. | For acquisitions that do not exceed 40% significance, comparative interim period financial information for the prior year’s interim period is no longer required. (The comparison period information is still required if significance exceeds 40%.) The requirement to include a third year of audited financials for an acquisition with greater than 50% significance has been eliminated, so no more than two years of audited financial statements (plus any required interim period financials) will be required. |
| Omission of Target Historical Financial Statements | Registration statements and certain proxy statements filed following a significant acquisition (or during the pendency of an acquisition of major significance) must include or incorporate by reference separate financial statements of the target, even after they have been filed on a Form 8-K, for a period of time. That period of time is, generally, until the target’s performance has been included in the registrant’s audited financial statements for at least 9 months, or 12 months in the case of a Form S-4 registration statement or proxy. However, that period could be 21 months, if significance exceeds 40%, and could be even longer for transactions of “major significance” (determined using a qualitative standard of whether the acquisition is of such significance that omission would materially impair an investor’s ability to understand the registrant’s historical financial results). | The time period for which separate financial statements of the target will be required is based on a simple, two-tier quantitative test:
If any of the significance tests exceeds 20%, but none exceed 40%, separate financial statements may be omitted (including from Form S-4 registration statements and proxy statements) once the operating results of the acquired business have been reflected in the registrant’s audited post-acquisition results for nine months. If any of the significance tests exceed 40%, separate financial statements may be omitted from Form S-4 registration statements and proxy statements once the operating results of the acquired business have been reflected in the registrant’s audited post-acquisition results for a complete fiscal year. The qualitative test requiring financial statements for acquisitions of “major significance” has been eliminated. |
| Treatment of Individually Insignificant Acquisitions | Audited financial statements covering a majority of the acquired businesses required (in addition to pro forma financial information), if the aggregate impact of individually insignificant acquisitions since the date of the registrant’s most recent audited balance sheet exceeds 50%. | Only pro forma financial information showing the aggregate effect of the acquired businesses in all material respects must be provided, if the aggregate impact of individually insignificant acquisitions since the date of the registrant’s most recent audited balance sheet exceeds 50%. |
| Permitted Pro Forma Adjustments | Pro forma financial information must reflect the transaction, with adjustments only for items that are directly attributable to the transaction, expected to have a continuing impact on the registrant, and factually supportable. Under this standard, forward-looking synergies and dis-synergies generally cannot be reflected in the pro forma financial information. | Pro forma financial information now includes three categories of adjustments: “transaction accounting adjustments”; “autonomous entity adjustments”; and “management’s adjustments.” A registrant must make adjustments that fall within the first two categories, but the third category is optional (and permitted only if certain conditions are met, including that management believes they would enhance an understanding of the pro forma effects of the transaction). |
Effective Date and Transition
These amendments are effective at the beginning of a registrant’s first fiscal year beginning after December 31, 2020 (January 1, 2021 for fiscal year end filers), and voluntary early compliance is permitted if the amendments are adopted in their entirety.
Where a registrant hasn’t opted voluntary early compliance and the mandatory compliance date falls during the grace period for filing financial statements (in other words, if a registrant has filed an Item 2.01 Form 8-K prior to the mandatory compliance date but will be filing the financial statements after the mandatory compliance date), the financial statements and pro forma financial information specified by the prior rules will be required.
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