Mergers and acquisitions could become a little more complicated for public companies this year as a result of changes in accounting standards and complexity around what needs to be reported.
A subtle change to the Financial Reporting Manual at the Securities and Exchange Commission in late December is causing some deal-making experts to pause over the effective dates of accounting rule for private entities that are, or want to be, acquisition targets for public companies, says Chris Clapp, managing director at consulting firm MorganFranklin.
“This is going to be a key component of due diligence for public companies going forward,” says Clapp. “Acquiring companies are going to need to assess target companies’ ability to comply. And if they can’t, it’s going to have to hold up a transaction until the target is prepared.”
Clapp is most concerned about revenue recognition, a massive new rule that public companies are required to begin observing in 2018. Soon after comes a new standard on lease accounting. That takes effect for public companies in 2019.
The adoption of revenue recognition for public companies has been daunting enough, with companies taking months to prepare new accounting policies, new procedures, and new internal controls over when and in what amounts they recognize revenue. Then new rules bringing nearly all leases into financial statements take effect in 2019.
Private companies, however, have an extra year to prepare for both of those new rules. Any time the Financial Accounting Standards Board establishes new accounting requirements, it often gives non-public entities extra time to implement.
“This is going to be a key component of due diligence for public companies going forward. Acquiring companies are going to need to asset target companies’ ability to comply. And if they can’t, it’s going to have to hold up a transaction until the target is prepared.”
Chris Clapp, Managing Director, MorganFranklin
In the context of a business combination, that leads to some accounting mismatch. When a public company purchases a private company, the public company is generally expected to present financial statements for the acquired entity on the same basis of accounting, says Beth Paul, a partner with PwC. Article 11 of Regulation S-X gives companies a host of guidance on when and how to present such pro forma reporting.
The SEC requires companies to present such pro forma financial information when a business combination is regarded as “significant” under SEC rules, says Paul. Significance is determined based on some specific tests that assess an acquiring entity’s investment, assets, and pre-tax income in relation to the entity it is acquiring.
Pro forma reporting involves recasting historic balance sheet and income statement information as if a transaction had happened earlier. The idea is to give investors a hint as to what a public company’s financial statements might have looked like if the acquired entity had been part of the organization for a period of time before the acquisition.
If a public company is purchasing a private company, that might mean recasting some of the private entity’s historic information so that it reflects the same accounting rule adoption timelines. That’s a tall order given the magnitude of accounting change associated with the new revenue rules, says Clapp.
The SEC even showed a bit of sympathy in July 2017 for how burdensome it might be for private entities to accelerate their adoption of the new revenue rules. The SEC signaled through FASB’s Emerging Issues Task Force that it would not object if certain “public business entities” followed private company adoption rules on revenue recognition and leasing if they would otherwise be regarded as private entities except for some narrow public filing requirements.
New text in SEC's Financial Reporting Manual
• If a registrant adopts a new accounting standard as of a different date and/or under a different transition method than a significant acquired business, the registrant must conform the date and method of adoption of the acquired business to its own in its pro forma financial information. The staff will consider requests for relief from this requirement. (Last updated: 12/1/2017)
• A registrant retrospectively adopts a new accounting standard on January 1, 2018 and in September 2018 it makes a significant acquisition and later files a Form 8-K that includes pro forma financial information for the year ended December 31, 2017 and the six months ending June 30, 2018. The registrant does not need to apply the new accounting policy to the pro forma information for periods prior to adoption until it has reflected the new standard in the historical financial statements for those periods. As such, only the 2018 pro forma information need reflect the adoption of the new standard, while the 2017 pro forma information is not required to reflect adoption of the new standard. However, if the registrant believes the effect of the new standard on 2017 historical information will be material, it should make appropriate disclosure to that effect in the notes to the pro forma financial information. (Last updated: 12/1/2017)
The SEC was thinking, for example of private entities in which a publicly listed registrant might have an equity method investment that passes some of those Regulation S-X significance tests. It was also thinking of instances when an acquired entity’s financial statements would need to be included with the parent company as a result of an acquisition.
“When you read the definition of a public business entity, when a company would have to provide to the SEC financial statements in regulatory filings, it would have accelerated the adoption of revenue recognition a year earlier using the public company dates,” says Christine Davine, a partner at Deloitte & Touche. “The SEC realized that could be very burdensome, so it made this announcement that said you can use private company adoption dates in these specific entities.”
That action led to some examination of guidance in the SEC’s Financial Reporting Manual, which maintained the position that companies would need to conform, says Davine. “Now that the SEC made the accommodation, would it revisit this guidance?” she asks.
Ultimately, in December, the SEC published an update to its FRM to be more explicit about its expectations. The SEC said if a registrant adopts a new accounting standard as of a different date or under a different transition method than a significant acquired business, the registrant must conform the date and method of adoption of the acquired entity to its own in its pro forma financial information.
The FRM contains an additional line, however, that should not be overlooked. “The staff will consider requests for relief from this requirement.” Financial reporting experts consider that to be an important addition to the guidance.
“It says you should conform, but it also says you can make requests for relief,” says Paul. “That’s a good thing for preparers.”
The SEC has demonstrated itself to be open to such requests, says Davine. The staff has indicated through different avenues that it is willing to hear reasonable requests for relief under Rule 3-13 of Regulation S-X, which addresses various scenarios where a public company might request a pass on a given filing requirement for any number of reasons.
SEC Chairman Jay Clayton even welcomed waiver requests in a speech he delivered in July 2017, where he reminded companies of the primary objective of capital formation. “There are circumstances in which the Commission’s reporting rules may require publicly traded companies to make disclosures that are burdensome to generate, but may not be material to the total mix of information available to investors,” he said. “Under Rule 3-13 of Regulation S-X, issuers can request modifications to their financial reporting requirements in these situations. I want to encourage companies to consider whether such modifications may be helpful in connection with their capital-raising activities and assure you that SEC staff is placing a high priority on responding with timely guidance.”
Kendra Decker, a partner at Grant Thornton, said she has found the SEC staff to be open to such conversations. “Overall, they are very receptive to talking to issuers in areas where it may be difficult for various reasons to comply with the requirements,” she says.
Davine is advising companies that are in the midst of a deal to be sure they are aware of accounting differences and the SEC’s position on those differences. Whether those differences may arise because of different adoption dates, different fiscal years, or different transition methods, “companies need to consider whether or not it will be practicable for you to conform in the pro forma,” she says. “To the extent it’s not practicable, you can ask for relief from the SEC.