DEVELOPMENTS IN THE DIVISION OF CORPORATION FINANCE AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS TWENTY-FOURTH ANNUAL NATIONAL CONFERENCE ON CURRENT SEC DEVELOPMENTS DECEMBER 10-11, 1996 LESLIE A. OVERTON ASSISTANT CHIEF ACCOUNTANT DIVISION OF CORPORATION FINANCE U.S. SECURITIES AND EXCHANGE COMMISSION * * The U.S. Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement of its employees. The views expressed in this paper are those of the author, and do not necessarily represent the views of the Commission or other members of the staff. INTRODUCTION Good afternoon. As an Assistant Chief Accountant in the Division of Corporation Finance, I will be the speaker closest to the review staff "trenches" that you will hear during this conference. Therefore, I would like to spend my allotted time talking with you about a variety of common issues and deficiencies that arise in the review of 1933 Act and 1934 Act filings. The broad major topics I would like to discuss are: I. Pro Forma Financial Statements A.Reg. S-X Rule 11-02(b)(6) B.Format C.Calculation of Tests - Reg. S-X Rule 1-02(w) II. Accounting Recognition and Disclosure A.Stock Options, Warrants and Restricted Stock B.Deferred Tax Assets and Valuation Allowance C.Implementation of FAS 121 D.Equivalent Market Value per Share ISSUES TO CONSIDER IN THE PREPARATION OF FILINGS WITH THE SEC I. Pro Forma Financial Statements - Regulation S-X Article 11 (also see Topic Three in 1996 edition of DCF Accounting Disclosure Rules and Practices) A.The meaning of Rule 11-02(b)(6) 1.Pro forma adjustments should only include the effects of changes that result directly from the transaction, are expected to have a continuing effect, and are factually supportable. a.In connection with purchase business combinations, changes in depreciation and amortization due to changes in asset bases, contracts with management, debt agreements and other direct effects of the merger should be included. (1)In carve-out situations where the historical financial statements of the target only include direct revenues and costs, the pro forma financial statements should also include the indirect costs expected for the target. (2)Consideration should be given to EITF 95-3 (Recognition of Liabilities in Connection with a Purchase Business Combination) for guidance as to the types of liabilities that may be recognizable in the pro forma financial statements. b.Changes resulting from management's plans subsequent to the combination, such as restructuring charges, reduced employment, and closure of some of the purchaser's facilities, are more akin to forecasts and should not be included. If subsequent events are likely to have a material effect on the future financial statements of the combined entity: (1)Presentation of forecasted information in the notes to the pro forma financial statements and other narrative portions of the document is encouraged. (2)Such information may also be included in a separate forecast. (3)MD&A should address the expected effects of the acquisition on the financial statements (i.e., a pro forma MD&A). 2.The notes to the pro forma financial statements should clearly explain the basis for the adjustments. 3.Specific adjustments a.Do not delete unusual items unrelated to the transaction. b.Do not assume interest income on the proceeds of an offering. c.Include the weighted average number of shares of common stock used to calculate earnings per share and the shares issued in a transaction on the face of the pro forma statements of operations. d.If the transaction results in significant changes to long-term debt or mandatorily redeemable preferred stock (MRPS), disclose the future maturities of pro forma long-term debt and MRPS in a note. B.Format 1.Consider the purpose of the filing. a.If shareholder approval or other action is being requested, then the pro forma effects of the transaction to be voted or acted upon should be separately presented. (1)The pro forma effects of other significant transactions, that are not contingent upon the transaction to be voted upon, should be reflected in additional columns or separate pro forma financial statements. (2)Effects of significant historical events that have occurred prior to the consummation of the transaction, such as a purchase business combination, should be reflected in separate pro forma financial statements adjusting the historical financial statements of the company. These pro forma financial statements amounts would carryforward into the pro forma financial statements reflecting the transaction to be voted upon by the shareholders. (3)Certain filings, such as Schedule 13e- 4 for issuer tender offers, may require only summarized financial information in the "plain vanilla" situation (e.g., cash for outstanding stock tender offer). Transactions that are other than "plain vanilla" should include additional financial information, including pro forma financial statements, if material to a decision by a security holder. 2.Business combination accounted for as a pooling a.The pro forma financial statements of the combined companies should be the historical financial statements of the companies after the merger. The only adjustments would normally be those to eliminate intercompany transactions, or to conform accounting policies and fiscal year-ends. b.However, if significant other pre-merger events occurred during the last fiscal year and subsequent interim periods up to the date of the merger or there will be other significant transactions concurrent with the merger, then the pro forma effects of those transactions should be presented separately. C.Calculation of tests under Regulation S-X Rule 1- 02(w) for significance of an acquiree pursuant to Regulation S-X Rule 3-05. 1.Generally, tests should be based on latest audited fiscal year end financial statements. a.The year end financial statements of the registrant and of the acquiree should be stated in U.S. GAAP and the registrant's reporting currency. b.As Kurt Hohl has discussed, the exception to the general rule applies if the registrant has previously made a significant acquisition reported on Form 8-K. In that case, the significance data may be applied to the pro forma data rather than the historical pre- acquisition data. 2.Income test a.Use absolute values of pretax income (loss) of registrant and target. b.Averaging (1)If the registrant's income for the most recent fiscal year is 10% or more lower than the average of last five fiscal years, average income of the registrant may be used in the test. (a)This exception does not apply to the target. (b)Loss years in the last 5 fiscal years should be assigned a zero value in determining the numerator, but the denominator should still be "5". II. Accounting Recognition and Disclosure A.Stock options, warrants and restricted stock 1.All issuers continuing to measure compensation under APB 25 (Accounting for Stock Issued to Employees) instead of FAS 123 (Accounting for Stock-Based Compensation) should continue to consider the "cheap stock" compensation issue discussed in Question 2 of Staff Accounting Bulletin Topic 4.D. It is not just applicable to issuers filing an initial public offering. The current market value of the issuer's stock and other terms of the award should be evaluated in determining the amount of compensation that should be recognized upon issuance. If the compensation is earned or the rights under the award vest over more than one year, then the gross amount of the deferred compensation should be presented on the face of the balance sheet. The amount of deferred compensation expense should be disclosed for each audited period of operations presented, if material. 2.Changes in the terms of stock options, warrants and restricted stock after they are issued, other than pursuant to the terms of the original agreement, generally constitute a new "measurement date" for purposes of APB 25. Additional compensation expense may be required to be recognized based on the market value of the company's stock at the new measurement date and the exercise price. a.Acceleration of only the vesting of an option is not a new measurement date under APB 25, as long as it is not done to prevent the option from terminating before it is vested (e.g., not accelerated in anticipation of a merger where the unvested options will lapse, or in anticipation of the employee's cessation of service). b.Under FAS 123, any changes would require revaluation of the option. B.Deferred Tax Assets and Valuation Allowance Disclosures in management's discussion and analysis (MD&A) and in the financial statements about the income tax provision should include the factors considered in determining the amount of any deferred tax assets valuation allowance, or lack thereof, if it is other than what might be expected based on other disclosures. If the company has a history of earning pretax income but has provided a valuation allowance for deferred tax assets, the negative factors supporting such conclusion should be discussed (e.g., continuing losses by foreign subsidiary). Conversely, if the company has a history of pretax operating losses but has not provided any valuation allowance for deferred tax assets, the positive factors considered or assumptions made about future results of operations should be disclosed. C.Implementation of FAS 121 - Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of 1.There should be no cumulative effect on the financial statements upon adoption of FAS 121, except for changes in the amounts of impairments previously recorded for long-lived assets to be disposed of that are still owned. a.FAS 121 changed the measurement of impairment of long-lived assets. b.FAS 121 did not change the timing of recognition of impairment. 2.Impairment of stand-alone goodwill should continue to be measured and recognized pursuant to APB 17 - Intangible Assets. 3.FAS 121 is not applicable to producing oil and gas properties accounted for by the 'full cost' method. D.Equivalent Market Value per Share In a merger proxy to be wrapped-around by a Form S-4, Item 3(g) of Form S-4 requires that the market value per share of the securities of the company being acquired are required to be presented on an equivalent basis, as well as the historical basis. This is in addition to the other comparative per share disclosures required by both Item 14 of Schedule 14A and Item 3 of Form S-4. In closing, I would like to remind you that prefiling consultations with the SEC staff are encouraged and may facilitate subsequent staff review. Any prefiling consultations should be referenced in the cover letter for the related filing to maximize the benefit. Thank you for your attention.