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Speech by SEC Staff:
Remarks before the 2006 AICPA National Conference on Current SEC and PCAOB Developments


Leslie A. Overton

Associate Chief Accountant, Division of Corporation Finance
U.S. Securities and Exchange Commission

Washington, D.C.
December 12, 2006

As a matter of policy, the Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the SEC staff.

Accounting and Reporting Issues for an IPO in Connection with a Merger of Entities under Common Control

Good morning. In preparing for this conference, I asked myself what's been happening in the business world that raised issues for CorpFin? You've probably noted that a lot of reporting companies have gone private in recent years, and I've read that trend is increasing. But we all know there are benefits to being an SEC registrant - for the company there's access to the public capital markets, lower cost of capital, and liquid shares that can be used for compensation, business acquisitions, etc. - and for the investors there's ownership of marketable securities - so I expect that eventually we'll see some of these private companies going public again. Over the last year, I've seen several registration statements where the venture capitalists decided it was a good time to act on their exit strategy. They combined some of the companies in their "stable" under one of the companies, or in a new company, in order to take the combined companies public through an IPO. More of these deals may be in the wings, so I want to remind you of some of the reporting and accounting issues they raise.

When an IPO registration statement is filed with the Commission that purports to include a merger of entities under common control, CorpFin screens it for various things, including whether it includes the necessary financial statements. Once it's determined that the registration statement is complete, only then does the staff review the accounting reflected in the financial statements. So I've organized my remarks in that order - 1st, the IPO reporting issues, and 2nd, some of the accounting issues associated with a merger of entities under common control.

Form and Content of the Financial Statements Required in the IPO

I. The first question you have to answer is whether the combination of entities under common control should be reflected in the historical financial statements or only in the pro forma financial statements?

  1. We believe the merger should be reflected in the historical F/S only if
    1. either the merger has occurred during the historical periods presented, or
    2. the combined entities will
      1. become a consolidated group by the time of effectiveness of the IPO registration statement, and
      2. the transaction through which the entities will become a consolidated group will be accounted for as a reorganization of entities under common control.
      3. That means control of each of the combining companies doesn't change as a result of the merger.
    3. If those conditions are not met, the separate historical F/S of the entities to be combined should be presented. If the merger occurs after effectiveness of the IPO, then the merger should be reflected only in the pro forma financial statements.
    4. As an aside, if a common control merger has occurred but post-merger results have not been published yet, an existing registrant may be required to file supplemental audited financial statements reflecting the merger if it files a registration statement.
  2. If the merger is presented in the pro forma financial statements:
    1. Then the pro formas should be presented for all the same periods as are required for the historical financial statements.
      1. Remember that a reorganization of entities under common control is accounted for similar to a pooling, and is required to be retroactively reflected in the F/S as a change in reporting entity.
      2. Essentially, the pro formas should reflect what the historical combined financials will look like after the combination.
    2. In contrast, the effects of other merger-related transactions should follow the general rule and only be reflected in the pro formas for the latest year and interim period. Examples of things that would follow the general rule would include
      1. business acquisitions,
      2. acquisition of minority interests,
      3. any change in capital structure resulting from the merger,
      4. transfers or spinoffs of assets to & from the combining entities before their combination, and
      5. changes in financing.

II. The second question you have to answer is which F/S are required? To answer that question, you have to ask yourself a series of questions.

  1. First, who is the parent? We think the parent could be
    1. any form of entity or an individual.
    2. It could also be a group of people if they constitute a "control group". Since it's been discussed at prior conferences, I won't elaborate on the notion of a control group except to say it's a shareholder group with >50% voting ownership bound either by close family ties, or by a contemporaneous written agreement to vote together.
    3. Now, no parent F/S are needed in the registration statement, but, as you'll see, determination of the parent affects the accounting in the combined F/S.
  2. Second question: Which of the combining companies is the predecessor?
    1. That's normally going to be the entity first controlled by the parent of the entities that are going to be combined.
    2. Since a predecessor has to provide the same F/S as if it were a registrant, Regulation S-X Rules 3-01 & 3-02 (or the comparable provisions of Regulation S-B) require full F/S for all periods. In other words, the predecessor is not eligible for any relief that might be available under S-X Rule 3-05 for an acquired business.
  3. Third question: What should the combined F/S (whether historical or pro forma) look like? They should look much like the consolidated F/S of the parent, but exclude the parent's assets and liabilities, operations and cash flows. That means, the combined F/S should reflect
    1. each combining company only from the date the parent acquired control, and
    2. the equity structure of the issuer.
    3. If the combining companies have different FYEs,
      1. you may need to include certain months twice or exclude certain months entirely to line up the FYEs or bring them within 90 days of each other, or
      2. you may have to add or subtract months so that the combined F/S for each year include each combining entity only for the number of months it was under common control during that year
    4. Just like in consolidated financials, you should eliminate intercompany items, transactions and profits.
    5. If a transferred company used different accounting methods than the receiving entity, its accounting methods can be changed to conform to those of the receiving entity. Such a change in accounting principle should be retroactively applied and the transferred company's prior F/S restated, whether they are included in the combined F/S or separately presented.
    6. Since the acquisition of equity not held by the parent is accounted for as the acquisition of minority interest, which I'll discuss further in a few minutes, we believe the combined F/S should reflect equity interests not owned by the parent as minority interest - both in the B/S and in the I/S.
    7. EPS and the composition of equity of each combining entity should be separately disclosed either on the face of the F/S or in the notes, unless the merger has already occurred. If the merger has occurred or will occur by effectiveness of the IPO, then EPS should be retroactively restated for all periods to reflect the change in capital structure. However, if there are significant cash distributions in the merger, then pro forma EPS should be presented for the most recent year and subsequent interim period only.
  4. Final question: Are any pre-acquisition F/S required under S-X Rule 3-05?
    1. Since each combining company is only reflected in the combined F/S from the date the parent gained control, F/S for periods prior to that date may be required for a combining company. Those 3-05 pre-acquisition financials are in addition to any pre-acquisition financials of the predecessor which are provided under S-X Rules 3-01 and 3-02.
    2. 3-05 F/S might also be required for businesses acquired by the combining companies during the historical periods presented.
    3. You may ask: How should significance be measured in determining if pre-acquisition financial statements are required?
      1. If the combination has already been retroactively reflected in the historical financial statements, then significance of an acquired business should be measured at the acquisition date against the combined F/S.
      2. SAB 80 may relieve some of the S-X 3-05 burden since it measures significance against the pro forma combined company, including any pending acquisitions.
        1. That means the relative significance of any business acquired by one of the combining companies would be measured by reference to the total combined business of the registrant at the time of the IPO.
        2. But SAB 80 is only applicable where a company was built by the aggregation of discrete businesses that remain substantially intact after acquisition.
        3. To qualify for SAB 80, the acquired business can't have been altered by post-acquisition decisions of the parent as to allocation of incoming orders between plants, locations, or entities.
    4. On the other hand, if the combination has not yet occurred and the registrant doesn't qualify for the SAB 80 relief, then significance should be measured against the predecessor. If you find that results in a requirement to present an unreasonable number of pre-acquisition F/S, I would encourage you to come talk to the staff.

Accounting Issues

OK, you've determined the form and number of financial statements required. Now let's move to the second topic and talk about some of the accounting issues you need to address.

I. First, let's talk about accounting for the merger itself.

  1. Transfers of net assets or exchanges of equity interests between entities under common control do not constitute business combinations. So, the net assets of the combining companies will come over at historical cost (by that I mean the parent's basis) to the extent of the parent's percentage ownership in each entity.
  2. Sometimes cash is distributed to the parent in the merger or the non-stock consideration paid for assets transferred differs from the parent's historical cost basis in those assets. Such transactions should be accounted for as a dividend to the parent. In some cases the inverse may occur, and any cash or other consideration received by the combined companies should be accounted for as a contribution to capital by the parent.
  3. When a minority interest is acquired by a parent, a subsidiary or by another affiliate, as in a merger of entities under common control, SFAS 141 requires purchase accounting.
    1. Exceptions to the application of purchase accounting for the minority interest are:
      1. One, if the merger is non-substantive. A merger is non-substantive if the minority interest does not change and if in substance the only assets of the combined entity after the exchange are those of the partially owned subsidiary prior to the exchange. A merger might also be non-substantive if the combining entities were each owned by the same shareholders in exactly the same percentages, even though those shareholders would not be considered a control group.
      2. Or two, purchase accounting is not applicable if the minority shareholders don't participate in the exchange. That means the minority interest in a combining company that remains outstanding after the merger has not changed.
    2. But which minority interests should get purchase accounting? Although it may seem odd when we're talking about a merger of entities under common control, you have to determine which company is the accounting acquirer. You have to determine the accounting acquirer in order to apply purchase accounting to the acquisition of the minority interests in the other combining companies.
  4. For the company that is the issuer in the merger, you need to figure out
    1. if it's the accounting acquirer, or
    2. if it'll be acquired in a reverse acquisition?
    3. That is, which entity's shareholders, including the parent's interest, will own the greatest percentage of the combined company?
    4. Of course, in figuring out which company is the accounting acquirer you can't ignore the other factors specified in paragraphs 17-19 of SFAS 141.

II. Once you've figured out which company is the accounting acquirer and which minority interests to be acquired are going to be fair valued, you have to determine the value of the issuer's shares exchanged in the merger. Without trying to tell you how that valuation should be done, let me make a few observations.

  1. In order to apply purchase accounting to the minority interest, the value of the shares issued are required to have an objective and reliable basis.
  2. And in addition to being relevant to the purchase of minority interests, the valuation of the issuer's shares may also affect measurement of compensation expense for options and shares issued pre-IPO.
  3. Since there is no other guidance to look to, it's reasonable to look to EITF 99-12 even though the merger itself does not get buscomb accounting. That EITF specifies that the fair value of shares to be exchanged should be determined at the date the merger agreement was reached.
    1. Now that raises an interesting question, since these are entities under common control - is there an agreement date? I suppose that depends on the specific facts, and I don't claim to have the answers.
      • Is there a minority interest that has to agree to the merger? In one common control merger I saw, a significant public minority equity interest existed for which a merger-proxy was required.
      • Or do the minority interests agree by accepting a tender or exchange offer when their acceptances could be at multiple dates? Maybe then you use the date the accepted offers become irrevocable or the actual date the exchange occurs.
      • Or can the parent just merge its interests in the combining companies with the minority interests in them remaining outstanding? But in that case the minority interest hasn't been purchased.
    2. As I said before, I think the valuation date will depend heavily on the specific facts and circumstances surrounding the merger.
  4. Lastly, don't forget to consider other valuation evidence available when a valuation methodology is used. That evidence might be provided by the terms of prior share transactions, by prior valuations and intervening events, or by the trading value of a public combining company's stock relative to its exchange ratio.

III. Perhaps the thorniest issue in these transactions is: When should push-down accounting be applied and reflected in the combined financial statements, and when should push-down be reflected in the separate F/S of a combining company that is itself an SEC registrant?

  1. The AICPA Issues Paper, EITF D-97, & SAB Topic 5.J. all provide us with some guidance.
    1. Generally, push-down is required if an entity becomes ≥95% owned, is optional if an entity is owned ≥80% but <95%, and is not allowed if an entity is owned <80% even though it may be controlled.
    2. That would seem to say that in the combined F/S (historical or pro forma), push-down could be applied at the time ≥80% control is acquired by the parent. But we've already said the combined F/S should look like the consolidated F/S of the parent, but without the parent's net assets, operations or cash flows. So where does that leave us?
      1. I expect we can agree that for the accounting acquirer in the merger, pushdown only needs to be applied in the combined financials if that company is ?95% owned by the parent.
      2. For the other combining companies, EITF 90-5 says the parent's basis in the other combining entities should be pushed down when those interests are transferred to another subsidiary. So the parent's basis in all entities but the accounting acquirer should be pushed down and reflected in the combined F/S.
      3. Note that if the parent is an individual, then the basis to be pushed down is determined "as if" that person prepared F/S in accordance with GAAP.
  2. You may wonder what happens if one of the combining companies is itself a public registrant, and will continue to be a separate registrant due to outstanding public debt or preferred stock? If the parent's basis in that company is pushed down in the combined financials, does the parent's basis now have to be pushed down to that company's separate F/S presented in its own SEC filings?
    1. First, we have to assume that, if the company was already ≥95% owned, any push-down previously required would already be reflected in that company's separate F/S.
    2. But where the parent owned between 80-95% of that company, the parent may have chosen not to apply pushdown in that company's separate F/S.
      1. You may know that the staff previously believed that in order for the parent to change that decision and pushdown its basis to the subsidiary's separate F/S, that change had to occur in connection with a significant event.
      2. Certainly, this merger would constitute such an event. Even in the absence of such an event, the staff has changed its view and believes pushdown results in a preferable presentation in all circumstances. So, although we would not require it, the staff would generally not object to a decision by the parent to retroactively pushdown its basis to the subsidiary's separate F/S when it owns between 80 to <95% of a subsidiary.
    3. However, in some cases, the parent can't control the form of ownership, meaning it can't control whether the acquired company continues to exist or is merged into the parent.
      1. If there's a significant amount of public debt or preferred stock outstanding, that's often when the parent can't control the form of ownership. In those cases, pushdown may not be required in the subsidiary's separate financials even if the subsidiary has become substantially wholly owned.
      2. We've also heard arguments against pushdown in the separate F/S of the subsidiary based on the notion that the subsidiary's other public security holders previously made their investment decisions using those historical F/S that didn't reflect pushdown. We consider that to be a weak argument, since you could make that argument for almost any change in the historical F/S, and we do believe pushdown results in a preferable presentation.

    IV. Finally, let's talk about impairments of a combining company's assets. When should they be recognized and how should they be measured?

    1. We believe impairments should be measured and recognized in the combined F/S based on the parent's basis. In other words, they should be recognized at the same time and in the same amount as they would have been had the parent prepared consolidated F/S.
    2. This applies to impairments of long-lived tangible and intangible assets, as well as impairments of goodwill.
    3. Remember, the parent's interests come over at carryover basis which is normally lower than their current FV and only the minority interests acquired are recorded at fair value, so you would expect the FV of the subsidiary as a whole to exceed its BV. If FV has been properly determined, any immediate impairment of assets anticipated following the application of purchase accounting to the acquisition of minority interests should be carefully examined. For example, in one case where the registrant expected to record a significant day 2 impairment, they determined upon further consideration that push-down of the parent's basis to the subsidiary's F/S had not been properly applied in prior years. Once,

      • the excess purchase price included in the parent's basis was allocated to the assets of the subsidiary,
      • depreciation and amortization of the assets was properly recorded,
      • the assets were evaluated for impairment, and
      • any indicated impairments were recognized in the historical F/S of the subsidiary,
      the registrant determined that no day 2 impairment was required to be recognized following the acquisition of the minority interests.

That ends my top-level review of some of the issues raised by common control mergers with an IPO. I hope you'll find it helpful if you're involved with one of these deals in the future.


Modified: 02/21/2007