Pro Forma Financial Information: Essential Takeaways for Lawyers

Understanding how to read and interpret key financial statements should not just be left to accountants and financial advisors. It is also critical to the success of a corporate lawyer to be adept at reviewing the various financial statements of a business for key pieces of information. Lawyers should have a basic mastery of how to read pro forma financial information, which reflect the continuing impact of certain significant acquisitions, dispositions, and other types of transactions.

Article 11 of Regulation S-X

Article 11 of Regulation S-X is a Securities and Exchange Commission (SEC) rule that sets forth the requirements for how pro forma financial statements should be presented and provides guidance in their preparation.

The purpose of pro forma financial disclosure is to provide investors with information about the continuing impact of an acquisition, disposition, or transaction on the business by showing how the specific transaction might have affected historical financial statements.

The presentation of Article 11 pro forma financial information may need to be included in a variety of SEC filings, such as a Form 8-K, Form S-1, Form S-4, or merger proxy statement.

The SEC publishes a Financial Reporting Manual that provides detailed guidance on the preparation and presentation of financial information for public companies. Topic 3 of the SEC’s Financial Reporting Manual provides interpretive guidance on pro forma financial statements.

Circumstances Requiring Presentation of Pro Forma Financials

Companies are required to present pro forma financial information when a significant business acquisition or disposition has occurred in the latest fiscal year or a subsequent interim period. Pro forma financials are also required if a significant business combination or disposition is reasonably likely to occur.

The completion of a transaction that involves an acquisition or disposition of assets may be reportable on a Form 8-K under Item 2.01. If the company is obligated to file a Form 8-K, pro forma financial statements for the transaction should be attached as an exhibit. The Form 8-K deadline for reporting a significant acquisition is 71 days from the occurrence of the transaction. There is no equivalent grace period for dispositions. The Form 8-K deadline for reporting a significant disposition is 4 business days from the occurrence of the transaction.

Pursuant to Article 11 of Regulation S-X, disclosure of pro forma financials may also be required in certain other circumstances if such disclosure would be material to investors. Such situations may include:

  • Roll-up transactions
  • Declaration of dividends by a subsidiary
  • Receipt or application of offering proceeds
  • Repayment of debt
  • Termination of revision of a tax or other cost sharing arrangement
  • Emergence from bankruptcy and registration of securities

Significance Tests

The requirement to include pro forma financial statements is dependent on the significance of the business acquisition, disposition, or other transaction. Significance is measured using three tests under Rule 1-02(w) of Regulation S-X — the investment test, asset test, and income test. As long as one of the three tests is satisfied, the transaction is considered significant. The threshold percentage is measured at the 20% significance level for a business combination and at the 10% significance level for the disposition of a business.

  • Investment test: The company’s investments in and advances to the business exceed the threshold percentage of the total assets of the company and its subsidiaries.
  • Asset test: The company’s proportionate share of the total assets of the business exceeds the threshold percentage of the total assets of the company and its subsidiaries.
  • Income test: The company’s equity in the income from continuing operations before income taxes, extraordinary items, and cumulative effect of a change in accounting principle of the business exceeds the threshold percentage of such income of the company and its subsidiaries.

Pro forma financial statements are required for individually insignificant businesses only if they are aggregated and deemed significant in the aggregate at the over 50% level.

Pro Forma Presentation

The pro forma financial statements generally consist of a pro forma condensed balance sheet and a pro forma condensed statement of income. The information is organized into columns showing the (i) historical financial information, (ii) pro forma adjustments, and (iii) pro forma results.

If the company and the acquired entity have different financial reporting periods, the statement of income should be presented using the company’s fiscal year end. An acquired entity’s statement of income should be brought up to within 93 days of the company’s fiscal year. This can be achieved by adding and deducting amounts from interim period financial statements.

An auditor report is not required for pro forma financial statements. To the extent an auditor report is provided for pro forma financial information, it should comply with the standards published by the American Institute of Certified Public Accountants (AICPA).

Pro Forma Adjustments

Pro forma adjustments give effect to events that are (i) directly attributable to the specific transaction, (ii) factually supportable with reliable and documented evidence, and (iii) anticipated to have a continuing impact. These adjustments broadly fall into three categories —transaction accounting adjustments, autonomous entity adjustments, and management adjustments. Pro forma adjustments are presented as if the transaction occurred at the beginning of the applicable fiscal year.