On May 21, 2020, the Securities and Exchange Commission (the SEC) announced the adoption of amendments to certain rules and forms relating to financial disclosures about acquisitions and dispositions of businesses “to improve for investors the financial information about acquired or disposed businesses, facilitate more timely access to capital, and reduce the complexity and costs to prepare the disclosure.” The amendments primarily affect Regulation S-X and related rules and forms. The SEC originally proposed the amendments in May 2019 and adopted them largely as proposed.

Background

Under Rule 3-05 of Regulation S-X, public reporting companies that acquire a business are generally required to provide separate audited annual and unaudited interim pre-closing financial statements of the target if such acquisition is “significant” to the registrant. The number of years of financials to be provided varies depending on the level of significance, as measured on a sliding scale by the investment, asset, and income tests in Rule 1-02(w) of Regulation S-X. Rule 3-14 of Regulation S-X requires similar disclosures in the context of significant real estate operations.

Public reporting companies are also required under Article 11 of Regulation S-X to provide pro forma financial information, which is based on the historical financial statements of the registrant and the acquired or disposed of business, and typically includes pro forma balance sheets and pro forma income statements for significant acquisitions or dispositions. This pro forma financial information demonstrates the financial information of the registrant and the acquired or disposed business had the applicable transaction closed at the beginning of the fiscal year.

As stated by the SEC and more fully described below, the following updates are contained in the amendments:

  • Update of the significance tests used under these and other rules to generally improve their application and assist registrants in making more meaningful significance determinations;
  • Expansion of the use of pro forma financial information in measuring significance;
  • Conforming, to the extent applicable, the significance threshold and tests for a disposed business to those used for an acquired business;
  • Requiring the financial statements of the acquired business to cover only up to the two most recent fiscal years;
  • Permitting disclosure of abbreviated financial statements for certain acquisitions of a component of an entity;
  • Permitting the use of, or reconciliation to, International Financial Reporting Standards as issued by the International Accounting Standards Board (IFRS-IASB) in certain circumstances;
  • No longer requiring separate acquired business financial statements once the business has been included in the registrant’s post-acquisition audited annual financial statements for either nine months or a complete fiscal year, depending on the level of significance;
  • Modifying and enhancing the required disclosure for the aggregate effect of acquisitions for which financial statements are not required or are not yet required;
  • Aligning Rule 3-14 with Rule 3-05 where no unique industry considerations exist;
  • Clarifying the application of Rule 3-14 regarding the determination of significance, the need for interim income statements, special provisions for blind pool offerings, and the scope of the rule’s requirements;
  • Amending the pro forma financial information requirements to improve the content and relevance of such information;
  • Clarifying when financial statements and pro forma financial information are required, and updating the language used in SEC rules to take into account concepts that have developed since adoption of the rules over 30 years ago; and
  • Making corresponding changes to the smaller reporting company requirements in Article 8 of Regulation S-X.

Amendments to Financial Disclosures

Update to Significance Test

Registrants apply the “significant subsidiary” test in Rule 1-02(w) to determine the significance of an acquisition under Rule 3-05. The final amendments revise the significance test by modifying the income test and the investment test.

The current income test compares a registrant’s equity in the income from continuing operations of the acquired business before income taxes, excluding amounts attributable to any non-controlling interests, to the same registrant metric reflected in its most recent annual financial statements. As amended, the income test now includes an additional revenue component comparing the registrant’s and its other subsidiaries’ share of the tested subsidiary’s consolidated total revenues (after intercompany eliminations) to the company’s consolidated total revenues for the most recently completed fiscal year. The tested subsidiary must meet both the revenue component and the net income component when the revenue component applies. Registrants may use the lower of the revenue component and the net income component to determine the number of periods for which financial statements to be provided under Rule 3-05 are required. Consistent with a comment received on the proposed rule, if the company and its consolidated subsidiaries or the tested subsidiary did not have material revenue in each of the two most recently completed fiscal years, the revenue component will not apply. The final amendments do not change the current requirement to use pre-tax income from continuing operations.

Currently, the investment test compares the investment in and advances to the acquired business against the registrant’s total assets, as reflected in its most recent annual financial statements. As amended, the investment test now compares the registrant’s investments in and advances to the tested subsidiary to the aggregate worldwide market value of the registrant’s voting and non-voting common equity, when available, limited expressly to acquisitions and dispositions. Aggregate worldwide market value is calculated daily for the last five trading days of the registrant’s most recently completed month ending prior to the earlier of the registrant’s announcement date or agreement date of the acquisition or disposition. For registrants without an aggregate worldwide market value, or when such a value is not available, the current test continues to apply. The current test further continues to apply for any additional purposes for which the Rule 1-02(w) definition is applicable. The final amendments include additional changes in order to clarify that the meaning of “investments in” the tested subsidiary is consideration transferred, adjusted to exclude the registrant’s and its subsidiaries’ proportionate interest in the carrying value of assets transferred by the registrant and its subsidiaries consolidated to the tested subsidiary that will remain with the combined entity after the acquisition. Further, “investments in” the test subsidiary include the fair value of contingent consideration if required to be recognized at fair value by the registrant at the acquisition date under U.S. Generally Accepted Accounting Principles (GAAP) or IFRS-IASB, as applicable.

Use of Pro Forma Information in Measuring Significance

Under the current rule, registrants may use pro forma financial information in making a significance determination if they have made a significant acquisition subsequent to the end of the latest fiscal year and filed Rule 3-05 financial statements and pro forma financial information on a Current Report on Form 8-K. The final amendments expand the use of pro forma financial statements by permitting registrants to measure significance using filed pro forma financial information that depicts only significant business acquisitions and dispositions consummated after the latest fiscal year-end for which the registrant's financial statements are required to be filed. This use of pro forma financial statements is conditioned on: (1) registrants having filed financial statements under Rule 3-05 or Rule 3-14 for any acquired businesses; and (2) registrants having filed the pro forma financial information required by Article 11 for any such acquired or disposed businesses.

Pro Forma Adjustments

As currently constructed, registrants providing pro forma information are precluded from making adjustments for the potential effects of post-acquisition actions expected to be taken by management. The only adjustments that are appropriate under Article 11 in the presentation are those that are directly attributable to the transaction and factually supportable. In the case of a pro forma condensed statement of comprehensive income, such adjustments must also be expected to have a continuing impact on the registrant.

In order to alleviate issues with inconsistent results and to more clearly define adjustment criteria, the SEC replaced the existing pro forma adjustment criteria in Rule 11-02 of Regulation S-X with simplified requirements (1) to depict the accounting for the transaction and (2) to provide the option to depict synergies and dis-synergies of the acquisitions and dispositions for which pro forma effect is being given. There are three categories of pro forma adjustments under the rule as amended:

  • Transaction Accounting Adjustments, which “reflect only the application of required accounting to the acquisition, disposition, or other transaction linking the effects of the acquired business to the registrant’s audited historical financial statements;”
  • Autonomous Entity Adjustments, which “reflect the operations and financial position of the registrant as an autonomous entity when the registrant was previously part of another entity;” and
  • Management’s Adjustments, which “include forward-looking information that depicts the synergies and dis-synergies identified by management in determining to consummate or integrate the transaction for which pro forma effect is being given.”

Under the final amendments, Transaction Accounting Adjustments and Autonomous Entity Adjustments are required, but Management Adjustments are optional and may be presented when the registrant views providing such adjustments as enhancing an understanding of the pro forma effects of the transaction. Management’s Adjustments must not be misleading to investors, and forward looking information there in is covered by the safe harbors under Rule 175 and Rule 3b-6.

Reduction of Number of Years of Financial Statements Required

Under the current rule, registrants need not provide Rule 3-05 financial statements if none of the significance tests (investment, asset or income) exceeds 20 percent. If any test falls between 20 percent and 40 percent, registrants must provide financial statements for the most recent fiscal year and any required interim periods. For any acquisition between the 40 percent and 50 percent significance levels, registrants must provide a second fiscal year of financial statements. Above 50 percent, a third fiscal year is required unless net revenues of the acquired business were less than $100 million in its most recent fiscal year.

As amended, registrants need to provide only two years of required financial statements for acquisitions exceeding 50 percent significance, reduced from three years. Therefore, the amended rule requires financial statements for at least the two most recent fiscal years and any interim periods specified in Rules 3-01 and 3-02 if any of the tests exceed 40 percent. For significance tests measuring between 20 percent and 40 percent, Rule 3-05 now requires financial statements for the “most recent” interim period specified in Rule 3-01 and 3-02, rather than “any” interim period, as previously allowed under the rule.

Modification of Disclosures for Individually Insignificant Businesses

Registrants currently must provide in a registration statement or proxy statement audited historical pre-acquisition financial statements covering at least the substantial majority of the businesses acquired, along with pro forma financial information required in Article 11, when the aggregate impact of these businesses acquired since the date of the most recent audited balance sheet exceeds 50 percent. The final amendments clarify that “individually insignificant businesses” include:

  • Any acquisition consummated after the registrant’s audited balance sheet date whose significance does not exceed 20 percent;
  • Any probable acquisition whose significance does not exceed 50 percent; and
  • Any consummated acquisition whose significance exceeds 20 percent, but does not exceed 50 percent, for which financial statements are not yet required by Rule 3-05(b)(4) because of the 75-day filing period.

As amended, the rule requires registrants to include pre-acquisition historical financial statements only for businesses for which individual significance exceeds 20 percent. Registrants are required to provide pro forma financial information depicting the aggregate effects of all “individually insignificant businesses” in all material respects.

Businesses with losses must be aggregated separately when applying the 50 percent income test. In the event that either group exceeds 50 percent, the disclosure requirements apply to all of the businesses subject to the aggregate test and must not be limited to either the businesses with losses or those with income.

Acquisition of a Component of an Entity

When registrants acquire a component of an entity that constitutes a “business,” as defined in Rule 11-01(d) of Regulation S-X, such as a product line, that is not a separate entity, subsidiary, or division, it may be difficult to present the financial information covered in Rule 3-05 of Regulation S-X. As amended, the rule now allows registrants to provide abbreviated financial statements and permit the mission of certain corporate overhead, interest, and income tax expenses, subject to satisfaction of certain conditions, in the event of a qualifying acquisition by the registrant. Examples of such conditions include: (1) the total assets or revenues of the acquired entity constitute 20 percent or less of the corresponding amounts of the seller and its consolidated subsidiaries as of and for the most recently completed fiscal year; and (2) the acquired entity was not a separate entity, subsidiary, operating segment (as defined by GAAP or IFRS-IASB, as applicable), or division during the periods for which disclosure of financial information would otherwise be required.

Separate Acquired-Business Financial Statements

Currently, registrants do not need to provide financial statements under Rule 3-05 after the operating results of the acquired company have been reflected in the audited consolidated financial statements of the registrant for a full fiscal year, unless the financial statements have not been previously filed or the acquired business is of major significance.

As amended, the rule no longer requires registrants to include financial statements under Rule 3-05 in registration statements and proxy statements for acquired companies that exceed 20 percent but are less than 40 percent in significance, provided the financial statements have been included in the registrant’s audited post-acquisition results for nine months. In the case of acquired companies exceeding 40 percent significance, registrants are not required to include financial statements in registration statements and proxy statements after they have been included in the registrant’s audited post-acquisition results for a full fiscal year. The amendments also relieve registrants of the requirement that they provide financial statements when they have not been previously filed or when they have been previously filed but the acquired company is of major significance.

The amendments also provide for applicable conforming changes to smaller reporting company requirements under Article 8 of Regulation S-X.

The final rules are effective on January 1, 2021. Registrants will not be required to apply the final amendments until the beginning of their fiscal year beginning after December 31, 2020. Registrants planning to file their initial registration statements need not apply the final amendments unless such registration statement is filed on or after December 31, 2020. Registrants who choose to voluntarily comply with the final amendments prior to the effective date must apply the final amendments in their entirety from the date of such early compliance.

The lawyers in Ballard Spahr’s Securities and Capital Markets Group advise clients on these SEC amendments.


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