Amendments to Financial Disclosures about Acquired and Disposed Businesses
By Rainer Martin, Senior Manager, Assurance Services
On May 20, 2020, the Securities and Exchange Commission (“SEC” or “Commission”), has adopted amendments to its rules and forms for public companies, including foreign private issuers, registered investment companies and business development companies to improve their application and to assist registrants in making more meaningful determinations of whether a subsidiary or an acquired or disposed business is significant and to improve the related disclosures. The changes are intended 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 disclosures.
The SEC has amended the requirements in Rule 1-02(w) of Regulation S-X– significant subsidiary)), Rule 3-05 (significance test), Rule 3-14 (special instructions to real estate operations to be acquired), Article 11 (pro forma financials), and related rules and forms.
The new rules will be effective January 1, 2021. Registrants may elect to comply with the amendments in advance of the effective date. Voluntary early compliance is generally permitted immediately provided that the new rules are applied in their entirety from the date of early compliance.
Among the more prominent changes are as follows:
- Updating the tests used to determine significance and expanding the use of pro forma financial information when measuring significance;
- Conforming the significance threshold and tests, to the extent applicable, for a disposed business to those used for an acquired business;
- Permit disclosure of abbreviated financial statements for certain acquisitions of a component of an entity;
- Revising the pro forma financial information requirements to improve the content and relevance;
- Reducing the maximum number of years for which financial statements of an acquired business are required to two years;
- No longer require 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 significance;
- Modify and enhance the required disclosure for the aggregate effect of acquisitions for which financial statements are not required or are not yet required;
- Make corresponding changes to the smaller reporting company requirements in Article 8 of Regulation S-X;
- Permit the use of or reconciliation to International Financial Reporting Standards in certain circumstances;
- Clarify when financial statements and pro forma financial information are required;
- Other amendments for specific industries:
- Align rules for financial Statements of acquired real estate operations with Rule 3-05
- Abbreviated Financial Statements for oil and gas producing operations
- Rules specific to the companies registered under the Investment Company Act and business development companies to address their unique attributes
The amendments will not apply to target company financial statements required to be included in a proxy statement or registration statement on Form S-4 or Form F-4 but will apply to the pro forma information provided therein pursuant to Article 11 and any financial information for other acquisitions and dispositions that is required to be disclosed in the registration statement pursuant to Rule 3-05 or Rule 3-14 (e.g., registrant or target company acquires), which will be aligned, where no unique industry conditions exist.
Financial statement periods required under Rule 3-05
(Not intended to be all inclusive and this release only covers aspects of amendments to Rule 3-05)
To explain the new Amended Rule 3-05(b)(2), the rule reduced the maximum number of years that audited financial statements are required under Rule 3-05 from three years to two. At the same time it also eliminated the requirement to provide financial statements for a comparative interim period when only one year of audited financial statements is required under Rule 3-05.
Amended Rule 3-05(b)(4) will now permit the omission of separate acquired business financial statements once the business has been included in the registrant’s post-acquisition audited annual financial statements for a minimum period of nine months or a complete fiscal year, depending on significance. This is a change from the previous requirements and eliminates certain provisions that required financial statements for older significant acquisitions to be included in filings.
In adopting these changes, the SEC highlighted the pre-existing provisions of Rule 4-01(a), which requires that a registrant provide “such further material information as is necessary to make the required statements, in light of the circumstances under which they are made, not misleading.”
Under the new Rules, Rule 3-05 Financial Statements will be required as follows:
Changes as it relates to the significance tests
The significance tests for disclosures of acquired and disposed businesses refer to the definition of “significant subsidiary” in Section 1-02(w) of Regulation S X. Under these amendment, the definition of “significant subsidiary” is revised as it relates to Investment and Income tests. However the new rules leave the Asset Test substantially “as is” but provide that, for acquisitions, intercompany transactions with the acquired business must be eliminated in computing the registrant’s and its subsidiaries’ consolidated total assets. These amendments would also impact the other disclosure requirements that refer to the “significant subsidiary” definition, such as disclosures in periodic reports under the Exchange Act and exhibits that are required to list a company’s significant subsidiaries, among others.
The current Investment Test compares the acquiring company’s investments in and advances to the acquired business to the total assets of the acquiring company, as shown on its most recent annual financial statements required to be filed on or before the acquisition date. The proposed amendments revises the investment test to instead compare the registrant’s investment in and advances to the acquired business to the aggregate worldwide market value of the registrant’s voting and non-voting common equity (“aggregate worldwide market value”). For purposes of the rule, the “aggregate worldwide market value” would be determined using an average of aggregate worldwide market value calculated daily for the last five trading days of the registrant’s most recently completed month prior the earlier of the registrant’s announcement date or agreement date of the acquisition of disposition. If the acquiring company does not have an aggregate worldwide market value, the existing test based on total assets would continue to apply. As a result, the definition applicable to determining significance of a wholly-owned subsidiary would not change in practice, and the new prong would apply only to acquired businesses and would compare the acquisition price to the aggregate worldwide market value of the acquiring company at the end of the most recently completed fiscal year.
Under the current rules, the income test compares the acquiring company’s equity in the income from continuing operations of the acquired business before income taxes, exclusive of amounts attributable to any noncontrolling interests, to the same measure of the acquiring company, as shown on its most recent annual financial statements required to be filed on or before the acquisition date. Relatively small acquisitions by companies with small net income or loss or break-even performance, which may not be considered material to investors, can often trigger disclosure requirements based on the Income Test, due to the exclusive focus on net income. The SEC staff frequently receives requests for relief from the disclosure requirements by companies in this situation.
As amended, a new revenue component to the income test is added to compare the registrant’s and its other subsidiaries’ proportionate share of the tested subsidiary’s consolidated total revenues (after intercompany eliminations) to the consolidated total revenues of the registrant for the most recently completed fiscal year. The revenue component does not apply if the registrant and the tested subsidiary do not have material revenue in each of the two most recently completed fiscal years. To satisfy a significance threshold under the income test, when the revenue component applies, the tested subsidiary/business must meet both the revenue component and the net income component.
In addition, if the tested subsidiary/business meets both the revenue and net income components, the registrant may use the lower of the revenue component and the net income component to determine the number of periods for which Rule 3-05 financial statements are required. The addition of a revenue component to the income test will provide an important check on acquisitions that are otherwise immaterial to investors but that meets the income test threshold simply because the registrant may have marginal or nonexistent net income in any given fiscal year.
Smaller reporting companies and issuers relying on Regulation A
The rule also amended Rule 8-04, which directs smaller reporting companies to Rule 3-05 for significance testing and thresholds. Form and content requirements will continue to be prepared in accordance with Rules 8-02 and 8-03. As a result, under the amendments, smaller reporting companies will continue to be required to provide up to two years of historical financial statements.
Because Part F/S of Form 1-A refers to Rule 8-04, the amendments to Rule 8-04 apply to issuers relying on Regulation A. Regulation A issuers will continue to be permitted to present the applicable periods. This will also permit smaller reporting companies and issuers relying on Regulation A to omit historical acquired financial statements if the acquired business has been included in the company’s results for either nine months or a complete fiscal year, depending on significance.