On May 21, the U.S. Securities and Exchange Commission (SEC) voted to adopt amendments, available here, to its rules and forms to assist companies in determining whether an acquired or disposed business is significant and to improve the disclosure requirements for financial statements relating to the acquisition or disposition of a business. Specifically, the SEC amended the financial disclosure requirements in Rule 3-05 (Financial Statements of Businesses Acquired or to Be Acquired), Rule 3-14 (Special Instructions for Real Estate Operations to Be Acquired) and Article 11 (Pro Forma Financial Information) of Regulation S-X, as well as related rules and forms. The SEC also adopted both new Rule 6-11 of Regulation S-X and amendments to Form N-14 for financial reporting of acquisitions involving investment companies. According to the SEC, these amendments will “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 final amendments, which are substantially similar to the amendments proposed by the SEC on May 3, 2019, become effective on Jan. 1, 2021. Any acquisitions and dispositions of businesses that are probable or consummated after that date must be evaluated for significance using the final amendments. The SEC will permit voluntary early compliance with the final amendments as long as the company electing such early compliance applies the final amendments in their entirety from the date of such early compliance.

Background

Under Rule 3-05, when a company acquires a significant business other than a real estate operation, the acquiring company must provide separate audited annual and unaudited interim pre-acquisition financial statements for the acquired business. The number of years of financial information that must be provided depends on the relative significance of the acquisition to the acquiring company. Whether an acquisition is significant under Rule 3-05 is determined by applying the investment, income and asset tests provided in the “significant subsidiary” definition in Rule 1-02(w) of Regulation S-X. Similarly, with respect to real estate operations, Rule 3-14 requires a company that has acquired a significant real estate operation to file financial statements with respect to such acquired operation.

Article 11 also generally requires companies to file unaudited pro forma financial information showing the impact of the acquisition or disposition to the acquiring company’s balance sheet and income statements.

The required financial statements and pro forma financial information generally must be filed within 75 days after consummation of the acquisition under Form 8-K and (for non-real estate acquisitions) in certain registration statements and proxy statements.

Summary of Final Amendments

Acquired Business Financial Statements Generally

Significance Tests

The final amendments revise the tests that are used to determine the significance of a business acquisition or disposition by modifying the investment test and the income test. The SEC intends the final amendments to more accurately reflect the relative significance to the acquiring company of the acquired business and to reduce anomalous results in the application of the definition of significant subsidiary. The final amendments leave the asset test substantively unchanged.

• Investment Test. Under current rules, the investment test compares the acquiring company’s investment in the acquired business with the value of the acquiring company’s total assets. The revised investment test instead compares an acquiring company’s investments in and advances to the acquired business with the “aggregate worldwide market value” of the acquiring company’s common equity, if available. Companies must use the average of aggregate worldwide market value calculated daily for the last five trading days of the company’s most recently completed month ending prior to the earlier of the announcement date or the agreement date of the transaction. If the acquiring company’s common equity does not have an aggregate worldwide market value, the current investment test will continue to apply.
• Income Test. Under current rules, the income test focuses on one component: net income (or income from continuing operations before taxes). The final amendments revise the income test to add a new revenue component, which compares an acquiring company’s proportionate share of the consolidated total revenues of the acquired business (after intercompany eliminations) with such consolidated total revenues of the acquiring company for the most recently completed fiscal year. The revised income test requires that if the acquiring company and the acquired business have recurring annual revenue, the acquired business must meet both the new revenue component and the net income component. The revenue component does not apply if either the acquiring company or the acquired business did not have material revenue in each of the two most recently completed fiscal years. The SEC did not adopt the proposed amendment to calculate income or loss from continuing operations after income taxes and retained the requirement to use income or loss from continuing operations before income taxes.

Use of Pro Forma Financial Information To Test Significance

Under the current rules, significance determinations must be made by comparing the most recent annual consolidated financial statements of the acquired business with those of the acquiring company filed at or prior to the date of acquisition. An acquiring company may use only pro forma (rather than historical) financial information if the company made a significant acquisition subsequent to the latest fiscal year-end and filed its financial statements and pro forma financial information on Form 8-K. The final amendments expand the circumstances in which an acquiring company can use pro forma financial information for significance testing, allowing the acquiring company 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 company’s financial statements are required to be filed, if certain conditions are satisfied.

Acquired Business Audited Financial Statements

The current rules require up to three years of audited financial statements for an acquired business if significance exceeds 50%. The final amendments reduce this requirement to two years. In addition, if a significance test exceeds 20% but not 40%, the final amendments require financial statements for the “most recent” interim period rather than “any” interim period and eliminate the need to provide a comparative interim period when only one year of audited financial statements is required.

Financial Statements for Component Acquisitions

When an acquiring company acquires a component of an entity, such as a product line or a line of business that constitutes a “business” for financial reporting purposes, the selling entity may be unable to provide financial statements for the acquired component. In addition, it may be impracticable for the selling entity to allocate its corporate overhead, interest and income tax expenses for purposes of providing such financial statements. To address these issues, the final amendments permit acquiring companies to provide both audited financial statements of assets acquired and liabilities assumed and statements of revenues and expenses that exclude corporate overhead, interest and income tax expenses, if certain conditions are satisfied.

Omission of Acquired Business Financial Statements

The current rules permit financial statements of an acquired business to be omitted once the operating results of the acquired business have been reflected in the audited consolidated financial statements of the acquiring company for a complete fiscal year, unless the financial statements of the acquired business have not been filed or, if the statements are filed, the acquired business is of major significance, in which case financial statements of such acquired business must be provided. The final amendments provide that financial statements will no longer be required in registration statements and proxy statements once the acquired business is reflected in filed post-acquisition financial statements for a complete fiscal year, regardless of whether financial statements of the acquired company have been filed or whether the acquired business is of major significance.

Individually Insignificant Acquisitions

The current rules provide that if the aggregate impact of “individually insignificant businesses” acquired since the date of the most recent audited balance sheet exceeds 50%, an acquiring company must include audited historical financial statements covering at least the “substantial majority” of the businesses acquired, as well as related pro forma financial information, in a registration statement or a proxy statement. The final amendments still require acquiring companies to provide pro forma financial information depicting the aggregate effects of all such businesses. However, historical financial statements will not be required to cover a substantial majority of the business acquired, but rather only acquired businesses whose individual significance exceeds 20%.

Pro Forma Financial Information

Under current rules, pro forma financial information typically includes a pro forma balance sheet and pro forma income statements based on the historical financial statements of the acquiring company and the acquired or disposed business. The pro forma balance sheet may reflect adjustments that are directly attributable to the transaction and are factually supportable, regardless of whether they are expected to have a continuing impact on the company. However, the pro forma income statement may reflect only adjustments that are directly attributable to the transaction, expected to have a continuing impact on the company and factually supportable.

The final amendments replace the existing pro forma adjustment criteria with simplified requirements to reflect the accounting for the transaction and to provide an option to present synergies of the transaction for which pro forma effect is being given. Specifically, the adjustment criteria are broken into the following three categories:

• Transaction Accounting Adjustments. These adjustments reflect only the application of required accounting to the transaction.
• Autonomous Entity Adjustments. These adjustments reflect the operations and financial position of the company as an autonomous entity if the company was previously part of another entity.
• Management’s Adjustments. These adjustments depict the synergies and dis-synergies identified by management in connection with the transaction for which pro forma effect is being given, if, in management’s opinion, such adjustments provide insight to investors into the potential effects of the transaction and the plans expected to be implemented by management.

Under the final amendments, transaction accounting adjustments and autonomous entity adjustments are required whereas management’s adjustments are discretionary.

Significance and Business Dispositions

Under current rules, pro forma financial information is required upon the disposition of a significant portion of a business if that disposition is not fully reflected in the financial statements of the acquiring company. The current rules further provide that a disposition of a business is significant if the disposed business meets the conditions of a significant subsidiary using a 10% significance threshold, not the 20% threshold used for business acquisitions.

The final amendments raise the significance threshold for a disposed business from 10% to 20% to conform to the significance threshold for an acquired business and also to align, as applicable, the tests used to determine significance of a disposed business to those used to determine significance of an acquired business.

Real Estate Operations

Currently, Rule 3-14, which applies to the financial statements of real estate operations acquired or to be acquired, differs from Rule 3-05 due to unique real estate industry considerations that warrant different disclosure. The final amendments generally align Rule 3-14 with the amendments to Rule 3-05 described above. The final amendments also clarify the application of Rule 3-14 with respect to significance determinations, interim financial statement requirements and other matters.

Investment Companies

The final amendments add a definition of significant subsidiary in Regulation S-X specifically tailored for investment companies and add a new Rule 6-11, modeled after the final amendments to Rule 3-05 and 3-14 described above, to address the financial statements of acquired investment funds. The final amendments also replace the pro forma financial information requirement currently applicable to investment companies with a requirement to provide supplemental financial information about the newly combined entity. Lastly, the final amendments adjust Form N-14 so that its disclosure requirements are consistent with the disclosures required in new Rule 6-11.