SEC Issues Final Rule to Improve Disclosures for Business Acquisitions and Dispositions
Introduction
On May 20, 2020, the SEC issued a final
rule1 that amends the financial statement requirements for acquisitions and
dispositions of businesses, including real estate operations, and related pro forma
financial information. As noted in the final rule, the amendments “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 disclosure.” Among other changes, the final rule modifies the
significance tests and improves the disclosure requirements for (1) acquired or to
be acquired businesses, (2) real estate operations, and (3) pro forma financial
information. In addition, the final rule includes amendments to financial
disclosures specific to smaller
reporting companies (SRCs)2 and investment
companies.3 The final rule is applicable for a registrant’s fiscal year beginning after
December 31, 2020. However, early application is permitted.
Background and Key Provisions of the Final Rule
SEC Regulation S-X, Rule 3-05,4 currently requires registrants, including entities undertaking an initial
public offering (IPO), to file the separate preacquisition financial statements for
a significant acquired or to be acquired business (acquiree). Similarly, SEC
Regulation S-X, Rule 3-14,5 may require a registrant to provide preacquisition financial statements for a
significant acquired or to be acquired real estate operation (real estate acquiree).
The financial statement periods required to be filed are based on the significance
levels determined by the registrant after performing the applicable significance
tests in SEC Regulation S-X, Rule 1-02(w)6 (i.e., the investment, asset, and income tests). Further, SEC Regulation S-X,
Article 11,7 requires a registrant to provide pro forma financial information depicting the
impact of a significant acquisition or disposition. These disclosures can be
important to investors because an acquisition or disposition may significantly
affect a registrant’s financial condition, results of operations, liquidity, and
future prospects. In drafting the final rule, the SEC took into consideration
constituents’ feedback on its May 2019 proposed
rule.8
Key amendments in the final rule will:
- Change the investment test to use the aggregate worldwide market value of common equity of the registrant when available.
- Change the income test to use the lower measure of significance based on (1) income from continuing operations before taxes or (2) revenue.
- Reduce the number of acquiree annual financial statement periods required to a maximum of the two most recent fiscal years.
- Require acquiree financial statements for an IPO in fewer circumstances.
- Modify the disclosure requirements for individually insignificant acquirees.
- Permit use of abbreviated financial statements for an acquiree in certain circumstances without a request for SEC staff permission.
- Extend the use of, and allow the reconciliation to, IFRS® Standards as issued by the International Accounting Standards Board (IASB®) (IFRS-IASB) in certain circumstances.
- Amend the pro forma financial information disclosures to require adjustments and certain disclosures for (1) “Transaction Accounting Adjustments” and (2) “Autonomous Entity Adjustments” when a registrant was previously part of another entity.
- Permit a registrant to present, in the explanatory notes to the pro forma financial information, “Management’s Adjustments” (e.g., synergies or dis-synergies for which there is a reasonable basis), if certain conditions are met.
- Align certain requirements for a real estate acquiree with those in Rule 3-05.
- Raise the significance threshold for reporting dispositions of a business from 10 percent to 20 percent to conform the threshold with that of a significant acquisition.
- Make other changes specific to SRCs and investment companies.
Despite these changes, many elements of Rule 3-05 were retained
under the amendments in the final rule. For example, although the amendments modify
two of the significance tests, the final rule retains the use of bright line
significance thresholds. In addition, the final rule retains the existing definition
of a business for SEC reporting purposes. This definition, which is outlined in SEC
Regulation S-X, Rule 11-01(d),9 focuses on the continuity of operations, including revenue-producing
activities, before and after the acquisition and is different from the definition in
ASC 80510 or IFRS 3.11 Further, some of the amendments codify existing SEC staff practice or
interpretation and thus may not result in a significant change in practice.
Connecting the Dots
Although the amendments may reduce the financial statement requirements under
Rule 3-05 (e.g., by eliminating a third year of acquiree financial
statements), they do not extend to (1) target companies included in a proxy
statement or registration statement on Form S-4 or (2) a company that is
considered the predecessor12 of a registrant.
Significant changes set forth in the final rule are discussed in further detail
below. The Appendix includes a table summarizing the
significant changes and a comparison of the disclosure requirements before and after
adoption of the final rule.
Measuring Significance
As noted above, a registrant is currently required to perform the following three
tests to determine the significance of an acquiree: the investment test, the asset
test, and the income test. The test that results in the highest significance level
is used to determine whether an acquisition is significant and the financial
statement periods that must be presented. These tests are also used to evaluate
significance in other circumstances, such as the disposition of a business (see the
Disposition of a Business section). The final rule amends
the investment and income test but does not modify the asset test.
Changes to the Investment Test for Business Acquisitions
Before adoption of the amendments, the investment test compared
(1) the investment in the acquiree (generally the consideration transferred as
measured in accordance with the applicable accounting standards)13 with (2) the total assets of the registrant as of the end of the most
recently completed fiscal year. This approach compared a fair value amount
(i.e., consideration transferred) with an amount that often may reflect
historical cost (i.e., total assets). The amendments modify the test to compare
(1) the investment in the acquiree14 with (2) the aggregate worldwide market value of the registrant’s common
equity. The aggregate worldwide market value is based on the average of the last
five trading days of the registrant’s most recently completed month-end before
the earlier of (1) the registrant’s announcement date or (2) the agreement date
of the acquisition. If the registrant has no aggregate worldwide market value
(e.g., when common equity is not publicly traded, including in an IPO), total
assets should be used, in a manner consistent with the existing investment
test.
Changes to the Income Test
Before adoption of the amendments, the income test consisted of a single
component based on income from continuing operations before income taxes (pretax
income), which often resulted in a high level of significance if a registrant
had breakeven or near breakeven income or loss. Therefore, registrants may have
been required to provide financial statements that were not material to
investors. To reduce anomalous results that can occur under the income test, the
amended income test consists of two components: the income component and the
revenue component, both of which are based on financial information for the most
recently completed fiscal year. A registrant must consider both components when
evaluating significance and, only if it finds the results of both to be
significant, uses the lower of the two components to determine the number of
periods for which acquiree financial statements are required. Under the amended test:
- The income component is determined by comparing the absolute values of (1) the acquiree’s pretax income or loss and (2) the registrant’s pretax income or loss.
- If both the registrant and the acquiree have material revenue in each of the two most recently completed fiscal years, the revenue component is calculated by comparing the acquiree’s revenue with the registrant’s revenue.
The amendments also change the calculation of a registrant’s average net income
for the last five fiscal years, as contemplated in the computational notes to
the existing Rule 1-02(w). The amendments require a registrant to use absolute
values to calculate its average net income for the last five fiscal years, when
applicable. This differs from the existing guidance in paragraph 2015.8 of the FRM, which indicates that “zero”
should be used for any loss years in the computation of the average. While the
revised calculation will increase the average income for those registrants that
have reported losses during the last five fiscal years, the amendments also
limit the use of income averaging to situations in which the revenue test is not
applicable (i.e., either the registrant or the acquiree did not have material
revenue in each of the two most recently completed fiscal years).
Connecting the Dots
The significance tests outlined in Rule 1-02(w) are used
throughout the SEC’s disclosure requirements and regulations, and the
final rule retains the consistent application of the significance tests,
with the exception of the investment test. Use of the aggregate
worldwide market value in the investment test applies only when a
registrant is evaluating business acquisitions and dispositions for
significance. The final rule retains the existing test (i.e., use of
total assets) in all other cases for which the investment test is
required. Therefore, registrants will continue to apply the existing
investment test when evaluating equity method investments for
significance in accordance with SEC Regulation S-X, Rule 3-09,15 or SEC Regulation S-X, Rule 4-08(g).16 The amended income test described above, including the revenue
component, however, will now apply when a registrant is evaluating
equity method investments for significance in accordance with Rules 3-09
or 4-08(g).
In addition, in the context of the income test, the
final rule does not provide specific thresholds for determining whether
the registrant and acquiree had material revenue. We believe that
registrants will need to exercise judgment when assessing, both
quantitatively and qualitatively, whether the registrant and acquiree
had material revenue.
Acquiree Financial Statements
The final rule allows, among other items, a registrant to (1) present fewer acquiree
financial statement periods, (2) present acquiree financial statements in fewer
circumstances, (3) use abbreviated financial statements without requesting SEC staff
permission, and (4) use, or reconcile to, IFRS-IASB in certain circumstances:
Fewer Acquiree Financial Statement Periods Required
- Changes in annual periods presented — Before adoption of the amendments, Rule 3-05 required registrants to present three17 years of audited financial statements of the acquiree when the results of any of the three significance tests exceeded 50 percent. The amendments eliminate the requirement to file the third year of audited financial statements; therefore, the maximum number of financial statement periods required for an acquiree is two18 years.
- Changes in interim periods presented — The amendments retain the requirement to provide interim financial statements but eliminate the requirement to provide the comparative prior-year interim period when only one year of audited acquiree financial statements are required (i.e., when any of the results of the significance tests are greater than 20 percent, but none are greater than 40 percent).
Connecting the Dots
While the SEC rules do not require interim periods of an
acquiree to be reviewed by an independent auditor, a review is often
performed at the request of management of the registrant. For the
auditor to complete a review of the current interim period, the results
of the prior-year comparable period may still need to be prepared.
Fewer Circumstances Requiring Acquiree Financial Statements
The amendments described above generally will result in fewer instances in which
acquiree financial statements are required. In addition, the amendments include
the following changes that will reduce the circumstances in which acquiree
financial statements are required.
-
Changes to the requirement for acquiree financial statements in an IPO — Under the amendments, acquiree financial statements are not required once the registrant’s audited financial statements reflect the operating results of the acquiree for at least:
- Nine months if any of the results of the significance tests are greater than 20 percent but none are greater than 40 percent.
- A complete fiscal year if the results of any of the significance tests are greater than 40 percent.
These changes may offer significant relief to companies undertaking an IPO since they may no longer be required to evaluate acquisitions that occurred before the most recently completed fiscal year. -
Changes to the requirements for individually insignificant acquisitions19 — In circumstances in which the aggregate significance of individually insignificant acquisitions exceeds 50 percent, the amendments (1) remove the existing requirement to provide separate financial statements for a “substantial majority” of the acquirees and (2) require financial statements only for acquirees whose results on any significance test exceed 20 percent and for which separate financial statements are not yet required to be filed.20 However, when the aggregate significance of individually insignificant acquisitions exceeds 50 percent, pro forma financial information must reflect the aggregate effects of all businesses acquired since the beginning of the fiscal year, even if preacquisition financial statements for such businesses are not required. In addition, the final rule now requires a registrant to include the aggregate impact of its real estate acquirees and its business acquirees to evaluate significance under the investment test. In a manner consistent with existing requirements, individually insignificant acquisition disclosures apply only to registration statements and proxy statements.
Connecting the Dots
Although the amendments eliminate the requirement to
provide separate financial statements for individually insignificant
acquirees, a registrant is still required to obtain sufficient
historical financial information about all of its individually
insignificant acquirees to prepare the required pro forma financial
information when aggregate significance exceeds 50 percent, as described
above. In addition, if material information is derived from financial
records that have not been subject to audit or review, it may affect the
level of comfort that auditors could provide to underwriters in
conjunction with a securities offering.
Use of Abbreviated Financial Statements Without a Request for SEC Staff Permission
Historically, the SEC staff has permitted registrants, through waiver
requests,21 to present audited financial statements of assets acquired and liabilities
assumed and statements of revenues and expenses (excluding corporate overhead,
interest, and taxes), referred to as abbreviated financial statements, when
certain criteria are met. The amendments permit registrants to present such
abbreviated financial statements for an acquiree without seeking permission from
the SEC staff when the following qualifying conditions are met:
- The assets and revenue of the acquiree represent 20 percent or less of the assets and revenue of the seller, as of and for the most recently completed fiscal year.
- The acquiree financial statements have not been previously prepared.
- The acquiree was not a separate entity, subsidiary, operating segment,22 or division during the periods for which acquiree financial statements would be required.
- The seller did not maintain the “distinct and separate accounts” that would be necessary to present financial statements that include the omitted expenses, and the preparation of such financial statements is impracticable.
The qualifying conditions and presentation requirements for
abbreviated financial statements in the amendments are generally consistent with
the criteria that the SEC staff historically applied when evaluating a waiver
request. When the qualifying conditions are not met, registrants may continue to
request permission through a waiver request.
Use of, or Reconciliation to, IFRS-IASB in Certain Circumstances
SEC rules and regulations distinguish between a foreign acquiree23 that meets the definition of a foreign business24 and one that meets the definition of an FPI.25 Before adoption of the amendments, only a foreign business acquiree was
permitted to present IFRS-IASB financial statements without reconciliation. The
amendments allow a registrant to present the financial statements of a foreign
acquiree that does not meet the definition of a foreign business in accordance
with IFRS-IASB without reconciliation to U.S. GAAP as long as the foreign
acquiree would qualify to use IFRS-IASB if it were a registrant (i.e., if it
would meet the FPI definition).
Connecting the Dots
Although the amendments increase the instances in which a registrant may
provide financial statements of a foreign acquiree prepared in
accordance with IFRS-IASB, without a reconciliation to U.S. GAAP, the
pro forma financial information reflecting the acquiree must nonetheless
be presented in accordance with the basis of presentation of the
registrant. That is, a registrant that prepares its financial statements
in accordance with U.S. GAAP and presents IFRS-IASB financial statements
for a foreign acquiree must obtain sufficient historical financial
information about the acquiree under U.S. GAAP to comply with the pro
forma requirements of the registrant.
The amendments also allow FPIs that prepare their financial statements in
accordance with IFRS-IASB to reconcile26 home-country GAAP foreign acquiree financial statements to IFRS-IASB,
rather than to U.S. GAAP as required under the existing requirements, if the
foreign acquiree meets the definition of a foreign business or the foreign
acquiree would meet the definition of an FPI if it were a registrant. The
amendments also clarify the application of IFRS 1,27 and certain SEC accommodations in a registrant’s reconciliation of
home-country GAAP to IFRS-IASB.
Pro Forma Financial Information
Pro forma financial information is generally required when separate financial
statements are provided under Rule 3-05 or Rule 3-14 for a significant acquiree or
real estate acquiree, respectively, or when there is a significant disposition of a
business or real estate operation. The objective of pro forma financial information
is to enable investors to understand and evaluate the impact of a transaction, such
as the acquisition or disposition of a business, by showing how that transaction (or
group of transactions) might have affected the registrant’s historical financial
position and results of operations had the transaction occurred at an earlier
date.
Under the existing requirements in Article 11, pro forma financial information was
generally presented in columnar form, with separate columns for the historical
financial information, pro forma adjustments, and pro forma results. The historical
financial statements were adjusted for amounts that were (1) directly attributable
to the transaction, (2) factually supportable, and (3) with respect to the statement
of comprehensive income, expected to have a continuing impact on the registrant. The
amendments significantly change the requirements for preparing pro forma financial
information by replacing the three criteria noted above with two categories of
required adjustments and one optional disclosure, as follows:
- Transaction accounting adjustments — These adjustments are limited to adjustments that reflect the accounting for the transaction in accordance with U.S. GAAP or IFRS-IASB, as applicable. They may include, among other items, the recognition of goodwill and intangible assets and adjustments of assets and liabilities to fair value on the balance sheet, as well as the related impacts on the statement of comprehensive income, under the assumption that the balance sheet adjustments were made as of the beginning of the fiscal year presented. For dispositions, the adjustments may reflect the disposal of assets and related impacts.
- Autonomous entity adjustments — These adjustments, which are only required if the registrant was previously part of another entity, reflect incremental expense or other changes necessary to reflect the registrant’s financial condition and results of operations as if it were a separate stand-alone entity. For example, if a public entity plans to distribute a portion of its business to its shareholders as a separate public company (e.g., spin-off), its pro forma financial statements must include autonomous entity adjustments to reflect the incremental costs expected to be incurred as if it were a separate stand-alone entity. If the distributed entity’s historical financial statements include allocated overhead costs of $5 million but it expects such costs to be $8 million as a stand-alone entity, a $3 million adjustment for additional overhead costs would be required, along with disclosures of the material assumptions and other qualitative information necessary for a fair and balanced presentation.
The amendments require registrants to provide separate columns in
their pro forma financial information for (1) historical financial information, (2)
transaction accounting adjustments, and (3) autonomous entity adjustments as well as
a pro forma total, which would include pro forma earnings per share. In the notes to
the pro forma financial information, a registrant must (1) clearly explain each
adjustment and (2) detail any revenues, expenses, gains and losses, and related tax
effects that will not recur in the registrant’s statement of comprehensive income
beyond a year from the transaction date.
Connecting the Dots
Before adoption of the amendments, adjustments to the pro
forma statement of comprehensive income were expected to have a continuing
(or recurring) impact on the registrant. The amendments do not distinguish
between adjustments that are deemed recurring and adjustments that are
deemed nonrecurring by management; however, they include a requirement to
disclose items that will not recur in the explanatory notes to the pro forma
financial information. For example, before adoption of the amendments, a
registrant’s pro forma statements of comprehensive income would include a
pro forma adjustment to remove nonrecurring acquisition-related transaction
costs. However, after adoption, such nonrecurring transaction costs must
remain in the pro forma statements of comprehensive income, with a
disclosure in the explanatory notes that such transaction costs are not
expected to recur.
Disclosure of Management’s Adjustments
In addition to the required adjustments noted above, the amendments give
registrants the flexibility to present, in the explanatory notes to the pro
forma financial information, management’s adjustments, which reflect synergies
and dis-synergies identified by management when evaluating whether to consummate
an acquisition. Management’s adjustments also may provide insight on the
potential effects of the acquisition and the plans that management expects to
take after the acquisition (which may include forward-looking information).28 Such adjustments, to the extent they do not qualify as a transaction
accounting or autonomous entity adjustment, may include, among other things,
closing facilities, discontinuing product lines, and terminating employees. When
synergies are presented, any related dis-synergies must also be presented.
Connecting the Dots
While the final rule does not define synergies or
dis-synergies, we believe that these terms generally refer to the
benefits (i.e., increased revenue or decreased expenses) and costs
(i.e., decreased revenue or increased expenses), respectively, that may
result from a transaction. The final rule requires registrants to
consider both, which ensures a balanced presentation.
To enable investors to separate the accounting impact of the transaction from the
impact of management’s plans after the transaction, the amendments require
management’s adjustments to only “be presented in the explanatory notes . . . in
the form of reconciliations of pro forma net income . . . and the related pro
forma earnings per share data to such amounts after giving effect to
Management’s Adjustments.” If pro forma amounts reflecting management’s
adjustments are disclosed elsewhere in a filing (e.g., management’s discussion
and analysis), pro forma amounts excluding management’s adjustments must
also be presented with equal or greater prominence along with a reference to the
reconciliation provided in the explanatory notes.
To present management’s adjustments, a registrant must meet the
following new conditions to ensure that such adjustments are presented
consistently and in a manner that would enhance an understanding of the
transaction:
- Basis of management’s adjustments — Management’s adjustments may only be presented in the explanatory notes to the pro forma financial information if (1) there is a reasonable basis for each adjustment, (2) the adjustments are limited to the effect of the synergies and dis-synergies for the periods presented, (3) reductions in an expense do not exceed the related expense reflected in the pro forma period presented, and (4) all such adjustments that, in the opinion of management, are necessary for a fair statement of the pro forma financial information are reflected (and a statement to that effect is provided).
- Form of presentation of management’s adjustments — In addition to the requirement to present management’s adjustments in the form of a reconciliation in the explanatory notes, the amendments also require certain disclosures to aid investors in evaluating management’s adjustments, including “the basis for and material limitations of each Management’s Adjustment, including any material assumptions or uncertainties of such adjustment, an explanation of the method of the calculation of the adjustment, if material, and the estimated time frame for achieving the synergies and dis-synergies.“29 These adjustments must reflect the most current assumptions available as of the effective date of a registration statement or filing date, which may require changes to previously issued pro forma financial information when it is provided in later filings.
Connecting the Dots
While the final rule introduces many new concepts for pro forma financial
information, the requirements for disclosure of pro forma amounts that
reflect management’s adjustments are consistent with a few of the
primary requirements for non-GAAP measures.30 For example, management’s adjustments must be presented in a
“reconciliation” format, and when such measures are presented outside
pro forma financial information, pro forma amounts excluding
management’s adjustments must also be presented with “equal or greater
prominence.”
Real Estate Operations
Companies in the real estate industry apply Rule 3-14 to report the acquisition or
probable acquisition of a real estate operation (real estate acquiree). The final
rule includes a number of changes to substantially align Rule 3-14 with Rule 3-05 in
an effort to reduce complexity while retaining certain industry-specific disclosures
where appropriate. In addition, the final rule includes several other changes to
Rule 3-14, many of which codify positions that the SEC staff has historically
applied and that were standard industry practice (and therefore are not discussed
below). Among other changes, the final rule:
- Increases the significance threshold from 10 percent to 20 percent for an individual real estate acquiree and disposed real estate operation.
- Increases the significance threshold from 10 percent to 50 percent for the aggregate impact of certain consummated and probable real estate acquisitions for which financial statements are (1) not required or (2) not yet required (individually insignificant real estate acquirees) and aligns the disclosure requirements with those in Rule 3-05 as described in the Changes to the requirements for individually insignificant acquisitions discussion above. For example, under the amendments, a registrant is not required to provide separate financial statements for any individually insignificant real estate acquiree; however, pro forma financial information should reflect the aggregate effects of all such real estate acquirees. In addition, the final rule now requires a registrant to consider the related requirements in Rule 3-05 if it has both real estate acquirees and business acquirees. In this case, the registrant would need to include the aggregate impact of its business acquirees and its real estate acquirees to evaluate significance under the investment test. In a manner consistent with existing requirements, these changes apply only to registration statements and proxy statements.
- Reduces the three-year annual financial statement requirement for significant real estate acquirees from related parties to one year and no longer differentiates the number of periods on the basis of whether the seller is a related party.
- No longer requires financial statements of a real estate acquiree in registration statements and proxy statements once the real estate acquiree has been reflected in the registrant’s financial statements for nine months (see the Changes to the requirement for acquiree financial statements in an IPO discussion for a summary of the analogous provision in Rule 3-05).
- Permits the filing of financial statements covering a period of 9 to 12 months to satisfy the one-year requirement for a real estate acquiree, in a manner consistent with Rule 3-05.
- Specifies that the investment test31 for assessing the significance of a real estate acquiree is consistent
with the evaluation of business acquisitions in accordance with Rule 3-05 in
that it compares the registrant’s investment in the real estate operation
(excluding any debt secured by the real properties that is assumed by the
registrant) to the registrant’s aggregate worldwide market value unless such
value is not available. In that case, in a manner consistent with current
practice, the investment test compares the registrant’s investment in the
real estate operation, including any debt secured by the real properties
that is assumed by the registrant, with the registrant’s total assets as of
the most recently completed fiscal year.Connecting the DotsBecause many real estate companies rely on mortgages and other debt to finance their investments, total assets may exceed their aggregate worldwide market value. Notwithstanding other changes described herein, for companies with an aggregate worldwide market value, the change to the investment test may result in higher levels of significance. Registrants may consider a waiver request when they believe the investment test would result in the filing of real estate acquiree financial statements that would not be material to investors. For companies for which an aggregate worldwide market value is not available (e.g., nontraded real estate investment trusts), there is no change to the substance of the investment test for real estate acquirees as currently applied.
- Conforms the requirements related to acquisitions of foreign real estate operations in Rule 3-14 with the analogous provisions in Rule 3-05 (see the Use of, or Reconciliation to, IFRS-IASB in Certain Circumstances section).
- Does not differentiate between a real estate acquiree with a triple-net lease and one without. Therefore, the final rule clarifies that a registrant must provide financial statements of a real estate acquiree in accordance with Rule 3-14 rather than provide the financial statements of the lessee or guarantor of the lease, which is the existing practice.32
- Codifies existing SEC staff practice for blind pool offerings, which is to calculate the significance of a real estate acquiree as set forth in paragraphs 2325.3 and 2325.5 of the FRM. In a manner consistent with current industry practice, the final rule also extends this guidance to business acquisitions under Rule 3-05 that are carried out during a blind pool offering.
Disposition of a Business
Before adoption of the amendments, Article 11 required pro forma
financial information for the disposition or probable disposition of a business when
it exceeded the 10 percent significance level on the basis of any of the three
significance tests noted above. The amendments raise the significance threshold from
10 percent to 20 percent and align the investment and income test with the revised
tests for a business acquisition. Therefore, for the investment test, a registrant
must compare the fair value of consideration received (including contingent
consideration) with the aggregate worldwide market value of the registrant (or, if
there is no market value, compare the carrying value of the disposed business with
the total assets of the registrant). This differs from the existing investment test,
as interpreted in paragraph
2130.2 of the FRM, which compared the greater of (1) the
carrying value of the disposed business or (2) the fair value of consideration
received with the registrant’s total assets. Similarly, under the amendments, the
registrant must consider both the income component and the revenue component of the
income test and compare pretax income and revenue of the disposed business with
those of the registrant.
Connecting the Dots
Although the amendments modify the investment test and increase the
significance threshold for the disposal of a business to 20 percent, they do
not modify such requirements for the acquisition or disposition of a
significant33 amount of assets that do not constitute a business in accordance with
Article 11. Form 8-K, Item 2.01, continues to require disclosure, including
pro forma financial information, for asset acquisitions and dispositions for
which significance exceeds 10 percent.
Smaller Reporting Companies
The final rule includes corresponding changes to the requirements for SRCs. Before
adoption of the amendments, SEC Regulation S-X, Article 8,34 required financial statements and pro forma financial information for
acquirees; however, it did not provide the same level of detailed guidance as Rule
3-05 and Article 11. After adopting the amendments, SRCs may continue to prepare
acquiree financial statements in accordance with Article 8 (e.g., the form and
content requirements); however, SRCs must refer to the requirements in Rules 3-05
and 3-14 for other requirements. Similar changes were made for pro forma financial
information, and thus SRCs must refer to Article 11 for the presentation and
disclosure of such information (except for the condensed format allowed for
SRCs).
Investment Companies
Before adoption of the amendments, investment companies followed the same general
requirements of Rule 3-05 and Article 11 as other registrants. However, because of
the unique characteristics of investment companies, it was often unclear how to
apply these rules.
The amendments add SEC Regulation S-X, Rule 6-11,35 and Rule 1-02(w)(2), which, among other things, provide
investment-company–specific significance tests: (1) the investment test, which
focuses on the value of the total investments, and (2) the income test, which uses
measures commonly included in the investment company’s financial statements, such as
changes in net assets from operations.36 In addition, the amendments (1) make certain revisions to the significance
thresholds that may reduce the need to provide financial statements and (2) limit
the number of audited financial statement periods required for an acquired fund to
one year and the most recent interim period. Further, the amendments allow the use
of U.S. GAAP financial statements for an acquired private fund supplemented by
schedules that comply with SEC Regulation S-X, Article 1237 (including a detailed schedule of investments), rather than financial
statements that comply with the provisions of Regulation S-X. The amendments also
replace the existing requirement for pro forma financial information for a fund
acquisition with a requirement to provide certain supplemental information about
fees and investments.
Effective Date and Transition
The final rule will become effective at the beginning of the registrant’s fiscal year
that starts after December 31, 2020 (e.g., the mandatory compliance date would be
January 1, 2021, for calendar-year-end companies). However, voluntary compliance is
permitted before the effective date as long as the final rule is applied in its
entirety on that date.
Registrants that (1) are subject to the reporting requirements of Section 13(a) or
15(d) of the Exchange Act on the mandatory compliance date and (2) file registration
statements on or after the mandatory compliance date may test acquisitions and
dispositions that occurred before the mandatory compliance date in accordance with
the rules that were applicable at the time the acquisitions or dispositions were
consummated. Further, registrants that initially report an acquisition or
disposition under Item 2.01 of Form 8-K before their mandatory (or voluntary)
compliance date must comply with the rules that were in effect when the initial Form
8-K was filed (or required to be filed), even if the financial statements and pro
forma information will be filed by amendment to the initial Form 8-K after the
mandatory (or voluntary) compliance date.
Example
- Registrant A acquires Company B on May 11, 2020.
- Company B is 55 percent significant to A under the rules in effect when the initial Form 8-K is filed. Therefore, A must provide B’s audited financial statements covering three years and any required interim periods.
- Registrant A files its initial Form 8-K announcing the acquisition on May 15, 2020 (i.e., within four business days). Registrant A has an additional 71 calendar days before it will be required to file B’s financial statements and pro forma financial information in a Form 8-K/A.
- Registrant A elects May 30, 2020, as its voluntary compliance date for the final rule.
- After adopting the amendments in the final rule, B is 41 percent significant to A.
Registrant A must file an amendment to its
initial Form 8-K and provide (1) B’s audited financial
statements covering three years, (2)
B’s required interim periods, and (3) related pro forma
financial information prepared under the prior guidance
within 71 calendar days of May 15, 2020 (i.e., within 71
calendar days of the initial Form 8-K filing). Even though
the amended Form 8-K must be filed after the voluntary
compliance date, since the initial Form 8-K was filed before
the voluntary compliance date, Registrant A must comply with
the requirements in effect when the initial Form 8-K was
filed (i.e., the requirements in effect before the adoption
of the amendments in the final rule). If A believes the
third year of financial statements of B are not material for
investors, it may consider requesting a waiver from the
SEC.
For companies filing an IPO, the final rule is effective for initial registration
statements first filed on or after the mandatory compliance date, including
assessment of probable and consummated acquisitions and dispositions, even those
consummated before the mandatory compliance date. Similarly, voluntary compliance is
permitted before the effective date as long as the final rule is applied in its
entirety.
Registrants are encouraged to reach out to SEC staff for additional transition
guidance in connection with early compliance with the rules.
Looking Ahead
This final rule represents a substantial simplification of the disclosure
requirements for business acquisitions and dispositions and highlights the SEC’s
continued focus on improving disclosure effectiveness and encouraging capital
formation. Recently, the SEC finalized amendments to simplify disclosures related to
guarantors and collateralizations of securities, which are discussed in Deloitte’s
March 10, 2020, Heads Up. Both of these rules address considerations
outlined in the SEC’s September 2015 request for comment on the effectiveness of
financial disclosures about entities other than the registrant. In addition to these
topics, the request for comment38 also addressed disclosures for equity method investments. While the amendments
to the significance tests described above will also modify the income test for
equity method investments, no further changes have been proposed to date.
Appendix — Summary of Key Changes
The following is a summary of the key changes in the final rule that have an impact
on the disclosures of an acquisition or disposition of a business in accordance with
Rule 3-05 and Rule 11-01; therefore, the summary does not address acquisitions of
real estate operations or acquisitions by business development companies, investment
companies, or SRCs. The table should be read in conjunction with this Heads
Up.
Before Amendments
|
Final Rule
| |
---|---|---|
Significance Tests
| ||
The investment test compares (1) the
investment in the acquiree with (2) the total assets
of the registrant.
|
The investment test compares (1) the
investment in the acquiree with (2) the aggregate worldwide market value of the registrant's
common equity. If there is no aggregate worldwide
market value of the registrant’s common equity, the test
uses the registrant’s total assets.
| |
The income test consists of a single
component based on financial information for the
most recent fiscal year:
|
The income test consists of two
components based on financial information for the
most recent fiscal year:
A registrant must consider both components when evaluating
significance, and only if it finds the results of both to be
significant, uses the lower of the two components to
determine the number of periods for which acquiree financial
statements must be presented.
The revenue component does not apply if
either the registrant or acquiree did not have material
revenue for the two most recently completed fiscal
years.
| |
In the calculation of a registrant’s average net income for
the last five fiscal years, “zero” must be used for any loss
years in the computation of the average.
|
In the calculation of a registrant’s average net income for
the last five fiscal years, absolute values must be
used in the computation of the average. However, income
averaging would only be available for the income component
of the income test if the registrant is not able to apply
the revenue component.
| |
Acquiree Financial Statements
| ||
On the basis of the highest level of significance,
registrants must provide audited annual financial statements
for the following number of years:
|
On the basis of the highest level of significance,
registrants must provide audited annual financial statements
for the following number of years:
| |
Unaudited interim financial statements for
the most recent interim period and the comparative prior-year interim period are required
for all levels of significance.
|
On the basis of the highest level of significance,
registrants provide the following unaudited interim
financial statements:
| |
Registrants must evaluate significance for all
acquirees during (1) the latest three fiscal years
(or the latest two fiscal years for emerging growth
companies and SRCs) and (2) any subsequent interim period
through the date the initial registration statement is
declared effective.
Audited financial statements are required
for the number of years indicated by the significance tests.
Preacquisition, postacquisition, or a combination of
preacquisition and postacquisition audited results may
satisfy the financial statement requirement.
|
Registrants must evaluate significance for all
acquirees during (1) the latest fiscal year and (2)
any subsequent interim period through the date the initial
registration statement is declared effective.
Audited preacquisition financial statements are required for
the number of years indicated by the significance tests
unless the registrant’s audited financial statements reflect
the operating results of the acquiree for:
| |
Individually insignificant acquisitions |
When filing a registration or proxy statement and the
aggregate significance of all individually insignificant
acquisitions exceed 50 percent, a registrant must provide:
|
When filing a registration or proxy statement and the
aggregate significance of all individually insignificant
acquisitions exceed 50 percent, a registrant must provide:
|
A registrant must seek SEC staff permission to use
abbreviated financial statements if it acquires net assets
that constitute a business.
|
A registrant may use abbreviated financial statements
without requesting SEC staff permission if it
acquires net assets that constitute a business that (1)
represent 20 percent or less of the seller’s revenue and
assets and (2) meet certain other criteria.
| |
A registrant is permitted to present IFRS-IASB financial
statements, without reconciliation to U.S. GAAP, if it
acquires a significant foreign acquiree that meets the
definition of a foreign business.
|
A registrant is permitted to present IFRS-IASB financial
statements, without reconciliation to U.S. GAAP, if it
acquires a significant foreign acquiree that meets the
definition of a foreign business or would meet the
definition of an FPI if it were a registrant.
| |
FPIs that prepare their financial statements in accordance
with IFRS-IASB must reconcile home-country GAAP financial
statements of a foreign acquiree to U.S. GAAP even
when the foreign acquiree meets the definition of a foreign
business or would meet the definition of an FPI if it were a
registrant.
|
FPIs that prepare their financial statements in accordance
with IFRS-IASB may reconcile home-country GAAP financial
statements of a foreign acquiree to IFRS-IASB if the
foreign acquiree meets the definition of a foreign
business or would meet the definition of an FPI
if it were a registrant.
| |
Pro Forma Financial Information
| ||
Adjustments must be:
|
Transaction accounting adjustments — These adjustments
must reflect the transaction in accordance with U.S. GAAP or
IFRS-IASB, as applicable.
| |
Autonomous entity adjustments — If the registrant was
previously part of another entity, these adjustments must
reflect the registrant’s financial condition and results of
operations as if it were a separate stand-alone entity.
| ||
Management’s adjustments (optional) —
These adjustments may reflect synergies and dis-synergies of
acquisitions and dispositions when certain criteria are
met.
| ||
Separate columns are presented for the:
|
Separate columns are presented for the:
Management’s adjustments, if presented, may not be reflected
on the face of the pro forma financial statements but should
be included in the explanatory notes in the form of a
reconciliation.
| |
Business Dispositions
| ||
A registrant must file a Form 8-K when a disposed business
exceeds 10 percent significance.
|
A registrant must file a Form 8-K when a disposed business
exceeds 20 percent significance.
|
Footnotes
1
SEC Final Rule Release No. 33-10786, Amendments to
Financial Disclosures About Acquired and Disposed Businesses.
2
SRCs, as defined in SEC Regulation S-K, Item 10(f)(1),
“General: Smaller Reporting Companies,” and issuers relying on SEC
Regulation A (collectively referred to as SRCs) should refer to the
discussion in the Smaller
Reporting Companies section for a summary of how the
amendments may affect them.
3
Investment companies registered under the Investment Company
Act of 1940 and business development companies (collectively referred to as
investment companies) should refer to the discussion in the Investment Companies
section for a summary of how the amendments may affect them.
4
SEC Regulation S-X, Rule 3-05, “Financial Statements of
Businesses Acquired or to Be Acquired.”
5
SEC Regulation S-X, Rule 3-14, “Special Instructions for
Real Estate Operations to Be Acquired.”
6
SEC Regulation S-X, Rule 1-02(w), “Definitions of Terms Used
in Regulation S-X: Significant Subsidiary.”
7
SEC Regulation S-X, Article 11, “Pro Forma Financial
Information.”
8
SEC Proposed Rule Release No. 33-10635, Amendments to
Financial Disclosures About Acquired and Disposed Businesses.
9
SEC Regulation S-X, Rule 11-01, “Presentation
Requirements.”
10
FASB Accounting Standards Codification (ASC) Topic 805,
Business Combinations.
11
IFRS 3, Business Combinations.
12
See paragraph 1170.1 of the SEC Division of
Corporation Finance’s Financial Reporting Manual (FRM).
13
ASC 805 governs the measurement of consideration
transferred unless the registrant is a foreign private issuer (FPI) that
reports in accordance with IFRS-IASB, in which case IFRS 3 should be
used.
14
The amendments clarify that the investment in the
acquiree must include (1) the fair value of contingent consideration if
it must be recognized at fair value under the applicable accounting
standards or (2) all contingent consideration (unless the likelihood of
payment is remote) if recognition at fair value is not required under
the applicable accounting standards.
15
SEC Regulation S-X, Rule 3-09, “Separate
Financial Statements of Subsidiaries Not Consolidated and 50
Percent or Less Owned Persons.”
16
SEC Regulation S-X, Rule 4-08(g), “General Notes
to Financial Statements: Summarized Financial Information of
Subsidiaries Not Consolidated and 50 Percent or Less Owned
Persons.”
17
Before adoption of the amendments, (1) the third year of
financial statements was not required if the acquiree reported
less than $100 million in revenue during its most recent fiscal
year and (2) when three years of financial statements were
required, the balance sheet for the third year could be
omitted.
18
Before adoption of the amendments, emerging growth companies
could omit the third year of any required acquiree financial
statements during their IPO of common equity securities or for
Form 8-K filings before the earlier of the filing or the filing
deadline of their first Form 10-K. In addition, SRCs were not
required to present more than two years of acquiree financial
statements. Therefore, the amendments align the maximum number
of acquiree financial statement periods to be presented for all
registrants.
19
Individually insignificant acquisitions
include any acquisitions after the most recent audited
annual balance sheet date that (1) were consummated and do
not exceed 20 percent, (2) were consummated within 75 days
of the date of the final prospectus or prospectus supplement
for a registration statement or the date the proxy statement
is mailed and exceed 20 percent but do not exceed 50
percent, and (3) are probable and do not exceed 50
percent.
20
The amendments may accelerate reporting of
historical financial statements for these acquirees in
certain registration statements and proxy statements.
21
Waiver requests are granted in accordance with the SEC staff’s delegated
authority under SEC Regulation S-X, Rule 3-13, “Filing of Other
Financial Statements in Certain Cases.”
22
FASB Accounting Standards Codification Topic 280, Segment
Reporting, defines operating segments. FPIs that report
in accordance with IFRS-IASB should refer to IFRS 8,
Operating Segments.
23
A foreign acquiree, as used in the context of this publication, is an
acquired or to be acquired business that is not incorporated in the
United States.
24
See paragraph 6110.4 of the FRM.
25
See paragraph 6110.2 of the FRM.
26
Such reconciliation is generally required if the significance of the
foreign acquiree exceeds 30 percent.
27
IFRS 1, First-Time Adoption of International Financial Reporting
Standards.
28
The amendments also revise Article 11 so that any forward-looking
information supplied is expressly covered by the safe harbors under
Securities Act Rule 175 and Exchange Act Rule 3b-6.
29
SEC Regulation S-X, Rule 11-02(a)(7)(ii)(D).
30
See SEC Regulation S-K Item 10(e), “Use of Non-GAAP Financial
Measures in Commission Filings.”
31
While a registrant that acquires real estate operations applies only
the investment test to measure significance, a registrant considers
all three significance tests outlined in Rule 1-02(w) when
evaluating whether a disposition of real estate operations is
significant.
32
See Section 2340 of the FRM
for existing guidance regarding properties subject to triple-net
leases.
33
Form 8-K, Item 2.01, Completion of Acquisition or
Disposition of Assets, states the acquisition or disposition
of assets that do not constitute a business in accordance with
Article 11 is significant “if the registrant’s . . . net book
value of such assets or the amount paid or received for the
assets upon such acquisition or disposition exceeded 10% of the
total assets of the registrant” [italics added].
34
SEC Regulation S-X, Article 8, “Financial Statements of Smaller Reporting
Companies.”
35
SEC Regulation S-X, Rule 6-11, “Financial Statements of Funds Acquired or to
Be Acquired.”
36
The final rule refers to including, for example, “any net
realized gains and losses and net change in unrealized gains and
losses.“
37
SEC Regulation S-X, Article 12, “Form and Content of Schedules.”
38
SEC Release No. 33-9929, Request for Comment on the
Effectiveness of Financial Disclosures About Entities Other Than the
Registrant.