On May 3, 2019, the SEC proposed for public comment amendments to its rules related to the financial statements required to be disclosed by SEC reporting companies or in IPOs in connection with an acquisition or disposal of a business. These proposed rule changes are intended to improve the information that investors receive regarding the acquisition and disposition of businesses, to facilitate more timely access to capital and to reduce complexity and compliance costs.
The rule proposal would primarily amend the following rules of Regulation S-X:
- Rule 3-05, which requires financial statements of businesses acquired or to be acquired by the company for varying periods, depending on the significance of the business.
- Article 11, which sets out the requirements for pro forma financial information relating to significant acquisitions and dispositions.
This publication highlights the most significant changes applicable to non-investment companies. The proposed amendments would not apply to financial statements related to the acquisition of a business that is the subject of a proxy statement or registration statement on Form S-4 or Form F-4.
Our practical guides, which summarize the existing rules on financial statements triggered by acquisitions, are available at: Financial Statements Triggered by Acquisitions—What You Need and When You Need Them.
Comments on the proposed rule are due by early July. The SEC will consider the comments received from the public on the proposed amendments, and any changes will take effect only once the SEC publishes a final rule release.
Acquired Business Financial Statement Requirements (Regulation S-X Rule 3-05)
Changes to Significance Tests
Rule 3-05 of Regulation S-X provides that, in situations where a business combination has occurred or is probable, the financial statements required to be presented for the business to be acquired are determined based on the significance of the acquired business as measured by the following three tests:
- Investment Test—The purchase price of the acquired business compared to the acquiring company’s consolidated total assets.
- Asset Test—The total assets of the acquired business compared to the acquiring company’s consolidated total assets.
- Income Test—The acquired business’s income from continuing operations before taxes, extraordinary items and cumulative effect of a change in accounting principle compared to that of the acquiring company.
Investment Test—The SEC is proposing to revise the investment test by changing the denominator to the aggregate worldwide market value of the acquiring company’s voting and non-voting common equity, rather than its consolidated total assets, on the basis that this would align the test more closely with the economic significance of the acquisition to the acquiring company. Where the company does not have an aggregate worldwide market value, the existing test would apply.
Income Test—The proposed rule recognizes that the existing income test can produce anomalous results—for example, by requiring financial statements for the acquired business when a very large company that has marginal or break-even net income or loss acquires a much smaller company with net income, even if the acquisition would otherwise not be material to investors. The SEC proposes to address this by adding a revenue component to the income test. While it would still be referred to as the “income test,” the proposed amendment would require, in addition to the calculation of the income component of the test, a revenue component. This would apply where both the acquiring company and the acquired business have recurring revenues and would consist of a comparison of the acquired business’s consolidated total revenues to that of the acquiring company for the most recently completed fiscal year. The lower of the income and the revenue component of the test would be used for purposes of determining the number of years for which acquired business financial statements are required to be presented.
To reduce anomalous results where the acquiring company or the acquired business does not have recurring annual revenues, and therefore only the income component of the test is used, the proposal would revise the income component to use a five-year average of the absolute value (treating net losses the same as net income) of net income or loss when income or loss for the latest fiscal year is at least 10% lower than the average income over the last five fiscal years. Currently, five-year average income that assigns zero to loss years is used for this calculation.
The income test calculation would also be simplified by using income or loss from continuing operations after income taxes, allowing companies to make the calculation using a line item from the face of the income statement, rather than trying to determine pre-tax operating income on the basis specified in the current rule. In addition, net income and average net income would be calculated using absolute values in order to mitigate the potential for misapplication that may result from inclusion of a negative amount in the computation.
Currently, if the significance of the acquired business exceeds 50% under any of the three tests, three years of audited financial statements are required for the acquired business. The proposed rule would change this by requiring a maximum of two years of historical financial statements if the significance of the acquisition exceeds 40%.
Where only one year of audited historical financial statements is required for the acquired business (i.e., for significance exceeding 20% but not exceeding 40% under any of the three tests), the rules would be revised to clarify that interim financial statements are required for only the most recent interim period, thereby eliminating the need to provide a comparative interim period.
Net Assets That Constitute a “Business”
Under the current rules, it can sometimes be difficult to produce Rule 3-05 financial statements for a component of an entity, such as a product line or a line of business contained in more than one subsidiary of the selling entity, which does not constitute a separate entity, subsidiary or division and for which separate and distinct accounts do not exist. In such situations, the proposed rule would allow companies to instead provide audited financial statements of assets acquired and liabilities assumed and statements of revenues and expenses (exclusive of corporate overhead, interest and income tax expenses), together with certain additional disclosures.
Oil and Gas Companies and Foreign Businesses
The proposed rule also addresses other topics relevant to specific types of companies:
- Oil and gas companies—The proposal would codify existing SEC guidance applicable to acquisitions of a business that includes significant oil and gas producing activities.
- Foreign businesses—The amended rules would allow acquired business financial statements to be prepared in accordance with IFRS as issued by the IASB (IFRS-IASB) without any reconciliations not only if the acquired business meets the definition of “foreign business,” but also if the acquired business would qualify to use IFRS-IASB if it were itself an SEC reporting company. Foreign private issuers that use IFRS-IASB would be able to reconcile home country GAAP acquired business financial statements to IFRS-IASB rather than U.S. GAAP.
Acquired Business Financial Statements in Registration Statements and Proxy Statements
Not Required if Already Reflected in Financial Statements for a Complete Fiscal Year
Current SEC rules permit acquired business financial statements to be omitted once the operating results of the acquired business have been reflected in the acquiring company’s audited consolidated financial statements for a complete fiscal year. However, such acquired business financial statements are required to be included when they have not previously been filed or when they have been previously filed but the acquisition is of major significance.
The proposed rule would no longer require acquired business financial statements to be included in registration statements and proxy statements once it has been reflected in the acquiring company’s filed post-acquisition financial statements for a complete fiscal year.
Use of Pro Forma Financial Information to Measure Significance
In measuring significance of acquired or disposed businesses, the existing rules do not allow for the use of pro forma financial information depicting significant dispositions or in connection with initial registration statements.
The SEC is proposing that, for all filings that require acquired business financial statements, companies may measure significance using previously filed pro forma financial information that only depicts significant business acquisitions and dispositions consummated after the latest fiscal year-end for which the company’s financial statements are required to be filed, provided that the acquired business financial statements and pro forma financial information required for any such acquisition or disposition have previously been filed.
Individually Insignificant Acquisitions
Under the current rules, audited historical pre-acquisition financial statements are generally not required if an acquired or to be acquired business (i) does not exceed 20% significance, or (ii) does not exceed 50% significance and the acquisition has either not yet occurred or closed within 74 days prior to the effective date of the registration statement. However, if the aggregate impact of “individually insignificant businesses” acquired since the date of the company’s most recent audited balance sheet exceeds 50%, audited historical pre-acquisition financial statements covering at least the substantial majority of the businesses acquired must be included in a registration statement or proxy statement. The related pro forma financial information is also required under Article 11 of Regulation S-X.
The proposed rule would require pro forma financial information depicting the aggregate effects of the acquired or to be acquired businesses and pre-acquisition financial statements only for those businesses whose individual significance exceeds 20% but are not yet required to file financial statements.
Financial Statements of Acquired Real Estate Operations (Regulation S-X Rule 3-14)
Aligning Rule 3-14 With Rule 3-05
Rule 3-14 of Regulation S-X provides for special acquired business financial statement requirements for real estate operations to address unique industry considerations. The SEC proposes to align Rule 3-14 with Rule 3-05 where no unique industry considerations exist. Specifically, the following requirements under Rule 3-14 are proposed to be aligned with Rule 3-05:
- Significance thresholds;
- Years of required financial statements for acquisitions from related parties;
- Permitting the filing of financial statements covering a period of nine to 12 months to satisfy the requirement for filing financial statements for acquired business;
- Timing of filing Rule 3-14 financial statements; and
- Omission of Rule 3-14 financial statements for real estate operations that have been included in the company’s financial statements.
The SEC also proposes other changes with regards to Rule 3-14:
- Scope of the requirements—The term “real estate operation” is not currently defined in either Regulation S-X or any other Securities Act or Exchange Act rules, and the term is open to interpretation. The SEC is proposing to define a real estate operation as “a business that generates substantially all of its revenues through the leasing of real property.”
- Significance tests—The proposed amendment would specify the use of a modified investment test when determining significance that compares the acquiring company’s investment in the real estate operation, including any debt secured by the real properties that is assumed by the acquiror, to the acquiring company’s total assets at the last audited fiscal year-end filed with the SEC.
- Interim financial statements—Rule 3-14 financial statements would be required for the most recent interim period prior to the acquisition.
- Special provision for blind pool offerings—for companies conducting continuous offerings over an extended period of time, the SEC proposes to apply adapted significance tests when determining whether they are required to provide Rule 3-14 financial statements.
Pro Forma Financial Information (Regulation S-X Article 11)
Adjustment Criteria and Presentation Requirements
Article 11 of Regulation S-X currently provides that the only adjustments that are appropriate in the presentation of a pro forma income statement are those that are (i) directly attributable to the transaction, (ii) expected to have a continuing impact on the SEC reporting company, and (iii) factually supportable. In a pro forma balance sheet, however, adjustments are permitted that are directly attributable to the transaction and factually supportable, regardless of whether the impact is expected to be continuing or nonrecurring.
The SEC proposes to amend Article 11 by replacing the existing pro forma adjustment criteria with simplified requirements. Specifically, the proposed amendments are comprised of two categories: (i) “Transaction Accounting Adjustments” to reflect the accounting for the transaction, and (ii) “Management’s Adjustments” to reflect reasonably estimable synergies and other transaction effects.
- Transaction Accounting Adjustments—In a pro forma balance sheet, the accounting for the transaction required by U.S. GAAP or IFRS-IASB should be depicted. In the pro forma income statement, the effects of the pro forma balance sheet adjustments should be reflected assuming these adjustments were made as of the beginning of the fiscal year presented.
- Management’s Adjustments—The proposed rule would require that Management’s Adjustments be presented through a separate column in the pro forma financial information after the presentation of combined historical statements and Transaction Accounting Adjustments. For each Management’s Adjustment, the SEC proposes to require (i) a description of the synergy or other transaction effects, (ii) disclosure of the underlying material assumptions, method of calculation and estimated time frame for completion, (iii) qualitative information necessary to give a fair and balanced presentation of the pro forma financial information, and (iv) any reportable processes involved, materials resources required and anticipated timing.
Significance Threshold for Business Dispositions
Article 11 currently provides that pro forma financial information is required upon a significant disposition or probable disposition of a significant portion of a business if that disposition is not fully reflected in the financial statements of the disposing company. A 10% significance threshold is used when determining whether a disposition of a business is significant.
The SEC is proposing to raise the significance threshold for business dispositions from 10% to 20%, in order to conform to the threshold used in Rule 3-05 to determine whether an acquired business is significant. The proposal also would conform the significance tests for business dispositions to those used for acquired businesses.