Other
Financial Disclosures about Acquired and Disposed Businesses
Dec. 30, 2020
A Small Entity Compliance Guide[1]
Introduction
On May 20, 2020, the U.S. Securities and Exchange Commission (“Commission”) voted to adopt amendments to the significance tests in the definition of “significant subsidiary,” and the financial disclosure requirements in Regulation S-X for acquisitions and dispositions of businesses[2], including real estate operations and investment companies (See Financial Disclosures About Acquired and Disposed Businesses, Release No. 33-10786 (the “Adopting Release”)). The changes are intended to help registrants make more meaningful determinations of whether a subsidiary or an acquired or disposed business is significant, 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.
Who is affected by the amendments?
The amendments affect all domestic and foreign issuers with classes of securities registered under the Securities Exchange Act of 1934 (“Exchange Act”) or Investment Company Act of 1940 (“Investment Company Act”) that need to make significance determinations relating to a subsidiary or an acquired or disposed business, as well as issuers offering securities in certain registration statements under the Securities Act of 1933 (“Securities Act”) or Regulation A offering statements.
What changes were made by the amendments?
The “significant subsidiary” definition in Rule 1-02(w) of Regulation S-X, Rule 405 of the Securities Act, and Rule 12b-2 of the Exchange Act was amended to update the significance tests for subsidiaries and for determinations relating to acquisitions and dispositions. When a registrant acquires a significant business, Regulation S-X requires financial disclosures relating to the acquisition. Rule 3-05 of Regulation S-X, which generally requires a registrant to provide separate audited annual and unaudited interim pre-acquisition financial statements of an acquired or to be acquired business, and Rule 3-14 of Regulation S-X, which similarly requires a registrant to provide financial statements for acquired or to be acquired real estate operations, were amended to update the financial information requirements. Article 11 of Regulation S-X, which requires registrants to file unaudited pro forma financial information showing how the acquisition or disposition might have affected the registrant’s financial statements, was also amended to update the pro forma financial information requirement. Article 8 of Regulation S-X, was amended to correspondingly amend these requirements for smaller reporting companies. Finally, the amendments revised the definition of “significant subsidiary” to be specifically tailored for investment companies in Investment Company Act Rule 8b-2 and add Rule 6-11 of Regulation S-X to address financial reporting for fund acquisitions.
These changes are discussed below.
1. Significance Tests (Rule 1-02(w), Rule 405, and Rule 12b-2)
The significance tests within the “significant subsidiary” definition in Rule 1-02(w), Rule 405, and Rule 12b-2 include an investment test, an asset test, and an income test that are applied when determining if a subsidiary is deemed significant for the purposes of certain Regulation S-X and Regulation S-K requirements as well as certain Securities Act and Exchange Act rules and forms. The amendments modified the investment test and income test.[3]
For ease of reference, set forth below are tables summarizing the amended “significant subsidiary” tests.
| Amended Investment Test | ||
|---|---|---|
| Numerator | Denominator | |
|
Market Value |
Registrant’s and its other subsidiaries’ investments in, and advances to the tested subsidiary. |
Registrant’s aggregate worldwide market value of its voting and non-voting common equity, calculated daily from the last five trading days of the most recently completed month ending prior to the earlier of the registrant’s announcement date or agreement date of the acquisition or disposition, or total consolidated assets where the registrant has no such aggregate worldwide market value. |
| Asset Test | ||
|---|---|---|
| Numerator | Denominator | |
|
Proportionate Share |
Registrant’s and its other subsidiaries’ proportionate share of total assets of the tested subsidiary (after intercompany eliminations) as of end of the most recently completed fiscal year. |
Registrant’s and its subsidiaries’ consolidated total assets (after intercompany eliminations) as of the end of the most recently completed fiscal year. |
| Amended Income Test[4] | ||
|---|---|---|
| Numerator | Denominator | |
|
Net Income Component |
Absolute value of the registrant’s and its other subsidiaries’ equity in the tested subsidiary’s consolidated income or loss from continuing operations before income taxes (after intercompany eliminations) attributable to the controlling interests for the most recently completed fiscal year. |
Absolute value of the registrant’s and its subsidiaries’ consolidated income or loss from continuing operations before income taxes (after intercompany eliminations) for the most recently completed fiscal year; |
|
Revenue Component |
Registrant’s and its other subsidiaries’ proportionate share of the tested subsidiary’s consolidated total revenues (after intercompany eliminations) for the most recently completed fiscal year. |
Registrant’s and its subsidiaries’ consolidated total revenues (after intercompany eliminations) for the most recently completed fiscal year. |
2. Acquired Business Financial Information (Rules 3-05 and 3-14 of Regulation S-X)
When a registrant acquires[5] a business other than a real estate operation, Rule 3-05 generally requires a registrant to provide separate audited annual and unaudited interim pre-acquisition financial statements of the business if it is significant to the registrant using the investment, asset, and income tests provided in Rule 1- 02(w), substituting 20% for 10%.
The amendments to Rule 3-05, among other things,
- require the financial statements of the acquired business to cover no more than the two most recent fiscal years;
- no longer require separate acquired business financial statements once the business has been included in the registrant’s audited financial statements for nine months or a complete fiscal year, depending on significance;
- modify and enhance the required disclosure for the aggregate effect[6] of acquisitions for which financial statements are not otherwise required or are not yet required in the registration statements or proxy statements to which the rule applies by eliminating historical financial statements for insignificant businesses and expanding the pro forma financial information to depict the aggregate effect in all material respects;
- permit abbreviated financial statements that omit certain expenses for certain acquisitions of the net assets of an entity and businesses that include oil and gas producing activities; and
- permit the use of, or reconciliation to, International Financial Reporting Standards as issued by the International Accounting Standards Board in certain circumstances.
When a registrant acquires[7] a significant real estate operation, Rule 3-14 similarly requires a registrant to file financial statements with respect to those operations. However, the required financial statements only include an abbreviated income statement. The amendments to Rule 3-14 align the requirements with Rule 3-05 where no unique industry considerations exist. In addition, the amendments to Rule 3-14 clarify the application of the rule regarding:
- the determination of significance;[8]
- the need for interim income statements;
- special provisions for blind pool offerings; and
- the scope of the rule’s requirements.[9]
The following table summarizes the financial statement reporting requirements, based upon the level of significance of the acquisition, as well as changes in disposition significance.
| Acquisition of a Business[10] - Amended Rules | ||
|---|---|---|
| Significance | Financial Statement Requirements | Pro Forma Financial Information Requirement |
|
20% or Less |
None. |
None. |
|
Greater than 20% < 40% |
Most recent fiscal year audited, as well as unaudited for the subsequent interim period. No comparative interim period needed. |
Pro forma financial information prepared in accordance with Article 11 for the registrant’s most recently completed fiscal year and subsequent interim period.[11] |
|
Greater than 40% |
If the acquired business is a real estate operation subject to Rule 3-14, the most recent fiscal year audited, as well as unaudited for the subsequent interim period. No comparative interim period needed. For all other acquired businesses, audited financial statements for the two most recent fiscal years, as well as most recent unaudited interim period and the comparative interim period of the prior year. |
|
| Disposition of a Business – Amended Rules | ||
| Significance | Financial Statement Requirement | Pro Forma Financial Information Requirement |
|
20% or Less |
None. |
None. |
|
Greater than 20% |
None. |
Pro forma financial information prepared in accordance with Article 11 for the registrant’s most recently completed fiscal year and subsequent interim period.[12] |
3. Pro Forma Financial Information (Article 11)
Article 11 requires pro forma financial information based on the historical financial statements of the registrant and the acquired or disposed business, and includes certain pro forma adjustments to the historical financial information. The amendments to Article 11 replace the existing pro forma adjustment criteria with three types of adjustments: transaction accounting adjustments, autonomous entity adjustments, and management adjustments.
For ease of reference, the following table summarizes the pro forma adjustment criteria in amended Article 11 regarding Pro Forma Financial Information requirements.
| Amended Article 11 - Revised Pro Forma Adjustment Criteria | ||
|---|---|---|
| Type of Adjustment | Adjustment Description | Required Adjustment? |
|
Transaction Accounting Adjustments Rule 11-02(a)(6)(i) |
Adjustments that reflect only the application of required accounting to the acquisition, disposition, or other transaction. |
Required. |
|
Autonomous Entity Adjustments Rule 11-02(a)(6)(ii) |
Adjustments that are necessary to reflect the operations and financial position of the registrant as an autonomous entity when the registrant was previously part of another entity. |
Required only when the registrant was previously part of another entity. |
|
Management’s Adjustments Rule 11-02(a)(7) |
Adjustments that depict synergies and dis-synergies of the acquisitions and dispositions for which pro forma effect is being given.[13] |
Optional. Permitted in the explanatory notes to the pro forma financial information if in management’s opinion such adjustments would enhance an understanding of the pro forma effects of the transaction, and specified conditions related to the basis for management’s adjustments and the form of their presentation are met.[14] |
4. Financial Statements of Smaller Reporting Companies (Article 8)
The amended rules revised Rule 8-04, Financial statements of businesses acquired or to be acquired, and Rule 8-06, Real estate operations acquired or to be acquired, to reference the requirements of Rule 3-05 and Rule 3-14, respectively. The amended rules also revise Rule 8-01 to expressly permit smaller reporting companies to apply Rule 3-06, Financial statements covering a period of nine to twelve months, which provides that the filing of financial statements covering a period of nine to 12 months shall be deemed to satisfy a requirement for filing financial statements for a period of one year in specified circumstances, including a significant business acquisition.
5. Financial Disclosures Related to Investment Companies
For financial reporting purposes, investment company registrants, including business development companies, must apply the general provisions in Articles 1, 2, 3, and 4 of Regulation S-X, unless subject to the special rules set forth in Article 6. The amended rules tailor the financial reporting requirements for investment company registrants with respect to their acquisitions of investment companies and other types of funds. Specifically, the rule amendments:
- Add a definition of “significant subsidiary” in Regulation S-X that relies on tailored investment and income tests based on the current Exchange Act Rule 8b-2 definition of “significant subsidiary”;
- Add new Rule 6-11 of Regulation S-X to specifically cover financial reporting in the event of a fund acquisition; and
- Eliminate the pro forma financial information requirement for investment companies and replace it with supplemental financial information more relevant to fund investors.
What are the compliance dates of the amendments?
The amendments are effective as of the beginning of the registrant’s fiscal year beginning after December 31, 2020 (the “mandatory compliance date”). Acquisitions and dispositions that are probable or consummated after the mandatory compliance date must be evaluated for significance using the final amendments.[15]
For initial registration statements first filed on or after the mandatory compliance date, all probable or consummated acquisitions and dispositions, including those consummated prior to the mandatory compliance date, must be evaluated for significance using the final amendments.[16]
Voluntary early compliance with the final amendments is permitted[17] in advance of the registrant’s mandatory compliance date provided that the final amendments are applied in their entirety from the date of early compliance.[18]
Other Resources
The adopting release for these amendments can be found on the Commission’s website at https://www.sec.gov/rules/final/2020/33-10786.pdf.
The Commission’s disclosure forms can be accessed on the agency’s website at https://www.sec.gov/forms.
Contacting the SEC
The Commission’s Division of Corporation Finance is happy to assist small companies and others with questions regarding the amendments. You may contact the Division’s Office of Chief Accountant for this purpose at (202) 551-3400 or https://www.sec.gov/forms/corp_fin_interpretive.
Questions on other Commission regulatory matters concerning small companies may be directed to the Division’s Office of Small Business Policy at (202) 551-3460 or smallbusiness@sec.gov.
The Commission’s Division of Investment Management’s Chief Counsel’s Office is also available to assist small entities and others with questions regarding the rule amendments applicable to investment companies. You may contact the Office for this purpose at 202-551-6825 or IMOCC@sec.gov.
[1] This guide, dated as of December 30, 2020, was prepared by the staff of the U.S. Securities and Exchange Commission as a “small entity compliance guide” under Section 212 of the Small Business Regulatory Enforcement Fairness Act of 1996, as amended. The guide summarizes and explains the rules adopted by the Commission, but is not a substitute for any rule itself. Only the rule itself can provide complete and definitive information regarding its requirements.
[2] In this guide, the term “business” refers to a business as defined in Rule 11-01(d) of Regulation S-X. The Regulation S-X definition of a “business” differs from the definition of a business in U.S. GAAP and IFRS as issued by the IASB.
[3] The Commission did not substantively revise the Asset Test; however, a number of non-substantive revisions to the significance tests were adopted.
[4] The amended income test adds a revenue component to the income test, such that a tested subsidiary will meet the test only if both the net income and revenue component are met, but the revenue component does not apply if the registrant or the tested subsidiary did not have material revenue in each of the two most recently completed years.
[5] In certain registration statements and proxy statements, the requirements also apply to probable acquisitions.
[6] In determining the aggregate impact of the investment test condition, amended Rule 3-05 also requires inclusion of the aggregate impact calculated in accordance with amended Rule 3-14 of any acquired or to be acquired real estate operations.
[7] In certain registration statements and proxy statements, the requirements also apply to probable acquisitions.
[8] Amended Rule 3-14 specifies that significance for acquisitions is determined based on the investment test only, modified in certain circumstances, and for dispositions it is determined using the investment, asset, and income tests.
[9] Amended Rule 3-14 defines a real estate operation as “a business that generates substantially all of its revenues through the leasing of real property.”
[10] See Note 2.
[11] In certain circumstances, pro forma statements of comprehensive income must be filed for all periods for which historical financial statements of the registrant are required.
[12] See discussion of Management’s Adjustments in 3. Pro Forma Financial Information below.
[13] An Instruction to the rule notes that any forward-looking information supplied is expressly covered by the safe harbor rules under § 230.175 and § 240.3b-6 of this chapter.
[14] Management’s Adjustments may only be presented in the explanatory notes to the pro forma financial information in the form of reconciliations of pro forma net income from continuing operations attributable to the controlling interest and the related pro forma earnings per share data to such amounts after giving effect to Management’s Adjustments.
[15] For registration statements filed on or after the mandatory compliance date, registrants that are subject to the reporting requirements of Section 13(a) or 15(d) of the Exchange Act at the mandatory compliance date may test acquisitions and dispositions consummated before the mandatory compliance date using rules that were in effect when the acquisitions and dispositions were consummated.
[16] Issuers relying on Regulation A filing initial offering statements on Form 1-A are not required to apply the final amendments until an initial offering statement is first filed on or after the mandatory compliance date. For initial offering statements first filed on or after the mandatory compliance date, all probable or consummated acquisitions and dispositions, including those consummated prior to the mandatory compliance date, must be evaluated for significance using the final amendments.
[17] To the extent that registrants have questions about application of the rules in connection with early compliance, they should reach out to Commission staff for additional transition guidance.
[18] For an acquisition or disposition of a business for which the disclosure required by an Item 2.01 Form 8-K has been filed (or was required to be filed) prior to the mandatory compliance date (or the voluntary early compliance date, if applicable), but for which Rule 3-05 or Rule 3-14 Financial Statements and Article 11 pro forma financial information are not required to be filed (e.g., in an Item 9.01 Form 8-K) until after the mandatory compliance date (or until after the voluntary early compliance date, if applicable), the registrant must file the financial statements and pro forma financial information required by the rules in effect when the Item 2.01 Form 8-K was required to be filed.