The amendments will become effective on January 1, 2021, but the SEC permits voluntary compliance with the amendments before the effective date.
On May 21, 2020, the Securities and Exchange Commission (SEC) adopted amendments to the financial disclosure requirements in Regulation S-X for acquisitions and dispositions of businesses.
The amendments are designed to assist registrants in determining whether an acquired or disposed business is significant and to improve the financial disclosure requirements applicable to significant acquisitions and dispositions. The purposes of the amendments are to provide investors with more meaningful financial information about acquired or disposed businesses, facilitate more timely access to capital and reduce the complexity and costs to prepare the disclosure.
The amendments will become effective on January 1, 2021, but the SEC permits voluntary compliance with the amendments before the effective date.
Background
When a registrant acquires or disposes a “significant” business (other than a real estate operation), Rule 3-05 of Regulation S-X requires the registrant to disclose audited annual and unaudited interim pre-acquisition financial statements of that business. Significance is determined using the “significant subsidiary” definition in Rule 1-02(w) of Regulation S-X, which sets forth three tests to determine significance: the “investment test,” the “asset test” and the “income test.” Real estate operations are subject to similar rules as set forth in Rule 3-14.
Additionally, under Article 11 of Regulation S-X, a registrant that acquires or disposes of a “significant” business is required to file unaudited pro forma financial information relating to the acquisition or disposition. These pro forma financial statements are based on the historical financial statements of the registrant and the acquired or disposed business and generally include adjustments to show how the transaction might have affected those financial statements.
Significance Tests
As noted above, whether or not a registrant has acquired or disposed of a significant subsidiary is determined based on the significance tests set forth in Rule 1-02(w) of Regulation S-X. The new amendments revise the significance tests to bring them more in line with the economics of a registrant’s interest in an acquired or disposed subsidiary and to better capture the significance of such subsidiary relative to the registrant, resulting in more salient disclosure for investors and reducing compliance burdens for the registrant. The current significance tests and the amendments to each test are summarized below.
Investment Test
The previous investment test compared the registrant and its other subsidiaries’ investments in the acquired or disposed subsidiary relative to the registrant and its subsidiaries’ consolidated total assets.
The newly adopted amendments revise the investment test to compare the registrant and its other subsidiaries’ investments in the acquired or disposed subsidiary relative to the aggregate worldwide market value of the registrant’s voting and nonvoting common equity. Pursuant to the newly adopted rules, if such aggregate worldwide market value is not available, the registrant must apply the investment test in its current form.
Income Test
The previous income test required a registrant to compare its and its other subsidiaries’ equity in the acquired or disposed subsidiary’s income from continuing operations before taxes relative to such income of the registrant and its subsidiaries.
The amendments add a new revenue component to the test, which requires a registrant to compare its and its other subsidiaries’ proportionate share of the acquired or disposed subsidiary’s total revenue relative to the registrant and its subsidiaries’ consolidated total revenue. Pursuant to the new amendments, however, the new revenue component will not apply if either the registrant and its subsidiaries or the acquired or disposed subsidiary did not have material revenue in each of the two most recently completed fiscal years. When the new revenue component applies, the acquired or disposed subsidiary will have to satisfy both the revenue component and the income component in order to satisfy the income test and be considered a significant subsidiary, but the lower of those components will be used to determine the number of disclosure periods required to be disclosed pursuant to Rule 3-05 of Regulation S-X.
Asset Test
The previous asset test compared the registrant and its other subsidiaries’ proportionate share of the acquired or disposed subsidiary’s total assets relative to the registrant and its subsidiaries’ consolidated total assets.
The newly adopted amendments do not substantively revise the asset test but do provide that, for acquisitions, intercompany transactions with the acquired subsidiary must be eliminated from the registrant and its subsidiaries’ consolidated total assets in applying the asset test.
Financial Statements for Significant Acquisitions
Depending on the relative significance of an acquired or disposed of significant subsidiary, Rule 3-05 of Regulation S-X requires the disclosure of financial statements for up to three years. The new amendments revise the look-back period and the requirement of financial statements for a comparative interim period, as summarized in the table below:
|
Significance Level |
Financial Statements Required |
|
|
Previous Rules |
Amendments |
|
|
No significance test exceeds 20% |
None |
None |
|
Any significance test exceeds 20%, but none exceeds 40% |
|
|
|
Any significance test exceeds 40%, but none exceeds 50% |
|
|
|
Any significance test exceeds 50% |
|
|
Abbreviated Financial Statements for Entity Components
When a registrant acquires assets that do not constitute a separate entity but constitute a “business” as defined in Rule 11-01(d) of Regulation S-X (e.g., a product line or a line of business contained in multiple subsidiaries), the target may not have separate financial statements or necessary information to prepare them as required under Rule 3-05 of Regulation S-X. In such cases, registrants have sought relief from the financial disclosure requirements or relied on the SEC’s informal guidance to provide abbreviated financial statements instead.
The new amendments now allow registrants to provide audited abbreviated financial statements―in the form of statements of assets acquired and liabilities assumed and statements of revenues and expenses―if the acquired business meets certain qualifying conditions, including the condition that total assets and total revenues of the acquired business constitute 20 percent or less of those amounts of the seller as of and for the most recent fiscal year.
Other Notable Changes
Foreign businesses: If a registrant is a foreign private issuer that prepares its financial statements using IFRS-IASB, the new amendments permit Rule 3-05 financial statements of an acquired foreign business prepared using home country GAAP to be reconciled to IFRS-IASB (rather than reconciled to U.S. GAAP). The new amendments also allow Rule 3-05 financial statements prepared in accordance with IFRS-IASB without reconciliation to U.S. GAAP if the acquired business would qualify as a foreign private issuer if it were a registrant.
Smaller reporting companies and issuers relying on Regulation A: The new amendments revise Rule 8-04 of Regulation S-X (which governs financial disclosure requirements of smaller reporting companies with respect to the acquisition or disposition of significant subsidiaries) to reference Rule 3-05 of Regulation S-X, as amended, for the requirements relating to the financial statements of acquired or disposed businesses. However, the form and content requirements of those financial statements which are currently governed by Rules 8-02 and 8-03 of Regulation S-X are not amended by the new amendments. The revisions to Rule 8-04 also apply to issuers relying on Regulation A.
Omission in registration statements and proxy statements: The new amendments eliminate the requirement to include Rule 3-05 financial statements in registration statements and proxy statements once the acquired business is reflected in filed post-acquisition registrant financial statements for nine months or one complete fiscal year, depending on the significance level of the acquired business.
Use of pro forma financial information to measure significance: The new amendments permit a registrant to measure the significance of an acquired or disposed of business using filed pro forma financial information that only depicts significant business acquisitions and dispositions consummated after the last fiscal year-end for which the registrant’s financial statements are required to be filed, subject to certain conditions.
Individually insignificant acquisitions: If a registrant acquires unrelated businesses that are individually insignificant but together would exceed 50 percent significance, the registrant must file historical audited financial statements and related pro forma financial information for those businesses constituting the substantial majority of the acquired businesses. The new amendments eliminate the requirement for pre-acquisition historical financial statements of individually insignificant businesses and only require such financial statements of any acquired business whose individual significance exceeds 20 percent.
Real estate operations: The new amendments also revise Rule 3-14 of Regulation S-X, which governs financial statement disclosure related to a registrant’s acquired real estate operations, to align with the amendments to Rule 3-05 described above.
Conclusion
In most cases, the streamlined and clarified financial disclosure requirements are expected to reduce compliance costs and facilitate access to capital. However, in certain cases where the new amendments cause some transactions to be significant that would not be deemed so under the previous rules, the new amendments could result in increased costs to the registrants. While it is unlikely that the amendments would affect a registrant’s decisions to engage in acquisitions or dispositions, they could impact the registrant’s ability to comply with reporting requirements for such transactions.
For More Information
If you have any questions about this Alert, please contact Darrick M. Mix, Barry Steinman, Phuong (Michelle) Ngo, any of the attorneys in our Capital Markets Group or the attorney in the firm with whom you are regularly in contact.
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