*This post has been updated as of August 4, 2020.
On May 20, 2020, the Securities and Exchange Commission formally adopted amendments to financial disclosure regulations regarding the acquisition and disposition of certain businesses. The final rules – which are intended to update disclosure requirements for the benefit of registrants and investors – represent the most comprehensive revision to the SEC’s regulations in this area in more than 30 years. The new rules can be found here.
Among other things, the new rules amend the definition of a “significant subsidiary” by altering prescribed significance tests under Rule 1-02(w) of Regulation S-X, as well as under Rule 405 of the Securities Act of 1933 and Rule 12b-2 under the Securities Exchange Act of 1934.
When the acquisition of a business has occurred or is probable, Rule 3-05 of Regulation S-X requires registrants to provide separate audited annual and unaudited interim pre-acquisition financial statements for the subject business, if the business is “significant” to the registrant.
If Rule 3-05 of Regulation S-X requires a registrant to provide separate financial statements for a business, then the registrant must also provide unaudited pro forma financial information related to the acquisition prepared in accordance with Article 11 of Regulation S-X.
In order to determine the “significance” of a business, Rule 1-02(w) requires a registrant to apply three tests: (i) an Income Test; (ii) an Assets Test; and (iii) an Investments Test.
The new rules provide revisions to the Income and Investments Tests, while leaving the Assets Test largely unaltered.
Investment and Income Tests, as currently in effect
With respect to determining the significance of an acquired business, under current rules (i.e., prior to the changes set forth in the May 20, 2020 adopting release):
- The Investment Test compares (i) the registrant’s investments in, and advances to, the acquired business with (ii) the total assets of the registrant reflected in its most recent annual financial statements required to be filed at or prior to the acquisition date; and
- The Income Test compares (i) the registrant’s equity in the income from continuing operations of the acquired business before income taxes (excluding amounts attributable to any noncontrolling interests), as reflected in the business’s most recent annual pre-acquisition financial statements, with (ii) the same measure reflected in the registrant’s most recent annual financial statements required to be filed at or prior to the acquisition date.
Post-Amendment Changes
Investment Test
The Investment Test is being modified, with respect to acquisitions and dispositions only, to require a registrant to compare its investments in, and advances to, the subject business against the registrant’s worldwide market value of voting and non-voting common equity.
To determine aggregate worldwide market value, registrants will use the average of aggregate worldwide market value calculated daily for the last five trading days of the registrant’s most recently completed month ending prior to the earlier of the registrant’s announcement date or agreement date of the acquisition or disposition.
The Investment Test remains unchanged for registrants who do not have an aggregate worldwide market value (i.e., will continue to be calculated based on the registrant’s total assets).
The SEC also clarified, among other things, certain items which are included and excluded from “investments in” the acquired business for purposes of calculations under the Investment Test.
Income Test
The Income Test is being modified to provide for the addition of a revenue component.
To satisfy the Income Test under the amended rules, the subject business must meet both the revenue component (when the revenue component applies) and the net income component – and for purposes of application of Rule 3-05 of Regulation S-X, the registrant may use the lower of the revenue component and the net income component to determine the number of periods for which financial statements are required under Rule 3-05 of Regulation S-X.
The revenue component will apply unless either the registrant or its subsidiaries consolidated or the subject business did not have material revenues in each of the two most recently completed fiscal years. If the revenue component does not apply, then only the net income component of the Income Test will be used to determine significance.
The SEC stated the rationale for the changes to the Income Test were to “reduce the anomalous result that registrants with marginal or break-even net income or loss in a recent fiscal year may be more likely to have tested subsidiaries deemed significant where they otherwise would not.”
The new revenue component compares (i) the registrant’s and its other subsidiaries’ proportionate share of the subject business’s consolidated total revenues (after intercompany eliminations) with (ii) the consolidated total revenues of a registrant for the most recently completed fiscal year.
The rules further clarify that “consolidated total revenue” refers to consolidated total revenues from continuing operations (after intercompany eliminations).
The amendments also make certain other clarifications and simplifications with respect to the Income Test.
In making these amendments, the SEC declined to adopt an accommodation for smaller reporting issuers who had requested that the revised test only require revenue, rather than income and revenue.
Multiple Acquisitions of Individually Insignificant Businesses
The SEC also revised the financial statement requirements for multiple acquisitions of individually insignificant businesses, as illustrated in the chart below.
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Previous Rule |
Amended Rule |
For multiple acquisitions of individually insignificant businesses aggregating to more than 50% significance on a combined basis:
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For multiple acquisitions of individually insignificant businesses aggregating to more than 50% significance on a combined basis:
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Generally, insignificant businesses include (i) any acquisition consummated after the audited balance sheet date whose significance does not exceed 20%; (ii) any probable acquisition whose significance does not exceed 50%; and (iii) any consummated acquisition whose significance exceeds 20%, but not 50%, for which financial statements are not yet required under Rule 3-05 because of the 75-day grace period.
Other changes
The new rules further effectuate the following, including, but not limited to:
- requiring the financial statements of an acquired business to cover no more than the two (2) most recent fiscal years;
- for acquisitions where a significance test exceeds 20%, but none exceeds 40%, eliminating the need to provide comparative interim period financial statements;
- conforming, to the extent applicable, the significance threshold and tests for a disposed business to those used for an acquired business;
- for the Investment Test, requiring the inclusion of the fair value of contingent consideration if required to be recognized at fair value at the acquisition date under GAAP (if recognition at fair value not required under GAAP, all contingent consideration must be included except where payment is remote);
- permitting disclosure of audited annual abbreviated financial statements and unaudited interim abbreviated financial statements for certain acquisitions of a component of an entity;
- expanding the use of pro forma financial information in measuring significance under certain circumstances;
- modifying disclosure requirements pertaining to individually insignificant acquisitions;
- in certain circumstances, permitting the use of, or reconciliation to, International Financial Reporting Standards (IFRS) rather than the Generally Accepted Accounting Principles in the United States (GAAP); and
- eliminating the requirement to provide in registration statements and proxy statements the financial statements for an acquired business once it has been included in the registrant’s post-acquisition financial statements for at least nine months or a complete fiscal year (depending on significance).
These amendments take effect on January 1, 2021. However, the SEC will permit voluntary compliance by registrants in advance of the effective date, provided that the amendments are applied in their entirety from the date of early compliance.