On May 21, the SEC finalized amendments to its rules and forms revising the disclosure requirements for financial statements relating to acquisitions and dispositions of businesses, which were adopted in substantially the same form as proposed in May 2019. The amendments were effected “to enhance the quality of information that investors receive while eliminating unnecessary costs and burdens.”
The final amendments will, among other things, update the definition of “significant subsidiary” in Rule 1-02(w) of Regulation S-X, Securities Act Rule 405, and Exchange Act Rule 12b-2 to update the investment and income significance tests in each rule, as summarized in the table below. (Since no substantive changes were made to the asset test, we have not included it in the table below.)
|Existing Test||Amended Test|
|Investment Test||The existing investment test compares the registrant’s investments in and advances to the target business (the tested subsidiary), generally constituting the purchase price paid in the case of an acquisition or disposition, with the registrant’s total assets reflected in its most recent annual financial statements required to be filed at or before the date of the acquisition or disposition.||
The new investment test will compare the registrant’s investments in and advances to the tested subsidiary to the registrant’s aggregate worldwide market value of the registrant’s voting and non-voting common equity, when available.
Aggregate Worldwide Market Value: In calculating the aggregate worldwide market value, registrants will be required to use the average of the aggregate worldwide market value calculated daily for the last five trading days of the registrant’s most recently completed month ending before the earlier of the registrant’s announcement date or agreement date of the acquisition or disposition.
|Income Test||The existing income test compares the registrant’s equity in the income from continuing operations of the target business before income taxes exclusive of amounts attributable to any noncontrolling interests, as reflected in the target business’s most recent annual pre-acquisition financial statements, with the same measure reflected in the registrant’s most recent annual financial statements required to be filed at or before the date of the acquisition or disposition (the net income component).||
The new income test requires that the registrant meet both the revenue component (as defined below, when the revenue component applies) and the net income component; however, 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.
Revenue Component: The new revenue component compares the registrant’s proportionate share of the subject business’s consolidated total revenues (after intercompany eliminations) with the consolidated total revenues of the registrant for the most recently completed fiscal year.
The changes to the investment test and income test as summarized above will have a significant impact in certain circumstances. For example, the revision of the income test to include a revenue component is a welcome change that should avoid anomalies which sometimes existed under the existing rules whereby the income test could be triggered in an overly expansive manner when, for example, the registrant had pre-tax net income close to zero. A small positive or negative pre-tax income would often result in the income test producing a disproportionate result as compared to the asset test, investment test and revenue.
Additionally, with respect to the change in the denominator of the investment test, for registrants that have a significantly higher market capitalization than total assets, this change may significantly increase the purchase price needed to trigger a financial statement filing requirement under the investment test in connection with acquisitions and dispositions.
Conversely, for registrants that have total assets significantly higher than their market capitalization, this change may significantly decrease the purchase price needed to trigger such financial statement filing requirements under the investment test (the Staff did not accept the position argued by some commentators following the adoption of the proposed rules that the indebtedness of the registrant (i.e., enterprise value) should be taken into account in the denominator of the investment test).
Other Key Aspects of the Final Amendments to Disclosure Requirements for Acquisitions and Dispositions
In addition, as summarized by the SEC, the final rules will do the following, among other things:
- Raise the significance threshold for dispositions to 20% from 10%, consistent with the threshold for acquisitions.
- Expand the use of pro forma financial information in measuring significance.
- Require the financial statements of the acquired business to cover no more than the two most recent fiscal years (compared to three years under the existing rules).
- Permit disclosure of financial statements that omit certain expenses for certain acquisitions of a component of an entity.
- No longer require separate acquired business financial statements once the business has been included in the registrant’s post-acquisition financial statements for nine months or a complete fiscal year, depending on significance.
- Align Rule 3-14 with Rule 3-05 where no unique industry considerations exist.
- Amend the pro forma financial information requirement by breaking out the adjustments into the following three categories:
- Mandatory “Transaction Accounting Adjustments,” reflecting only the application of required accounting to the transaction, which would require registrants to depict (1) in the pro forma condensed balance sheet the accounting for the transaction required by GAAP or IFRS standards, as applicable, and (2) in the pro forma condensed income statements, the effects of pro forma balance sheet adjustments, assuming the adjustments were made as of the beginning of the fiscal year.
- Mandatory “Autonomous Entity Adjustments,” reflecting the operations and financial position of the registrant as an autonomous entity if the registrant was previously part of another entity, and clarifying that such adjustments are required when the condition for their presentation is met and that they must be presented in a separate column from Transaction Accounting Adjustments.
- Optional “Management’s Adjustments,” depicting synergies and dis-synergies of the acquisitions and dispositions for which pro forma effect is being given if, in management’s opinion, such adjustments would enhance an understanding of the pro forma effects of the transaction and certain conditions related to the basis and the form of presentation are met.
- The modified rules, therefore, require as conditions for presenting such Management’s Adjustments that there is a reasonable basis for each such adjustment; the adjustments are limited to the effect of such synergies and dis-synergies on the historical financial statements that form the basis for the pro forma statement of comprehensive income as if the synergies and dis-synergies existed as of the beginning of the fiscal year presented; and the pro forma financial information reflects all Management’s Adjustments that are, in the opinion of management, necessary to a fair statement of the pro forma financial information presented and a statement to that effect is disclosed.
- Additionally, if presented, Management’s Adjustments must 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.
Registrants will not be required to apply the final amendments until 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. Voluntary early compliance with the final amendments is permitted 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.
If you have any questions about the SEC’s final amendments, please feel free to email the authors directly or, if applicable, contact your primary Bass, Berry & Sims relationship attorney.
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