While we have been busy in 2020 learning how to social distance, wear masks and do Zoom meetings, the SEC has spent the year turning out a relentless tsunami of new rules and amendments of old ones. Among the latter are extensive amendments to the financial disclosure obligations of a public company when it acquires or disposes of a business. Adopted in May 2020, these long-awaited amendments go into effect on January 1, 2021, so a summary seems timely.
Given the extent and complexity of these amendments, we will summarize them in installments. This first installment considers the changes to the periods to be presented in the financial statements, the amendments to the Investment Test and the Income Test in the definition of a “significant subsidiary,” and the codification of the staff practice of permitting abbreviated financial statements for acquisitions of components of an entity. In reading this and future summaries, bear in mind that the new rules are complex and need to be reviewed carefully against the detailed terms of an acquisition or disposition.
Background: When does an acquisition or disposition trigger financial disclosures?
In general, when an acquisition by a public company has occurred or is probable (a term of art that does not necessarily mean what you think it means), Rule 3-05(a) of Regulation S-X requires the filing of separate audited annual and unaudited interim historical (pre-transaction) financial statements of the business being acquired (“Rule 3-05 Financial Statements”), if the acquisition is “significant” to the buyer, as discussed below. The determination of whether a “business” has been acquired is made in accordance with Rule 11-01(d) of Regulation S-X. Consistent with the current rules, when an acquisition involves two or more businesses that are “related” (as defined in Rule 3-05(a)), they will generally be treated as a single business. In other words, the buyer cannot avoid filing financial statements for the acquired business by treating two related transactions as separate. Also, Rule 3-05 does not distinguish between acquisitions of stock vs. assets, nor does its applicability depend upon the structure of the transaction.
Periods to be Presented in Financial Statements – Amendments to Rule 3-05(b)
The current rules
Under the rules currently in effect, the significance of an acquisition, and the periods to be presented in the financial statements of an acquired business, are determined using the tests specified in the definition of “significant subsidiary” in Rule 1-02(w) of Regulation S-X. If none of the tests exceeds 20%, financial statements are not required. However, if any of the tests exceeds 20%, the buyer must furnish historical financial statements of the acquired business. The number of years and the interim periods that must be furnished is based upon the extent to which the conditions exceed 20%, as summarized in the following table.
| Rule 3-05 Financial Statements – Periods to Be Presented (Current Requirements) |
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| Significance Level of Target | 3 Most Recent Fiscal Years (audited) |
2 Most Recent Fiscal Years (audited) |
Most Recent Fiscal Year (audited) |
Most Recent Interim Period (unaudited) | Corresponding Prior Year Interim (unaudited) |
| No condition exceeds 20% | No financial statements required. | ||||
| One or more conditions exceed 20%, but none exceed 40% | – | – | X | X | X |
| One or more conditions exceed 40%, but none exceed 50% | – | X | – | X | X |
| One or more conditions exceed 50% | X | – | – | X | X |
The new rules
The newly adopted amendments to Rule 3-05(b) cap the number of fiscal years to be presented in the historical financial statements of the acquired business at two years, eliminating the current requirement of three years for acquired businesses whose “significance level” exceeds 50%. The SEC also eliminated the current requirement to include the corresponding prior year interim period of a business whose significance to the company does not exceed 40%. The following table summarizes the periods to be presented in Rule 3-05 Financial Statements, under the amendments to Rule 3-05(b).
| Rule 3-05 Financial Statements – Periods to Be Presented (As Amended) |
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| Significance Level of Target | 3 Most Recent Fiscal Years (audited) |
2 Most Recent Fiscal Years (audited) |
Most Recent Fiscal Year (audited) |
Most Recent Interim Period (unaudited) | Corresponding Prior Year Interim Period (unaudited) |
| No condition exceeds 20% | No financial statements required. | ||||
| One or more conditions exceed 20%, but none exceed 40% | – | – | X | X | – |
| One or more conditions exceed 40%, but none exceed 50% | – | X | – | X | X |
| One or more conditions exceed 50% | – | X | – | X | X |
What is a “Significant Subsidiary”? – Amendments to Rule 1-02(w)
“Significant subsidiary” is defined in Rule 1-02(w) of Regulation S-X, and generally consists of three tests for determining the significance of a subsidiary to a company:
- the “Investment Test,” which measures the company’s investment in or advances to a subsidiary as a percentage of the company’s total assets;
- the “Income Test,” which measures the company’s share of the net income from the continuing operations of a subsidiary before taxes as a percentage of the company’s net income before taxes and other deductions; and
- the “Asset Test,” which measures a subsidiary’s total assets, as a percentage of the company’s total assets.
In addition to evaluating the significance of a subsidiary, the tests in Rule 1-02(w) are used to measure the significance of various other matters under SEC rules and forms, including the significance of a disposed business to the seller and the significance of an acquired business to the buyer. In the case of an acquisition, the tests in Rule 1-02(w) serve as the basis for determining whether a company will be required to file Rule 3-05 Financial Statements for the acquired business and, if so required, the periods to be presented in such financial statements.
Note that the form of the business being acquired or sold is irrelevant; the term “significant subsidiary” applies whether the business is a corporation, partnership, limited liability company, or otherwise, and applies even if what is being acquired or sold is just a group of assets.
To address shortcomings in the Investment Test and the Income Test that materialize when they are used to measure the significance of an acquisition or disposition and to help companies make more meaningful determinations about the significance of an acquisition or disposition, the SEC made changes to both Tests that are specifically targeted to acquisitions and dispositions and designed to yield more accurate measures. In the final rules, as described below, the SEC (i) added the concept of a company’s “aggregate worldwide market value” to the Investment Test, and (ii) added a revenue metric to the Income Test. No substantive changes were made to the Asset Test.
Amendments to The Investment Test
The Investment Test for a “significant subsidiary” involves a comparison of (x) a company’s and its other subsidiaries’ investments in and advances to the tested subsidiary, to (y) the total assets of the company and its subsidiaries consolidated. The final rules contain a number of important amendments to the Investment Test with respect to acquisition and disposition transactions, including: (A) a new metric that replaces “total assets of the company and its subsidiaries,” (B) clarification regarding the treatment of contingent consideration in acquisition transactions, and (C) two new measures of significance for transactions involving combinations of entities or businesses that are under common control. The principal changes to the Investment Test in the final rules are summarized in (A) – (C), below.
The New “Aggregate Worldwide Market Value” Metric
When measuring the significance of an acquisition or disposition, the first component of the Investment Test is the company’s “investments in and advances to” the acquired or disposed business, which is, generally, the purchase price (or sale price); and this metric tends to be consistent with the fair value of the acquisition or the disposed business. On the other hand, the second component of the Investment Test, “total assets of the registrant and its subsidiaries consolidated,” is a book value metric, and it often differs significantly from fair value. It is this “mismatch” of metrics (the comparison of fair value to book value) that renders the Investment Test, in many cases, poorly suited for evaluating the significance of acquisitions and dispositions.
To address this “mismatch” of metrics when applying the Investment Test to acquisitions and dispositions, the SEC changed the second component of the Investment Test. Specifically, the final rules replace “total assets of the registrant and its subsidiaries consolidated” with an entirely new metric: “aggregate worldwide market value of the registrant’s voting and non-voting common equity.” The SEC reasoned that the aggregate worldwide market value metric is more consistent with “fair value” and the purchase or sale price of the acquired or disposed business, and should provide companies and investors with a more accurate and meaningful measure of the significance of an acquired or disposed business to the company.
Under the final rules, a company’s aggregate worldwide market value is determined by taking the average of the aggregate worldwide market value calculated daily for the last five trading days of the company’s most recently completed month ending prior to the earlier of the company’s announcement date or agreement date of the acquisition or disposition. This new metric applies solely to acquisitions and dispositions; and the final rules continue to employ the existing Investment Test for all other purposes for which the Rule 1-02(w) definition of a “significant subsidiary” is applicable. Under the final rules, companies will also use the existing Investment Test for acquisitions and dispositions when a company does not have an aggregate worldwide market value.
Clarifications Regarding the Treatment of Contingent Consideration
In acquisition transactions, the consideration often includes a contingent component. Excluding the contingent portion of the consideration from the Investment Test diminishes the significance of an acquisition and could result in a company’s failure to file the financial statements of a significant acquisition. To resolve uncertainties regarding whether to include or exclude the contingent component of the consideration in the Investment Test for the significance of an acquisition, the final rules generally provide that a company should include the fair value of all contingent consideration in the “investments in and advances to” metric of the Investment Test. However, the final rules further provide that a company should exclude the contingent component of the consideration from the Investment Test if (i) the company is not required under GAAP (or under IFRS-IASB, if applicable) to recognize contingent consideration at fair value at the acquisition date, and (ii) the likelihood of payment of the contingent consideration is remote.
Additional Clarifications Regarding to the Investment Test
The final rules include a few additional amendments to the Investment Test, including the following:
Clarifying Amendments Regarding Acquisition Transactions:
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- For acquisitions, “investments in and advances to” means the fair value of the consideration for the acquired business or real estate operations.
- The consideration in an acquisition should be adjusted to exclude the company’s and its subsidiaries’ proportionate interests in the carrying value of assets transferred to the target that will remain with the combined entity after the acquisition.
Clarifying Amendments Regarding Disposition Transactions:
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- When a company has an aggregate worldwide market value, the “investments in and advances to” metric equals the fair value of the consideration (including contingent consideration) for the disposed business or real estate operations.
- When a company does not have an aggregate worldwide market value, the “investments in and advances to” metric equals the carrying value of the disposed business.
Combinations Between Entities or Businesses Under Common Control. The final rules add the following two new metrics specifically relating to combinations between entities or businesses that are under common control:
Share Exchanges Exceeding 10%. A combination between entities or businesses that are under common control is significant and satisfies the Investment Test for significance when the number of common shares exchanged (or to be exchanged) exceeds 10% of the company’s common shares outstanding at the date the combination is initiated.
Asset Acquisitions Exceeding 10%. A combination between entities or businesses that are under common control is significant and satisfies the Investment Test for significance when the net book value of the tested subsidiary exceeds 10% of the total assets of the company and its subsidiaries consolidated.
Amendments to the Income Test
The current Income Test focuses solely on a company’s net income, which is susceptible to non-recurring historical and/or infrequent expenses, gains and losses. When the current Income Test is applied to acquisitions and dispositions of businesses, such non-recurring and infrequent expenses, gains and losses can produce aberrant results. The final rules contain a number of amendments to the Income Test that address this issue, including:
- the addition of a new revenue component, which compares the revenue of the acquired or disposed business to the company’s revenue, and
- the use the average of the absolute values of net income.
The principal changes to the Income Test are summarized in A – C, below.
The New Revenue Component
Under the current Income Test, the significance of a subsidiary or acquisition is determined solely by comparing (x) a company’s equity in the pre-tax income from the continuing operations of the tested subsidiary (or the acquisition target), to (y) the company’s pre-tax income from the company’s continuing operations. Income is determined exclusive of amounts attributable to any noncontrolling interests and is based on the company’s most recently completed fiscal year. In the case of an acquisition, the income of the acquired business is based on its most recent annual pre-acquisition financial statements, and the company’s income is based on company’s most recent annual financial statements required to be filed at or prior to the acquisition date. For a company that has experienced marginal or break-even net income or loss in a recent fiscal year, the Income Test can cause “false positive” test results; and when such determinations of significance involve an acquisition, a company will be required to file Rule 3-05 Financial Statements for acquisitions that are otherwise not material to investors. Conversely, for a company that experienced significant non-recurring gains in a recent fiscal year, the Income Test can produce a “false negative” and cause a company to fail to file Rule 3-05 Financial Statements for a subsidiary or an acquisition that is likely to have a material future impact on the company.
The SEC noted that revenue is an important alternative indicator of the operations of a business, and generally has less variability than net income. Under the new revenue component of the Income Test, (x) a company’s and its other subsidiaries’ proportionate share of the tested subsidiary’s consolidated total revenues from continuing operations (after intercompany eliminations), is compared to (y) such consolidated total revenues of the company for the most recently completed fiscal year.
The addition of the revenue component to is expected to yield more accurate determinations of significance and reduce the instances where immaterial acquisitions are deemed significant for purposes of Rule 3-05 Financial Statements. However, the new revenue component only provides a meaningful assessment of significance where a company (and its subsidiaries consolidated) and a tested subsidiary (or acquisition) each has material revenue over the course of time. Therefore, under the final rules, the new revenue component of the Income Test does not apply unless the company (and its subsidiaries consolidated) and the tested subsidiary (or target) have material revenue in each of the two most recently completed fiscal years. When the new revenue component applies, a finding of significance requires that the company and its subsidiaries consolidated and the tested subsidiary (or acquired or disposed business) must exceed both the new revenue and the net income components of the Income Test. It is important to note that for purposes of Rule 3-05 Financial Statements, the final rules permit a company to use the lower percentage of the revenue component and the net income component to determine the number of periods for which Rule 3-05 Financial Statements are required.
Income Averaging and Use of Absolute Values
When a company and/or the acquired or disposed business does not have recurring annual revenues, the new revenue component of the Income Test cannot be utilized to determine the significance of the acquisition or disposition; and in such circumstances, companies will have to fall back on the net income component of the Income Test to evaluate significance. In order to minimize the occurrence of irregular results when a company must use net income, instead of revenue, to measure the significance of an acquisition or disposition, the final rules contain certain changes to the income component of the Income Test, as discussed below.
Under the current Income Test, Computational Note 2 to Rule 1-02(w) provides that when the income of a company (and its subsidiaries consolidated) for the most recent fiscal year is more than 10% lower than the company’s average income for the last five fiscal years, the company should substitute average income for net income in the Income Test. In addition, current staff guidance indicates that when calculating average income for the last five years, companies should use “zero” for the loss years. The final rules affirm that the income component of the Income Test is applicable even when a company has experienced losses from continuing operations. Further, the final rules delete Computational Note 2 and expressly provide that a company should use absolute values of net income for its loss years (instead of zero) when calculating its average income for the last five years.
Additional Clarifications and Simplifications
The final rules include further non-substantive amendments to the Income Test in order to simplify the description of the Test. Further amendments were made to Rule 1-02(w) to clarify that it is not intended to modify the existing Rule 3-05(a)(3) requirement that acquisitions of a group of related businesses must be treated as if they are a single acquisition.
Correlative amendments were made to Rules 3-05(b)(3) and Rule 11-01(b)(3) to clarify that if an acquired business meets the conditions in new Rules 3-05(e) and 3-05(f), the company can omit certain expenses from the acquired business’s revenues when applying the Income Test.
The term “significant subsidiary” is also defined in Securities Act Rule 405 and in Exchange Act Rule 12b-2. Accordingly, in order to simplify and maintain uniformity of the definition of “significant subsidiary” throughout SEC rules, the final rules include amendments to Securities Act Rule 405 and Exchange Act Rule 12b-2 that fully conform with the definition in Rule 1-02(w).
Abbreviated Financial Statements – Acquisitions of Components of An Entity
New Rule 3-05(e)
When a company acquires a product line or group of assets that constitutes a “business,” as defined in Rule 11-01(d) of Reg. S-X, the company is required to file Rule 3-05 Financial Statements for the acquired business when the acquisition is significant to the company. However, when the product line or group of assets is not a separate entity, a subsidiary, an operating segment or a division of the seller and represents only a small component of the seller’s business, the seller often (i) does not have separate financial statements for such components of its business, and (ii) has not allocated its corporate overhead, interest and income tax expenses to such product line or other business component. Under such circumstances, the preparation of Rule 3-05 Financial Statements by the buyer can be very difficult and costly, and the SEC staff has historically authorized buyers to file abbreviated financial statements, in lieu of Rule 3-05 Financial Statements, where the buyer has sought relief under Rule 3-13 from such hardship.
New Rule 3-05(e) of Regulation S-X codifies the staff’s historical relief of allowing companies to file abbreviated financial statements for acquisitions of components of an entity, provided that (i) certain qualifying conditions are met, and (ii) the company makes certain additional disclosures.
The following table provides a ready summary of the qualifying conditions and the additional presentation requirements prescribed by new Rule 3-05(e) for abbreviated financial statements.
| Summary of Rule 3-05(e) – Abbreviated Financial Statements | |
| Qualifying Conditions: | Under new Rule 3-05(e), a registrant may file audited annual and unaudited interim abbreviated financial statements for acquisitions of components of a seller’s business, provided the following conditions are met: |
| (i) the statement of comprehensive income may be a statement of revenues and expenses (exclusive of corporate overhead, interest and income tax expenses), and the title of the statement must be appropriately modified to indicate it omits certain expenses; | |
| (ii) the acquired business was not a separate entity, subsidiary, operating segment (as defined in U.S. GAAP or IFRS-IASB, as applicable), or division of the selling entity during the periods for which the acquired business financial statements would be required; and | |
| (iii) Interest expense may only be excluded from the statement of comprehensive income if the debt to which the interest expense relates will not be assumed by the registrant or its subsidiaries consolidated | |
| In situations where an acquisition does not meet the qualifying conditions of new Rule 3-05(e), Rule 3-13 remains available for registrants to seek relief where unique circumstances render the preparation and filing of Rule 3-05 Financial Statements impractical. | |
| Presentation Requirements: | Where a registrant qualifies to file Rule 3-05(e) abbreviated financial statements in lieu of Rule 3-05 Financial Statements, the following presentation requirements apply: |
| (i) The statement of comprehensive income may be a statement of revenues and expenses, with the title of the statement appropriately modified to indicate it omits certain expenses: | |
| (ii) The statement of comprehensive income may omit corporate overhead expenses, interest expense, and income taxes; provided, however, that interest expense may only be excluded if the debt to which the interest expense relates will not be assumed by the registrant or its subsidiaries consolidated; and | |
| (iii) The statement of comprehensive income must include expenses incurred by or on behalf of the acquired business during the pre-acquisition financial statement periods to be presented including, but not limited to, costs of sales or services, selling, distribution, marketing, general and administrative, depreciation and amortization expense, and research and development, but may otherwise. | |
| The Notes to the abbreviated financial statements must include the following additional disclosures: | |
| (i) The type of omitted expenses and the reason(s) why they are excluded from the financial statements; | |
| (ii) An explanation of the impracticability of preparing financial statements that include the omitted expenses; | |
| (iii) A description of how the financial statements presented are not indicative of the financial condition or results of operations of the acquired business going forward because of the omitted expenses; and | |
| (iv) Information about the business’s operating, investing, and financing cash flows, to the extent available. | |
Part II will discuss the remaining aspects of the new rules.