SEC Updates Financial Disclosure Requirements for Acquired and Disposed Businesses

June 4, 2020

On May 20, 2020, the U.S. Securities and Exchange Commission (SEC) announced it had adopted final rules amending Rule 1-02(w), Rule 3-05, Rule 3-14, and Article 11 of Regulation S-X. References in this Alert to “Rule” or “Article” shall mean the applicable provision of Regulation S-X, unless indicated otherwise. Those interrelated sets of rules and regulations are the framework for determining the level of financial information to be disclosed after a public company acquires or disposes of a business, or, in some cases, where a business acquisition is probable but not yet completed. The disclosure requirements vary depending on the disclosure context, such as in annual and period reports, registration statements or proxy statements, and are determined based on “significance tests” applied to the acquired or disposed business.

Effective date: The amendments in the final rule will become effective Jan. 1, 2021. However, voluntary compliance with the final amendments is permitted in advance of the effective date.

The SEC noted that these amendments are intended to improve for investors the financial information presented about acquired and disposed businesses, reduce the complexity and costs to prepare the disclosure and facilitate more timely access to capital.

The SEC adopted a number of amendments under the final rule. The most significant amendments include the following.

1. Updating the significance tests to improve application and help registrants make more meaningful significance determinations

These updates include revisions to the “income” test and the “investment” test in Rule 1-02(w), as detailed in the paragraphs below.

Changes to the investment test: Under the new investment test, the registrant will compare its investment in and advances to the acquired or disposed business to the aggregate worldwide market value of the registrant’s voting and nonvoting common equity, rather than its total assets, when the test is used for acquisitions or dispositions. The existing test, using total assets, will continue to apply (1) for acquisitions and dispositions in circumstances where the registrant does not have an aggregate worldwide market value and (2) when used for the additional purposes for which the Rule 1-02(w) definition is applicable.

Effect of the amended rules: Investment test using market capitalization improves test validity. The revised investment test compares the investment in and advances to the acquired or disposed business to the registrant’s market capitalization rather than its assets. Generally, a registrant’s market capitalization is higher than its total assets, thus making it less likely that an acquisition or disposition will be considered significant. This revised test will especially benefit registrants that are “asset-light” companies that might have tripped the significance trigger under the existing investment test solely because the value of their assets is low when compared to the asset value of the acquired or disposed business.

Changes to the income test: Under the final rule, the SEC revised the income test to (1) add a new revenue component and (2) use net income or loss from continuing operations, after income taxes, rather than before income taxes, to make the income test more reflective of the net impact on a registrant’s financial statements. To satisfy the revised income test, the acquired or disposed business must meet both the revenue component and the net income component. The new revenue component compares a registrant’s and its other subsidiaries’ proportionate share of the consolidated total revenues (after intercompany eliminations) of the acquired or disposed business to such consolidated total revenues of the registrant for the most recently completed fiscal year. The revenue component does not apply if either the registrant (and its subsidiaries on a consolidated basis) or the acquired or disposed business did not have material revenue in each of the two most recently completed fiscal years. The final rule includes a technical change to the income test to use the absolute value of equity in the consolidated income or loss from continuing operations of the acquired or disposed business and to use absolute values for calculating average net income. This change is intended to mitigate the potential for misinterpretation that may result from inclusion of a negative amount in the computation.

Effect of the amended rules: Adding revenue component to income test will help certain registrants. Under the revised income test, the acquired or disposed business must meet both the revenue and income threshold to pass the income test for significance. Having to pass two tests means that fewer subsidiaries are likely to be considered significant. The change in the income test will particularly benefit registrants in growth industries that may have minimal income but considerable revenues.

Effect of the amended rules: Registrants with “loss years” no longer penalized under the income test. The revised income test compares the absolute value of the registrant’s and the net loss or income of the acquired or disposed business. This revised test means that a registrant that suffers a net loss in any year is less likely to have an acquired or disposed business pass the significance test.

Asset test: The final rule did not make any substantive revisions to the asset test.

2. Requiring the financial statements of the acquired business to cover only up to the two most recent fiscal years

The SEC revised Rule 3-05 to eliminate the requirement to provide the third year of financial statements in the context of acquiring or disposing of significant businesses. In deciding to eliminate this requirement, the SEC noted that the third year of pre-acquisition financial statements are less likely to be indicative of the current financial condition and results of operations of the acquired or disposed business and the audit of those financial statements may add significant costs and time to the preparation of the disclosure.

3. Permitting disclosure of abbreviated financial statements for certain acquisitions of a component of an entity

Under the new rule, the SEC noted that companies often acquire a component of an entity that is a business under Rule 11-01(d), but that does not actually constitute a separate entity, subsidiary, etc., such as a product line or a line of business. Since these businesses often do not have separate financial statements or do not maintain separate accounts, a registrant may be unable to provide the required financial statements. The amendments permit registrants to file abbreviated financials that omit corporate overhead, interest and income tax expense if the following conditions are met: (1) the total assets and total revenues (both after intercompany eliminations) of the acquired or to-be-acquired business constitute 20 percent or less of such corresponding amounts of the seller (and its subsidiaries on a consolidated basis) for the most recently completed fiscal year; (2) separate financial statements for the business have not previously been prepared; (3) the acquired business was not a separate entity, subsidiary, operating segment or division during the periods for which the acquired business financial statements would be required; and (4) the seller has not maintained the distinct and separate accounts necessary to present financial statements that include the omitted expenses and it is impracticable to prepare such financial statements. If the acquired or to be acquired business satisfies these conditions, the final rule provides additional guidance about how the audited abbreviated financial statements must be presented.

4. No longer requiring separate acquired business financial statements once the business has been included in the registrant’s post-acquisition audited financial statements for either nine months or a complete fiscal year, depending on significance

The amendments to the rule allow omission of pre-acquisition financial statements for businesses that exceed 20 percent but do not exceed 40 percent significance once they are included in the company’s audited post-acquisition results for nine months. For businesses that exceed 40 percent significance, pre-acquisition financial statements may be omitted once they are included in the company’s post-acquisition results for a fiscal year.

5. Modifying and enhancing the required disclosure for the aggregate effect of acquisitions for individually insignificant acquisitions

The final rule will require registrants to provide (1) pre-acquisition historical financial statements only for those businesses whose individual significance exceeds 20 percent and (2) pro forma financial information depicting the aggregate effects of all “individually insignificant businesses” in all material respects. These changes are intended to reduce the burdens of preparing disclosure about immaterial acquisitions and negotiating with sellers to timely provide historical financial statements, while the new requirement to provide pro forma financial information that shows the aggregate effect of the acquired businesses in all material respects should make it easier for investors to understand the overall effect of those acquisitions on the registrant.

Effect of amended rule: Registrants must monitor the obligation to provide pro forma financial information on the aggregate effect of acquired businesses. The final rules add a disclosure requirement that obligates registrants to provide pro forma financial information depicting the aggregate effect in all material respects of acquired businesses that are individually insignificant. This obligation is triggered if the aggregate impact of businesses acquired or to be acquired since the date of the most recent audited balance sheet filed for the registrant, for which financial statements are either not required or are not yet required, exceeds 50 percent for any condition (including the investment test or the income test). This is a new compliance burden on registrants to the extent they are required to present information about acquisitions, in an aggregated form, which they have not disclosed in the past. Registrants that have acquired or disposed of multiple companies since their fiscal year must monitor this requirement, conduct the applicable tests of acquisitions or dispositions, and make additional disclosures when required.

6. Amending the pro forma financial information requirements to improve the content and relevance of such information

The final rules amend Article 11 by replacing the existing pro forma adjustment criteria with simplified requirements broken out into three categories:

  1. “Transaction Accounting Adjustments” reflecting only the application of required accounting to the transaction;
  2. “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
  3. 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.

Effect of amended rules: Changes in the pro forma disclosure requirements may lead to interpretive questions and require additional time. The final rules establish three categories of adjustment criteria for pro forma information: Transaction Accounting Adjustments, Autonomous Entity Adjustments and optional Management’s Adjustments. As companies and their counsel and accountants begin to apply these revised adjustment criterial categories, questions about how to categorize adjustments, depict the pro forma financials and make the required disclosures, questions and issues will arise. Companies may need to plan for more time to address these issues, collaborate with the target subsidiary’s personnel, coordinate with the auditors and draft the disclosures under the revised rules.

7. Adopting other changes

Other changes in the final rule include (1) expanding the use of pro forma financial information in measuring significance; (2) conforming, to the extent applicable, the significance threshold and tests for a disposed business to those used for an acquired business; (3) permitting the use of, or reconciliation to, International Financial Reporting Standards as issued by the International Accounting Standards Board (IFRS-IASB) in certain circumstances; (4) aligning Rule 3-14 with Rule 3-05 where no unique industry considerations exist; (5) clarifying the application of Rule 3-14 regarding the determination of significance, the need for interim income statements, special provisions for blind pool offerings and the scope of the rule’s requirements; (6) amending the pro forma financial information requirements to improve the content and relevance of such information; (7) clarifying when financial statements and pro forma financial information are required; and (8) making corresponding changes to the smaller reporting company requirements in Article 8 of Regulation S-X.

Key Takeaways from the Final Rule:

Less burdensome disclosure. The final rules will reduce the number and scope of historical and pro forma financial information that registrants must file in connection with acquisitions and dispositions. The SEC believes that these changes to the disclosure requirements will improve the investor’s access to financial information about acquired or disposed businesses, facilitate the registrant’s more timely access to capital, and reduce the complexity and costs to prepare the disclosure for registrants.

Form 8-K Item 2.01 Threshold Not Changed. While the final rules include revisions to Item 2.01 of Form 8-K to clarify its application to acquisitions and dispositions that constitute real estate operations, the final rules do not change the Item 2.01 8-K trigger threshold at 10 percent for acquisitions or dispositions of assets.  As such, registrants must still file a Form 8-K reporting certain information about an acquisition or disposition if the registrant’s and its other subsidiaries’ equity in the net book value of such assets or the amount paid or received for the assets on such acquisition or disposition exceeded 10 percent of the total assets of the registrant and its consolidated subsidiaries.  This means that a registrant may have a transaction that is “material” enough to requiring filing of a Form 8-K within four business days of the transaction’s completion but is not “material” enough to require pro forma financial information. 

Registrants should consult with counsel and accountants when disclosing an acquisition or disposition. Evaluating and formulating disclosures about significant acquisitions or dispositions can be complex and requires care and planning, even for seasoned public companies. Preparing these financial and business disclosures and coordinating with auditors is time-consuming and requires advance planning. Closing and post-closing checklists should include Rule 3-05 financial statements and Article 11 pro forma disclosures, including the 75-day filing deadline. Public companies should work closely with accountants to conduct the significance tests, develop historical and pro forma financial disclosures, and communicate with counsel to assure their filings are timely and complete.

For additional guidance on the information in this alert, please contact any of the authors below, any member of McGuireWoods’ securities compliance team or your primary McGuireWoods contact.

McGuireWoods’ securities compliance team assists public companies with their reporting obligations under the Securities Exchange Act of 1934, including forms 10-K, 10-Q and 8-K, Section 16 reports and DEF 14A (proxy statements), as well as with Regulation FD and Regulation G compliance. We prepare insider trading policies, develop training programs and assist with other aspects of securities transactions engaged in by company officers, directors and significant security holders, including 10b5-1 plans and Rule 144 compliance.