As part of its ongoing review of the disclosure requirements under federal securities laws, the Securities and Exchange Commission (SEC) has proposed amendments relating to business acquisitions and dispositions by registrants. The proposed rule, dated May 3, 2019, seeks "to improve the information that investors receive regarding the acquisition and disposition of businesses" and "to facilitate more timely access to capital and to reduce complexity and compliance costs of these financial disclosures."

The amendments primarily affect various rules under Regulation S-X as well as other related rules and forms. The SEC also proposed a new Rule 6-11 of Regulation S-X and amendments to Form N-14, which relate to financial reports for acquisitions by investment companies.

Current Financial Disclosure Requirements for Acquired Businesses

Rule 3-05 of Regulation S-X requires registrants to provide separate audited annual and unaudited interim pre-acquisition financial statements of an acquired business if such business is significant to the registrant. Registrants are required to include a number of years of financial statements of the acquired business, which varies depending on the level of significance (as measured by the investment, asset, and income tests in Rule 1-02(w) of Regulation S-X). Rule 3-14 of Regulation S-X requires similar disclosures in the context of significant real estate operations.

Article 11 of Registration S-X requires registrants filing financial statements under Rule 3-05 or Rule 3-14 to also file unaudited pro forma financial information. Pro forma information, which is based on the historical financial statements of the registrant and the acquired or disposed of business, typically includes a balance sheet and income statement and provides adjustments demonstrating the effect the acquisition or disposition would have on the financial statements had the acquisition or disposition occurred earlier.

Proposed Amendments to Financial Disclosures

The proposed rule changes include a number of revisions to the current disclosure requirements in the context of mergers and acquisitions. The proposed rules include the following changes, among others.

Updates to Significance Tests

As noted above, registrants apply the "significant subsidiary" test in Rule 1-02(w) to determine an acquisition's significance. The proposed changes update the income test and investment test. Currently, the investment test compares the investment in and advances to the acquired business against the total assets of a registrant, as reflected in its most recent annual financial statements. The new investment test would compare "the registrant's investment in and advances to the acquired business to the aggregate worldwide market value of the registrant's voting and non-voting common equity ('aggregate worldwide market value'), when available."

The current income test compares a registrant's equity in the income from continuing operations of the acquired business before income taxes, excluding amounts attributable to any non-controlling interests, to the same registrant metric reflected in its most recent annual financial statements. 

The proposed rule adds a new revenue component to the existing income component of the income test, and the tested subsidiaries would be required to meet both. The new revenue component would compare the registrant's and its other subsidiaries' proportionate share of the tested subsidiary's consolidated total revenues (after intercompany elimination) to the consolidated total revenues for the registrant's most recently completed fiscal year. These changes are intended to reduce anomalous test results and "reduce complexity and preparation costs without sacrificing material information that investors may need to evaluate these transactions."

Use of Pro Forma Information in Measuring Significance

Currently, registrants may use pro forma financial information in making a significance determination if they have made a significant acquisition subsequent to the end of the latest fiscal year and filed Rule 3-05 financial statements and pro forma financial information on a Current Report on Form 8-K. The proposed rule would expand the use of pro forma financial statements by permitting registrants to measure significance using filed pro forma financial information that depicts only significant business acquisitions and dispositions consummated after the latest fiscal year-end for which the registrant's financial statements are required to be filed. This use of pro forma financial statements would be conditioned on: (1) registrants having filed financial statements under Rule 3-05 or Rule 3-14 for any acquired businesses; and (2) registrants having filed the pro forma financial information required by Article 11 for any such acquired or disposed businesses.

Reduction of Number of Years of Financial Statements Required

Under the current rule, registrants need not provide Rule 3-05 financial statements if none of the significance tests (investment, asset, or income) exceeds 20%. If any test falls between 20% and 40%, registrants must provide financial statements for the most recent fiscal year and any required interim periods. For any acquisition between the 40% and 50% significance levels, registrants must provide a second fiscal year of financial statements. Above 50%, a third fiscal year is required unless net revenues of the acquired business were less than $100 million in its most recent fiscal year.

The SEC's proposed rule reduces the number of years of required financial statements for the acquired business from three years to two years for an acquisition exceeding 50% significance. The proposal would further revise Rule 3-05 in cases where the significance test measures between 20% and 40%, "to require financial statements for the 'most recent' interim period specified in Rule 3-01 and 3-02 rather than 'any' interim period."

Modification of Disclosures for Individually Insignificant Businesses

The proposed changes to Rule 3-05 would also update the financial information required in connection with "individually insignificant businesses." Registrants currently must provide in a registration statement or proxy statement audited historical pre-acquisition financial statements covering at least the substantial majority of the businesses acquired, along with pro forma financial information required in Article 11, when the aggregate impact of these businesses acquired since the date of the most recent audited balance sheet exceeds 50%. The proposed rule retains the 50% threshold with certain modifications, but also would require registrants to provide pro forma financial information depicting the aggregate effects of applicable individually insignificant acquired businesses in all material respects while also requiring pre-acquisition historical financial statements only for those businesses whose individual significance exceeds 20% but are not yet required to file financial statements.

Clarification of When Financial Statements and Pro Forma Information Are Required

The SEC also seeks to clarify when registrants must provide financial statements and pro forma information. Amended Rule 3-05 as proposed would require registrants to provide financial statements "if a business acquisition has occurred during the most recent fiscal year or subsequent interim period for which a balance sheet is required by [Article 3] of Regulation S-X ... or if a business acquisition has occurred or is probable after the date that the most recent balance sheet has been filed."

Relaxing Requirement of Separate Acquired-Business Financial Statements

Currently, registrants need not provide Rule 3-05 financial statements after the operating results of the acquired business have been reflected in the audited consolidated financial statements of the acquiring company for a full fiscal year, unless the financial statements have not been previously filed or the acquired business is of major significance. The proposed rule would no longer require financial statements in registration statements or proxy statements after the acquired business is reflected in filed post-acquisition company financial statements for a full fiscal year. This change would end the requirement that registrants provide financial statements under Rule 3-05 when such financial statements have not been previously filed or when they have been previously filed but the acquired business is of major significance.

In addition to the proposed rule changes above, the SEC also proposed the following changes:

• Permit disclosure of financial statements that omit certain expenses for certain acquisitions of a component of an entity;
• Permit the use in certain circumstances of, or reconciliation to, International Financial Reporting Standards as issued by the International Accounting Standards Board;
• Conform the significance threshold and tests for a disposed business;
• Amend the pro forma financial information requirements to improve the content and relevance of such information; and
• Add a new Rule 6-11 and amend Form N-14 to cover financial reporting for fund acquisitions by investment companies and business development companies.