This article is an illustration of SAB Topic 1.J, the exception to the SEC significance tests established for Initial Public Offerings. If you have not already done so, we encourage you to read the first article in this two part series: SEC Significance Tests: Overview. The first article will explain the significance tests in great detail, and will introduce Topic 1.J.
There is one exception to the general SEC significance test rules that is particularly important to companies that are looking to go public in the future. The SEC realized that by applying Regulation S-X Rules 3-05 and 1-02(w) literally, companies that are going through an IPO could potentially be required to submit statements for acquired companies that were previously considered material at the time of acquisition but have become immaterial over the course of the months or years since the acquisition due to growth in assets and earnings. As such, the SEC designed an exception for companies going through an IPO, as explained in Staff Accounting Bulletin (SAB) Topic 1: Financial Statements, Sub-topic J: “Application of Rule 3-05 in Initial Public Offerings (SAB Topic 1.J).”
The following example illustrates how to apply SAB Topic 1.J for companies that have executed acquisitions before going public. This illustration is a modified version of an illustration originally found on SEC,gov. To view the original illustration, visit the following link: SAB Topic 1.J.
Our example begins with one company, “Registrant,” acquiring six unique companies (hereafter referred to as companies A through F) at different times over the course of two years (20X7-20X8). After acquiring all 6 companies, Registrant files Form S-1 on February 20, 20X9, containing its audited consolidated financial statements as of and for the three years ended December 31, 20X8. The following example will walk through an evaluation of Registrant’s responsibility to provide separate pre-acquisition audited financial statements for each acquired entity.
Below are the dates of acquisition for each entity, as well as the months of audited financial statements that are contained within Registrant’s post-acquisition audited results for each entity.
SAB Topic 1.J informs us that “In order for the pre-acquisition audited financial statements of an acquiree to be omitted from the registration statement, the following conditions must be met:
- the combined significance of businesses acquired or to be acquired for which audited financial statements cover a period of less than 9 months may not exceed 10%;
- the combined significance of businesses acquired or to be acquired for which audited financial statements cover a period of less than 21 months may not exceed 20%; and
- the combined significance of businesses acquired or to be acquired for which audited financial statements cover a period of less than 33 months may not exceed 40%”
In other words, if the acquiring company’s post-acquisition audited results do not contain the required months of data for an acquired company (9, 21, or 33 months), and the aggregate significance of the largest possible combination of acquired entities does not exceed the delineated significance level (10, 20, or 40%, respectively), pre-acquisition audited financial statements for years 1, 2, or 3, respectively, need not be provided to the SEC.
When comparing the significance of an entity to the conditions listed above, it is important to note that for SAB Topic 1.J, Registrant is to use the highest level of significance found when completing the three tests for each entity (asset test, earnings test, and investment test), as shown in the diagram below.
The following are the results of the significance tests performed for each of the six acquired entities, tested at the time the acquirer’s registration statement was filed:
Next, we evaluate the aggregate significance of multiple acquisitions by the years of data contained within the post-acquisition consolidated financial statement. We will complete our analysis in three phases: Phase 1, compare all entities in aggregate for which audited financial statements cover a period of less than 9 months; Phase 2, compare all entities in aggregate for which audited financial statements cover a period of less than 21 months; and Phase 3, compare all entities in aggregate for which audited financial statements cover a period of less than 33 months.
Phase 1 – 20X8 (10% threshold)
As F exceeds the 10% significance threshold on its own, it cannot be included in the aggregate comparison and is not eligible to be omitted from the parent Company’s financial statements. Therefore, E comprises the remaining “aggregate” to be tested. As E’s significance test falls below 10%, it is the only acquiree for which pre-acquisition financial statements may be omitted for 20X8, the most recent fiscal year.
Phase 2 – 20X7 (20% threshold)
As C exceeds the 20% significance threshold on its own, it cannot be included in the aggregate comparison, and is not eligible to be omitted. With the three remaining entities all below the threshold, the largest possible aggregation of significance must be calculated. The aggregate of all three entities—33% (13% + 9% + 11%)—exceeds the threshold by 13%, and thus requires an elimination of at least one entity from the aggregate calculation to bring the total at or below 20%. As the only possible combination of entity significance levels within that threshold is that of E and F, D is eliminated from the calculation. Having met the required threshold in aggregate, financial statements for E and F may be omitted for 20X7, the year preceding the most recent fiscal year.
Phase 3 – 20X6 (40% threshold)
Individually, no entity exceeds the 40% threshold of this phase. It is therefore a matter of determining the largest possible combination of individual entity significance levels that is within the threshold. The only possible combination that includes three entities and still remains at or below 40%, is the combination of D, E and F, with an aggregate significance of 33%. Having met the required threshold in aggregate, financial statements for D, E and F may be omitted for 20X6, the second year preceding the most recent fiscal year.
Having determined which entities can be omitted from certain years of Registrant’s financial statements, the minimum months of financial statements required can now be calculated. Under normal circumstances, the SEC requires a minimum of 33 months of financial statements to be presented for each significant entity, unless the entity has existed for less than 33 months, in which case the length of the life of the entity would be required. The following diagram will illustrate the new minimum financial statement requirements, adjusted for the omission calculated in phases 1 through 3. The omission calculation looks at each phase, and adds 12 months for each year that omission was permitted, capped at 33 months. For example, entity D was not within the required thresholds for phase 1 and 2, but was within threshold for phase 3, thus permitting the acquirer to omit the financial statements for entity D for year 20X6 (12 months of statements).
The following table illustrates the months of audited financials required in addition to those contained within Registrant’s post-acquisition consolidated financial statements. The required number of months is calculated by subtracting the number of months contained in the consolidated financial statements from the newly calculated minimum months required.
This example has demonstrated the proper application of SAB Topic 1.J to six unique entities that were acquired by a single company. If you have additional questions regarding SAB Topic 1.J or the original rule 3-05 found in Regulation S-X, take a look at our SEC Significance Tests article.