During the course of your company’s efforts to grow and become increasingly profitable, acquiring another business may become a real possibility. Understanding the implications an acquisition can have on your financial reporting requirements is important if your company is public or hopes to go public someday. Upon the acquisition of a business or group of business, your company will need to perform a set of tests (often called “significance tests”) to determine the significance of the acquisition. The SEC requires that audited financial statements be provided for significant acquired businesses, as well as probable business acquisitions, in the Form 8-K (“8-K”). Determining when these additional statements are required, how many years of statements are required, and what details need to be included within the 8-K can be very challenging, and these complexities often catch companies off guard. This article will begin by addressing the challenges surrounding these requirements, and will provide instructions for navigating the SEC’s significance tests and financial statement requirements. To conclude, this article will address an exception the SEC has made for companies going through an IPO.
The foundation of these acquisition financial statement requirements can be found in SEC Regulation S-X (“Reg S-X”). Rule 1-02(w) of Reg S-X contains the tests that must be completed to determine whether a business is significant. This rule, combined with rule 3-05, defines the guidance for how many years of statements are required and the associated filing deadlines.
Prior to performing the significance tests, however, you need to understand what qualifies as a business according to the SEC so that you can determine whether these tests are relevant to your acquisition. Our Business Combinations article touches on this topic, and discusses Rule 11-01(d), which clarifies the definition of a business for the purpose of the significance tests. The article further explains that in addition to a “separate entity, subsidiary, or division” qualifying as a separate business, “a lesser component of an entity” may qualify as well, and that there are several considerations to make when determining what constitutes a business. Those considerations are the way in which the entity produces revenue before and after the acquisition, as well as the attributes that make up the component before and after the transaction. The Business Combinations article also establishes that while ASC 805 can normally be used to determine whether an acquisition meets the definition of a business, technically both definitions (Reg S-X rule 11-01(d)’s definition and ASC 805’s) should be used, independent of one another, in making that determination.
Once the elements of your acquisition have been properly defined, the significance tests can be applied.
Rules 1-02(w) and 3-05 discuss the three tests to be used in this process. These tests allow a company to compare important financial figures of the acquisition target with their own to determine if the acquisition is considered significant. When completing these tests, compare the most recent pre-acquisition, annual audited consolidated financial statements of the acquirer to the most recent pre-acquisition annual (or quarterly if in existence for less than a year) financial statements of the acquired business (or group of businesses).
The tests are defined as follows:
- Asset Test – As the acquirer, compare your share of the acquired business assets to your own total consolidated assets.
- Investment Test – Compare total consideration transferred as payment for acquired business to the filing/acquiring company’s total consolidated assets.
- Income Test – Compare the pre-tax income from the continuing operations of the acquired business to the pre-tax income from continuing operations of the acquirer.
- If the filing company’s income reported in the most recent year is at least 10% lower than the most recent five-year average of their income, the five-year average should be used as a substitute for the most recent year’s income in the comparison.
- If a loss was reported in the most recent year, compare the absolute value of said loss to the five-year average of income, following the 10% rule established above. When computing the five-year average, any loss years should simply be represented by a zero in the numerator, and the denominator should remain unaffected.
The SEC also requires that any individually insignificant acquisitions (i.e., those that do not meet the 20% significance test) be tested in the aggregate together with: probable business acquisitions with a significance level of less than or equal to 50%, and any recent acquisitions between 20% and 50% significance. These recent acquisitions should have been completed within the last 75 days, and, due to their level of significance, would normally fall outside the purview of the reporting requirements.
The calculated levels of significance will correlate with the following requirements:
- Any level of significance below 20% does not require any additional statements to be filed with the SEC.
- Any level above 20% but below 40% requires one year of statements.
- Any level above 40% but below 50% requires two years of statements.
- Any level above 50% requires three years of statements.
- Additionally, for any probable acquisitions that are greater than 50% significant, three years of statements are required. According to Regulation S-X Rule §§210.3-05(2)(iv) however, “financial statements for the earliest of the three fiscal years required may be omitted if net revenues reported by the acquired business in its most recent fiscal year are less than $50 million.”
- Finally, if the aggregate of individually insignificant acquisitions is greater than 50%, the financial statements for the majority of the insignificant acquisitions would be required for the most recent fiscal year and the most recent interim periods.
The financial statements that are filed in accordance with Rule 3-05 must include Target and Pro Forma Statements that include the following, both for the annual and most recent interim periods:
- Balance Sheet (unless the acquisition is reflected in the filing company’s audited balance sheet)
- Income Statement
- Statement of Cash Flows
- Related Disclosures
Interim financials must also include income statement and cash flows for the interim period of the prior fiscal year. Additionally, if the acquired company doesn’t qualify as a public company under GAAP guidance, then the GAAP disclosure requirements for public companies are not required. According to EY, however, “An entity whose financial statements are included in a registrant’s SEC filing under Rule 3-05 of Regulation S-X meets the definition of a public business entity under ASU 2013-12.” Therefore, if a company has chosen to use the alternative accounting methods put forth by the private company council, they would be required to apply GAAP accounting and reporting standards to any statements provided to meet the filing requirements of Rule 3-05. EY further notes that “the financial statements also must comply with Regulation S-X but do not need to be audited in accordance with standards issued by the Public Company Accounting Oversight Board.”
The allowed age of the financial statements presented to the SEC varies depending on the status of the filer and the type of filing. If the target currently files as a public company with timely filings, your target financials need not be more recent than their 10-K and 10-Q.
If the target currently files as a private company, your target financials need to be as current as those provided by a non-accelerated filing public company filing with the SEC. The actual timing of target financials statements required to be filed by your company in this case would be as follows:
- Annual financials – Must be provided within 90 days after the target’s fiscal year-end.
- Interim financials – Must cover the target’s quarter-end that occurred within the last 135 days.
- Unless interim financials cover the third quarter, in which case they will stand as current until the next annual financial statements must be filed.
If the target currently files as a foreign business or foreign private issuer, the timing of financials statements required is as follows:
- Annual financials – Must be provided three months after the target’s fiscal year-end.
- Interim financials – Must cover a minimum of six months and be provided nine months after the targets fiscal year-end.
With the acquisition of a significant business, the SEC requires a company to file multiple Forms 8-K in three different stages.
- The first time an 8-K must be filed is at the point of signing. When both companies sign the acquisition agreement, the acquiring company must file an 8-K within four business days of signing to announce the material acquisition. Though target or pro forma financial statements are not required at this point, some companies may choose to include certain financial information.
- The second time an 8-K must be filed is at the close of the acquisition. Once again, this form is due within four business days of the close, but still, no financial statements are required at this point.
- The third time an 8-K must be filed is 75 days after the close, or 71 days after the due date of the closing 8-K. This filing is considered an amendment to the closing 8-K (part II above), and is denoted as an 8-K/A; it must include the target and pro forma statements for acquisitions exceeding the 20% significance level. If the statements have been provided previously in a proxy statement or in a prior registration, they need not be filed again.
There are many exceptions to the general rules that have been explained above. The purpose of this article is not to describe every possible deviation from the rules, but rather, to provide a general background to prepare you for future acquisitions. Consequently, it is very important that you consult Reg S-X and the rules contained therein for your unique circumstances. You should also consider consulting the SEC Staff Financial Reporting Manual and your auditors for further understanding of the rules and their intended application. Furthermore, when evaluating the acquisition of real estate operations or oil and gas properties, a different set of rules should be used.
There is one exception to the general rules that is particularly important to companies 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 have become immaterial to them 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).
EY explains that SAB Topic 1.J applies to those companies that have been established through the aggregation of “discrete businesses that remain substantially intact after the acquisition1,” but does not apply to companies that fall within two specific categories: 1) those that alter the significance of the acquired business through post-acquisition activities, and 2) those that are not able to provide post-acquisition results for the acquired business on a standalone basis.
Rather than measuring against the acquiring company prior to the inclusion of the target, as would normally be done, SAB Topic 1.J states that the significance tests “can be measured against the combined entities.” This means that the tools used for measuring significance are the pro forma financial statements as of the most recent audited fiscal year rather than historical financial statements as of the actual acquisitions. In regard to these pro forma statements, Topic 1.J states that “the pro forma balance sheet should be as of the date of the registrant’s latest balance sheet included in the registration statement2.” EY clarifies that in circumstances in which the pro forma balance sheet used in the IPO registration statement is “as of an interim date,” the registrant will need to “prepare a pro forma balance sheet as of the most recent audited balance sheet date included in the IPO registration statement.”
In an effort to help companies filing initial registration statements, the SEC has permitted companies fitting that description to minimize the number of months of financials required to be filed by counting what is already contained within the acquirer’s audited statements as part of the required months of statements. EY notes that in so doing, the filing company must make sure that there is no gap in their acquired business’s pre- and post-acquisition audited financial statements. This means that companies who fall within the scope of SAB Topic 1.J are able to use post-acquisition audited financial statements to either partially or completely fulfill the requirement to provide pre-acquisition audited financial statements for their significant acquired entities.
SAB 1.J also 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 need not be provided to the SEC (the year(s) of audited statements that can be omitted correlate to the level of significance of the company).
According to Topic 1.J, when comparing the significance of an entity to the conditions listed above, the registrant is to use the highest level of significance from the three tests completed for each entity.
Filing Timeline for Exception
For companies that are registering or offering securities, the SEC provides a grace period for the filing of target and pro forma statements. If a significant acquisition was closed within the 74 days prior to the registration effective date (or has not closed) and the significance level does not exceed 50%, the SEC does not require target or pro forma statements that were not filed previously. This means a company that makes an acquisition at or below 50% significance within 75 days of filing their S-1 does not have to include target or pro forma statements in their registration statement. The 75-day 8-K deadline does still apply, however, so if a company reaches the 75-day deadline one month after their effective date, an 8-K/A would still be required.
In the case that an acquisition (even those that are only probable or have closed within the last 74 days) or aggregation of acquisitions exceeds the 50% significance level, target and pro forma financial statements are required by the SEC in the registration statement. In regard to aggregate acquisitions, the SEC requires the significance tests be conducted for all acquisitions that are individually at or below the 20% significance level and were closed after the most recently audited balance sheet date, combined with any acquisitions that are probable or have closed within the last 74 days.
As the application of this exception can be confusing, we have provided an additional article demonstrating how a company would apply the exception if they are permitted to do so. The article is titled “SEC Significance Tests: Topic 1.J Example.”
The decision whether to apply the exception is made by each individual company, not the SEC. A Company may elect not to apply the exception in some cases, as it can at times create a bigger burden for companies than would a strict application of the rule.
SEC significance tests are necessary for determining the reporting requirements of a company that has recently acquired another business. Depending on the significance of the acquisition, zero, one, two, or three years of the target company’s most recent financial statements may need to be filed with the SEC. The exception explained in SAB Topic 1.J can be applied by companies filing initial registration statements when doing so will ease the burden placed upon them by Reg S-X Rule 3-05. As the acquisition of another business can bring with it so much additional work, understanding the SEC’s significance tests and related reporting requirements is an important part of creating a smooth transition. Furthermore, understanding the SEC significance tests and their application can be crucial to carrying out a timely IPO, as these tests and their accompanying filling requirements can cost a company in time and money if not properly planned for.
- Codification of Staff Accounting Bulletins Topic 1: Financial Statements, Subtopic J. Application of Rule 3-05 In Initial Public Offerings
- EY, Best practices when going through the IPO registration process.
- Electronic Code of Federal Regulations, Application of Regulation S-X: §210.1-02 Definitions of terms used in Regulation S-X (17 CFR part 210).
- Electronic Code of Federal Regulations, Application of Regulation S-X: §210.3-05 Financial statements of businesses acquired or to be acquired.
- Electronic Code of Federal Regulations, Application of Regulation S-X: §210.11-01 Presentation requirements.
- Deloitte, SEC reporting for business combinations and related topics: A Roadmap to applying SEC Regulation S-X to the acquisition of a business
- Shearman and Sterling, LLP, Financial Statements Triggered by Acquisitions—When You Need Them: A Practical Guide for US Public Companies, Part II
- Shearman and Sterling, LLP: Financial Statements Triggered by Acquisitions—What You Need: A Practical Guide for US Public Companies, Part I
- EY, Best practices when going through the IPO registration process
- Also known as the Form S-1, the registration statement is a set of documents that is filed with the SEC to register securities for public offering. The document includes information related to the operational and financial position of the filing company, as well as an explanation of the securities being offered, and any other information pertinent to protect potential buyers.