Amendments to Financial Disclosures About Acquired and Disposed Businesses

Federal RegisterAug 31, 2020

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 210, 230, 239, 240, 249, 270 and 274

[Release No. 33-10786; 34-88914; IC-33872; File No. S7-05-19]

RIN 3235-AL77

Amendments to Financial Disclosures About Acquired and Disposed Businesses

AGENCY:

Securities and Exchange Commission.

ACTION:

Final rule.

SUMMARY:

We are adopting amendments to our rules and forms to improve their application, assist registrants in making more meaningful determinations of whether a subsidiary or an acquired or disposed business is significant, and to improve the disclosure requirements for financial statements relating to acquisitions and dispositions of businesses, including real estate operations and investment companies. The changes are intended to improve for investors the financial information about acquired or disposed businesses, facilitate more timely access to capital, and reduce the complexity and costs to prepare the disclosure.

DATES:

Effective Date:

The final rules are effective on January 1, 2021.

Compliance Dates:

See Section II.F. for further information on transitioning to the final rules.

FOR FURTHER INFORMATION CONTACT:

Todd E. Hardiman, Associate Chief Accountant, at (202) 551-3516, Jessica Barberich, Associate Chief Accountant, at (202) 551-3782, or Craig Olinger, Senior Advisor to the Chief Accountant, at (202) 551-3400, or Steven G. Hearne, Senior Special Counsel, at (202) 551-3430, in the Division of Corporation Finance; Joel Cavanaugh, Senior Counsel, at (202) 551-3173, Jenson Wayne, Assistant Chief Accountant, at (202) 551-6918, or Mark T. Uyeda, Senior Special Counsel, at (202) 551-6792, in the Division of Investment Management, U.S. Securities and Exchange Commission, 100 F Street, NE, Washington, DC 20549.

SUPPLEMENTARY INFORMATION:

We are adopting amendments to:

Commission

reference

CFR citation

(17 CFR)

Regulation S-X

§§ 210.1-01 through 210.13-02.

Rule 1-02(w)

§ 210.1-02(w).

Rule 3-05

§ 210.3-05.

Rule 3-06

§ 210.3-06.

Rule 3-09

§ 210.3-09.

Rule 3-14

§ 210.3-14.

Rule 3-18

§ 210.3-18.

Rule 5-01

§ 210.5-01.

Rule 6-01

§ 210.6-01.

Rule 6-02

§ 210.6-02.

Rule 6-03

§ 210.6-03.

Article 8:

Rule 8-01

§ 210.8-01.

Rule 8-03

§ 210.8-03.

Rule 8-04

§ 210.8-04.

Rule 8-05

§ 210.8-05.

Rule 8-06

§ 210.8-06.

Article 11:

Rule 11-01

§ 210.11-01.

Rule 11-02

§ 210.11-02.

Rule 11-03

§ 210.11-03.

Securities Act of 1933 (Securities Act):

Securities Act Rule 405

§ 230.405.

Form S-11

§ 239.18.

Form N-2

§§ 239.14 and 274.11a-1.

Form N-14

§ 239.23.

Form 1-A

§ 239.90.

Securities Exchange Act of 1934 (Exchange Act):

Exchange Act Rule 12b-2

§ 240.12b-2.

Form 8-K

§ 249.308.

Form 10-K

§ 249.310.

Investment Company Act of 1940 (Investment Company Act):

Rule 8b-2

§ 270.8b-2.

We also

are adding 17 CFR 210.6-11 (new “Rule 6-11”) to Regulation S-X.

15 U.S.C. 77a

et seq.

15 U.S.C. 78a

et seq.

15 U.S.C. 80a-1

et seq.

Table of Contents

I. Introduction and Background

II. Discussion of Final Amendments

A. Amendments to the Definition of “Significant Subsidiary” and Generally Applicable Financial Statement Requirements for Acquired Businesses

1. Significance Tests

2. Audited Financial Statements for Significant Acquisitions

3. Financial Statements for Net Assets That Constitute a Business

4. Financial Statements of a Business That Includes Oil and Gas Producing Activities

5. Timing and Terminology of Financial Statement Requirements

6. Foreign Businesses

7. Smaller Reporting Companies and Issuers Relying on Regulation A

B. Amendments Relating to Rule 3-05 Financial Statements Included in Registration Statements and Proxy Statements

1. Omission of Rule 3-05 Financial Statements for Businesses That Have Been Included in the Registrant's Financial Statements

2. Use of Pro Forma Financial Information To Measure Significance

3. Disclosure Requirements for Individually Insignificant Acquisitions

C. Rule 3-14—Financial Statements of Real Estate Operations Acquired or To Be Acquired

1. Align Rule 3-14 With Rule 3-05

2. Definition of Real Estate Operation

3. Significance Tests

4. Interim Financial Statements

5. Smaller Reporting Companies and Issuers Relying on Regulation A

6. Blind Pool Real Estate Offerings

D. Pro Forma Financial Information

1. Adjustment Criteria and Presentation Requirements

2. Significance and Business Dispositions

3. Smaller Reporting Companies and Issuers Relying on Regulation A

E. Amendments to Financial Disclosure About Acquisitions Specific to Investment Companies

1. Amendments to Significance Tests for Investment Companies

2. Proposed Rule 6-11 of Regulation S-X

3. Pro Forma Financial Information and Supplemental Financial Information

4. Amendments to Form N-14

F. Transition

III. Other Matters

IV. Economic Analysis

A. Introduction

B. Baseline and Affected Parties

C. Potential Benefits and Costs of the Final Rule

1. Potential Benefits

2. Potential Costs

D. Economic Effects of Specific Amendments

1. Significance Tests

2. Audited Financial Statements for Significant Acquisitions

3. Financial Statements for Net Assets That Constitute a Business

4. Financial Statements of a Business That Includes Oil and Gas Producing Activities

5. Timing and Terminology of Financial Statement Requirements

6. Foreign Businesses

7. Smaller Reporting Companies and Issuers Relying on Regulation A

8. Omission of Rule 3-05 and Rule 3-14 Financial Statements and Related Pro Forma Financial Information for Businesses That Have Been Included in the Registrant's Financial Statements

9. Use of Pro Forma Financial Information To Measure Significance

10. Disclosure Requirements for Individually Insignificant Acquisitions

11. Rule 3-14—Financial Statements of Real Estate Operations Acquired or To Be Acquired

12. Pro Forma Financial Information

13. Significance and Business Dispositions

14. Amendments to Financial Disclosure About Acquisitions Specific to Investment Companies

E. The Effects on Efficiency, Competition, and Capital Formation

F. Alternatives Considered

1. Approaches to the Significance Tests

2. Approaches to Financial Statement Requirements

3. Approaches to Adopting Pro Forma Adjustments

4. Alternatives to the Income Test for Investment Companies

V. Paperwork Reduction Act

A. Summary of the Collection of Information

B. Effect of the Amendments on Existing Collections of Information

1. Estimated Effects on Burdens for Registrants Other Than Investment Companies

2. Estimated Effects of the Proposed Amendments on Paperwork Burdens for Investment Company Registrants

C. Aggregate Burden and Cost Estimates for the Amendments

VI. Final Regulatory Flexibility Act Analysis

A. Reasons for, and Objectives of, the Final Amendments

B. Significant Issues Raised by Public Comments

C. Small Entities Subject to the Proposed Rules

D. Reporting, Recordkeeping, and Other Compliance Requirements

E. Agency Action To Minimize Effect on Small Entities

VII. Statutory Authority

I. Introduction and Background

On May 3, 2019, the Commission proposed amendments to improve for investors the financial information about acquired and disposed businesses, facilitate more timely access to capital, and reduce the complexity and costs to prepare the disclosure.

Specifically, the Commission proposed amendments to the requirements for financial statements relating to acquisitions and dispositions of businesses, including real estate operations, in Regulation S-X Rule 3-05,

Financial statements of businesses acquired or to be acquired;

Rule 3-14,

Special instructions for real estate operations to be acquired;

Article 11,

Pro Forma Financial Information;

and other related rules and forms.

The proposed amendments resulted from an ongoing, comprehensive evaluation of our disclosure requirements.

The Commission also proposed new Rule 6-11 and amendments to Form N-14 to specifically govern financial reporting for acquisitions involving investment companies.

See Amendments to Financial Disclosures about Acquired and Disposed Businesses,

Release No. 33-10635 (May 3, 2019) [84 FR 24600 (May 28, 2019)] (“Proposing Release”).

Unless otherwise noted, references in this release to “Rule” or “Rules” are to the rules under Regulation S-X.

The Commission also proposed related amendments to Regulation S-X with respect to the definition of “significant subsidiary” in Rule 1-02(w); Rule 3-06,

Financial statements covering a period of nine to twelve months;

and Article 8,

Smaller Reporting Companies.

In addition, the Commission proposed amendments to Form 8-K for current reports, Form 10-K for annual and transition reports, and the definition of “significant subsidiary” in Exchange Act Rule 12b-2, Securities Act Rule 405, and Rule 8b-2 under the Investment Company Act.

The staff, under its Disclosure Effectiveness Initiative, is reviewing the disclosure requirements in Regulation S-X and in 17 CFR 229.10 through 229.1305 (“Regulation S-K”) and is considering ways to improve the disclosure regime for the benefit of both companies and investors. The goal is to comprehensively review the requirements and make recommendations on how to update them to facilitate timely, material disclosure by companies and shareholders' access to that information.

Under Rule 3-05, a registrant that acquires a business

other than a real estate operation

is generally required to provide separate audited annual and unaudited interim pre-acquisition financial statements of the business if it is significant to the registrant (“Rule 3-05 Financial Statements”). Recognizing that certain acquisitions have a greater impact on a registrant than others, Rule 3-05 addresses the reporting requirements for businesses acquired or to be acquired based on the “significant subsidiary” definition in Rule 1-02(w) using a sliding scale approach.

A registrant that has acquired, or proposes to acquire, a significant real estate operation

similarly must file separate audited annual and unaudited interim abbreviated income statements with respect to such operations (“Rule 3-14 Financial Statements”).

Additionally, registrants required to file Rule 3-05 Financial Statements or Rule 3-14 Financial Statements also are required to file unaudited pro forma financial information as prescribed by Article 11.

The pro forma financial information is based on the historical financial statements of the registrant and the acquired or disposed business, and generally includes adjustments intended to show how the acquisition or disposition might have affected those financial statements had the transaction occurred at an earlier time.

Rule 3-05 requires disclosure if the “business combination has occurred or is probable.”

See

17 CFR 210.3-05(a). Registrants determine whether a “business” has been acquired by applying Rule 11-01(d) of Regulation S-X. The definition of “business” in Regulation S-X focuses primarily on whether the nature of the revenue-producing activity of the acquired business will remain generally the same as before the transaction. This determination is separate and distinct from a determination made under the applicable accounting standards.

Rule 3-05 also applies to registrants that are registered investment companies and business development companies.

Instructions for the Presentation and Preparation of Pro Forma Financial Information and Requirements for Financial Statements of Businesses Acquired or To Be Acquired,

Release No. 33-6413 (Jun. 24, 1982) [47 FR 29832 (Jul. 9, 1982)] (“Rule 3-05 Adopting Release”).

Neither Regulation S-X nor any other Securities Act or Exchange Act rule provides a definition of a “real estate operation” or an explanation of what is meant by the reference to “properties” in Rule 3-14.

See

Rule 3-14. Rule 3-14 was adopted as part of the Commission's effort to establish a centralized set of instructions in Regulation S-X and is based on the disclosure requirements in Item 6(b) for Form S-11 as adopted in 1961.

See Uniform Instructions as to Financial Statements—Regulation S-X,

Release No. 33-6234 (Sept. 2, 1980) [45 FR 63682 (Sept. 25, 1980)]. Rule 3-14 Financial Statements are abbreviated because the rule requires that they exclude historical items that are not comparable to the proposed future operations of the real estate operation such as mortgage interest, leasehold rental, depreciation, corporate expenses, and federal and state income taxes. Additionally, Rule 3-14 generally only requires one year of Rule 3-14 Financial Statements.

See

Rules 11-01 and 11-02. Pro forma financial information typically includes a pro forma balance sheet as of the end of the most recent period for which a consolidated balance sheet of the registrant is required and pro forma statements of comprehensive income for the registrant's most recent fiscal year and for the period from the most recent fiscal year end to the most recent interim date for which a balance sheet is required.

Form 8-K generally requires registrants to file Rule 3-05 Financial Statements, Rule 3-14 Financial Statements, and related pro forma financial information within 75 days after consummation of the acquisition.

A similar 75-day filing period applies to registration statements and proxy statements for acquired or to be acquired businesses requiring Rule 3-05 Financial Statements,

but not for acquired or to be acquired businesses requiring Rule 3-14 Financial Statements.

Item 2.01 of Form 8-K requires that registrants make certain disclosures upon the acquisition or disposition of a significant amount of assets, including assets that constitute a business, within four business days after the consummation of the transaction. It does not require reporting for probable acquisitions or dispositions. Item 9.01 of Form 8-K provides that the required financial statements and pro forma financial information for the acquired business (including a real estate operation) may be filed not later than 71 calendar days after the initial report on Form 8-K is required to be filed, providing approximately 75 calendar days to file the acquired business financial statements and related pro forma financial information. A registrant may need to update the periods presented in Form 8-K in certain subsequently filed registration statements and proxy statements.

See

17 CFR 210.3-12.

Rule 3-05(b)(4) and Rule 11-01(c) provide that registration statements not subject to the provisions of 17 CFR 230.419 and proxy statements need not include separate financial statements of the acquired or to be acquired business and related pro forma financial information if the business does not exceed any of the conditions of significance in the definition of “significant subsidiary” in Rule 1-02(w) at the 50 percent level, and either (A) the consummation of the acquisition has not yet occurred; or (B) the date of the final prospectus or prospectus supplement relating to an offering as filed with the Commission pursuant to 17 CFR 230.424(b) or the mailing date in the case of a proxy statement, is no more than 74 days after consummation of the business combination, and the financial statements have not previously been filed by the registrant. A similar provision applies to smaller reporting companies, but it is linked to the effective date of the registration statement instead of the date of the final prospectus or prospectus supplement.

See

Rule 8-04(c)(4).

In addition, certain registration statements

and proxy statements

require audited financial statements and unaudited pro forma financial information for the substantial majority of individually insignificant consummated and probable acquisitions since the date of the most recent audited balance sheet if a significance test exceeds 50 percent for any combination of acquisitions subject to Rule 3-05.

This additional requirement does not apply to all registration statements, such as registration statements filed on 17 CFR 239.16b (“Form S-8”).

See

Rule 3-05(b)(2)(i). Smaller reporting companies provide the same disclosure under Rule 8-04(c)(3).

Commenters broadly supported the objectives of the proposed rules or were generally in favor of the proposals.

While commenters were largely supportive of the proposals, we also received recommendations for modifying or further considering aspects of the proposed amendments that commenters believed could be clarified and improved.

After reviewing and considering the public comments and recommendations, we are adopting the amendments largely as proposed. As we discuss further below, in certain cases we are adopting the proposed rules with modifications that are intended to address comments received.

Comment letters related to the Proposing Release are available at

https://www.sec.gov/comments/s7-05-19/s70519.htm.

In addition, the SEC's Small Business Capital Formation Advisory Committee (“SBCFAC”) adopted a recommendation generally supportive of the proposed rules subject to their specific recommendations.

See

U.S. Securities & Exchange Commission Small Business Capital Formation Advisory Committee, Recommendation on the Commission's Proposal to Amend Financial Disclosure Requirements Relating to Acquisitions and Dispositions of Businesses (Aug. 23, 2019) (“SBCFAC Recommendations”), available at

https://www.sec.gov/spotlight/sbcfac/recommendations-rule-3-05-and-accelerated-filer-definition.pdf.

II. Discussion of Final Amendments

Generally, the final amendments will not affect the financial statements related to the acquisition of a business that is the subject of a proxy statement or registration statement on 17 CFR 239.25 (“Form S-4”) or 17 CFR 239.34 (“Form F-4”); however, in certain circumstances application of the amended significance tests may affect whether the financial statements of a subject business that is not an Exchange Act reporting company are required to be included in such a proxy statement or registration statement. The final amendments will apply to pro forma financial information provided pursuant to Article 11 and financial information for acquisitions and dispositions otherwise required to be disclosed pursuant to Rule 3-05 or Rule 3-14. These amendments also do not affect the requirements in 17 CFR 210.3-02 (“Rule 3-02”) or Rule 8-01 relating to predecessor companies.

We are amending the requirements in Rule 1-02(w), Rule 3-05, Rule 3-14, Article 11, and related rules and forms. The amendments generally:

• Update the significance tests used under these and other rules to generally improve their application and assist registrants in making more meaningful significance determinations;

• Expand the use of pro forma financial information in measuring significance;

• Conform, to the extent applicable, the significance threshold and tests for a disposed business to those used for an acquired business;

• Require the financial statements of the acquired business to cover only up to the two most recent fiscal years;

• Permit disclosure of abbreviated financial statements for certain acquisitions of a component of an entity;

• Permit the use of, or reconciliation to, International Financial Reporting Standards as issued by the International Accounting Standards Board (“IFRS-IASB”) in certain circumstances;

• No longer require separate acquired business financial statements once the business has been included in the registrant's post-acquisition audited annual financial statements for either nine months or a complete fiscal year, depending on significance;

• Modify and enhance the required disclosure for the aggregate effect of acquisitions for which financial statements are not required or are not yet required;

• Align Rule 3-14 with Rule 3-05 where no unique industry considerations exist;

• Clarify 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;

See

Section II.C.6 below for a description of a blind pool offering.

• Amend the pro forma financial information requirements to improve the content and relevance of such information;

• Clarify when financial statements and pro forma financial information are required, and update the language used in our rules to take into account concepts that have developed since adoption of the rules over 30 years ago; and

• Make corresponding changes to the smaller reporting company requirements in Article 8 of Regulation S-X.

In addition, we are amending regulatory requirements specific to investment companies registered under the Investment Company Act and business development companies

(collectively, “investment companies”) as discussed in more detail in Section II.E. below.

“Business development company” is defined in Section 2(a)(48) of the Investment Company Act, 15 U.S.C. 80a-2(a)(48).

A. Amendments to the Definition of “Significant Subsidiary” and Generally Applicable Financial Statement Requirements for Acquired Businesses

The “significant subsidiary” definition in Rule 1-02(w) includes investment, asset, and income tests that are applied when determining if a subsidiary is deemed significant for the purposes of certain Regulation S-X and Regulation S-K requirements as well as certain Securities and Exchange Act rules and forms.

Whether an acquisition is significant under Rule 3-05 is determined by applying these tests,

which generally can be described as follows:

In addition to its use in Rule 3-05 and Rule 3-14, the Rule 1-02(w) definition of “significant subsidiary” is used in the following rules:

• 17 CFR 210.9-03, which requires bank holding companies and banks to reflect on their balance sheets certain loans and indebtedness of their significant subsidiaries;

• 17 CFR 210.11-01(b), which specifies when a business combination or disposition of a business shall be considered significant;

• 17 CFR 210.3-09, 17 CFR 210.4-08(g) (“4-08(g)”), and Item 17(c)(2) of 17 CFR 249.220f (“Form 20-F”), which rely on the significance tests to determine the financial statements and summarized financial information required for the registrant's equity method investees;

• 17 CFR 229.601(b)(21) and Instruction 8 as to Exhibits of Form 20-F, to determine the subsidiaries that must be included in the list of subsidiaries required as an exhibit;

• Item 17(b)(7) of Form S-4, to determine the financial statements required for domestic target companies being acquired that do not meet the requirements to use 17 CFR 239.34 (“Form S-3”);

• Item 17(b)(5) of Form F-4, to determine the financial statements required for foreign companies being acquired that do not meet the requirements to use 17 CFR 239.34 (“Form F-3”);

• Item 4.C of Form 20-F, which requires a detailed list of the registrant's significant subsidiaries;

• 17 CFR 229.304(a)(1) and (2), Item 9(d) of 17 CFR 240.14a-101 (“Schedule 14A”), Item 4.01 of Form 8-K, Item 4 of 17 CFR 239.93 (“Form 1-U”), and Item 16F of Form 20-F, which require disclosure about changes in the auditors of the registrant (or issuer, as applicable) or its significant subsidiaries;

• Item 3 of 17 CFR 249.308a (“Form 10-Q”) and Item 13 of Form 20-F, which require disclosure about defaults of the registrant and its significant subsidiaries and material arrearages/delinquencies in the payment of dividends on preferred stock of the registrant or any of its significant subsidiaries;

• 17 CFR 229.101(a)(1), which requires certain disclosures, such as bankruptcy, receivership or similar proceedings and the nature and results of any other material reclassification, merger, or consolidation, of the registrant and any of its significant subsidiaries;

• 17 CFR 229.103, which requires disclosure of certain legal proceedings, including bankruptcy and similar proceedings, for the registrant and any of its significant subsidiaries; and

• Item 4.A.4 of Form 20-F, which requires general disclosure about the development of and structural changes in the business of the registrant and its significant subsidiaries.

Rule 3-05 provides for use of a 20 percent significance threshold, rather than the 10 percent threshold indicated in Rule 1-02(w). The

Commission raised the threshold in Rule 3-05 from 10 percent to 20 percent in 1996 in order to reduce compliance burdens in response to concerns that the requirement to obtain audited financial statements for a business acquisition may have caused companies to forgo public offerings and to undertake private or offshore offerings.

See Streamlining Disclosure Requirements Relating to Significant Business Acquisitions,

Release No. 33-7355 (Oct. 10, 1996) [61 FR 54509 (Oct. 18, 1996)] (“1996 Streamlining Release”). As a result of this amendment, the significance thresholds in Rule 3-05 have diverged from those used for Rule 3-14 and for dispositions since that time.

• “Investment Test”—the registrant's and its other subsidiaries' investments in and advances to the acquired business are compared to the total assets of the registrant reflected in its most recent annual financial statements required to be filed at or prior to the acquisition date;

• “Asset Test”—the registrant's and its other subsidiaries' proportionate share of the acquired business's total assets reflected in the business's most recent annual pre-acquisition financial statements is compared to the total assets of the registrant reflected in its most recent annual financial statements required to be filed at or prior to the acquisition date; and

• “Income Test”—the registrant's and its other subsidiaries' equity in the income from continuing operations of the acquired business before income taxes, exclusive of amounts attributable to any noncontrolling interests, as reflected in the business's most recent annual pre-acquisition financial statements, is compared to the same measure reflected in the registrant's most recent annual financial statements required to be filed at or prior to the acquisition date.

1. Significance Tests

We are amending the significance tests provided in Rule 1-02(w) to improve their application and to assist registrants in making more meaningful determinations of whether a subsidiary or an acquired or disposed business is significant. Specifically, we are revising the Investment Test and the Income Test and making other conforming changes. The Commission did not propose to substantively revise the Asset Test; however, a number of non-substantive revisions to the significance tests generally were proposed and are being adopted.

The final amendments also provide that, for acquisitions, intercompany transactions with the acquired business must be eliminated from the registrant's and its subsidiaries' consolidated total assets when computing the Asset Test.

For example, the final amendments label the conditions as the “Investment Test,” the “Asset Test,” and the “Income Test” and clarify that the significance tests compare the “tested” subsidiary's amounts to the registrant's.

a. Investment Test

The Investment Test compares the registrant's and its other subsidiaries' investments in and advances to the tested subsidiary to the total assets of the registrant and its subsidiaries consolidated reflected at the end of the most recently completed fiscal year, or in the case of an acquired business, in the registrant's most recent annual financial statements required to be filed at or prior to the acquisition date.

i. Proposed Amendments

The Commission proposed to revise the Investment Test to compare the registrant's and its other subsidiaries' investments in and advances to the tested subsidiary to the aggregate worldwide market value of the registrant's voting and non-voting common equity (“aggregate worldwide market value”), when available, and to retain the existing test when the registrant does not have an aggregate worldwide market value.

As proposed, aggregate worldwide market value would be determined as of the last business day of the registrant's most recently completed fiscal year, which for acquisitions and dispositions would be at or prior to the date of acquisition or disposition. The Commission additionally proposed amendments relating to contingent consideration

and combinations between entities or businesses under common control.

The value under the proposed rule would have differed from the value currently used by registrants to determine accelerated filer status under Exchange Act Rule 12b-2 because it would include the value of common equity held by affiliates and it would be determined as of the last business day of the registrant's most recently completed fiscal year. By contrast, Exchange Act Rule 12b-2 looks to the value of common equity held by non-affiliates and is determined as of the last business day of the registrant's most recently completed second fiscal quarter.

See

Exchange Act Rule 12b-2.

The Commission proposed to require that the “investment in” the tested subsidiary in an acquisition include the fair value of contingent consideration required to be recognized at fair value by the registrant at the acquisition date under U.S. Generally Accepted Accounting Principles (“U.S. GAAP”) or IFRS-IASB, as applicable. If recognition at fair value is not required, the proposed amendment would require all contingent consideration to be included, except sales-based milestones and royalties, unless the likelihood of payment is remote. For similar reasons, the Commission proposed that the “investment in” the tested subsidiary in a disposition equal the fair value of the consideration, which would include contingent consideration, for the disposed subsidiary when comparing it to the registrant's aggregate worldwide market value or the carrying value of the disposed subsidiary when comparing it to the registrant's total assets.

The Commission proposed that the Investment Test would be met for a combination between entities or businesses under common control when either net book value of the tested subsidiary exceeds 10 percent of the registrants' and its subsidiaries' consolidated total assets or the number of common shares exchanged or to be exchanged by the registrant exceeds 10 percent of its total common shares outstanding.

The Commission proposed the use of aggregate worldwide market value in the Investment Test to address a measurement mismatch: The comparison of the registrant's and its other subsidiaries' investments in and advances to the tested subsidiary,

which for an acquisition or disposition is typically the purchase or sales price and is generally consistent with fair value, to the registrant's total assets measured at book value. Using aggregate worldwide market value instead of total assets was intended to address this mismatch for acquisitions and dispositions by comparing measures that are generally consistent with fair value, thereby providing a more meaningful measure of significance.

Rules 3-05 and 3-14 use the conditions in Rule 1-02(w) when establishing the test for registrants to determine whether financial statements are required for businesses acquired or to be acquired. While we recognize that acquired businesses are often not subsidiaries, we use the term “tested subsidiary” throughout this release, rather than “tested business” or another term, when referring to the conditions in Rule 1-02(w) in connection with the determination in Rule 3-05 and Rule 3-14.

ii. Comments

Commenters generally supported the proposal to revise the Investment Test.

Many commenters expressly supported the proposed use of aggregate worldwide market value of the registrant's voting and non-voting common equity, when available.

Some commenters who supported the use of aggregate worldwide market value recommended measuring it closer to the date of the acquisition or disposition because of the potential fluctuation and

volatility of the stock price.

Other commenters recommended extending the use of a fair value measure to initial public offerings, such as by allowing issuers to estimate their aggregate worldwide market value at the anticipated offering date.

See, e.g.,

letters from Bass Berry & Sims PLC (“Bass Berry”), Cravath, Swaine & Moore LLP (“Cravath”), Deloitte & Touche LLP (“DT”), Eli Lilly and Company (“Eli Lilly”), Institute of Management Accountants (“IMA”), KPMG LLP (“KPMG”), PNC Financial Services Group, Inc. (“PNC”), Securities Industry and Financial Markets Association (“SIFMA”), and The Williams Companies, Inc. (“Williams”). We received no comments specific to our proposals to provide further instructions on a registrant's and its other subsidiaries' “investments in” the tested subsidiary for acquisitions and dispositions or to clarify the applicability of the Investment Test to combinations between entities under common control.

See, e.g.,

letters from Ball Corporation (“Ball”), CFA Institute (“CFA”), Cravath, Davis Polk and Wardwell LLP (“Davis Polk”), DT, Eli Lilly, Financial Executives International (“FEI”), KPMG, MTBC, Inc. (“MTBC”), RSM US LLP (“RSM”), SIFMA, Shearman and Sterling LLP (“Shearman”), and Williams.

See also

SBCFAC Recommendations.

See, e.g.,

letters from BDO USA LLP (“BDO”), Center for Audit Quality (“CAQ”), CFA, Cravath, Crowe LLP (“Crowe”), Davis Polk, DT, Ernst & Young LLP (“EY”), Grant Thornton LLP (“GT”), IMA, Liberty Global plc (“Liberty”), MTBC, KPMG, RSM, Sullivan & Cromwell LLP (“S&C”), and Shearman. Commenters recommended a variety of alternatives including particular dates, ranges of dates or averages linked to the announcement, agreement or transaction dates, the most recently completed fiscal quarter, or confidential submission or filing dates of registration statements.

See, e.g.,

BDO, CAQ, Crowe, Davis Polk, GT, RSM, S&C, SIFMA, and Shearman.

See, e.g.,

letters from BDO, Crowe, EY, and RSM.

See also

letters from Cravath and Davis Polk suggesting additional accommodations for initial public offerings.

A number of commenters, however, expressed concern relating to the use of aggregate worldwide market value.

One of these commenters suggested that aggregate worldwide market value would introduce market volatility into the test.

Other commenters suggested that aggregate worldwide market value would not reflect fair value when significant amounts of stock are held by affiliates, the registrant is highly leveraged or its capital structure is complicated.

Two commenters supported the use of aggregate worldwide market value for acquisitions and dispositions, but expressed concern about its use for measuring significance of equity method investees because it introduces a historical cost versus fair value disparity (

e.g.,

comparing investments in and advances to the equity method investee to the registrant's aggregate worldwide market value).

See

letters from The Allstate Corporation (“Allstate”), Affiliated Managers Group, Inc. (“AMG”), Bass Berry, Council of Institutional Investors (“CII”), Davis Polk, Denbury Resources Inc. (“Denbury”), DT, GT, IMA, and Liberty.

See

letter from AMG.

See

letters from Allstate, Bass Berry, DT, and GT.

But see

letter from CFA (recommending using a lower significance threshold or supplementing the revised test in such circumstances).

See

letters from DT and Williams. DT recommended that the Commission consider any potential impact of such changes on Rules 3-09 and 4-08(g) and other existing rules and staff guidance, while Williams recommended expressly retaining the existing requirement when evaluating equity method investments for significance under Rule 4-08(g).

Some commenters recommended using the “enterprise value” of the registrant as a more accurate reflection of the fair value of the entities,

despite acknowledging a lack of agreed-upon definition of the term

or that enterprise value may necessitate adjustment to the numerator of the Investment Test to reflect leverage.

These commenters recommended a variety of potential definitions for enterprise value or adjustments to equity market value that could be made to calculate enterprise value.

Some commenters offered other alternatives, such as using the lower of the existing Investment Test denominator (the registrant's consolidated total assets) or aggregate worldwide market value.

One commenter expressed concern that the proposed Investment Test could encourage certain transactions that, in the long-term, may not be in the best interest of an acquirer's shareholders.

See

letters from Bass Berry, Cravath, Davis Polk, Denbury, IMA, Liberty, and Shearman. Liberty went further and suggested that an Investment Test using enterprise value obviates the need for other significance tests.

See

letters from IMA and Shearman.

See

letter from Shearman. The commenter noted that if enterprise value is used, the numerator would also need to be revised to account for leverage by using the sum of the purchase price paid and the amount of debt, net of cash and cash equivalents, assumed.

See

letters from Bass Berry, Davis Polk, IMA, and Shearman. Bass Berry recommended defining “enterprise value” as “(a) the equity value of the registrant (that is, the aggregate worldwide market value of the registrant's common equity as set forth above), plus (b) the value of the registrant's indebtedness, minority interests and preferred stock . . . , less (c) the cash and cash equivalents of the registrant as of the end of its most recent fiscal year.” Cravath recommended using the sum of the investments in and advances to the tested subsidiary, plus total debt to be assumed compared to the sum of the aggregate worldwide market value plus total debt without eliminating cash. Shearman noted that the basic definition takes the fair value of the equity and adds total debt and subtracts cash and cash equivalents and suggested if the Commission were to use “net debt,” it would also need to adjust the purchase price to the sum of the purchase price paid and the amount of net debt assumed. IMA recommended that the Commission include the registrant's common and preferred stock, as well as its debt (including finance lease obligations) and that a registrant be permitted to use either the carrying amount of debt and/or preferred stock without a readily-determinable fair value or the carrying amount of debt, preferred stock and the residual equity. Davis Polk recommended “the addition of the principal amount of the acquirer's outstanding debt to its equity market value.”

See

letters from Allstate and New York City Bar Association, Committee on Securities Regulation (“NYCBA—Sec.”).

See

letter from CII.

See also

Section II.A.1.a. of the Proposing Release.

See

letter from Cravath.

See

letter from GT. Separately, GT also recommended clarifying whether all contingent consideration should be included in the numerator if the likelihood of payment of all contingent consideration or any part thereof is more than remote.

iii. Final Amendments

We are adopting amendments to the Investment Test, with modifications from what was proposed in response to comments received.

Aggregate Worldwide Market Value

We are adopting amendments to the Investment Test, substantially as proposed, to compare the registrant's and its other subsidiaries' investments in and advances to the tested subsidiary to the aggregate worldwide market value of the registrant's voting and non-voting common equity, when available,

but expressly limiting this amendment to acquisitions and dispositions.

As proposed, we are retaining the existing test for acquisitions and dispositions in circumstances where the registrant does not have an aggregate worldwide market value. We are also retaining the existing test when used for the additional purposes for which the Rule 1-02(w) definition is applicable.

As with the proposed rule, the value under the final rule differs from the value currently used by registrants to determine accelerated filer status under Exchange Act Rule 12b-2.

See supra

note 26.

See

Section II.A.1.c.iii below for a discussion about retaining the existing Investment Test in other circumstances. The final rules reorganize and renumber proposed Rule 1-02(w)(1)(i) to effect these changes.

See

Rule 1-02(w)(1)(i)(C) and the discussion on Conforming Changes

supra

Section II.A.1.c.

In an acquisition or disposition, the registrant's and its other subsidiaries' “investments in”

the tested subsidiary are generally the consideration transferred or received (

i.e.,

the purchase or sales price) for the net assets acquired or sold. For acquisitions and dispositions, we believe that aggregate worldwide market value more closely aligns with the purchase or sale price used in the numerator of the Investment Test and provides a measure that is readily available and objectively determined by the market. Use of aggregate worldwide market value in these circumstances will address the mismatch whereby purchase or sale price is a measure of net assets generally consistent with fair value while the registrant's total assets to which it is currently compared reflects gross assets measured at book value.

The Investment Test uses the phrase “investments in and advances to.” In this way, the numerator of the Investment Test includes two parts: “investments in” and “advances to.” Our references to “investments in” in this release are intended to focus the particular discussion on the first part of the numerator of the Investment Test. Any such reference should not be read to suggest the numerator of the Investment Test excludes the second part, “advances to.”

The book value of the registrant's total assets may not fully reflect the registrant's current fair value. For example, the Investment Test uses the carrying value of a registrant's total assets as of the most recent annual balance sheet date, which represents a combination of fair value for certain assets (

e.g.,

financial instruments) and historical cost for other assets (

e.g.,

property, plant and equipment and intangible assets). The test further excludes the value of certain assets not permitted to be recognized (

e.g.,

certain internally developed intangible assets) and is not reduced by the value of liabilities.

We are not adopting the suggestion of some commenters to use “enterprise value” for the Investment Test. The use of aggregate worldwide market value, unlike “enterprise value,” will avoid the need to define a term that does not have an agreed-upon definition. Moreover, it avoids having to establish additional adjustments to the “investments in and advances to” the tested subsidiary in order to convert the Investment Test numerator from essentially an equity value to an enterprise value, which we believe would be necessary if an enterprise value denominator were used. We also are not adopting the suggestion to use the lower of the existing Investment Test denominator (

i.e.,

the registrant's consolidated total assets) or aggregate worldwide market value. While we note the observation that a company with substantial assets that is highly leveraged may have a relatively small market capitalization, the suggested “lower of” standard is not linked to leverage nor do we believe the existence of leverage necessarily precludes the need for disclosure about acquired and disposed businesses.

In response to commenters' suggestions and concerns regarding market volatility, we are modifying the proposal to require registrants to use the average of aggregate worldwide market value calculated daily for the last five trading days of the registrant's most recently completed month ending prior to the earlier of the registrant's announcement date or agreement date of the acquisition or disposition. We are persuaded by commenters who suggested that market volatility and changes in market value unrelated to the acquisition could affect the determination of aggregate worldwide market value. We believe that using a more recent measurement period that is averaged to moderate daily variability more accurately reflects aggregate worldwide market value for purposes of computing significance based on the purchase or sale price while retaining a readily available and easily determinable measure of aggregate worldwide market value.

As proposed, the final rules will continue to require use of the total assets of the registrant and its subsidiaries consolidated when a registrant does not have an aggregate worldwide market value. We did not modify the final rule to permit, as suggested by some commenters, the estimation of aggregate worldwide market value when no such market value exists because we believe such an approach could introduce, rather than eliminate, complexity, and would be inconsistent with our intent of requiring that the determination, where possible, be based on readily available and easily and objectively determinable amounts that exist at the earlier of the announcement or agreement date.

For example, a public float approach similar to that in 17 CFR 229.10(f)(1) (“Item 10(f)(1) of Regulation S-K”) relies on an estimated public offering price measured relative to the filing date, which could cause the estimate to already encompass the value of the tested business when the acquisition has already occurred or when the anticipated offering or filing date occurs after the earlier of the announcement or agreement date.

Contingent Consideration

We are amending the Investment Test, substantially as proposed, to clarify that for acquisitions, the registrant's and its other subsidiaries' “investments in”

the tested subsidiary is the consideration transferred, adjusted to exclude the registrant's and its subsidiaries' proportionate interest in the carrying value of assets transferred by the registrant and its subsidiaries consolidated to the tested subsidiary that will remain with the combined entity after the acquisition. The amendments further indicate that the registrant's and its other subsidiaries' “investments in” the tested subsidiary shall include the fair value of contingent consideration if required to be recognized at fair value by the registrant at the acquisition date under U.S. GAAP or IFRS-IASB, as applicable; however if recognition at fair value is not required, it shall include all contingent consideration, except contingent consideration for which the likelihood of payment is remote. We believe inclusion of contingent consideration provides a more accurate measure of an acquired business's relative significance. We were not persuaded by commenters that contingent consideration should be excluded from the Investment Test when the acquired business (as defined in Rule 11-01(d)) will be accounted for as an asset acquisition under U.S. GAAP. Contingent consideration can be a material component of the consideration provided to acquire a Rule 11-01(d) business and its exclusion from the significance tests could result in the under-identification of acquisitions for which financial statements are necessary to reasonably inform investors.

See supra

note 53.

The proposed amendment would have permitted the exclusion of contingent consideration in the form of sales-based milestones and royalties from the Investment Test when recognition of contingent consideration at fair value is not required under U.S. GAAP or IFRS-IASB, as applicable. The proposal was intended to promote ease of calculation while maintaining the objective of the test as a reliable indicator of relative significance; however, commenter feedback made evident that there are a wide variety of contingent consideration arrangements with variable terms that require estimation beyond sales-based milestones and royalties. Rather than expanding the exclusion to encompass these other arrangements, we are persuaded by the commenter who observed that the exclusion of such consideration from the significance tests when the likelihood of their payment was more than remote could result in under-identification of acquisitions that would materially affect the registrant's financial statements. Therefore, the final amendments do not provide for any such exception.

In order to further clarify the requirements related to the amount of contingent consideration

to include in the Investment Test when recognition at fair value is not required under U.S. GAAP or IFRS-IASB, as applicable, the final rules modify the proposed language, which provided for inclusion of “all contingent consideration unless the likelihood of payment is remote,” to require inclusion of “all contingent consideration, except contingent consideration for which the likelihood of payment is remote.”

We are not persuaded by the suggestion to permit registrants to determine significance of an acquisition using the fair value of the contingent consideration arrangement when fair value is not required by U.S. GAAP or IFRS-IASB, as applicable, as a means to mitigate the risk that an acquisition may be deemed significant for arrangements for which there is a wide range of possible outcomes in the eventual amount of contingent consideration that may be owed. We note that the standard we are adopting is one employed in practice today. To the extent that unique facts and circumstances may trigger significance when financial statements are not reasonably necessary to inform investors, we believe such a situation is best addressed through 17 CFR 210.3-13 (“Rule 3-13”).

See

Rule 3-13 of Regulation S-X, which provides that the Commission may, upon the request of the registrant, and where consistent with the protection of investors, permit the omission of one or more required financial statements or the filing in substitution therefor of appropriate statements of comparable character. The Commission has delegated authority to the staff in the Division of Corporation Finance to grant requests for relief under Rule 3-13.

Other Amendments

The final amendments provide, as proposed, that the registrant's and its other subsidiaries' “investments in” the tested subsidiary exclude the registrant's and its other subsidiaries' proportionate interest in the carrying value of assets transferred by the registrant to the tested subsidiary that will remain with the combined entity after the acquisition. The final amendments also provide, as proposed, that in a disposition, the registrant's and its other subsidiaries' “investments in” the tested subsidiary equal the fair value of the consideration (which includes contingent consideration) for the disposed subsidiary when comparing it to the registrant's aggregate worldwide market value or, when the registrant has no such aggregate worldwide market value, the carrying value of the disposed subsidiary when comparing it to the registrant's total assets. The final amendments additionally provide, as proposed, that the Investment Test is met when either net book value of the tested subsidiary exceeds 10 percent of the registrant's and its subsidiaries' consolidated total assets or the number of common shares exchanged or to be exchanged by the registrant exceeds 10 percent of its total common shares outstanding at the date the combination is initiated for combinations between entities or businesses under common control.

The addition of net book value to the test recognizes that such combinations may be effected by transferring net assets, rather than exchanging shares, and that the resulting accounting by the entity who receives net assets or equity interests (

i.e.,

the receiving entity) typically recognizes the combination using the parent's historical carrying value of the transferred entity or business.

See, e.g.,

FASB ASC 805-50-30-5.

b. Income Test

The Income Test compares the registrant's equity in the tested subsidiary's income from continuing operations before income taxes exclusive of amounts attributable to any noncontrolling interests to such income of the registrant for the most recently completed fiscal year. In the case of an acquisition, the Income Test similarly compares the registrant's equity in the income from continuing operations of the acquired business before income taxes, exclusive of amounts attributable to any noncontrolling interests, as reflected in the business's most recent annual pre-acquisition financial statements, to the same measure of the registrant reflected in its most recent annual financial statements required to be filed at or prior to the acquisition date.

i. Proposed Amendments

The Commission proposed to revise the Income Test to reduce the anomalous results that may occur by relying solely on net income

and to reduce complexity and preparation costs without sacrificing material information for investors. The Commission proposed to:

Net income can include infrequent expenses, gains, or losses that can distort the determination of relative significance.

• Add a new revenue component to the test;

• Revise the net income component to use income or loss from continuing operations

after

income taxes, instead of

before

income taxes;

• Calculate the net income component using absolute values;

• Revise the Income Test to use the average of the absolute value of net income when the existing 10 percent threshold in Computational Note 2 to Rule 1-02(w) is met and the proposed revenue component does not apply; and

• Make additional clarifications and simplifications.

Specifically, the Commission proposed to clarify that the Income Test may be determined using the acquired business's revenues less the expenses permitted to be omitted by proposed Rules 3-05(e) and 3-05(f) under certain conditions and to make additional non-substantive amendments to the net income component in order to simplify the description and application.

The proposed revenue component would compare the registrant's and its other subsidiaries' proportionate share of the tested subsidiary's consolidated total revenues (after intercompany eliminations) to such consolidated total revenues of the registrant for the most recently completed fiscal year. Under the proposal, where the registrant and its subsidiaries consolidated and the tested subsidiary have recurring annual revenue,

the tested subsidiary must meet both the new revenue component and the net income component, and in the case of the application of the test in Rule 3-05, could 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.

Where a registrant or tested subsidiary does not have recurring annual revenues, the revenue component is less likely to produce a meaningful assessment and therefore only the net income component would apply.

ii. Comments

Commenters broadly supported the revisions to the Income Test and made various recommendations to improve specific components of the Income Test.

See, e.g.,

letters from Bass Berry, Cravath, DT, Eli Lilly, IMA, KPMG, PNC, SIFMA, and Williams. We received no comments on the additional clarifications and simplifications.

Revenue Component

Commenters broadly supported the addition of a revenue component to the Income Test.

One commenter recommended establishing significance when registrants meet either revenue or net income.

Another commenter noted that the inclusion of the revenue component would reduce instances of anomalous significance results, but noted that using a lower of revenue or net income approach could result in under-identification of acquisitions expected to have a material future impact and suggested considering the use of a lower revenue threshold.

Another commenter suggested requiring only the revenue component, and not the income component, for smaller reporting companies.

See, e.g.,

letters from AMG, Ball, Bass Berry, BDO, Cravath, Eli Lilly, FEI, GT, Liberty, NYCBA—Sec., Pfizer, PricewaterhouseCoopers LLP (“PWC”), SIFMA, Shearman, and Williams.

See also

SBCFAC Recommendations. Some of these commenters suggested further accommodations for equity method investees.

See, e.g.,

letters from GT and AMG.

See

letter from CFA.

See

letter from GT. In contrast, one commenter explicitly supported using the same percentage thresholds for the revenue component and the income component and indicated its belief that

there was no meaningful risk that the income component of the Income Test would under-identify material transactions.

See

letter from Cravath.

See

letter from MTBC.

Recurring Annual Revenues

A number of commenters, particularly accounting and auditing firms, expressed concern that the term “recurring annual revenues” may not be clear and requested additional guidance as to the meaning.

One commenter recommended using “two or more years of revenue” as an alternative.

See, e.g.,

letters from BDO, CAQ, Cravath, Crowe, DT, EY, GT, KPMG, MTBC, PWC, RSM, and SIFMA.

See

letter from MTBC.

Income Taxes

A few commenters supported the proposal to use income from continuing operations

after

income taxes because it would simplify the calculation and would permit registrants to use information directly from the income statement.

However, many other commenters recommended that the Commission continue to use income or loss from continuing operations

before

income taxes in the Income Test.

While using after-tax amounts may simplify the determinations, these commenters expressed concern that after-tax numbers could distort the significance determination due to factors such as the tax status of the entity (such as for a pass-through entity)

or the volatility of income taxes (due to changes in tax laws or valuation allowances).

See

letters from Ball and Eli Lilly.

See, e.g.,

letters from AMG, BDO, CAQ, Cravath, Crowe, EY, FEI, GT, KPMG, Pfizer, PWC, Ira Rosner (“Rosner”), RSM, Shearman, and Williams.

See, e.g.,

letters from AMG, BDO, CAQ, Cravath, Crowe, EY, GT, KPMG, PWC, Rosner, RSM, and Williams.

See, e.g.,

letters from CAQ, EY, FEI, KPMG, Pfizer, PWC, and RSM.

Income Averaging and Use of Absolute Values

Commenters generally supported the revisions relating to income averaging calculations

and the use of absolute values.

Some commenters recommended further revisions, such as using three-year averaging or permitting five-year averaging for all registrants regardless of recurring revenue.

See

letters from AMG, BDO, and Pfizer.

See

letters from AMG, Eli Lilly, IMA, and Pfizer.

See, e.g.,

letters from AMG, BDO, and IMA.

iii. Final Amendments

As discussed in more detail below, we are adopting the amendments to the Income Test substantially as proposed, but with some modifications to improve its application and to assist registrants in making more meaningful significance determinations.

Revenue Component

As proposed, we are revising the Income Test to add a revenue component in order to reduce the anomalous result that registrants with marginal or break-even net income or loss in a recent fiscal year may be more likely to have tested subsidiaries deemed significant where they otherwise would not. This anomalous result is particularly relevant where it would require Rule 3-05 Financial Statements for acquisitions that otherwise would not be considered material to investors. To satisfy the Income Test under the final amendments, the tested subsidiary must meet both the revenue component and the net income component when the revenue component applies, and for purposes of the application of Rule 3-05, may use the lower of the revenue component and the net income component to determine the number of periods for which Rule 3-05 Financial Statements are required. The new revenue component compares a registrant's and its other subsidiaries' proportionate share of the tested subsidiary's consolidated total revenues (after intercompany eliminations) to such consolidated total revenues of the registrant for the most recently completed fiscal year. We are modifying the description of the tested subsidiary's consolidated total revenue to clarify that consolidated total revenue refers to consolidated total revenue from continuing operations (after intercompany eliminations).

See

Rule 1-02(w)(1)(iii).

Revenue is an important indicator of the operations of a business and generally has less variability than net income. For example, expenses related to historical capitalization that will no longer be incurred (

e.g.,

interest expense) as well as infrequent expenses, such as those for litigation or impairment, can affect net income, but not revenue. The effect of historical expenses that will no longer be incurred and infrequent expenses on an income-based test may be to either deem as insignificant an acquired business that is expected to have a material future impact on the registrant or deem as significant an acquired business that is not expected to have a material future impact on the registrant. While we considered other metrics, we believe the addition of “revenue” is a more appropriate indicator to help avoid anomalous results, and therefore, we added a revenue component to the net income component of the Income Test rather than have separate tests based on revenue and net income.

By revising the Income Test to require that the registrant exceed both the revenue and net income components when the revenue component applies, we believe the test will more accurately determine whether a tested subsidiary is significant to the registrant. This will also reduce the frequency of immaterial acquisitions being deemed significant for purposes of Rule 3-05.

Prior to 1974, the “significant subsidiary” definition included a revenue test, but not a net income test. In 1974, the Commission added a separate net income test. In 1981, the Commission eliminated the revenue test and retained the net income test noting in part that “. . . the presentation of additional financial disclosures of an affiliated entity may not be meaningful if the affiliate has a high sales volume but a relatively low profit margin” and observing that in such circumstances, the affiliate has little financial effect on the operating results of the consolidated group.

See Separate Financial Statements Required by Regulation S-X,

Rels. No. 33-6359 (Nov. 6, 1981) [46 FR 56171 (Nov. 16, 1981)].

We are not adopting the recommendation to use a lower significance threshold for the revenue component to mitigate the potential risk that use of a lower of revenue or net income approach could result in under-identification of significant subsidiaries, and in particular of acquisitions expected to have a material future impact on the registrant. The risk of under-identification is not unique to a “lower of” approach, but rather is inherent in basing the requirement to provide financial information on percentage threshold tests. We believe under-identification risk is mitigated, however, because even if the Income Test is not satisfied, the definition of “significant subsidiary” could be met by satisfying either the Asset Test or the Investment Test. Further, to simplify compliance, the significant subsidiary percentage threshold historically has been the same for all tests included in the “significant subsidiary” definition, notwithstanding that the threshold has been changed from time to time. In light of these considerations, we do not find a compelling reason at this time to differentiate the threshold for the revenue component of the Income Test from the threshold used in the net income component of the Income Test and in the Asset and Investment Tests.

We also are not adopting the recommendation to apply only the

revenue component, and not the income component, for smaller reporting companies. We continue to believe both components taken together are important indicators in determining the need for financial information about acquired and disposed businesses.

Recurring Annual Revenue

Under the proposed amendments, where either a registrant and its subsidiaries consolidated or the tested subsidiary did not have recurring annual revenue, the new revenue component would not have been available to determine the number of periods for which Rule 3-05 Financial Statements are required. However, we are persuaded by commenters who noted that the term “recurring annual revenue,” as proposed, was not sufficiently clear to determine when the revenue component would apply and may have inappropriately suggested that there would be discretion in determining the amount of revenue to be included. The revenue component is unlikely to produce a meaningful assessment where the registrant or the tested subsidiary does not have material revenue over the course of time. We are therefore modifying the Income Test consistent with a comment we received, to provide that the revenue component does not apply if either the registrant and its subsidiaries consolidated or the tested subsidiary did not have material revenue in each of the two most recently completed fiscal years. We believe the amendment will allow registrants to determine more easily whether the revenue component applies, and when it does apply, will clarify that all revenues must be included.

Income Taxes

The Commission proposed to calculate income or loss from continuing operations

after

income taxes, permitting a registrant to use line item disclosure from its financial statements, to simplify the determination. We are persuaded by commenters that using

after

tax information may result in significance determinations that are less consistent and meaningful because they could be distorted due to factors such as the tax status of the entity or the volatility of income taxes. We are therefore not adopting the proposed amendment to calculate income or loss from continuing operations

after

income taxes and are retaining the requirement to use income or loss from continuing operations

before

income taxes.

Income Averaging and Use of Absolute Values

We are adopting amendments, as proposed, to clarify the net income component by inserting references to the absolute value of equity in the tested subsidiary's consolidated income or loss from continuing operations, which we believe will mitigate the potential for misinterpretation that may result from inclusion of a negative amount in the computation. We are also adopting as proposed the use of absolute values for calculating average net income. As noted above, commenters generally supported the improvements to income averaging calculations

and the use of absolute values.

See

letters from AMG, BDO, and Pfizer. We are not adopting one commenter's recommendation to use a three-year average. The five-year average is a longstanding standard and it is not clear that a three-year average would yield a more meaningful outcome. We also are not adopting the recommendation to extend the use of income averaging when the revenue component applies. Under existing requirements, income averaging is required when its conditions for use are met. However, those conditions also limit its use to mitigating anomalous results. We believe the adoption of a revenue component will mitigate anomalous results more effectively while simplifying the Income Test, and that use of income averaging to mitigate anomalous results should therefore be necessary only when the revenue component does not apply.

See

letters from AMG, Eli Lilly, IMA, and Pfizer.

Additional Clarifications and Simplifications

We are additionally amending Rules 3-05(b)(3) and 11-01(b)(3) as proposed to clarify that the Income Test may be determined using the acquired business's revenues less the expenses permitted to be omitted by new Rules 3-05(e) and 3-05(f) if the business meets the conditions in those rules, as well as making additional non-substantive amendments to the net income component in order to simplify the description of the test. Specifically, we are replacing, as proposed, the phrase “exclusive of amounts attributable to any noncontrolling interests” in the net income component with the phrase “attributable to the controlling interests.”

We are also revising Rule 1-02(w) to remove the Computational Note designation but retaining the substance of the notes in the rule and making conforming amendments consistent with the amendments to the revised Income Test. Additionally, we are revising Rule 1-02(w)(1)(iii)(B)(

) to clarify that the rule 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. Finally, we are moving the Note to Rule 1-02(w) into the rule itself.

c. Conforming Changes

i. Proposed Amendments

As noted above, several of our rules and forms require disclosure related to “significant subsidiaries” or otherwise rely on the significance tests in Rule 1-02(w) to determine the disclosure required.

The Commission's proposed amendments to Rule 1-02(w) would update the definition and the tests therein, but would nonetheless result in these tests continuing to apply consistently across these applications. The term “significant subsidiary” is also defined in Securities Act Rule 405, Exchange Act Rule 12b-2, and Investment Company Act Rule 8b-2. The Securities Act Rule 405 and Exchange Act Rule 12b-2 definitions historically have been generally consistent with the Rule 1-02(w) definition. Accordingly, the Commission proposed to conform the definitions of “significant subsidiary” in Securities Act Rule 405 and Exchange Act Rule 12b-2 to the amended definition in Rule 1-02(w).

See supra

note 23.

In the Proposing Release, the Commission proposed to exclude from the definition of “significant subsidiary” in Securities Act Rule 405 and Exchange Act Rule 12b-2 the proposed amendments to Rule 1-02(w) that would be applicable only to disclosure requirements under Regulation S-X, specifically proposed Rule 1-02(w)(1)(iii)(B)(

). Unlike these other rules, the definition of “significant subsidiary” in Rule 8b-2 historically has differed from the Rule 1-02(w) definition. As proposed, we also are conforming the Rule 8b-2 definition of “significant subsidiary” to the new definition added to Rule 1-02(w)(2) that is specifically tailored for investment companies.

See

Section II.E below.

ii. Comments

With the exception of equity method investments, commenters did not address the specific proposed conforming changes. Some commenters suggested that the use of aggregate worldwide market value in the proposed Investment Test could introduce a new historical cost versus fair value disparity when evaluating equity method investments under Rules 3-09 and 17 CFR 210.4-08(g) (“4-08(g)”) because the registrant's and its other subsidiaries' “investments in and advances to” the investee may not be equivalent to a fair value amount when the investee is not newly acquired.

In expressing support for the addition of a revenue component to the Income Test when testing the significance of equity method investees under Rules 3-09 and 4-08(g), one of these commenters

suggested several changes to the manner in which the revenue component would be calculated for equity method investees under Rules 3-09 and 4-08(g).

Another commenter noted that for equity method investees, whose revenues are not consolidated in the registrant's financial statements, the results of the proposed revenue component of the Income Test may not be meaningful.

See, e.g.,

letters from AMG, DT, and Williams.

See

letter from AMG. Specifically, the commenter recommended modifying the denominator of the revenue component to include all of the equity method investee's GAAP revenue such that the revenue component would compare the registrant's “proportionate share” of the equity method investee's revenue to the sum of the registrant's GAAP revenue and 100 percent of the equity method investee's GAAP revenue, without which the commenter suggested the proposal would produce incongruous comparisons. The commenter further recommended guidance on how to calculate “proportionate share” to address situations where a registrant may receive a share of revenue from an equity method investee that is different from the percentage of equity that the registrant may own and requested that the guidance include some level of discretion to allow registrants to use a method reasonably calculated to reflect the economic benefit the registrant receives relative to the equity method investee's GAAP revenue.

See

letter from GT.

iii. Final Amendments

We are adopting the conforming amendments substantially as proposed with certain modifications in response to comments. The amendments are intended to reflect more accurately the relative significance to a registrant of a tested subsidiary and to reduce anomalous results in the application of the definition of “significant subsidiary.” As discussed in the Proposing Release, by maintaining the historical conformity between the “significant subsidiary” definitions, these amendments will avoid unnecessary regulatory complexity through consistent application of significance determinations made at the acquisition date and those made post-acquisition when the acquired business is a subsidiary of the registrant.

In a change from the proposal and in order to simplify and maintain uniformity of the definition throughout our rules, the amendments to Securities Act Rule 405 and Exchange Act Rule 12b-2 will fully conform with the definition in Rule 1-02(w), including Rule 1-02(w)(1)(iii)(B)(

See

Proposing Release at Section II.A.1.

We are persuaded by commenters that using the registrant's aggregate worldwide market value instead of the registrant's total assets in the Investment Test would have inadvertently introduced a mismatch when evaluating equity method investments under Rules 3-09 and 4-08(g) because the registrant's and its other subsidiaries' “investments in and advances to” the investee may not be equivalent to a fair value amount when the investee is not newly acquired. Because a registrant's and its other subsidiaries' “investments in and advances to” would not necessarily be equivalent to fair value for purposes other than acquisitions or dispositions, we are also persuaded that the registrant's aggregate worldwide market value should not be used in place of the registrant's total assets for the additional purposes for which the “significant subsidiary” definition is used.

Accordingly, we are retaining the comparison to the registrant's total assets used in the existing Investment Test for testing significance of equity method investees under Rules 3-09 and 4-08(g), as well as for the additional purposes for which the definition is used.

See supra

note 23.

Id.

We are not adopting any modifications to the proposed Income Test in response to comments received related to its application under Rules 3-09 and 4-08(g) to investments accounted for using the equity method. We added the revenue component for acquisitions and dispositions of businesses to mitigate anomalous results produced by the current test based only on net income. We believe the revenue component can serve a similar role related to the application of Rules 3-09 and 4-08(g) to equity method investments.

Additionally, using a test based on an amount that is not consolidated is not unprecedented for investments accounted for using the equity method. As the Commission has noted, the Asset Test applies to Rule 4-08(g), even though the total assets of the equity method investee are not consolidated by the registrant.

Further, we believe the fact that significance is not determined on the basis of a single test and that Rule 4-08(g) disclosure about equity method investees is required if significance is met either individually or on an aggregated basis by any combination of investees at the 10 percent level will help mitigate any potential adverse effects and help to provide an appropriate level of financial information about equity method investees.

The staff considers this additional factor when exercising its delegated authority under Rule 3-13 when a registrant makes a request to omit Rule 3-09 financial statements on the basis that the current income test produces an anomalous result.

See Request for Comment on the Effectiveness of Financial Disclosures About Entities Other Than the Registrant,

Release No. 33-9929 (Sept. 25, 2015) [80 FR 59083 (Oct. 1, 2015)] at note 51 (“In 1994, Rule 3-09 was revised to eliminate the asset test; however, the test was retained for Rule 4-08(g) to ensure a minimum level of financial information about an investee when the investment test was small, but a registrant's proportionate interest in the Investee's assets was material, as might be the case for a highly-leveraged Investee.

See Financial Statements of Significant Foreign Equity Investees and Acquired Foreign Businesses of Domestic Issuers and Financial Schedules,

Release No. 33-7118 (Dec. 13, 1994) [59 FR 65632].”).

We are not persuaded to provide additional guidance on determining “proportionate interest” for the revenue component. We observe that “proportionate interest” is required to determine basis difference under U.S. GAAP or IFRS-IASB, as applicable, as well as the equity in the income of the investee. We believe proportionate interest used for those purposes will inform its use for the revenue component. Similarly, we are not persuaded that the equity method investee's revenue should be added to the registrant's revenue as it is not part of that revenue.

2. Audited Financial Statements for Significant Acquisitions

Depending on the relative significance of the acquired or to be acquired business, Rule 3-05 Financial Statements may be required for up to three years.

Rule 3-05 Financial Statements are required for the most recent fiscal year and any required interim periods if any of the Rule 3-05 significance tests exceeds 20 percent, but none exceeds 40 percent, a second year is required if any test exceeds 40 percent, but none exceeds 50 percent, and a third year is generally required if any of the tests exceeds 50 percent. Rule 3-05 contains an additional requirement for certain registration statements and proxy statements related to the aggregate effect of individually insignificant businesses, which may trigger a requirement for Rule 3-05 Financial Statements for a business for which none of the significance tests exceeds 20 percent.

See

17 CFR 210.3-05(b)(2). A smaller reporting company is subject to similar requirements under Rule 8-04 of Regulation S-X, but financial statements are only required for up to two fiscal years.

a. Proposed Amendments

The Commission proposed to revise Rule 3-05 to require only up to two years of Rule 3-05 Financial Statements. The Commission also proposed to revise Rule 3-05 for acquisitions where a significance test exceeds 20 percent, but none exceeds 40 percent, to require financial statements for the “most recent” interim period specified in 17 CFR 210.3-01 and 210.3-02 (“Rules 3-01 and 3-02”) rather than “any” interim period. This proposed revision would eliminate the need to provide a comparative interim period when only one year of audited Rule 3-05 Financial Statements is required.

b. Comments

Commenters broadly supported the proposals,

with no commenters opposing the changes.

See, e.g.,

letters from Ball, Bass Berry, CFA, Cravath, Eli Lilly, FEI, Liberty, National Association of Real Estate Investment Trusts (“NAREIT”),

Nasdaq, Inc. (“Nasdaq”), NYCBA—Sec., S&C, and SIFMA.

See also

SBCFAC Recommendations.

c. Final Amendments

We are adopting the amendments as proposed to revise Rule 3-05 to require up to two years of Rule 3-05 Financial Statements. Unlike the historical financial statements of the registrant upon which investors rely to make investment decisions about the registrant, Rule 3-05 Financial Statements are used, along with pro forma financial information, to discern how the acquired business may affect the registrant. Due to their age, the third year of Rule 3-05 Financial Statements is less likely to be indicative of the current financial condition, changes in financial condition, and results of operations of the acquired business. Such financial statements also do not reflect the changes in the acquired business or combined entity that occur post-acquisition or the accounting required by the registrant's comprehensive basis of accounting. Moreover, the requirement to prepare and obtain an audit of the third year of pre-acquisition financial statements can add significant incremental cost and time to the preparation of the disclosure. Such burdens are further exacerbated if a change in the acquired business's management or independent auditor has occurred, which may also delay a registrant's time to market and access to capital.

We are additionally amending Rule 3-05 as proposed for acquisitions where a significance test exceeds 20 percent, but none exceeds 40 percent, to require financial statements for the “most recent” interim period specified in Rules 3-01 and 3-02 rather than “any” interim period. The revision eliminates the need to provide a comparative interim period when only one year of audited Rule 3-05 Financial Statements is required. In these circumstances, we believe that the most recent interim period provides the most relevant and material information to investors. Requiring a comparative interim period when there is no requirement for a corresponding comparative annual period would have limited utility for investors and imposes an additional burden on registrants to prepare such information.

In adopting these changes, we note that regardless of the number of years presented, if trends depicted in Rule 3-05 Financial Statements are not indicative or are otherwise incomplete, 17 CFR 210.4-01(a) (“Rule 4-01(a)”) requires that a registrant provide “such further material information as is necessary to make the required statements, in light of the circumstances under which they are made, not misleading.”

3. Financial Statements for Net Assets That Constitute a Business

Registrants frequently acquire a component of an entity that is a business as defined in Rule 11-01(d) but does not constitute a separate entity, subsidiary, or division, such as a product line or a line of business contained in more than one subsidiary of the selling entity. These businesses may not have separate financial statements or maintain separate and distinct accounts necessary to prepare Rule 3-05 Financial Statements because they often represent only a small portion of the selling entity. In these circumstances, making relevant allocations of the selling entity's corporate overhead, interest, and income tax expenses necessary to provide Rule 3-05 Financial Statements may be impracticable and Commission staff has permitted registrants to instead provide audited abbreviated financial statements of the acquired business in the form of statements of assets acquired and liabilities assumed and statements of revenues and expenses.

Commission staff has exercised delegated authority pursuant to Rule 3-13 in these circumstances. In addition, Commission staff has provided informal guidance to address practical questions related to these and other financial reporting issues in the Division of Corporation Finance's Financial Reporting Manual (“FRM”), available at

https://www.sec.gov/divisions/corpfin/cffinancialreportingmanual.pdf

(last updated Dec. 1, 2017). The FRM is not a rule, regulation or statement of the Commission and the Commission has neither approved nor disapproved its content.

See

FRM at Section 2065

Acquisition of Selected Parts of an Entity may Result in Less than Full Financial Statements

(“FRM 2065”).

a. Proposed Amendments

The Commission proposed Rule 3-05(e) to permit registrants to provide audited abbreviated financial statements in the form of statements of assets acquired and liabilities assumed, and statements of revenues and expenses (exclusive of corporate overhead, interest and income tax expenses) if the acquired business met certain qualifying and presentation conditions.

More specifically, under proposed Rule 3-05(e), a registrant would be permitted to present audited abbreviated financial statements of an acquired or to be acquired business

if:

The proposal did not specifically label the conditions as “qualifying conditions” and “presentation conditions.” However, we are using these labels, in part, to clarify the requirements and, in part, to simplify the comparison between the final amendments and the proposed amendments.

Neither the proposal nor the rules we are adopting affect the requirements in Rule 3-02 or 17 CFR 210.8-01 relating to predecessors.

• The business constitutes less than substantially all of the assets and liabilities of the seller and was not a separate entity, subsidiary, segment, or division during the periods for which the acquired business financial statements would be required;

• Separate financial statements for the business have not previously been prepared; and

• 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.

Under proposed Rule 3-05(e), if the acquired or to be acquired business satisfies the above conditions, the audited abbreviated financial statements must also conform to certain presentation conditions, including:

• Interest expense may only be excluded from the statements if the debt to which the interest expense relates will not be assumed by the registrant or its subsidiaries consolidated;

• The statements of revenues and expenses do not omit selling, distribution, marketing, general and administrative, and research and development expenses incurred by or on behalf of the acquired business during the periods to be presented; and

• The notes to the financial statements include certain additional disclosures.

Specifically, the additional disclosure would include: The type of omitted expenses and the reasons why they are excluded from the financial statements; information about the business's operating, investing, and financing cash flows, to the extent available; an explanation of the impracticability of preparing financial statements that include the omitted expenses; and 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.

b. Comments

Commenters generally supported permitting abbreviated financial statements,

although one commenter recommended that the Commission consider whether abbreviated financial statements satisfy investors' needs when the acquired business is a significant portion of the selling entity.

This commenter recommended the Commission provide a threshold on what constitutes “substantially all”

100

and questioned whether using a “small

portion of the selling entity” might be a better standard than “less than substantially all of the assets and liabilities of the seller.”

101

Another commenter recommended requiring registrants to indicate how abbreviated financial statement information is integrated into the pro forma financial information and suggested that the Commission clarify what type of auditor assurance would be provided for abbreviated financial statement information.

102

See, e.g.,

letters from BDO, CAQ, Cravath, Debevoise & Plimpton LLP (“Debevoise”), DT, Eli Lilly, EY, FEI, GT, IMA, PWC, RSM, and S&C.

See

letter from GT.

100

Id.

GT noted that absent any threshold, there would likely be diversity in how registrants interpret this phrase.

101

See

letter from GT. This commenter noted that in the Proposing Release the Commission had recognized that there could be challenges in making allocations of the selling entity's corporate overhead, interest, and taxes when the acquired business constitutes only a small portion of the selling entity. However, the commenter stated its view that the language in the proposed rule would allow registrants that acquire a significant portion of the selling entity to present abbreviated financial statements, as long as such business does not meet any of the other conditions outlined in the proposal.

102

See

letter from CFA.

Some commenters sought additional clarification of the terms, such as defining “separate entity,” “subsidiary,” “segment,” and “division” in the context of an acquisition.

103

Other commenters questioned the use of “impracticable” recommending further clarification or a reduced standard.

104

One commenter sought clarification on the meaning of “previously prepared.”

105

Another commenter requested that the Commission clarify the nature of expenses to be included in the abbreviated financial statements by describing those that may be omitted or those that must be presented, but not both, noting that it is unclear whether the identified expenses are intended to be all-inclusive.

106

103

See, e.g.,

letters from CAQ, Crowe, DT, PWC, and RSM.

104

See, e.g.,

letters from Debevoise, EY and GT.

105

See

letter from GT.

106

See

letter from DT. Another commenter recommended that the Commission also permit registrants to exclude any remaining amounts classified as other income or other expense, subject to the same or similar requirements.

See

letter from IMA.

Some commenters sought clarification of when carve-out financial statements of an acquired business would be appropriate.

107

One commenter suggested that in the absence of clarification, the more comprehensive carve-out financial statements may be less commonly used,

108

while another commenter recommended that the Commission codify certain staff practices

109

as they relate to presenting carve-out financial statements.

110

107

See

letters from BDO, CAQ, Crowe, DT, EY, GT, PWC, and RSM. Neither our proposal nor the final rule addresses carve-out financial statements. “Carve-out financial statements” is a generic term used to describe separate financial statements that are derived from the financial statements of a larger parent company. They are often differentiated from abbreviated financial statements in that reasonable allocations of corporate overhead expenses can be made such that the underlying preparation issues involve the scope of the businesses to be included in the historical financial statements, not whether financial statements can be prepared.

108

See

letter from DT.

109

See

FRM

supra

note 94 at Section 2065; Staff Accounting Bulletin No. 1.B.,

Allocation Of Expenses And Related Disclosure In Financial Statements Of Subsidiaries, Divisions Or Lesser Business Components Of Another Entity.

110

See

letter from GT.

c. Final Amendments

We are adopting amendments to our rules to permit registrants to provide audited annual and unaudited interim abbreviated financial statements substantially as proposed, with certain modifications described below. Recognizing the difficulty registrants face in obtaining and the cost of preparing Rule 3-05 Financial Statements in these circumstances, we believe permitting abbreviated financial statements coupled with the additional required disclosures appropriately balances the cost of preparing the financial disclosures with the protection of investors.

The following chart compares our proposal to the final rules.

Proposed

Adopted

Qualifying conditions

The business constitutes less than substantially all of the assets and liabilities of the seller

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 consolidated as of and for the most recently completed fiscal year.

The business was not a separate entity, subsidiary, segment, or division during the periods for which the acquired business financial statements would be required

The acquired business was not a separate entity, subsidiary, operating segment (as defined in U.S. GAAP or IFRS-IASB, as applicable), or division during the periods for which the acquired business financial statements would be required.

Separate financial statements for the business have not previously been prepared

No substantive change.

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

No substantive change.

Presentation requirements

The balance sheet may be a statement of assets acquired and liabilities assumed

No substantive change.

The statement of comprehensive income may be a statement of revenues and expenses (exclusive of corporate overhead, interest and income tax expenses) if certain presentation requirements are met

No substantive change. The title of the statement of comprehensive income must be appropriately modified to indicate it omits certain expenses.

Corporate overhead expenses may be excluded from the statement of comprehensive income provided that the statement does not omit selling, distribution, marketing, general and administrative, and research and development expenses incurred by or on behalf of the acquired business during the periods to be presented

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, and research and development, but may otherwise omit corporate overhead expenses.

Interest expense may be excluded from the statements if the debt to which the interest expense relates will not be assumed by the registrant or its subsidiaries consolidated

No substantive change.

Income tax expense may be omitted

No substantive change.

The notes to the financial statements 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

No substantive change.

We are persuaded by commenter feedback that a condition focused on whether the acquired business is a small portion of the selling entity would be a more appropriate standard than “less than substantially all of the assets and liabilities of the seller” for permitting the use of abbreviated financial statements. A “small portion of the selling entity” standard would help ensure that abbreviated financial statements are not used when the component of the selling entity acquired is sufficiently large such that presentation of the seller's financial statements, along with pro forma financial information that removes the portion of the seller not acquired, would best inform investors about the business acquired. We are also persuaded that absent any threshold, there would likely be divergence in how registrants interpret “small portion of the selling entity.”

111

Accordingly, we are adopting amendments to replace the proposed “less than substantially all of the assets and liabilities of the seller” condition for use of abbreviated financial statements with a condition that “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 consolidated as of and for the most recently completed fiscal year.”

112

We believe that 20 percent or less is an appropriate level for identifying when the acquired business is a small portion of the selling entity because, at that level, it is reasonable to expect that expenses would not be fully allocated and that comparisons of total assets and total revenues will be sufficient for this purpose.

113

A 20 percent threshold also is generally consistent with the staff's granting of relief pursuant to Rule 3-13 in such situations. In situations where an acquired business exceeds the 20 percent threshold but the registrant nonetheless confronts unique challenges in making the relevant allocations necessary to provide Rule 3-05 Financial Statements, the registrant could continue to seek relief pursuant to Rule 3-13.

111

See

letter from GT.

112

See

amended Rule 3-05(e)(1)(i).

113

A comparison of pre-tax income will not ordinarily be meaningful because pre-tax income will seldom be readily determinable for acquisitions of this nature.

Of the various terms recommended by commenters for definition or clarification, we were persuaded that the term “segment” should be further refined to clarify that it refers to an “operating segment (as defined in U.S. GAAP or IFRS-IASB, as applicable)” rather than, for example, a reportable segment. We note that many of the other terms cited by commenters have long been associated with the historical practice of using abbreviated financial statements and we believe their meanings are generally understood. To the extent registrants have unique circumstances relating to the application of these terms in the context of a transaction, the registrant could seek relief pursuant to Rule 3-13. We are therefore not persuaded that further clarification is necessary in order to implement proposed Rule 3-05(e).

We believe that the qualifying conditions for use of abbreviated financial statements included in the final rule are appropriate to delineate the circumstances for their permitted use and provide an appropriate balance between investor protection and capital access. As noted above, one commenter requested clarity on the expenses to be included in abbreviated financial statements. In response to this comment, we have sought to improve the description of required expenses by:

• Reorganizing the rule text into “qualifying conditions” and “presentation requirements” and shortening the introductory paragraph;

114

See

amended Rule 3-05(e).

• Clarifying that the expenses required in 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, but may otherwise omit corporate overhead expense, interest expense for debt that will not be assumed by the registrant or its subsidiaries consolidated, and income tax expense; and

• Adding cost of sales or services and depreciation and amortization expense to the list of expenses that must be included in abbreviated financial statements and clarifying that it is an illustrative list.

115

The title of the statement of comprehensive income must be appropriately modified to indicate it omits certain expenses.

As previously noted, neither our proposal nor the final rule address “carve-out financial statements.” Given that carve-out financial statements are not addressed by this release and because issues relating to carve-out financial statements may require unique judgments that involve the balance between investor protection and capital access, we believe questions relating to carve-out financial statements are best addressed on the basis of their unique facts and circumstances through the staff consultation process.

116

See

Rule 3-13,

supra

note 58.

4. Financial Statements of a Business That Includes Oil and Gas Producing Activities

Rule 3-05 applies to acquisitions of a significant business

117

that includes oil and gas producing activities.

118

However, Rule 3-05 does not specify industry-specific disclosures regarding such activities. In the absence of specific requirements, registrants generally provide certain industry-specific disclosures specified in FASB ASC Topic 932

Extractive Activities—Oil and Gas

(“ASC 932 Disclosures”)

119

on an unaudited basis for each full year of operations presented for the acquired business.

117

See

Rule 11-01(d).

118

See

the definition of “oil and gas producing activities” at 17 CFR 210.4-10(a)(16).

119

See

FASB ASC Topic 932

Extractive Activities—Oil and Gas,

932-235-50-3 through 50-11 and 932-235-50-29 through 50-36, and FRM

supra

note 94 at Section 2065.12. These supplemental disclosures are a subset of those required in the financial statements of publicly traded companies with significant oil- and gas-producing activities and provide additional context for those financial statements.

Rule 3-05 also does not specify the form and content of Rule 3-05 Financial Statements when the acquired business generates substantially all of its revenues from oil and gas producing activities. Often, this type of business represents a component of an entity, but does not constitute a separate entity, subsidiary, operating segment (as defined in U.S. GAAP or IFRS-IASB, as applicable), or division for which separate financial statements exist and for which historical depreciation, depletion and amortization expense is likely not meaningful to an understanding of the potential effects of the acquired business on the registrant.

120

In these circumstances when certain criteria are met, Commission staff, pursuant to Rule 3-13 and delegated authority, has permitted registrants to provide abbreviated financial statements that consist of income statements modified to exclude expenses that are not expected to be comparable to future operations.

121

120

Historical depreciation, depletion and amortization expense is frequently not maintained at the property level and does not reflect the acquiring company's basis in the properties.

121

See

FRM

supra

note 94 at Section 2065.6, 2065.11, and 2065.12. Permitting registrants in these circumstances to substitute abbreviated income statements that omit expenses not comparable to future operations is consistent with the financial statement requirements specified in Rule 3-14 for acquired real estate operations. Rule 3-14 specifies that Rule 3-14 Financial Statements must omit depreciation expenses not comparable to future operations.

a. Proposed Amendments

The Commission proposed Rule 3-05(f) to codify the reporting practices for oil and gas producing activities by requiring certain ASC 932 Disclosures on an unaudited basis for each full year of operations presented for the acquired business. In addition, where the oil and gas producing business represents a component of an entity that does not constitute a separate entity, subsidiary, segment, or division for which separate financial statements exist and for which historical depreciation, depletion and amortization expense is likely not meaningful to an understanding of the potential effects of the acquired business on the registrant, the Commission proposed to permit registrants to provide abbreviated financial statements that consist of income statements modified to exclude expenses not comparable to future operations.

b. Comments

One commenter specifically supported the codification of current practices relating to a business that includes oil and gas producing activities as proposed

122

while another commenter supported the proposal generally but suggested removing one of the conditions.

123

No commenters opposed the proposed amendments.

122

See

letter from KPMG. KPMG also suggested permitting abbreviated financial statements for businesses that service oil and gas fields (

e.g.,

the acquisition of a midstream facility or storage facility).

123

See

letter from Cravath. Cravath recommended removing the condition that the business “was not a separate entity, subsidiary, segment, or division.”

c. Final Amendments

We are adopting the amendments substantially as proposed. Specifically, for a significant acquired business that includes

significant oil- and gas-producing activities

(as defined in the FASB ASC Master Glossary),

124

Rule 3-05 Financial Statements must include certain ASC 932 Disclosures, which may be presented as unaudited supplementary information for each full year of operations presented for the acquired business.

125

Additionally, Rule 3-05 Financial Statements may consist of only audited statements of revenues and expenses that exclude depreciation, depletion and amortization expense, corporate overhead expense, income taxes, and interest expense that are not comparable to the proposed future operations if: (1) Substantially all of the revenues of the business are generated from

oil-and gas-producing activities

(as defined in § 210.4-10(a)(16)), and (2) the qualifying conditions for abbreviated financial statements described in Section II.A.3.c above are met.

126

In these circumstances, the footnote disclosures described in Section II.A.3.c above must also be provided.

127

As discussed in the Proposing Release, we believe that codifying these practices provides clarity for registrants regarding the application of Commission rules in these circumstances, which we believe will facilitate compliance to the benefit of both registrants and investors.

128

124

We are adopting this definition of

significant oil- and gas-producing activities

to be consistent with current practice. Accordingly, the FASB's threshold for determining when ASC 932 Disclosures of unaudited supplemental information is required will be applied in determining specified disclosures in ASC 932-235-50 for purposes of Rule 3-05 Financial Statements, even if the acquired business is not a publicly-traded company.

125

See

ASC 932-235-50-3 through 50-11 and ASC 932-235-50-29 through 50-36.

126

We were not persuaded by the commenter suggesting the condition that the business “was not a separate entity, subsidiary, segment, or division” should be removed. We believe this condition can be indicative of circumstances where reasonable allocations necessary to prepare financial statements can be made.

127

The amendments revise proposed Rule 3-05(f) to simplify its text and to reference the applicable qualifying and presentation conditions of amended Rule 3-05(e).

128

See

Section II.A.4 of the Proposing Release.

5. Timing and Terminology of Financial Statement Requirements

a. Proposed Amendments

The Commission proposed several revisions to Rule 3-05 and Article 11 to clarify when Rule 3-05 Financial Statements and pro forma financial information are required and to update the language in the rules to take into account concepts that have developed since their original adoption over 30 years ago.

b. Comments

Commenters were generally supportive of the proposed changes.

129

Some commenters sought clarification that the “applicable independence standards” in the proposed requirement that financial statements be “prepared in accordance with this regulation (including the independence standards in § 210.2-01 or, alternatively if the business is not a registrant, the applicable independence standards)” would be those related to the auditing standards under which the required financial statements of the acquired or to-be-acquired business were audited.

130

One commenter further recommended clarifying whether the reference to “filed” in the phrase in proposed Rule 11-01(b)(3) “most recent annual consolidated financial statements filed at or prior to the date of acquisition or disposition” is the same as “required to be filed” and how the phrase “most recent annual financial statements of each such business” applies to nonpublic acquired or to-be-acquired businesses.

131

Another commenter recommended that the timing of the pro forma financial information be accelerated to a date closer to when the deal is announced to the public.

132

Another commenter recommended that the “significant subsidiary” definition should explicitly state that the amounts used for testing should be derived from “consolidated” financial statements of the tested subsidiary and of the registrant.

133

129

See, e.g.,

letters from Cravath and Eli Lily.

130

See

letters from CAQ, Crowe, and RSM.

See also

letters from KPMG (recommending “independence standards would be those applicable under the auditing standards used to perform the audit of the acquired or to be acquired business”) and Deloitte (recommending

clarification as to whether “applicable independence standards” refers to any independence standards other than those described in either Article 2,

Qualifications and Reports of Accountants,

or the independence standards of the AICPA).

131

See

letter from Deloitte.

132

See

letter from CFA (recommending four business days after the occurrence of the event with the ability to extend the deadline to a maximum of 30 days in order to balance the compliance burden with the imperative of timely disclosure to the market). Item 9.01 of Form 8-K currently permits up to approximately 75 days after consummation of an acquisition.

133

See

letter from Eli Lily.

c. Final Amendments

We are adopting the amendments substantially as proposed with some additional changes reflecting the suggestions of commenters and our further consideration of the proposals. Specifically, we are amending Rule 3-05 and Article 11, as proposed, to:

• Specify that financial statements are required if a business acquisition has occurred during the most recent fiscal year or subsequent interim period for which a balance sheet is required by 17 CFR 210.3-01 of Regulation S-X (“Rule 3-01”), or if a business acquisition has occurred or is probable after the date that the most recent balance sheet has been filed;

134

and

134

We are amending Rule 3-05(a)(1) to clarify when financial statements are required and to conform the language in those requirements with the current requirements in Rule 11-01(a). Additionally, in conforming Rule 3-05(a)(1) with Rule 11-01(a), the explanation that the acquisition of a business encompasses the acquisition of an interest in a business accounted for by the equity method was moved from Rule 3-05(a)(1)(i) to Rule 3-05(a)(2)(ii).

• Provide in Rules 3-05(b)(3) and 11-01(b)(3)(i)(C) that a registrant may continue to determine significance using amounts reported in its Form 10-K for the most recent fiscal year when the registrant has filed its Form 10-K after the acquisition consummation date, but before the date the registrant is required to file financial statements of the acquired business on Form 8-K.

135

Pursuant to Rule 3-13, registrants have been permitted to omit Rule 3-05 Financial Statements if an acquired business is not significant using these amounts. We are establishing by rule that registrants are permitted, rather than required, to use the Form 10-K filed after consummation to measure significance in this circumstance to avoid creating an incentive for registrants to delay the filing of their Form 10-K.

We additionally are updating the terminology and language used by revising Rule 3-05 and Article 11, as proposed, to:

• Clarify that “financial statements” need not include related schedules specified in 17 CFR 210.12 (“Article 12”);

136

Item 9.01(a)(2) of Form 8-K already provides that supporting schedules of financial statements need not be filed and the staff further applies this approach to acquired business financial statements required in registration statements and proxy statements.

See

FRM

supra

note 94 at Section 2005.2.

• Clarify that a “business” that is a real estate operation is subject to Rule 3-14 instead of Rule 3-05;

• Clarify in Rule 3-05(a)(2)(ii) that Rule 3-05 applies when the fair value option is used in lieu of the equity method to account for an acquisition because the disclosure required by U.S. GAAP on a post-acquisition basis, and related disclosure provided pursuant to Rules 3-09 and 4-08(g), includes summarized financial information or separate financial statements of the business after the acquisition;

• Replace the term “furnish” with “file” to make clear that the information required by Rule 3-05 and Article 11 must be filed with the Commission;

137

Throughout Rule 3-05 and Article 11, the regulatory text indicates that financial statements “shall be furnished.”

See

Rule 3-05(a)(1), (b)(1), (b)(2)(i), (ii), (iii), and (iv), and (b)(4)(ii) and (iii), Rule 11-01(a) and Instruction 2 to Rule 11-02(b). At the time the Commission adopted Rule 3-05, the Commission made no distinction between “furnished” and “filed.”

See

Rule 3-05 Adopting Release.

• Clarify that references to “Regulation S-X” in Rule 3-05, Rule 3-14, and Rule 6-11 include the independence standards in 17 CFR 210.2-01 (“Rule 2-01”) unless the business is not a registrant, in which case the applicable independence standards would apply;

• Replace references to the terms “business combination” and “combination between entities under common control” with the term “business acquisition” to make clear that Rule 3-05 and Article 11 are not limited to “business combinations” as that term is used in U.S. GAAP and IFRS-IASB;

138

and

138

We similarly are adopting a conforming amendment to the Instruction to Item 9.01 of Form 8-K.

• Replace the term “majority-owned” with the term “subsidiaries consolidated,” as that term more accurately conveys which subsidiaries are required to be included in the registrant's financial statements.

139

Rule 3-05 uses the term “subsidiaries consolidated” to conform to the term used elsewhere in Regulation S-X.

See, e.g.,

Rule 1-02(w), Rule 3-01, and Rule 3-02. We additionally are replacing the term in Item 2.01 of Form 8-K.

Finally, we are adopting the following clarifying amendments, as proposed, to Rules 1-02(w), 3-05, Form 8-K and Article 11 to:

• Replace the reference to “total assets” of the tested subsidiary in the Asset Test with the tested subsidiary's “consolidated total assets” as that term conveys more accurately the amount to be used in the Asset Test;

140

Consistent with a comment we received, we are adopting this change to clarify that all amounts used in the significant subsidiary tests that are derived from financial statements of the tested subsidiary and the registrant should be based on consolidated amounts.

See supra

note 133. The Investment Test and Income Test, as proposed, already specified the requirement to use consolidated amounts.

• Replace the term “shall” with clearer language, such as by indicating when a registrant “must” file or disclose certain information;

• Revise proposed Rule 11-01(b)(3) to:

○ Simplify its organization;

○ Clarify that it does not apply to the continuous real estate offerings described in new Rule 11-01(b)(4);

141

See

Section II.C.6. Proposed Rule 3-14(b)(2)(iii) was relocated and relabeled as Rule 11-01(b)(4).

○ Replace the reference to “filed” with “required to be filed” to more clearly reflect existing practice;

142

Use of “required to be filed” would also clarify that the 15-day extension provided by Form 12b-25 does not serve to revert the significance determination to an earlier year during the 15-day extension.

○ Remove the reference to related real estate operations for combined pre-acquisition financial statements;

143

and

143

The reference to related real estate operations is not necessary in this context because only a modified Investment Test is required for significance testing of these acquisitions.

○ Clarify what financial statements of a nonpublic acquired or to-be-acquired business must be used in the significance determination;

144

The amended rules replace the phrase “most recent annual financial statements of each such business” with “the business's pre-acquisition or pre-disposition financial statements for the same fiscal year as the registrant or, if the fiscal years differ, the business's most recent fiscal year that would be required if the business had the same filer status as the registrant.”

• Revise Instruction 4 to Item 2.01 of Form 8-K to include the same clarification of the scope of Rule 3-05 with regards to interests in businesses that will be accounted for under the equity method or, in lieu of the equity method, the fair value option;

145

and

145

Item 2.01 of Form 8-K does not explicitly clarify the treatment of interests in businesses that will be accounted for under the equity method or, in lieu of the equity method, the fair value option. However, the determination of whether an acquisition involves a business is consistent between Item 2.01 of Form 8-K and Rule 3-05, because both Instruction 4 to Item 2.01 of Form 8-K and Rule 3-05(a)(2)(ii) refer to the same definition of a business in Rule 11-01(d), and the requirements of Item 2.01 of Form 8-K are linked to the requirements of Rule 3-05 through Item 9.01 of Form 8-K. This amendment conforms Item 2.01 of Form 8-K to include the additional clarification from Rule 3-05.

• Conform technical terminology inconsistencies throughout the rules.

146

For example, proposed Rule 3-05(c) has been amended to include a reference to the definition of a foreign business in Rule 1-02(l) to be consistent with proposed Rule 3-05(d) which already included the reference.

We are not adopting modifications to clarify, as requested by commenters, the “applicable independence standards” in the proposed requirement that financial statements be “prepared in accordance with this regulation (including the independence standards in § 210.2-01 or, alternatively if the business is not a registrant, the applicable independence standards)” because the independence standards applicable for a particular audit are not necessarily linked to the auditing standards used for such an audit. For example, for purposes of auditing non-issuer Rule 3-05 or Rule 3-14 Financial Statements, an auditor may follow AICPA auditing and independence standards but also may elect to perform the audit under PCAOB auditing standards. Our amendments are not intended to change practice by referring to “applicable independence standards,” but rather to acknowledge that for an acquired or to be acquired business that is a non-issuer, an auditor is not required to follow the independence standards in Rule 2-01 for purposes of auditing Rule 3-05 and Rule 3-14 Financial Statements. As a result, if the acquired or to be acquired business is not an issuer, the auditor should look to the applicable ethics and independence standards that would apply in issuing the audit report for such business in satisfying the audit requirement for purposes of the Rule 3-05 and Rule 3-14 Financial Statements.

We are also not adopting requirements to accelerate the timing of providing pro forma financial information, as one commenter suggested. For acquisitions, pro forma financial information is based on the audited financial statements of the acquired business for periods prior to the acquisition of the business by the registrant. In these circumstances, our requirements provide additional time for registrants to obtain acquired business pre-acquisition historical financial statements, which we believe should also continue to extend to pro forma financial information.

147

See, e.g.,

Item 9.01 of Form 8-K.

6. Foreign Businesses

Regulation S-X permits the use of IFRS-IASB without reconciliation to U.S. GAAP in financial statements of foreign private issuers.

148

Rule 3-05 similarly permits the use of IFRS-IASB in financial statements of foreign businesses. However, if Rule 3-05 Financial Statements of a foreign business are prepared on a basis of accounting other than U.S. GAAP or IFRS-IASB, such as home-country GAAP, the Rule 3-05 Financial Statements are required to be reconciled to U.S. GAAP even if the registrant is a foreign private issuer that prepares its financial statements in accordance with IFRS-IASB.

149

148

See

17 CFR 210.4-01.

149

See

Item 17 of Form 20-F and

Financial Statements of Significant Foreign Equity Investees and Acquired Foreign Businesses of Domestic Issuers and Financial Schedules,

Release No. 33-7118 (Dec. 13, 1994) [59 FR 65632 (Dec. 20, 1994)] (“1994 Acquired Foreign Business Release”).

Further, while the definitions of “foreign private issuer”

150

and “foreign business”

151

have similarities, they have different ownership requirements such that a business could qualify to be a “foreign private issuer” if it were a registrant, but not qualify to be a “foreign business” when it is acquired by a registrant. In this circumstance, a registrant acquiring such a business is not permitted to present Rule 3-05 Financial Statements of the acquired business prepared in accordance with IFRS-IASB, even when those financial statements are already available and even though the acquired business could present IFRS-IASB financial statements if it were a registrant. Instead, the Rule 3-05 Financial Statements must be prepared in accordance with U.S. GAAP.

152

150

See

Securities Act Rule 405. The term “foreign private issuer” means any foreign issuer, other than a foreign government, that does not meet the following criteria as of the last business day of its most recently completed second fiscal quarter: (i) More than 50 percent of the outstanding voting securities of such issuer are directly or indirectly owned of record by residents of the United States; and (ii) Any of the following: (a) The majority of the executive officers or directors are United States citizens or residents; (b) More than 50 percent of the assets of the issuer are located in the United States; or (c) The business of the issuer is administered principally in the United States.

151

See

17 CFR 210.1-02(l). The term “foreign business” means a business that is majority owned by persons who are not citizens or residents of the United States and is not organized under the laws of the United States or any state thereof, and either: (1) More than 50 percent of its assets are located outside the United States; or (2) The majority of its executive officers and directors are not United States citizens or residents.

152

Alternatively, the Rule 3-05 Financial Statements may be prepared in accordance with a basis of accounting other than U.S. GAAP provided a reconciliation to U.S. GAAP under Item 18 of Form 20-F is included.

See

1994 Acquired Foreign Business Release.

a. Proposed Amendments

The Commission proposed to permit Rule 3-05 Financial Statements for an acquired foreign business prepared using home country GAAP to be reconciled to IFRS-IASB rather than U.S. GAAP if the registrant is a foreign private issuer that prepares its financial statements using IFRS-IASB. The Commission also proposed to permit Rule 3-05 Financial Statements to be prepared in accordance with IFRS-IASB without reconciliation to U.S. GAAP if the acquired business would be a foreign private issuer if it were a registrant.

b. Comments

Commenters generally supported the proposal,

153

with some recommending providing additional relief by allowing reconciliation to IFRS-IASB rather than U.S. GAAP for a business that prepares its financial statements using home-country GAAP and does not meet the definition of a foreign business but that would be a foreign private issuer if it were a registrant.

154

One commenter additionally suggested that the Commission provide guidance on the applicability of IFRS 1,

First-time Adoption of IFRS,

155

and accommodations under Form 20-F when reconciling to IFRS-IASB.

156

Irrespective of the GAAP being applied or reconciled to, some commenters recommended that the Commission consider permitting required audit reports on the financial statements of acquired foreign businesses to be prepared in accordance with International Standards on Auditing (“ISAs”) issued by the International Auditing and Assurance Standards Board.

157

153

See, e.g.,

letters from Chris Barnard (“Barnard”), Cravath, DT, NAREIT, Nasdaq, and PWC.

154

See, e.g.,

letters from BDO, CAQ, DT, EY, KPMG, and RSM. Some of these commenters recommended simplifying the rules by expanding proposed Rule 3-05(c) and eliminating proposed Rule 3-05(d).

See, e.g.,

letters from CAQ, EY, KPMG, and RSM.

155

IFRS 1 provides recognition, measurement, and disclosure requirements, as well as certain transitional exceptions, for entities that present IFRS-IASB financial statements for the first time.

156

See

letter from DT. DT indicated that certain accommodations offered under Form 20-F, Item 17, such as to not remove the effects of inflation accounting pursuant to Item 17(c)(2)(iv)(2) when the conditions of IAS 29,

Reporting in Hyperinflationary Economies,

are not met, or to not reconcile the effects of proportionate consolidation for investments in joint ventures pursuant to Item 17(c)(2)(vii), may be inconsistent with IFRS- IASB requirements.

157

See

letters from Barnard, BDO, KPMG, and PWC.

c. Final Amendments

We are adopting the amendments substantially as proposed, but with some modifications after consideration of the comments received. We are amending the rules in order to increase the consistency between the basis of accounting used by acquired businesses and foreign private issuers, as well as to permit acquired businesses and registrants to avoid unnecessary costs, such as one-time presentations of the U.S. GAAP reconciling information where such information would not be material to investors.

Specifically, we are adopting the proposed amendments to Rule 3-05(c) to permit foreign private issuers that prepare their financial statements using IFRS-IASB to reconcile Rule 3-05 Financial Statements of foreign businesses prepared using home country GAAP to IFRS-IASB rather than U.S. GAAP because this will provide more comparable information and better facilitate analysis of the financial statements. The reconciliation to IFRS-IASB is required generally to follow the form and content requirements in Item 17(c) of Form 20-F.

Additionally, we are adopting, as proposed, Rule 3-05(d) to permit Rule 3-05 Financial Statements to be prepared in accordance with IFRS-IASB without reconciliation to U.S. GAAP

158

if the acquired business would qualify as a foreign private issuer if it were a registrant. As discussed in the Proposing Release, we believe financial statements prepared in accordance with IFRS-IASB provide sufficient information for investors for this purpose.

159

In circumstances where the registrant presents its financial statements in U.S. GAAP, the pro forma financial information reflecting the acquisition will continue to be required to be presented in U.S. GAAP.

158

Under the rule, acquired foreign business financial statements may use IFRS-IASB without reconciliation to U.S. GAAP, even when the registrant prepares its financial statement using U.S. GAAP.

159

See Section II.A.6.a. of the Proposing Release.

After considering comments received on the proposals, we are modifying the proposed amendments to additionally permit an acquired business that would qualify as a foreign private issuer if it were a registrant to reconcile to IFRS-IASB rather than U.S. GAAP when the registrant is a foreign private issuer that uses IFRS-IASB. We agree with commenters that reconciliation to IFRS-IASB will provide more comparable information and better facilitate analysis of the financial statements in this circumstance as well.

In response to comments, we are adopting two additional modifications to the proposed amendments to clarify that:

• IFRS 1,

First-time Adoption of IFRS,

will be applicable when reconciling to IFRS-IASB; and

• Form 20-F accommodations that are inconsistent with IFRS-IASB will not be available when reconciling to IFRS-IASB.

We believe it is appropriate to specify that IFRS 1 will be applicable when reconciling Rule 3-05 Financial Statements to IFRS-IASB, because a business that is reconciling to IFRS-IASB for the first time will face many of the same challenges in determining the relevant financial statement amounts as it would if it were directly presenting its financial statements under IFRS-IASB for the first time. Similarly, we believe it is appropriate to specify that Form 20-F accommodations that are inconsistent with IFRS-IASB will not be available when reconciling to IFRS-IASB. These accommodations, such as to not remove the effects of inflation accounting when the conditions of IAS 29 are not met or to not reconcile the effects of proportionate consolidation in joint ventures,

160

were adopted in the context of reconciling to U.S. GAAP rather than IFRS-IASB. They were also adopted when the range of accounting practices around the world was wider than it is today and before IFRS-IASB was established in its current form. We believe that use of accommodations that are inconsistent with IFRS-IASB would not result in sufficient information for investors in this context.

160

See supra

note 156.

We are not combining proposed Rule 3-05(c) and 3-05(d) as suggested by some commenters. Rule 3-05(c) addresses the financial statement requirements for an acquired business that meets the definition of a foreign business. Rule 3-05(d) addresses the financial statement requirements for an acquired business that does not meet the definition of a foreign business but that would be a foreign private issuer if it were a registrant. We believe that separate paragraphs will permit registrants to more easily determine which requirements apply to their acquired businesses. Separate paragraphs will also help to clarify that foreign businesses under Rule 3-05(c) may apply the other applicable accommodations in Form 20-F while the businesses that fall under Rule 3-05(d) cannot.

161

For example, foreign businesses under Rule 3-05(c) may apply the age of financial statement requirements in Item 8 of Form 20-F, and may apply the accommodation in Item 17(c)(2)(v) of Form 20-F that allows them to not reconcile their financial statements to U.S. GAAP if the significance of the foreign business is below 30 percent.

Finally, we are not adopting revisions to accept ISAs in audit reports on Rule 3-05 Financial Statements of foreign businesses as suggested by some commenters. Use of ISAs in Commission filings would involve broader considerations than Rule 3-05 Financial Statements, potentially including the appropriateness of their use for audits of foreign private issuer financial statements. We believe such an approach would require a thorough evaluation of the appropriateness of the use of ISAs and is beyond the scope of these amendments.

7. Smaller Reporting Companies and Issuers Relying on Regulation A

Rule 8-04 provides smaller reporting company disclosure requirements for the financial statements of businesses acquired or to be acquired. Part F/S of Form 1-A (“Part F/S”)

162

directs an issuer relying on 17 CFR 230.251 through 230.263

163

to present financial statements of businesses acquired or to be acquired,

164

as specified by Rule 8-04, but permits the periods presented to be the shorter of those applicable to issuers relying on Regulation A and the periods specified by Article 8.

165

162

17 CFR 239.90.

163

Regulation A—Conditional Small Issues Exemption (“Regulation A”).

164

See

paragraph (b)(7)(iii) of Part F/S of Form 1-A.

165

See

paragraph (b)(7) of Part F/S of Form 1-A.

a. Proposed Amendments

The Commission proposed to revise Rule 8-04 to reference to Rule 3-05 for the requirements relating to the financial statements of businesses acquired or to be acquired, other than for form and content requirements for such financial statements, which would continue to be prepared in accordance with 17 CFR 210.8-02 (“Rule 8-02”) and Rule 8-03.

166

Rule 3-05(b)(1) currently requires financial statements specified in Rule 3-01 and 3-02 for the

business to be acquired. Similarly, Rule 3-05(b)(2) also references Rule 3-01 and 3-02. Under the proposal, smaller reporting companies would apply Rule 3-05 but would substitute Rule 8-02 and Rule 8-03, as applicable, wherever Rule 3-05 references Rule 3-01 and 3-02. In this way, the proposal was intended to apply the election permitted for smaller reporting companies to prepare their financial statements in accordance with the form and content requirements in Article 8 rather than the other form and content requirements specified elsewhere in Regulation S-X (subject to the exceptions noted in Rule 8-01 Preliminary Note 2 to Article 8) to businesses acquired by smaller reporting companies.

Additionally, because Part F/S of Form 1-A refers to Rule 8-04, the proposed revisions to Rule 8-04 would apply to issuers relying on Regulation A. As a result, under the proposed amendments, smaller reporting companies would continue to be required to provide up to two years of acquired business historical financial statements and issuers relying on Regulation A would continue to be permitted to present the shorter of the periods applicable under Regulation A and the periods specified by Article 8.

167

Additionally, the proposed revisions would have expressly permitted smaller reporting companies and issuers relying on Regulation A to omit such financial statements if the acquired business has been included in the registrant's results for a complete fiscal year.

See

further discussion of omission of Rule 3-05 Financial Statements in Section II.B.1 above. We also proposed to add references to Rule 8-04 in Rule 3-06 and to Rule 3-06 in Note 6 to Article 8 to expressly permit smaller reporting companies and issuers relying on Regulation A to file financial statements covering a period of nine to 12 months to satisfy the requirement for filing financial statements for a period of one year for an acquired business.

b. Comments

A few commenters provided comments specifically related to smaller reporting companies and smaller issuers.

168

One commenter expressly supported the proposal to conform the rules applicable to smaller reporting companies to the generally applicable rules.

169

Other commenters offered specific recommendations relating to smaller registrants

170

or generally suggested the Commission consider whether issuers relying on Regulation A warrant different treatment.

171

168

See, e.g.,

letters from BDO, EY, MTBC, and RSM.

See also

SBCFAC Recommendations.

169

See

letter from BDO.

170

See

letter from MTBC (recommending that smaller registrants only apply the revenue component of the Income Test).

171

See

SBCFAC Recommendations (recommending that the Commission continue to look at “Regulation A companies and whether they warrant different treatment under these rules”).

c. Final Amendments

We are adopting the amendments substantially as proposed. We are revising Rule 8-04 to reference to Rule 3-05 for the requirements relating to the financial statements of businesses acquired or to be acquired, other than for form and content requirements for such financial statements, which would continue to be prepared in accordance with Rules 8-02 and 8-03. These revisions should ease compliance burdens and clarify the application of our rules for smaller reporting companies and issuers relying on Regulation A by focusing them on the more complete and better understood provisions of Rule 3-05. They will also expressly permit smaller reporting companies and issuers relying on Regulation A to omit historical acquired business financial statements if the acquired business has been included in the registrant's results for either nine months or a complete fiscal year, depending on significance.

We are also revising Rule 8-01 as proposed, to add a paragraph expressly permitting application of Rule 3-06 to the preparation of financial statements of smaller reporting companies and issuers relying on Regulation A

172

and to amend the instruction in Item 9.01 of Form 8-K to include references to Rule 8-04 in order to conform the instruction to the text of Item 9.01, which already addresses the rules applicable to smaller reporting companies.

172

In addition, we are revising Rule 8-01 to remove the reference to the instruction relating to pro forma presentation requirements.

See

Section II.D.3. In a non-substantive change from our proposal, we are also renaming Rule 8-01 “General Requirements for Article 8” and re-designating Notes 1 through 5 of Rule 8-01 as paragraphs (a) through (e).

We considered whether issuers relying on Regulation A should be treated differently or whether smaller registrants should be subject to further differentiated requirements, such as only complying with the revenue component of the Income Test, as one commenter suggested. We determined not to further differentiate disclosure for issuers relying on Regulation A and smaller reporting companies because we think the rules as adopted result in important investor information that we do not believe should be further reduced or modified.

173

We believe that existing accommodations should offset some of the burden associated with the disclosures that would be required by the rules. For example, Rule 8-01(b) provides, with limited exceptions, that smaller reporting companies electing to prepare their financial statements with the form and content required by Article 8 need not apply the other form and content requirements in Regulation S-X, and Form 1-A Part F/S provides that, in certain circumstances, financial statements of businesses acquired or to be acquired may be unaudited, may be for shorter periods than provided in Rule 8-04, and need not be updated if the most recent annual or interim balance sheet is not older than nine months. Further, as discussed below, the final rules contain a number of provisions that, while applicable to issuers of all sizes, should help ease the burden of providing the required financial information for smaller reporting companies and issuers relying on Regulation A.

174

173

For example, we believe it is important that smaller reporting companies and issuers relying on Regulation A be required to provide pro forma financial information when consummation of other transactions has occurred or is probable for which disclosure of pro forma financial information would be material to investors.

See Section

II.D.3. We also note that significance tests are not one-size-fits-all tests, but instead contemplate the unique facts and circumstances of a registrant or issuer because they measure significance of the acquired or disposed business relative to the registrant or issuer.

174

For example, we believe the significance tests we are adopting will provide more meaningful indicators of significance and mitigate anomalous significance results.

As revised, Rule 8-04 continues to require up to two years of acquired business historical financial statements. Additionally, and in accordance with current practice, the revised rule expressly permits smaller reporting companies to omit such financial statements if the acquired business has been included in the registrant's results for a complete fiscal year.

175

We are also adding references to Rule 8-04 in Rule 3-06 and to Rule 3-06 in Article 8, as proposed, to expressly permit smaller reporting companies to file audited financial statements covering a period of nine to 12 months to satisfy the requirement for filing financial statements for a period of one year for an acquired business.

175

See

further discussion of omission of Rule 3-05 Financial Statements in Section B.1. above.

The amendments also provide that a smaller reporting company is eligible to exclude acquired business financial statements from a registration statement if the business acquisition was consummated no more than 74 days prior to the date of the relevant final prospectus or prospectus supplement, rather than 74 days prior to the effective date of the registration statement as under current Rule 8-04(c)(4).

176

We believe it is appropriate to consistently look to the date of the final prospectus or prospectus supplement for registrants,

177

as Rule 3-05 currently

does, because that date could be later than the effective date, particularly in the case of a delayed offering, which some smaller reporting companies are now permitted to conduct.

178

We are also making conforming changes to Rule 8-05 for smaller reporting companies to be consistent with the changes we are making to Article 11.

179

176

See

proposed Rule 3-05(b)(4)(i)(B).

177

See

1996 Streamlining Release

supra

note 24 (noting that the date of an offering is specified as

the date of the final prospectus or prospectus supplement relating to the offering).

178

See

General Instruction I.B.6 of Form S-3 and

Amendments to Smaller Reporting Company Definition,

Release No. 33-10513 (June 28, 2018) [83 FR 31992 (July 10, 2018)].

179

See

Section II.D.3 below.

B. Amendments Relating to Rule 3-05 Financial Statements Included in Registration Statements and Proxy Statements

1. Omission of Rule 3-05 Financial Statements for Businesses That Have Been Included in the Registrant's Financial Statements

Rule 3-05(b)(4)(iii) generally permits Rule 3-05 Financial Statements to be omitted once the operating results of the acquired business have been reflected in the audited consolidated financial statements of the registrant for a complete fiscal year. However, Rule 3-05 Financial Statements are required to be included when they have not been previously filed, or when the Rule 3-05 Financial Statements have been previously filed but the acquired business is of major significance to the registrant.

If Rule 3-05 Financial Statements have not been previously filed, they must be provided even if the acquired business is included in post-acquisition audited results. The staff has historically not objected, however, to registrants reducing the Rule 3-05 Financial Statement periods presented by the equivalent period that the acquired business is included in the registrant's post-acquisition audited results.

180

The staff's position has been limited to circumstances where there is no gap between the latest date of the pre-acquisition audited financial statements of the acquired business and the earliest date of the registrant's audited post-acquisition results.

See

FRM

supra

note 94 at Section 2030.4 “Initial Registration Statements—Using Pre-Acquisition and Post-Acquisition Audited Results.”

Registrants must also continue to present Rule 3-05 Financial Statements that have been previously filed if the acquired business is of such significance to the registrant that omission of those Rule 3-05 Financial Statements would materially impair an investor's ability to understand the historical financial results of the registrant. Rule 3-05 provides, as an example, that an acquired business meeting at least one of the significance tests set forth in Rule 1-02(w) at the 80 percent level at the date of the acquisition would require the registrant to continue to file the financial statements of the acquired business. Notwithstanding the rule's reference to materiality, in practice the rule is typically applied, consistent with this example, on the basis of quantitative significance determinations.

181

See, e.g.,

FRM

supra

note 94 at Section 2040.2 “ ‘Major Significance' and Previously Filed Acquiree Financial Statements.”

a. Proposed Amendments

The Commission proposed to no longer require Rule 3-05 Financial Statements in registration statements and proxy statements once the acquired business is reflected in filed post-acquisition registrant financial statements for a complete fiscal year. The Commission also proposed to eliminate the “major significance” exception.

b. Comments

Commenters generally supported the proposed amendments.

182

One commenter, however, encouraged the Commission to seek additional input and consider whether the proposed amendments would provide investors with sufficient information and whether additional financial statements may be necessary above a certain significance threshold.

183

182

See, e.g.,

letters from Bass Berry, BDO, CAQ, Cravath, DT, Eli Lilly, FEI, KPMG, Pillsbury Winthrop Shaw Pittman, LLP, PWC, and Nasdaq.

183

See

letter from GT. This commenter cited an example where an initial public offering registrant consummates a very large acquisition in the year prior to the most recently completed fiscal year for which financial statements are being provided for the registrant. The commenter noted that while the registrant would be required to provide its historical financial statements for two years, the acquired business's financial statements would be limited to the period for which it is included in the registrant's post-acquisition results. The commenter further observed that, in its experience, disclosure pursuant to Regulation S-K, Item 303,

Management's discussion and analysis of financial condition and results of operations,

may not clearly isolate the effects of the acquisition on results of operations. The commenter suggested as an example that the Commission could consider requiring an initial public offering registrant to provide financial statements for the same number of periods as required in subsequent Securities Act and Exchange Act filings or for the same number of periods as the 50 percent threshold would require, prior to proceeding with a securities offering.

A number of commenters recommended permitting registrants to exclude separate financial statements once the acquired business has been included in the post-acquisition audited financial statements for at least nine months.

184

Commenters analogized to the Rule 3-06 requirements, noting that Rule 3-06 only requires nine months of pre-acquisition audited financial statements for an acquisition that exceeds 20 percent, but does not exceed 40 percent, significance.

185

In expressing support for using nine months, one of these commenters noted that the Commission could consider a requirement to disclose any material information impacting any pre-acquisition period that would otherwise be required absent the use of Rule 3-06 to supplement required financial statements.

186

184

See, e.g.,

letters from BDO, CAQ, Crowe, DT, EY, GT, KPMG, PWC, and RSM.

185

See, e.g.,

letters from BDO and DT. One of these commenters further noted that staff practice as documented in FRM 2040.2 generally permits omission of previously filed acquired business financial information once it is included in the registrant's post-acquisition results for nine months.

See

letter from DT. The other commenter recommended allowing 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 registrant's audited post-acquisition results for nine months and for businesses that exceed 40 percent significance once they are included in the registrant's post-acquisition results for a complete fiscal year.

See

letter from BDO.

186

See

letter from Crowe.

c. Final Amendments

We are adopting revisions substantially as proposed with some modifications in response to comments received. Specifically, we are adopting the proposed elimination of the requirement to include Rule 3-05 Financial Statements in registration statements and proxy statements once the acquired business is reflected in filed post-acquisition registrant financial statements. However, in response to comments, we are modifying the requisite time period.

We are persuaded by commenters that our proposal unnecessarily perpetuates existing differences in the length of reporting periods that exist between Rule 3-05 and Rule 3-06 for an acquisition that is at least 20 percent, but not more than 40 percent, significant. One condition in Rule 3-05 for omitting Rule 3-05 Financial Statements is that the acquired business has been included in the registrant's post-acquisition results for a complete fiscal year. However, Rule 3-06 permits the filing of Rule 3-05 Financial Statements covering a period of nine months to satisfy the Rule 3-05 requirement for filing financial statements for a period of one year. While these reporting periods relate to different circumstances, omission under Rule 3-05 as compared to inclusion

under Rule 3-06, we do not believe those circumstances are sufficiently different for acquisitions that are at least 20 percent, but not more than 40 percent, significant (

i.e.,

significant at the one year level) to warrant disclosures for different time periods. To provide consistency between the Rule 3-05 and Rule 3-06 requirements, the amendments will 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 registrant's audited post-acquisition results for nine months (rather than the proposed complete fiscal year).

187

Rule 3-06 does not require incremental disclosure in order for the filing of financial statements covering a period of nine months to be deemed to satisfy a requirement for filing financial statements for a period of one year. Because our amendments seek to make Rule 3-05 more consistent with Rule 3-06, the final amendments do not include an incremental disclosure requirement within Rule 3-05 to disclose material information impacting any pre-acquisition period that would otherwise be required absent the use of amended Rules 3-05 and 3-06. However, we observe that existing requirements, such as those in Item 303 of Regulation S-K,

Management's discussion and analysis of financial condition and results of operations,

and Rule 4-01(a) would require such disclosure when it is material to the registrant, and we believe that information would be sufficient for this purpose.

Because Rule 3-06 limits the use of a nine month period to financial statements that would otherwise be required for a period of one year, the amendments retain the existing complete fiscal year Rule 3-05 requirement when Rule 3-05 Financial Statements for a period of two years are required (

i.e.,

significance exceeds 40 percent). Specifically, the amendments allow omission of pre-acquisition financial statements for businesses that exceed 40 percent significance once they are included in the registrant's post-acquisition results for a complete fiscal year.

These final amendments also eliminate the requirement that Rule 3-05 Financial Statements be provided when they have not been previously filed or when they have been previously filed but the acquired business is of major significance. This requirement can delay a registrant's offering and thereby its access to capital, while providing information that is often less meaningful to investors, because the utility of pre-acquisition periods diminishes over time after the acquired business is reflected in post-acquisition results, and because the post-acquisition results of the combined business are generally not comparable to the pre-acquisition results of the acquired business.

188

Similarly for financial information provided regarding acquisitions of “major significance,” the utility of pre-acquisition periods diminishes over time after the acquired business is reflected in post-acquisition results. Additionally, with electronic filing requirements, which were established after the “major significance” rule, previously filed financial information about the acquired business is readily accessible through the Commission's EDGAR filing system.

188

See

FRM

supra

note 94 at Section 2030.4. The accommodation provided by Commission staff did not sufficiently ameliorate these effects and often resulted in financial statements of the acquired business that depicted partial, rather than complete, reporting periods that did not coincide with the end of either the acquired business's or the registrant's fiscal periods.

We believe inclusion of post-acquisition results in the registrant's audited financial statements for the requisite time period should generally provide investors with sufficient information to make informed investment decisions about the registrant. Further, even without the major significance requirement to include some, but not all, of the previously filed pre-acquisition financial statements of the acquired business, Regulation S-X provides that a registrant must provide “such further material information as is necessary to make the required statements, in light of the circumstances under which they are made, not misleading.”

189

See

Rule 4-01(a).

We are not persuaded that additional financial statements of acquired businesses should be provided in initial registration statements when an acquisition is reflected in post-acquisition audited results for nine months when the acquisition is significant at the one year level or included for a complete fiscal year when the acquisition is significant at the two year level. Pre-acquisition financial statements by their nature are less likely to be indicative of the current financial condition, changes in financial condition, and results of operations of the acquired business as they age. If, in an unusual circumstance, pre-acquisition financial statements are necessary for the protection of investors even though the acquired business has been included in the registrant's post-acquisition results for a complete fiscal year, the

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