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US Securities and Exchange Commission

Divided SEC Scales Back Disclosure for Business Combination

Thomson Reuters Tax & Accounting  

Thomson Reuters Tax & Accounting  

By Soyoung Ho

The SEC on May 21, 2020, said it has voted to scale back corporate disclosure requirements in order to reduce the complexity and costs of preparing financial information related to acquisitions and dispositions of other businesses despite opposition by some investor protection advocates.

The vote took place a day before, and the final amendments were published on May 20 in Release No. 33-10786, Amendments to Financial Disclosures about Acquired and Disposed Businesses. The rules become effective on January 1, 2021, but the SEC said companies can apply them early.

“This action, which is designed to enhance the quality of information that investors receive while eliminating unnecessary costs and burdens, will benefit investors, registrants and the market more generally,” SEC Chairman Jay Clayton said.

The agency approved to issue the final rule in seriatim, which means that the commissioners submitted their votes individually rather than holding an open meeting. The commission under the leadership of Clayton has been frequently issuing a rulemaking document without holding a public meeting.

Clayton, who sets the agenda, during his tenure has largely focused on cutting back requirements for companies who have for years complained that the rules are too burdensome while offering no commensurate value to investors.

But many investor protection advocates believe existing rules are beneficial because companies are required to provide detailed useful information, and thus investors are able to make informed decisions when deciding to buy or sell stocks of a particular company. And Commissioner Allison Herren Lee voted against the final rule.

“Unfortunately, today’s rulemaking does not adequately address the risks of reduced transparency for investors with respect to this activity, nor does it properly examine the potential effects on competition, particularly in the present economic climate where the risks that arise from overly concentrated markets are heightened,” Lee wrote in her dissent.

When the SEC issued the proposal—which the final release is based on—in May 2019 in Release No. 33-10635Amendments to Financial Disclosures about Acquired and Disposed Businesses, comment letters showed a dividing line between businesses and investors. Businesses, who back any effort to reduce compliance burdens, suggested more changes to further simplify the requirements. But investor advocates said the SEC had not provided sufficient evidence about how investors will gain from the changes.

Former SEC chief accountant Lynn Turner, a strong investor advocate, also criticized the commission’s decision to adopt the streamlined rules.

“Yet another in a long and growing list of anti-investor rule makings, destined to reduce the returns investors earn in the U.S .Capital markets,” he said. “As a result, these changes should enhance the competitiveness of foreign markets over time.”

Revised Rules

The rule changes, the market regulator said, are intended to better help operating public companies as well as investment companies determine whether a subsidiary or an acquired or disposed business is significant.

The final release streamlines Rule 3-05 and Rule 3-14, among other rules in Regulation S-X, which lays out the specific form and content of financial reports. And the changes update certain rules in the regulation which have not been comprehensively addressed since they were adopted over 30 years ago.

When a company acquires a significant business, other than a real estate operation, Rule 3-05 generally requires the company to provide separate audited annual and unaudited interim pre-acquisition financial statements for that business. The number of years of financial information that must be provided depends on the relative significance of the acquisition to the company.

Similarly, Rule 3-14 addresses real estate operations, and it requires a company that has acquired a significant real estate operation to file financial statements of the acquired entity. The SEC is updating the significance tests under the rules by revising the investment test and the income test. This deals with whether an acquisition is sufficiently large to affect future financials of the combined company.

Currently, the investment test compares the “company’s investment in and advances to the acquired business to the carrying value of the acquiring company’s total assets.” The SEC revised the test based on the aggregate worldwide market value of common equity when available.

The commission also revised the income test by adding a revenue component and expanded the use of “pro forma” financial information in measuring significance.

Article 11 of Reg S-X requires companies to file unaudited pro forma financial information related to business combinations. Pro forma financial information typically includes a pro forma balance sheet and pro forma income statements based on the historical financial statements of the company and the acquired or disposed business, including adjustments intended to show how the acquisition or disposition might have affected those financial statements.

Among other things, the SEC is replacing the existing pro forma adjustment criteria with simplified requirements to describe the accounting for the transaction.

The final rule also requires the financial statements of the acquired business to cover no more than the two most recent fiscal years. It allows companies to present financial statements that omit certain expenses for certain acquisitions of a component of an entity. The SEC said it will no longer require separate acquired business financial statements once the business has been included in the company’s post-acquisition financial statements for nine months or a complete fiscal year, depending on significance.

Lee’s Dissent

In explaining her dissent, Lee said that she is concerned that the SEC is going ahead with a rule that will likely facilitate mergers and acquisitions (M&As) without assessing their costs and risks: “the risk to investors of less transparency regarding the economics of an acquisition, and the risk of increasing economic concentration, which is heightened at present where large companies that are better positioned to weather the current economic conditions may pursue predatory takeovers of smaller, struggling businesses.”

She was making a reference to the effect authorities’ efforts to contain a novel coronavirus has had on the economy as many companies have faced massive business disruptions.

“The current COVID-19 crisis and its devastating impact on the financial condition of many companies brings into sharp focus the problems that can arise from a truncated timeframe for analysis of prior financial results,” Lee said. “Under the final rule, investors will have (at most) two years of prior financial statements. If one of those years is severely impacted by the COVID-19 crisis, will investors have sufficient information with respect to valuation? How much critical perspective may be lost because of the potentially anomalous period?”

 

This article originally appeared in the May 22, 2020 edition of Accounting & Compliance Alert, available on Checkpoint.

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