[Federal Register Volume 85, Number 169 (Monday, August 31, 2020)]
[Rules and Regulations]
[Pages 54002-54074]
[FR Doc No: 2020-11479]

Vol. 85

Monday,

No. 169

August 31, 2020

Part III

Securities and Exchange Commission

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17 CFR Parts 210, 230, 239, et al.

Amendments to Financial Disclosures About Acquired and Disposed
Businesses; Final Rule

Federal Register / Vol. 85, No. 169 / Monday, August 31, 2020 / Rules
and Regulations

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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.

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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<PHONE_NUMBER>, Jessica Barberich, Associate Chief
Accountant, at<PHONE_NUMBER>, or Craig Olinger, Senior Advisor to the
Chief Accountant, at<PHONE_NUMBER>, or Steven G. Hearne, Senior
Special Counsel, at<PHONE_NUMBER>, in the Division of Corporation
Finance; Joel Cavanaugh, Senior Counsel, at<PHONE_NUMBER>, Jenson
Wayne, Assistant Chief Accountant, at<PHONE_NUMBER>, or Mark T. Uyeda,
Senior Special Counsel, at<PHONE_NUMBER>, 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:

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            Commission reference                CFR citation (17 CFR)
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Regulation S-X.............................  Sec.  Sec.   210.1-01
                                              through 210.13-02.
    Rule 1-02(w)...........................  Sec.   210.1-02(w).
    Rule 3-05..............................  Sec.   210.3-05.
    Rule 3-06..............................  Sec.   210.3-06.
    Rule 3-09..............................  Sec.   210.3-09.
    Rule 3-14..............................  Sec.   210.3-14.
    Rule 3-18..............................  Sec.   210.3-18.
    Rule 5-01..............................  Sec.   210.5-01.
    Rule 6-01..............................  Sec.   210.6-01.
    Rule 6-02..............................  Sec.   210.6-02.
    Rule 6-03..............................  Sec.   210.6-03.
Article 8:
    Rule 8-01..............................  Sec.   210.8-01.
    Rule 8-03..............................  Sec.   210.8-03.
    Rule 8-04..............................  Sec.   210.8-04.
    Rule 8-05..............................  Sec.   210.8-05.
    Rule 8-06..............................  Sec.   210.8-06.
Article 11:
    Rule 11-01.............................  Sec.   210.11-01.
    Rule 11-02.............................  Sec.   210.11-02.
    Rule 11-03.............................  Sec.   210.11-03.
Securities Act of 1933 (Securities Act):
 \1\
    Securities Act Rule 405................  Sec.   230.405.
    Form S-11..............................  Sec.   239.18.
    Form N-2...............................  Sec.  Sec.   239.14 and
                                              274.11a-1.
    Form N-14..............................  Sec.   239.23.
    Form 1-A...............................  Sec.   239.90.
Securities Exchange Act of 1934 (Exchange
 Act): \2\
    Exchange Act Rule 12b-2................  Sec.   240.12b-2.
    Form 8-K...............................  Sec.   249.308.
    Form 10-K..............................  Sec.   249.310.
Investment Company Act of 1940 (Investment
 Company Act): \3\
    Rule 8b-2..............................  Sec.   270.8b-2.
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    We also are adding 17 CFR 210.6-11 (new ``Rule 6-11'') to
Regulation S-X.
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    \1\ 15 U.S.C. 77a et seq.
    \2\ 15 U.S.C. 78a et seq.
    \3\ 15 U.S.C. 80a-1 et seq.
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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.\4\ 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,\5\
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.\6\ The proposed amendments resulted from an ongoing,
comprehensive evaluation of our disclosure requirements.\7\ The
Commission also proposed new Rule 6-11 and amendments to Form N-14 to
specifically govern financial reporting for acquisitions involving
investment companies.
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    \4\ 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'').
    \5\ Unless otherwise noted, references in this release to
``Rule'' or ``Rules'' are to the rules under Regulation S-X.
    \6\ 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.
    \7\ 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.
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    Under Rule 3-05, a registrant that acquires a business \8\ other
than a real estate operation \9\ 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.\10\ A registrant that has
acquired, or proposes to acquire, a significant real estate operation
\11\ similarly must file separate audited annual and unaudited interim
abbreviated income statements with respect to such operations (``Rule
3-14 Financial Statements'').\12\ 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.\13\ 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.
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    \8\ 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.
    \9\ Rule 3-05 also applies to registrants that are registered
investment companies and business development companies.
    \10\ 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'').
    \11\ 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.
    \12\ 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.
    \13\ 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.
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    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.\14\ 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,\15\ but not for
acquired or to be acquired businesses requiring Rule 3-14 Financial
Statements.
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    \14\ 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.
    \15\ 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).
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    In addition, certain registration statements \16\ 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.\17\
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    \16\ This additional requirement does not apply to all
registration statements, such as registration statements filed on 17
CFR 239.16b (``Form S-8'').
    \17\ See Rule 3-05(b)(2)(i). Smaller reporting companies provide
the same disclosure under Rule 8-04(c)(3).
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    Commenters broadly supported the objectives of the proposed rules
or were generally in favor of the proposals.\18\ 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.\19\ 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.
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    \18\ Comment letters related to the Proposing Release are
available at https://www.sec.gov/comments/s7-05-19/s70519.htm.
    \19\ 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.
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II. Discussion of Final Amendments \20\
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    \20\ 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.
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    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,\21\ and the scope of the
rule's requirements;
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    \21\ See Section II.C.6 below for a description of a blind pool
offering.
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     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 \22\ (collectively, ``investment
companies'') as discussed in more detail in Section II.E. below.
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    \22\ ``Business development company'' is defined in Section
2(a)(48) of the Investment Company Act, 15 U.S.C. 80a-2(a)(48).
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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.\23\ Whether an acquisition
is significant under Rule 3-05 is determined by applying these
tests,\24\ which generally can be described as follows:
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    \23\ 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.
    \24\ 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.

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     ``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.\25\
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.
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    \25\ 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.
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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.\26\ 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 \27\ and combinations
between entities or businesses under common control.\28\
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    \26\ 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.
    \27\ 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.
    \28\ 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.
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    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,\29\ 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.
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    \29\ 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.
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ii. Comments
    Commenters generally supported the proposal to revise the
Investment Test.\30\ Many commenters expressly supported the proposed
use of aggregate worldwide market value of the registrant's voting and
non-voting common equity, when available.\31\ 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.\32\ 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.\33\
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    \30\ 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.
    \31\ 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.
    \32\ 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.
    \33\ 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.
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    A number of commenters, however, expressed concern relating to the
use of aggregate worldwide market value.\34\ One of these commenters
suggested that aggregate worldwide market value would introduce market
volatility into the test.\35\ 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.\36\ 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).\37\
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    \34\ 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.
    \35\ See letter from AMG.
    \36\ 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).
    \37\ 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).
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    Some commenters recommended using the ``enterprise value'' of the
registrant as a more accurate reflection of the fair value of the
entities,\38\ despite acknowledging a lack of agreed-upon definition of
the term \39\ or that enterprise value may necessitate adjustment to
the numerator of the Investment Test to reflect leverage.\40\ 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.\41\ 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.\42\ 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.\43\
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    \38\ 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.
    \39\ See letters from IMA and Shearman.
    \40\ 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.
    \41\ 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.''
    \42\ See letters from Allstate and New York City Bar
Association, Committee on Securities Regulation (``NYCBA--Sec.'').
    \43\ See letter from CII. See also infra at note 454 and
accompanying text.
---------------------------------------------------------------------------

    In response to the Commission's proposal to require that the
registrant's and its other subsidiaries' ``investments in'' the tested
subsidiary include contingent consideration, some commenters supported
including the fair value of contingent consideration when it is
required to be measured at fair value under U.S. GAAP \44\ but
expressed opposition or concern about including contingent
consideration when the acquired business will be accounted for as an
asset acquisition under U.S. GAAP.\45\ Other commenters recommended
permitting registrants to determine significance using the fair value
of the contingent consideration arrangement when fair value is not
required by U.S. GAAP or IFRS-IASB, as applicable,\46\ or extending the
proposed sales-based milestones and royalties exception.\47\ One
commenter more broadly recommended not requiring the inclusion of
contingent consideration that is not required to be recognized under
applicable accounting standards.\48\ However, another commenter
expressed concern that the exclusion of sales-based milestones and
royalties from the Investment Test for acquisitions for which U.S. GAAP
does not require contingent consideration to be measured at fair value
may result in under-identification of acquisitions that would
materially affect the registrant's financial statements.\49\
---------------------------------------------------------------------------

    \44\ See, e.g., letters from Allstate, AMG, Pfizer, Inc.
(``Pfizer''), and SIFMA.
    \45\ See, e.g., letters from Pfizer, and SIFMA.
    \46\ See letter from IMA.
    \47\ See letters from IMA and SIFMA. See also Section II.A.1.a.
of the Proposing Release.
    \48\ See letter from Cravath.
    \49\ 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,\50\ but expressly limiting this amendment to
acquisitions and dispositions.\51\ 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.\52\
---------------------------------------------------------------------------

    \50\ 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.
    \51\ 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.
    \52\ 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'' \53\ 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.\54\
---------------------------------------------------------------------------

    \53\ 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.''
    \54\ 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.\55\
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    \55\ 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'' \56\ 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.
---------------------------------------------------------------------------

    \56\ 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.\57\
---------------------------------------------------------------------------

    \57\ 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'').\58\
---------------------------------------------------------------------------

    \58\ 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.\59\
---------------------------------------------------------------------------

    \59\ 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 \60\
and to reduce complexity and preparation costs without sacrificing
material information for investors. The Commission proposed to:
---------------------------------------------------------------------------

    \60\ 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.\61\
---------------------------------------------------------------------------

    \61\ 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,\62\ 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.
---------------------------------------------------------------------------

    \62\ 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.\63\
---------------------------------------------------------------------------

    \63\ 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.\64\ One commenter recommended establishing
significance when registrants meet either revenue or net income.\65\
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.\66\

Another commenter suggested requiring only the revenue component, and
not the income component, for smaller reporting companies.\67\
---------------------------------------------------------------------------

    \64\ 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.
    \65\ See letter from CFA.
    \66\ 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.
    \67\ 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.\68\ One
commenter recommended using ``two or more years of revenue'' as an
alternative.\69\
---------------------------------------------------------------------------

    \68\ See, e.g., letters from BDO, CAQ, Cravath, Crowe, DT, EY,
GT, KPMG, MTBC, PWC, RSM, and SIFMA.
    \69\ 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.\70\ However, many other commenters
recommended that the Commission continue to use income or loss from
continuing operations before income taxes in the Income Test.\71\ 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) \72\ or the volatility of
income taxes (due to changes in tax laws or valuation allowances).\73\
---------------------------------------------------------------------------

    \70\ See letters from Ball and Eli Lilly.
    \71\ See, e.g., letters from AMG, BDO, CAQ, Cravath, Crowe, EY,
FEI, GT, KPMG, Pfizer, PWC, Ira Rosner (``Rosner''), RSM, Shearman,
and Williams.
    \72\ See, e.g., letters from AMG, BDO, CAQ, Cravath, Crowe, EY,
GT, KPMG, PWC, Rosner, RSM, and Williams.
    \73\ 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 \74\ and the use of absolute values.\75\ Some
commenters recommended further revisions, such as using three-year
averaging or permitting five-year averaging for all registrants
regardless of recurring revenue.\76\
---------------------------------------------------------------------------

    \74\ See letters from AMG, BDO, and Pfizer.
    \75\ See letters from AMG, Eli Lilly, IMA, and Pfizer.
    \76\ 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).\77\
---------------------------------------------------------------------------

    \77\ 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.\78\ 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.
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    \78\ 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)].
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    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 \79\ and the use of absolute values.\80\
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    \79\ 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.
    \80\ See letters from AMG, Eli Lilly, IMA, and Pfizer.
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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)(3) 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.\81\ 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).\82\
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    \81\ See supra note 23.
    \82\ 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)(3). 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.\83\ 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).\84\ 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.\85\
---------------------------------------------------------------------------

    \83\ See, e.g., letters from AMG, DT, and Williams.
    \84\ 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.
    \85\ 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.\86\ 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)(3).
---------------------------------------------------------------------------

    \86\ 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.\87\ 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.\88\
---------------------------------------------------------------------------

    \87\ See supra note 23.
    \88\ 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.\89\ 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.\90\
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.\91\
---------------------------------------------------------------------------

    \89\ 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.
    \90\ 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].'').
    \91\ 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.\92\
---------------------------------------------------------------------------

    \92\ 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,\93\ with no commenters
opposing the changes.
---------------------------------------------------------------------------

    \93\ 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.\94\
---------------------------------------------------------------------------

    \94\ 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'').
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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.\95\ 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 \96\ if:
---------------------------------------------------------------------------

    \95\ 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.
    \96\ 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.\97\
---------------------------------------------------------------------------

    \97\ 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,\98\ 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.\99\ 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\
---------------------------------------------------------------------------

    \98\ See, e.g., letters from BDO, CAQ, Cravath, Debevoise &
Plimpton LLP (``Debevoise''), DT, Eli Lilly, EY, FEI, GT, IMA, PWC,
RSM, and S&C.
    \99\ 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\
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    \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\
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    \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          The total assets and
                               constitutes less      total revenues
                               than substantially    (both after
                               all of the assets     intercompany
                               and liabilities of    eliminations) of
                               the seller.           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  The acquired
                               a separate entity,    business was not a
                               subsidiary,           separate entity,
                               segment, or           subsidiary,
                               division during the   operating segment
                               periods for which     (as defined in U.S.
                               the acquired          GAAP or IFRS-IASB,
                               business financial    as applicable), or
                               statements would be   division during the
                               required.             periods for which
                                                     the acquired
                                                     business financial
                                                     statements would be
                                                     required.
                              Separate financial    No substantive
                               statements for the    change.
                               business have not
                               previously been
                               prepared.
                              The seller has not    No substantive
                               maintained the        change.
                               distinct and
                               separate accounts
                               necessary to
                               present financial
                               statements that
                               include the omitted
                               expenses and it is
                               impracticable to
                               prepare such
                               financial
                               statements.
Presentation requirements...  The balance sheet     No substantive
                               may be a statement    change.
                               of assets acquired
                               and liabilities
                               assumed.
                              The statement of      No substantive
                               comprehensive         change. The title
                               income may be a       of the statement of
                               statement of          comprehensive
                               revenues and          income must be
                               expenses (exclusive   appropriately
                               of corporate          modified to
                               overhead, interest    indicate it omits
                               and income tax        certain expenses.
                               expenses) if
                               certain
                               presentation
                               requirements are
                               met.
                              Corporate overhead    The statement of
                               expenses may be       comprehensive
                               excluded from the     income must include
                               statement of          expenses incurred
                               comprehensive         by or on behalf of
                               income provided       the acquired
                               that the statement    business during the
                               does not omit         pre-acquisition
                               selling,              financial statement
                               distribution,         periods to be
                               marketing, general    presented
                               and administrative,   including, but not
                               and research and      limited to, costs
                               development           of sales or
                               expenses incurred     services, selling,
                               by or on behalf of    distribution,
                               the acquired          marketing, general
                               business during the   and administrative,
                               periods to be         depreciation and
                               presented.            amortization, and
                                                     research and
                                                     development, but
                                                     may otherwise omit
                                                     corporate overhead
                                                     expenses.

                              Interest expense may  No substantive
                               be excluded from      change.
                               the statements if
                               the debt to which
                               the interest
                               expense relates
                               will not be assumed
                               by the registrant
                               or its subsidiaries
                               consolidated.
                              Income tax expense    No substantive
                               may be omitted.       change.
                              The notes to the      No substantive
                               financial             change.
                               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.
------------------------------------------------------------------------

    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.
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    \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.
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    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\
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    \114\ See amended Rule 3-05(e).
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     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\
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    \115\ The title of the statement of comprehensive income must be
appropriately modified to indicate it omits certain expenses.
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    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\
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    \116\ See Rule 3-13, supra note 58.

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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.
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    \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\
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    \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.
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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.
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    \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.''
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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 Sec.  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\
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    \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.
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5. Timing and Terminology of Financial Statement Requirements
a. Proposed Amendments
    The Commission proposed several revisions to Rule 3-05 and Article