1 AICPA 1996 Twenty-Fourth Annual National Conference on Current S EC Developments December 10-11, 1996 Washington, D.C. DEVELOPMENTS IN THE DIVISION OF CORPORATION FINANCE Remarks by Kurt R. Hohl Associate Chief Accountant Division of Corporation Finance U.S. Securities and Exchange Commission _________________________________________________________________ _______ The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Mr. Hohl, and do not necessarily represent the views of the Commission or the other members of the staff of the Commission. Introduction I appreciate the opportunity to speak at this event again, and to share a few thoughts about issues often encountered in the Division of Corporation Finance. Today, I will discuss the staff's views regarding (1) issues related to financial statements of an acquired business, (2) financial statements required for acquired real estate properties, and (3) effects of subsequent events on financial statements required in filings. If time permits after everyone on the panel has spoken, I'll be happy to answer any questions you may have. Issues Related to Financial Statements of an Acquired Business Today, I intend to focus on three issues on this topic; (1) the determination of what constitutes a "business", (2) financial statement requirements related to acquisitions of selected portions of a business, and (3) tests of significance pursuant to Rule 3-05 of Regulation S-X. What Constitutes a Business? A "business" for purposes of Rule 3-05 is identified by evaluating whether there is sufficient continuity of operations so that disclosure of prior financial information is material to an understanding of future operations. There is a presumption that a separate entity, subsidiary, or division is a business. A lesser component, such as a product line, also may be considered a business. In evaluating whether a lesser component is a business, consideration should be given to the following factors that are set forth in Rule 11-01(d) of Regulation S-X: A. whether the nature of the revenue producing activity generally will remain the same; B. whether the facilities, employee base, distribution system, sales force, customer base, operating rights, production techniques, or trade names remain after the acquisition. [SX 11-01(d)] The staff's analysis of whether an acquisition constitutes the acquisition of a business, rather than of assets, focuses primarily on whether the nature of the revenue producing activity previously associated with the acquired assets will remain generally the same after the acquisition. New carrying values of assets, or changes in financing, management, operating procedures, or other aspects of the business are not unusual following a business acquisition. Such changes typically do not eliminate the relevance of historical financial statements. Registrants that have succeeded to a revenue producing activity by merger or acquisition, with at least one of the factors listed in (B) above remaining after the acquisition, should be encouraged to obtain concurrence from the staff in advance of a filing if they intend to omit financial statements related to the assets and activity. Registrants may direct requests for interpretative letters related to appropriate financial statements of an acquired entity or group of assets to the Division's Chief Accountant's Office. Acquisitions of Selected Parts of an Entity. In some circumstances, a registrant does not acquire or succeed to all of the assets and liabilities of another entity. If the registrant acquires or succeeds to substantially all of the entity's key operating assets, complete audited financial statements of the other entity usually will be required. Elimination of specified assets and liabilities not acquired or assumed by the registrant is depicted in pro forma financial statements presenting the effects of the acquisition. Full audited financial statements of the entity are presumed to be necessary in order to provide investors with the complete and comprehensive financial history of the acquired business. In other circumstances, the selling entity will retain significant operating assets, or significant operating assets that comprised the seller will continue to be operated by an entity other than the registrant. Financial statements of the larger entity of which the acquired business was a part may be misleading or uninformative. In that case, audited financial statements usually should be presented for the acquired component business, excluding the continuing operations retained by the larger entity. The staff may accept audited statements of assets and liabilities acquired and statements of revenues and direct expenses if it is impracticable to prepare the full financial statements required by Regulation S-X, and explanation of that impracticability is included in the filing. The staff would expect the statement of revenues and direct expenses to exclude only those costs not directly involved in the revenue producing activity, such as corporate overhead and interest. Accompanying pro forma financial statements should include adjustments for excluded items as if the business had been acquired at the beginning of the periods presented. Registrants should refer to pro forma requirements of Article 11 of Regulation S-X. Requests for substitution of abbreviated financial information in lieu of full financial statements should be directed to the Division's Chief Accountant's Office prior to filing. Tests of Significance Rule 3-05 of Regulation S-X requires registrants to provide financial statements if the acquisition is significant. Significance of acquiree is determined by comparing the most recent pre-acquisition audited annual statements of the acquired business to registrant's pre-acquisition consolidated statements as of the end of the most recently completed audited fiscal year filed with the Commission. If the acquisition was made after the most recent fiscal year and the registrant files its Form 10-K for that year before the due date of the Form 8-K, the staff has not objected if significance is evaluated relative to the most recently completed fiscal year. If the registrant has previously made a significant acquisition and it was fully reported on Form 8-K, the significance test may be applied to the pro forma data rather than historical pre-acquisition data. For purposes of evaluating significance in this situation, compare pre-tax operating income for the acquired entity's latest fiscal year to the pro forma income statement for the latest audited annual period provided in the Form 8-K. For the investment and asset tests, compare the registrant's investment in the acquired entity and the assets of the acquired entity for the latest fiscal year to the pro forma balance sheet comprising the latest audited balance sheet of the registrant. That pro forma balance sheet may or may not have been included in the Form 8-K, depending on when the Form 8-K was filed. The pro forma interim period balance sheet should not be used for determining significance unless the interim periods of the registrant are audited. For purposes of computing the significance tests with pro forma information, only those pro forma adjustments directly attributable to the transaction (e.g. purchase price allocation, depreciation, and amortization) should be included in determining the pro forma income statement and balance sheet. If the registrant chooses to compute significance using pro forma information, it must do so for all three significance tests. The acquired business is not considered part of the registrant's base in determining significance. For additional information regarding the significance tests, refer to Rule 1-02(w) of Regulation S-X. Financial Statement Requirements for Real Estate Acquisitions Basic Requirements (Securities Act and Exchange Act Reporting) Rule 3-14 of Regulation S-X requires that financial statements of each operating real estate property (or group of related properties) acquired that is significant at the 10% level or higher be filed in a Form 8-K and in all transactional filings (registration statements and proxies). The significance test is computed by comparing the registrant's investment in the property to the registrant's total assets at the latest audited fiscal year filed with the Commission. While Rule 3-05 of Regulation S- X permits the determination of significance to be made using pro forma financial information included in a Form 8-K reporting a significant acquisition, this determination of significance is not applicable to Rule 3-14 of Regulation S-X. Because the purchase of real estate by companies engaged in real estate activities is not considered to be an acquisition in the ordinary course of business, Item 2 Form 8-Ks are required to report these transactions. In addition to providing financial statements for consummated significant acquisitions, Rule 3-14 requires financial statements of operating real estate properties for probable acquisitions that are significant at the 10% level in transactional filings. Further, Rule 3-14 requires financial statements of operating real estate properties acquired or to be acquired that are individually insignificant, if such acquisitions, in aggregate with other individually insignificant acquired or to be acquired properties, exceed 10% of the registrant's total assets. However, in certain instances the staff has granted relief under this requirement to permit omission of audited financial statements of an individually insignificant property that is significant below the 5% level if: (a) the property is acquired from an unrelated party, (b) descriptive and unaudited summarized financial information about the property is provided and (c) audited financial statements of the substantial majority of all individually insignificant properties acquired or to be acquired are provided. Application of Rule 3-14 is limited to real estate operations. The reduced financial statements requirements available to real estate operations are premised on the continuity and predictability of cash flows ordinarily associated with commercial and apartment property leasing. Nursing homes, hotels, motels, equipment rental operations and other businesses that are more susceptible to variations in costs and revenues over shorter periods due to market and managerial factors are not considered to be "real estate operations". Thus, Rule 3-05, rather than Rule 3-14 and the special undertaking in the industry guide, is applicable to those businesses. Effects of Subsequent Events of Financial Statements Required in Filings Certain events that occur after the end of a fiscal year will require retroactive restatement of that year's financial statements if they are reissued. Such events include consummation of a business combination to be accounted for as a pooling-of-interests and adoption of a formal plan to discontinue a business segment. If the pre-event financial statements are not reissued in connection with any filing under the Securities Act or Exchange Act, restatement of annual information need not occur until its inclusion in the registrant's next Annual Report on Form 10-K. However, restated quarterly information is required in subsequent Form 10-Qs. For the information of investors, a registrant may elect to file under cover of Form 8-K (Item 5) audited restated financial statements following such an event. However, restated financial statements must be furnished if a registrant is required to include its financial statements in a filing made under the Securities Act or Exchange Act that will be made effective subsequent to an event requiring retroactive restatement under GAAP. Business Combination Accounted for as A Pooling-of-Interests In some cases, registrants elect to present as promptly as possible their historical financial statements on a basis that reflects consummation of a post-balance sheet merger accounted for as a pooling-of-interests. In addition, Item 11(b) of Form S- 3 requires "restated financial statements prepared in accordance with Regulation S-X" in registration statements filed or amended after the date of a business combination accounted for as a pooling-of-interests. (The staff believes the guidance in Form S- 3 is applicable to any registration statement or proxy following a pooling-of-interests.) However, paragraph 61 of APB Opinion No. 16 provides that until the financial statements for the period encompassing consummation of the combination have been issued, "the financial statements issued should be those of the combining company and not those of the resulting combined corporation." Paragraph 61 also requires that each combining company "disclose as supplemental information in notes to financial statements or otherwise, the substance of a combination consummated before financial statements are issued and the effects of the combination on reported financial position and results of operations." The form of the financial statements of the registrant to be furnished in Commission filings depends on whether financial statements for a post-consummation period have been published. The staff believes that the post-merger results reporting requirement of paragraph 61 of APB 16 can be satisfied by the release of summary financial information (S-X 1-02(bb)) in a Form 8-K for a post-combination period of not less than one month. I. Prior to release of post-combination financial information Until post-combination results are published, financial statements giving effect to the pooling should be presented in transactional filings or in voluntary supplemental filings as "supplemental financial statements." If the financial statements are required to be furnished in connection with an Exchange Act or Securities Act filing, the supplemental financial statements should be audited and prepared in accordance with Regulation S-X, with an audit report date subsequent to the consummation of the transaction but prior to publication of post-combination results. Typically, these statements are filed on an Item 5, Form 8-K. If the restated financial statements are furnished pursuant to the requirements of a registration statement or proxy, MD&A and applicable industry guide information should also be restated or expanded to provide necessary information about the combined entity. Any registration statement made effective or proxy materials mailed prior to publication of post-combination financial information must include the audited historical financial statements of the registrant, without giving effect to the business combination. Presentation of audited supplemental financial statements restated for the pooling-of-interests does not satisfy the requirement to furnish the registrant's financial statements. II. Subsequent to release of post-combination financial information After post-combination financial information has been published, the financial statements required in registration statements and proxies are the complete set of audited financial statements (not supplemental) that give retroactive effect to the pooling-of-interests. A Form 10-K reporting on the year ending prior to the consummation date of the pooling-of-interests must include the registrant's historical financial statements, without giving effect to the pooling-of-interests, even if post- combination operating results have been published prior to filing the Form 10-K. Inclusion of audited supplemental financial statements in the Form 10-K is encouraged, but not required. Interim reports on Form 10-Q and other interim financial statements filed for periods ending after consummation should be presented on a basis that retroactively reflects the pooling-of-interests for all periods presented. Prior Exchange Act filings reporting on periods ending before consummation of the merger should not be amended, although the registrant may elect to furnish recast information for earlier periods in accordance with the guidance in this section. Discontinued Operations If a registrant is required to include financial statements in a registration statement or proxy as of a date on or after the date the management adopts a qualifying plan to discontinue a business segment (the measurement date), restatement of all periods prior to the measurement date in accordance with APB 30 is required. This guidance is applicable even where the filing incorporates by reference annual audited financial statements issued prior to the measurement date. The auditor's consent to incorporation of those financial statements in a registration statement or proxy is deemed a reissuance that requires consideration of the effects of subsequent events. Moreover, the financial statements prepared by management and included in the filing are required to comply with GAAP at the date of effectiveness or mailing, necessitating restatement pursuant to APB 30. Stock Splits Stock splits also require retroactive presentation. Ordinarily, the staff would not require the restatement of previously filed financial statements that are incorporated by reference into a registration statement or proxy for reasons solely attributable to a stock split. In lieu thereof, the staff will accept inclusion of selected financial data which includes relevant per share information for all periods, with prominent disclosure of the stock split. * * * * *