If the transaction is a sale of a preexisting legal entity, and is not an IPO or spin transaction, then the determination of whether the legal entity or management approach should be used is based on whether the divested business represents “substantially all” of the legal entity.
SEC FRM 2065.1 through
SEC FRM 2065.2 provide the guidance for this evaluation. If the divested business represents “substantially all” of the legal entity, the entity should apply the legal entity approach. If the divested business does not represent “substantially all” of the legal entity, the entity should apply the management approach.
SEC FRM 2065.1 Acquire Substantially All of an Entity –
If the registrant acquires or succeeds to substantially all of the entity's key operating assets, 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 these circumstances, 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.
SEC FRM 2065.2 Acquire Less than Substantially All of an Entity –
In some circumstances, a registrant does not acquire or succeed to substantially all of the assets and liabilities of another entity. For example, the selling entity may retain significant operating assets, or significant operating assets that comprised the seller may continue to be operated by an entity other than the registrant. In these circumstances, financial statements of the larger entity of which the acquired business was a part may not be informative. In that case, audited financial statements usually should be presented for the acquired component business, excluding the continuing operations retained by the larger entity. Registrants should evaluate their facts and circumstances to determine whether to apply the guidance in Section 2065.3 (carve-out financial statements) or in Sections 2065.4 through Section 2065.12 (abbreviated financial statements).
There is not a bright line test to make the substantially all assessment. Rather, it requires judgment and is based on the particular facts and circumstances. The analysis might consider a comparison of financial metrics (such as total assets, revenue, operating income, pre-tax income, operating cash flows being disposed versus remaining) and operating metrics, like total stores.
Example CO 2-3 illustrates the appropriate approach when a sale constitutes substantially all of a legal entity.
EXAMPLE CO 2-3
An acquisition of “substantially all” of a legal entity
Company A, an existing SEC registrant, owns and operates a national chain of convenience stores. Company A will acquire the shares of Acquiree B (a legal entity) in February 20x1 in a transaction that will be accounted for as an acquisition of a business in accordance with
ASC 805,
Business Combinations. Acquiree B owns and operates a national chain of 100 convenience stores. In January, prior to its acquisition by Company A, Acquiree B transfers 5 stores that are not being acquired by Company A to Acquiree B’s shareholder. The 95 stores remaining in Acquiree B represent approximately 95% of the key operating assets of Acquiree B prior to its acquisition. The acquisition of Acquiree B and the remaining stores is significant to Company A and requires financial statements under
Regulation S-X Rule 3-05.
How should the 5 stores not being acquired be reflected in Acquiree B’s 20x0 financial statements?
Analysis
In preparing financial statements under
Regulation S-X Rule 3-05, Company A would present separate financial statements of Acquiree B including all 100 stores in its
Form 8-K because Company A has acquired “substantially all” of Acquiree B’s key operating assets. The elimination of the remaining assets and liabilities not acquired (i.e., the 5 stores transferred prior to the acquisition by Company A) would be depicted in pro forma financial information in accordance with
Regulation S-X Article 11.
Example CO 2-4 illustrates the determination of the appropriate approach when a sale does not constitute substantially all of a legal entity.
EXAMPLE CO 2-4
An acquisition of “less than substantially all” of a legal entity
Company A, an existing SEC registrant, owns and operates a national chain of convenience stores. Company A will acquire the shares of Acquiree B (a legal entity) in a transaction that will be accounted for as an acquisition of a business in accordance with
ASC 805. Acquiree B owns and operates a national chain of 100 convenience stores. Prior to its acquisition by Company A, Acquiree B will transfer 60 stores that are not being acquired by Company A to Acquiree B’s shareholder. The 40 stores remaining in Acquiree B represent approximately 40% of the key operating assets of Acquiree B prior to its acquisition. The acquisition of Acquiree B and the remaining stores is significant to Company A and requires financial statements under
Regulation S-X Rule 3-05.
How should the 60 stores not being acquired be reflected in Acquiree B’s financial statements?
Analysis
Given that the 60 stores not acquired by Company A represent significant operating assets retained by the seller, Company A would likely determine that the full financial statements of Acquiree B including all 100 stores would not be meaningful to the users of the financial statements. Rather, in preparing financial statements under
Regulation S-X Rule 3-05, Company A would present carve-out financial statements for the 40 stores of Acquiree B. The footnotes to the financial statements should disclose that they represent the financial statements of the acquired component of Acquiree B (i.e., the 40 stores acquired). The financial statements would not represent that they consist of the consolidated financial statements of legal Acquiree B since the consolidated financial statements of legal Acquiree B would include all 100 stores.