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By Leonard Weinstock

W hen a public corporation makes its first acquisition, it is often surprised to find the Securities and Exchange Commission has rules that under certain conditions require the filing of audited financial statements of the acquired business in a Form 8-K. Based on certain measurements, audited statements for periods of up to three years may be required. These rules apply whether the acquisition is a "pooling-of-interests" or a "purchase," or is in the form of an asset purchase or acquisition of capital stock. The Form 8-K filing is due 15 days after the date of closing of the transaction, although an extension for up to 60
days from the due date of the original Form 8-K can be obtained if the audited financial statements are not readily

By being aware of these requirements, a registrant and its advisors can plan to obtain the audited financial statements and other data from the selling parties, usually at less cost and with less time pressure. It is not unusual for the purchase or merger agreement to contain a provision that the selling party will provide the specified financial statements for the Form 8-K as a condition of the deal. Also, if the cost of obtaining a preexisting auditor's report can be structured at the seller's expense, it can sometimes be obtained at a lower cost, even if the seller is ultimately reimbursed.

Is It a Business?

The first step in deciding whether audited financials are required is sometimes a subjective one. A decision must be made based on the prevailing facts and circumstances as to whether the acquisition constitutes a "business." Often it is obvious that a business has been acquired. Sometimes, however, this is not the case when some, but not all, of the assets of an entity have been acquired. Guidance on deciding what constitutes a business is provided in Rule 11-01(d) of Regulation S-X, which states that while there is a presumption a separate entity, subsidiary, or division is a business, a lesser component of an entity may still constitute a business if--

* the nature of the revenue-producing activity of the component will remain generally the same as before the transaction; or

* any of the following attributes remain with the component after the transaction:

* physical facilities,

* customer base,

* employee base,

* operating rights,

* market distribution system,

* production techniques,

* sales force, or

* trade names.

If in doubt whether a business is being acquired, a call to the SEC for a discussion of the issue can often resolve the matter. While some members of the SEC staff have publicly stated they tend to be liberal in interpreting this rule, it is the author's observation that the opposite is more often the case. So when in doubt, call the SEC.

Significant Subsidiary Tests

Once it has been determined that a business has been acquired, the requirement for audited statements is based on a measure of the significance of the acquired business to the registrant. These are referred to as the "significant subsidiary" tests. There are three independent measurements that must be made:

* The registrant's investment in the acquired business (i.e., its cost plus any advances) as compared with the registrant's total assets as at the end of its last fiscal year;

* Total assets of the acquired business at its last fiscal year-end, as compared with the registrant's total assets as at the end of its last fiscal year; and

* Pretax earnings or loss from continuing operations of the acquired business for its last full fiscal year, as compared with the registrant's pretax earnings or loss from continuing operations for its last full fiscal year.

If any of these tests exceed the percentages stated below, audited financial statements are required for inclusion in a Form 8-K filing as follows:

* 10% up to 20%--one year's complete set (balance sheet, statement of operations, and cash-flows statement).

* 20% up to 40%--two years' complete set

* Over 40%--latest two years' balance sheets, plus three years' statements of operations and cash flows.

If the registrant completes a series of smaller acquisitions in any fiscal year for which individual audited statements are not required based on the above measurements, they must be aggregated and remeasured to see if, in total, they would constitute a significant subsidiary. If, in the aggregate, these exceed 20% for any of the foregoing bases of measurement, audited financial statements covering at least the substantial majority of the businesses acquired, combined if appropriate, must be provided for at least the most recent fiscal year.

These tests are made by using the financial statements of the acquired businesses as at and for their latest full fiscal years as compared with the registrant's most recent annual statements filed at or prior to the acquisition date. However, if the registrant makes previous "significant" acquisitions in a year for which audited financial statements were obtained and filed in a Form 8-K, the above computations can be made using pro forma statements that combine the previous acquisitions with the registrant's prior year amounts. This, in effect, will raise the computational base for some of the measurement factors as the year progresses.

Attached is a decision tree in the form of a flow chart that illustrates the foregoing. Also attached is an exhibit that is an example of how this flow chart would work using a hypothetical assumption that the registrant's 1995 year-end financial statements reflect total assets of $120 million and pretax earnings of $15 million.

Other Observations

Absolute Numbers. The earnings tests are made on the basis of absolute numbers, regardless of whether either or both are positive (profits) or negative (losses).

Some Flexibility. A registrant can substitute its five-year average pretax earnings from continuing operations (excluding any loss years) in performing the earnings tests, if this produces a greater measurement base.

Small Business Issuers. Different rules exist for small business issuers subject to Regulation S-B. Here the three-step significant subsidiary tests still apply but only at the 10% level. The registrant, however, needs to obtain the latest year-end audited balance sheet and two years' audited statements of operations and cash flows. Also, if previous financial statements have not been audited at the date of acquisition, there is an automatic waiver of the audit requirement if none of the significant subsidiary tests exceeds 20%; if any of the tests exceed 20% but are less than 40%, only one year's audited statements of operations and cash flows are required.

Foreign Entities. If the acquired entity is located in a foreign country, the audited financial statements can be stated in foreign currency and be presented under the generally accepted accounting principles of that country. However, the reconciliations with U.S. GAAP required under item 17(c)(2) of the instructions to Form 20-F must be included with, or in a note to, the financial statements, or a statement must be made that there are no material differences between the application of the foreign GAAP and U.S. GAAP. Also, the foreign auditor's report should state that U.S. generally accepted auditing procedures were applied in their performance of the audit and state the basis of preparation, if other than U.S. GAAP.

Obstacles to Obtaining Audited Financials. In some instances it is truly impossible (as opposed to very costly) to obtain audited financial statements. The SEC will grant a waiver of the audit requirements but this must be applied for. In instances where it is possible but impractical to obtain audited financial statements at a reasonable cost, a waiver request will be denied, but the SEC will agree to take "no action" with respect to the nonfiling. Any such request, however, should be made with extreme caution and with the advice of legal counsel. This situation will result in the inability to enter into certain future securities registrations until such time as the registrant's financial statements contain the acquired entity's results of operations for the number of years subject to the audit requirement.

Audit Costs. Some auditors, knowing they are being terminated as a result of their client being acquired, take advantage of the 8-K audit requirement and charge higher fees to reissue their audit report. If the purchase agreement is structured so the cost of obtaining the auditor's report is a seller's expense, it might be obtained at less cost. This may be especially true if the seller will have some continuing relationship with its former auditor or would otherwise be in a position to exercise influence. Often, the purchaser has no leverage with the seller's auditors and has to pay whatever is demanded.

Other Filings Have Different Rules

The foregoing is a summary of a series of rather complex rules and does not cover the inclusion of unaudited historical and pro forma financial data and financial statements of acquired or to-be-acquired businesses in other SEC filings, such as registration statements. Reference should be made to the rules of the particular form, to Regulation S-X or S-B, and to interpretations in Staff Accounting Bulletins. *

Leonard Weinstock, CPA, is director of accounting and auditing services for Cornick, Garber & Sandler, LLP and is former chairman of the SEC Practice Committee of the New York State Society of CPA's.


John F. Burke, CPA

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