U.S. Financial Statements: A Guide for Non-U.S. Issuers

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1 U.S. Financial Statements: A Guide for Non-U.S. Issuers By Alexander Cohen, Kirk Davenport and Adam Cohen Latham & Watkins operates as a limited liability partnership worldwide with an affiliate in the United Kingdom and Italy, where the practice is conducted through an affiliated multinational partnership. This article is reprinted with permission from the August 3, 2003 issue of. Copyright

2 US financial statements: Co-published section Contents Page Summary 59 Background 59 Annual and interim financial statements 59 Audited annual financial statements 59 Unaudited interim financial statements 60 Selected financial information; capitalization 61 Reconciliation to US Generally accepted accounting principles (Gaap) 61 Annual audited and interim unaudited financial statements 61 Selected financial information 62 Management s discussion and analysis (MD&A) 62 The Sarbanes-Oxley Act: Non-Gaap financial measures and off-balance-sheet arrangements 62 Background 62 Non-Gaap financial measures 63 Off-balance sheet and other MD&A disclosure 63 Audit reports; currency translation 64 Audit reports 64 Currency translation 64 Financial statements of recent and probable acquisitions; pro forma financial information 65 General 65 Financial statement requirements 66 Operating real estate 66 MD&A 67 Pro forma financial information 67 Reconciliation to US Gaap 67 Guarantor financial statements 67 Investments accounted for under the equity method 70 Industry guides and other transaction-specific guidance 70 Industry guides 70 Supplemental schedules for certain transactions 70 Special requirements for public offerings 71 Item 17 and Item Segment reporting 71 Coverage ratios 72 Financial statements for secured offerings 72 Other customary information 72 Special considerations in Rule 144A transactions 73 Conclusion 73 58

3 Co-published section US financial statements: Summary The most frequently asked question at all-hands meetings is What financial statements are needed? That seemingly simple question can prove very complicated to answer. This guide provides a roadmap to the financial statement requirements that apply when a foreign private issuer 1 (a term that covers most non-us issuers other than foreign governments) offers securities to the public in the US, lists its securities for trading in the US or files a US annual report. 2 We also briefly discuss financial statements in connection with Rule 144A transactions. (For ease of illustration, we have assumed that the issuer s fiscal year is the calendar year.) Background When a foreign private issuer makes a public offering in the US, it must generally file a registration statement with the US Securities and Exchange Commission (SEC) and distribute a prospectus (which is part of the registration statement). Similarly, listings or quotations on a US stock market require filing a registration statement with the SEC. Once public, a foreign private issuer is required to file an annual report on Form 20-F with the SEC. Registration statements and annual reports must contain a basic package of financial statements and other financial information. The US Securities Act of 1933, as amended (Securities Act), the US Securities Exchange Act of 1934, as amended (Exchange Act) and the related rules and regulations under these statutes detail the disclosure requirements through the use of Forms (such as Forms F-1, F-3 and 20-F). The Forms not only contain their own disclosure requirements, but also specify certain items that must be disclosed under Securities Act Regulation S-K (which governs disclosure other than financial statements) and Securities Act Regulation S-X (S-X) (which governs financial statements). Although the requirements of the Securities Act and the Forms are not strictly applicable to private offerings in the US that involve resales under Rule 144A, it has become standard practice to follow many of these requirements in Rule 144A offerings, with certain exceptions discussed below. Annual and interim financial statements Audited annual financial statements What must be provided? Consolidated annual financial statements of the issuer, audited by an independent auditor and accompanied by an audit report, consisting of: 3 balance sheet; income statement; statement of changes in equity; cash flow statement; related notes and schedules required by the system of accounting standards under which the financial statements were prepared; and if not included in the primary financial statements, a note analyzing the changes in each caption of shareholders equity presented in the balance sheet. Note that separate financial statements may need to be included for guarantors, and both separate financial statements and certain pro forma financial information may be required for acquired entities. (See sections entitled Financial statements of recent and probable acquisitions; pro forma financial information and Guarantor financial statements, below.) 59

4 US financial statements: Co-published section How many years must be included? Audited financial statements must cover each of the latest three financial years, 4 except that: if the issuer has been in existence less than the prescribed number of years, it is enough to provide information for the life of the issuer and its predecessors; 5 if a jurisdiction outside the US does not require a balance sheet for the earliest year of the three-year period, that balance sheet may be omitted; and 6 in an initial registration statement, if the financial statements are presented in accordance with US Gaap (rather than reconciled to US Gaap), the earliest of the three years of financial statements may be omitted if that information has not previously been included in a filing made under the Securities Act or the Exchange Act. 7 In addition, whenever audited financial statements are required for a period of one, two or three years, under S-X Rule 3-06 a single audited period of nine to 12 months may count as a year if: the issuer has changed its fiscal year during the period; the issuer has made a significant business acquisition for which financial statements are required under S-X Rule 3-05 (discussed below) and the financial statements covering the interim period pertain to the business being acquired; or the SEC grants permission to do so under S-X Rule 3-13, provided that financial statements are filed that cover the full fiscal year or years for all other years in the time period (note, however, that this permission is rarely granted). Under S-X Rule 3-06, the SEC will accept financial statements for periods of not less than nine, 21 and 33 consecutive months as substantial compliance with the requirement to provide financial statements for one, two and three years, respectively. How old can the financial statements be? 8 The last year of audited financial statements cannot be more than 15 months old at the time of the offering or listing, except: in the case of a registration statement relating to an initial public offering, the audited financial statements must be as of a date not older than 12 months prior to the time the document is filed; 9 and in the case of a registration statement relating to an offering of securities: (1) upon the exercise of outstanding rights granted pro rata to all existing security holders of the applicable class; (2) pursuant to a dividend or interest reinvestment plan; or (3) upon the conversion of outstanding convertible securities or upon the exercise of outstanding transferable warrants, the financial statements may be up to 18 months old. 10 Unaudited interim financial statements What must be provided? If a registration statement becomes effective more than nine months after the end of the last audited financial year, the issuer must also provide consolidated interim financial statements. (Interim financial statements are not required for annual reports.) Those financial statements: 11 may be unaudited, but must either be reconciled to, or prepared in accordance with, US Gaap; must cover at least the first six months of the financial year, unless the issuer publishes more current interim information, in which case that information must be included; should include a balance sheet, income statement, cash flow statement, statement of changes to equity and selected note disclosures; 60

5 Co-published section US financial statements: What must be provided? (continued) may be in condensed form, as long as they contain the major line items from the latest audited financial statements and include the major components of assets, liabilities and equity (in the case of the balance sheet); income and expenses (in the case of the income statement); and the major subtotals of cash flows (in the case of the cash flow statement); and should include comparative interim statements for the same period in the prior financial year, except that the requirement for comparative balance sheet information may be met by presenting the year-end balance sheet. The SEC encourages (but does not require) issuers to have an independent auditor review the interim financial statements. If a review is carried out and is referred to in the registration statement, a copy of the interim review report must be included in the document. 12 Selected financial information; capitalization Selected financial information The issuer must include selected historical financial income statement and balance sheet data for each of the last five fiscal years. 13 However, selected financial data for either or both of the two earliest years may be omitted if the issuer represents to the SEC in the review process that this information cannot be provided, or cannot be provided on a restated basis, without unreasonable effort or expense. 14 If interim financial statements are included, the selected financial data should be updated for that interim period (which may be unaudited, if that fact is stated) and comparative data from the same period in the prior financial year should be provided, except that the requirement for comparative balance sheet data may be met by presenting the year-end balance sheet information. 15 Statement of capitalization and indebtedness The issuer must include a statement of capitalization and indebtedness as of a date no earlier than 60 days prior to the date of the registration statement. 16 (Annual reports need not include a statement of capitalization and indebtedness.) 17 The capitalization statement must show the issuer s capitalization on an actual basis and, if applicable, adjusted to reflect the sale of the securities being issued and the intended use of proceeds of the issuance. The capitalization statement should distinguish between guaranteed and unguaranteed, and secured and unsecured, indebtedness. Reconciliation to US Gaap Annual audited and interim unaudited financial statements The annual audited and interim unaudited financial statements of a foreign private issuer included in a registration statement or an annual report may be prepared using either US Gaap, local homecountry Gaap or international accounting standards (IAS). 18 If local Gaap or IAS is used in the preparation of the financial statements, the consolidated financial statements (both annual and interim) must include a reconciliation to US Gaap. 19 The reconciliation comprises both disclosure of the material variations between local Gaap or IAS and US Gaap, as well as a numerical quantification of those variations. 20 A foreign private issuer registering for the first time must reconcile only the two most recently completed fiscal years (and any interim period). 21 The following items frequently require discussion and quantification as a result of the reconciliation requirements: business combinations; stock compensation; restructuring charges; 22 impairments; deferred or capitalized costs; investments; foreign currency translations; deferred taxes; pensions; derivatives; research and development; and revenue recognition. 23 In particular: With respect to income statements, net income is reconciled in a tabular format, on the face of the income statement or in a note to the income statement. Each material variation must be described and quantified as a separate reconciling item, although several material variations may be combined on the face of the income statement if shown separately in a note. 24 Earnings per share computed according to US Gaap must be included if materially different from earnings per share under local Gaap or IAS

6 US financial statements: Co-published section With respect to balance sheets, a reconciliation must be prepared for any line item that would have been materially different had that item been prepared using US Gaap. 26 With respect to cash flow statements, for each period for which an income statement is presented and reconciled, a cash flow statement prepared in accordance with US Gaap or International Accounting Standard No. 7 must be included or, alternatively, an explanatory note to the financial statements must be included that describes the differences that would have resulted if the information had been prepared using US Gaap. 27 defaults on debt and material restrictions on dividends or other legal constraints on the use of assets; material changes in the relative amounts of constituent elements comprising line items presented on the face of the financial statements; significant terms of financings which would reveal material cash requirements or constraints; material subsequent events, such as events that affect the recoverability of recorded assets; Selected financial information Like the annual and interim financial statements, the required selected financial information may also be prepared using US Gaap, local Gaap or IAS. 28 A reconciliation to US Gaap of local Gaap or IAS selected financial information must generally be provided for all five years covered by the selected financial information (and any interim periods). 29 First-time registrants, however, need only prepare reconciliations for the two most recent years (and any interim periods). 30 In that case, an additional year of reconciliation is required for each year following the initial offering in subsequent annual reports. 31 In addition, if a foreign private issuer prepares its primary financial statements in accordance with US Gaap (rather than reconciling to US Gaap), it may present the five years of selected financial information under local Gaap or IAS without reconciliation, 32 although the SEC staff will require at least two years of selected financial data under US Gaap (and will require the full five years if the earliest three years are available under US Gaap). 33 Management s discussion and analysis A foreign private issuer s management s discussion and analysis (MD&A) disclosure should focus on its primary financial statements, whether those statements are prepared in accordance with US Gaap, local Gaap or IAS. 34 To the extent those statements are prepared under local Gaap or IAS, a discussion should be included of the reconciliation to US Gaap and any differences between local Gaap or IAS and US Gaap not otherwise discussed in the reconciliation and needed for an understanding of the financial statements as a whole. 35 Even if a foreign private issuer prepares its financial statements under Item 17 rather than the more extensive requirements of Item 18, some disclosures routinely made under US Gaap may rise to a level of materiality requiring disclosure in MD&A. 36 (For a discussion of the differences between Item 17 and Item 18, see the section entitled Special requirements for public offerings Item 17 and Item 18, below.) These include: 37 material undisclosed uncertainties (such as reasonably possible loss contingencies 38 ), commitments (such as those arising from leases) and credit risk exposures and concentrations; material unrecognized obligations (such as pension obligations); material changes in estimates and accounting methods, and other factors or events affecting comparability; material related-party transactions that may affect the terms under which material revenues or expenses are recorded; and significant accounting policies and measurement assumptions not disclosed in the financial statements, including methods of costing inventory, recognizing revenues and recording and amortizing assets, which may bear upon an understanding of operating trends or financial condition. The Sarbanes-Oxley Act: Non-Gaap financial measures and off-balance sheet arrangements Background On July , US president George W Bush signed into law the US Sarbanes-Oxley Act of 2002, which he called the most far-reaching reforms of American business practice since the time of Franklin Delano Roosevelt. The Sarbanes-Oxley Act applies to all issuers including foreign private issuers that: have registered securities under the Exchange Act; are required to file reports under Section 15(d) of the Exchange Act; or have filed a registration statement under the Securities Act that has not yet become effective. 39 This means that any foreign private issuer that has listed its securities in the US, or issued securities to the public in the US whether or not listed (for example, in a registered exchange offer for high-yield bonds) is subject to the Sarbanes-Oxley Act. A foreign private issuer that has not sold securities to the public in the US, or that has fewer than 300 US shareholders, or that is exempt from Exchange Act registration by virtue of Exchange Act Rule 12g3-2(b) is not subject to the requirements of the Sarbanes- Oxley Act. Accordingly, when we refer in this section to issuers and foreign private issuers we mean those companies that are subject to Sarbanes-Oxley. The Sarbanes-Oxley Act has wide-ranging implications for issuers. We summarize below two key provisions of Sarbanes- Oxley relating to financial disclosure. 62

7 Co-published section US financial statements: Non-Gaap financial measures Section 401(b) of the Sarbanes-Oxley Act requires the SEC to issue rules limiting the use of pro forma financial information in various ways. In response, the SEC has adopted both a new disclosure regulation, Regulation G, and new rules applicable to disclosure in filings with the SEC under Item 10 of Regulation S- K. 40 The SEC has chosen to refer in the rules to non-gaap financial measures rather than pro forma financial information, to avoid confusion with existing SEC rules on pro forma financial information (such as Article 11 of Regulation S-X). 41 Regulation G Regulation G applies whenever an issuer, or a person acting on its behalf, publicly discloses material information that includes a non-gaap financial measure. 42 Non-Gaap financial measure is broadly defined as a numerical measure of financial performance that excludes (or includes) amounts that are otherwise included (or excluded) in the comparable measure calculated and presented in the financial statements under Gaap. 43 For a foreign private issuer, Gaap means the local Gaap under which the financial statements were prepared, unless the measure in question is derived from US Gaap, in which case Gaap means US Gaap for purposes of applying the requirements of Regulation G to the disclosure of the measure. 44 Regulation G requires that disclosure of this sort be accompanied by the most directly comparable financial measure calculated in accordance with Gaap, and a reconciliation of the differences between the two. 45 In addition, Regulation G prohibits an issuer from making any non-gaap financial measure public if it contains a material misstatement or omits to include information needed to make the included measure not misleading. 46 Regulation G took effect on March A foreign private issuer is exempt from Regulation G if: 48 its securities are listed or quoted outside the US; the non-gaap financial measure being used is not derived from or based on a measure calculated and presented in accordance with US Gaap; and the disclosure is made outside the US. Regulation S-K Item 10(e) Distinct from Regulation G, the SEC has adopted limitations on the use of non-gaap financial measures in filings (whether annual reports on Form 20-F, or registration statements in connection with offerings in the US or US listings) as new Item 10(e) of Regulation S-K. Item 10(e) applies to any SEC filings made in respect of financial years ended after March Item 10(e) requires that whenever an issuer includes a non-gaap financial measure in an SEC filing it must also include: 50 a presentation, with equal or greater prominence, of the most directly comparable Gaap financial measure; a reconciliation of the differences between the non-gaap financial measure and the most directly comparable Gaap financial measure; a statement why management believes the non-gaap financial measure provides useful information for investors; and to the extent material, a statement of the additional purposes for which management uses the non-gaap financial measure. Furthermore, Item 10(e) prohibits in SEC filings, among other things: 51 non-gaap measures of liquidity that exclude items requiring cash settlement, other than earnings before interest and tax (Ebit) and earnings before interest, tax, depreciation and amortization (Ebitda); the adjustment of non-gaap measures of performance to eliminate or smooth items characterized as non-recurring, unusual or infrequent when the nature of the charge or gain is such that it is reasonably likely to recur within two years or there was a similar charge or gain within the prior two years; and the use of titles or descriptions for non-gaap financial measures that are the same as, or confusingly similar to, titles or descriptions used for Gaap financial measures. Item 10(e) contains an exemption from these prohibitions for a foreign private issuer if the non-gaap financial measure relates to the local Gaap used in the issuer s primary financial statements, is required or expressly permitted by the standard-setter that establishes the local Gaap, and is included in the issuer s annual report for its home jurisdiction. 52 Off-Balance sheet and other MD&A disclosure Section 401(a) of the Sarbanes-Oxley Act requires the SEC to implement rules requiring issuers to disclose material off-balance sheet transactions. The SEC s rules go beyond off-balance sheet transactions, however, and also address certain topics covered in its prior MD&A initiatives. 53 The rules take the form of amendments to Item 5 of Form 20-F, and accordingly apply to all registration statements filed by foreign private issuers (whether under the Securities Act or Exchange Act), as well as annual reports. Off-balance sheet arrangements Effective for SEC filings for fiscal years ending on or after June , 54 an issuer must disclose, in a separately captioned section of MD&A, off-balance sheet arrangements that either have, or are reasonably likely to have, a current or future material effect on the issuer s financial condition, results of operations, or liquidity. 55 To the extent necessary to understand these arrangements, the disclosure must include: 56 the nature and business purpose of the off-balance sheet arrangements; the importance to the issuer of the off-balance sheet arrangements in respect of liquidity, capital resources, market risk support, credit support or other benefits; 63

8 US financial statements: Co-published section the amount of revenues, expenses and cash flows arising from these arrangements; the nature and amounts of any interests retained, securities issued or amounts incurred by the issuer under these arrangements; the nature and amounts of any other obligations or liabilities (contingent or otherwise) arising from these arrangements that are reasonably likely to become material and the triggering events that could cause them to arise; and any known events or trends that will, or are reasonably likely to, result in the termination or reduction in availability to the issuer of these arrangements and the course of action the issuer proposes to take in response. An off-balance sheet arrangement is defined to include any transaction, agreement or contractual arrangement to which an entity unconsolidated with the issuer is a party under which the issuer has certain obligations or interests. 57 Because the definition of offbalance sheet arrangement incorporates concepts from US Gaap, foreign private issuers will need to refer to US Gaap for some of the disclosure items. 58 However, the MD&A disclosure should focus on the primary financial statements in the document (while taking reconciliation to US Gaap into account). 59 Table of contractual obligations For fiscal years ending on or after December , 60 an issuer must also include in its SEC filings a table of contractual obligations as of the end of the latest balance sheet date showing the items listed in the table at the bottom of this page. 61 The term purchase obligations means an enforceable agreement to purchase goods or services that is binding on the issuer and that specifies key commercial terms (such as quantity and price). 62 With the exception of purchase obligations, the classifications of categories shown in the table are defined by reference to US Gaap. However, an issuer that prepares financial statements in accordance with non-us Gaap should include those items of contractual obligations in the table that are consistent with the classifications used in the Gaap under which its primary financial statements are prepared. 63 Contingent liabilities and commitments Although it has issued proposed rules with respect to disclosure requirements for contingent liabilities and commitments, the SEC has declined to adopt final rules. In the meantime, the SEC s existing guidance on the subject which suggests a tabular format of specified categories 64 is controlling. 65 Audit reports; currency translation Audit reports Audited financial statements must be accompanied by an audit report, covering each of the audited periods. 66 The audit report must include, among other things, the opinion of the responsible accountant as to (1) the financial statements covered by the report and the accounting practices and principles set forth in those financial statements and (2) the consistency of the application of the accounting principles used. 67 Any matter that the responsible accountant takes exception to must be clearly identified. 68 The SEC will generally not accept an audit report containing a disclaimer or qualification. 69 In addition, the SEC takes the view that financial statements requiring a qualification in the audit report as to compliance with the applicable body of accounting standards do not meet the requirements for SEC filings, regardless of whether the primary basis for accounting is US Gaap, local Gaap or IAS. 70 Note that the audit report must state that the audit has been conducted in compliance with US Generally accepted auditing standards (Gaas), even for non-us Gaap financials. 71 The auditor must also meet US standards for independence. 72 Currency translation Foreign private issuers may state amounts in their financial statements in any currency they deem appropriate (the reporting currency). 73 However, only one currency may be used as reporting currency. 74 The reporting currency must be prominently disclosed on the face of the financial statements. 75 The issuer must also disclose if dividends will be paid in a different currency and any material exchange restrictions or controls relating to the reporting currency, the currency of the issuer s domicile or the currency in which dividends will be paid. 76 If the reporting currency is not the US dollar, US dollarequivalent financial statements or convenience translations must not be included, except that an issuer may present a translation of the most recent fiscal year and any subsequent interim period. 77 The exchange rate used for any convenience translations should Contractual obligations Long-term debt obligations Capital (finance) lease obligations Operating lease obligations Purchase obligations Other long-term liabilities reflected on the issuer s balance sheet under the Gaap of the primary financial statements Total Payments due by period Total Less than More than 1 year years years 5 years 64

9 Co-published section US financial statements: be as of the most recent balance sheet date included in the registration statement, except where the exchange rate of the most recent practicable date would yield a materially different result. 78 The SEC will allow an issuer to recast its previously reported financial statements for periods prior to January into euros, using the exchange rate between the euro and the prior reporting currency fixed on January In addition, issuers that do not prepare their financial statements in US dollars must provide disclosure of the exchange rate between the reporting currency and the US dollar. 80 That disclosure should show: the exchange rate at the last practicable date; the high and low exchange rates for each month during the previous six months; and for the five most recent financial years, and any subsequent interim period covered by the financial statements, the average rates for each period (based on the average exchange rates on the last day of each month during the period). 81 Financial statements of recent and probable acquisitions; pro forma financial information General In addition to financial statements of the issuer, S-X Rule 3-05 generally requires the inclusion in registration statements for public offerings or US listings (but not annual reports) 82 of audited financial statements for a significant acquisition of a business that has closed, or as soon as the acquisition becomes probable in cases where the transaction is at the highest level of significance (as discussed below). Furthermore, where a material acquisition has occurred or is probable, S-X Rule generally requires pro forma financial information in the registration statement for the most recent fiscal year and most recent interim period. The term business is defined in S-X Rule 11-01(d) to include an operating entity or business unit, but excludes machinery and other assets that do not generate a distinct profit or loss stream. 83 Acquisitions of related businesses are treated as a single acquisition for purposes of the significance tests. Businesses are considered related if they are owned by a common seller, under common management, or their acquisitions are conditional upon each other or a single common event. The term probable is interpreted to mean more likely than not. The SEC Staff has taken the view that an acquisition becomes probable upon the signing of a letter of intent. 84 Whether financial statements for recent and probable acquisitions must be included in the filing also depends upon the significance of the acquisition. Significance of an acquired business is evaluated under S-X Rule 1-02(w) based upon three criteria: the amount of the issuer s investment in the acquired business compared to the issuer s total assets; the total assets of the acquired business compared to the issuer s total assets; and the pre-tax income 85 of the acquired business compared to the issuer s pre-tax income; in each case, based on the issuer s most recent audited financial statements. 86 The amounts used are determined on the basis of US Gaap rather than local Gaap or IAS (as used by the issuer or the acquired company). 87 Generally: if the acquired business exceeds 20% of any of the three significance criteria, then one year of audited financial information is required, as well as the interim financial information that would be required for the issuer; if it exceeds 40%, then two years of audited and interim financial information is required; and if it exceeds 50%, three years of audited and interim financial information is required. 65

10 US financial statements: Co-published section Financial statement requirements The table below summarizes the financial statement requirements in connection with acquisitions. Acquisition scenario Individual acquisition below the 20% significance level. Individual acquisition (or multiple acquisitions of related businesses, as described above) in excess of the 20% significance level, but below the 40% level. Multiple acquisitions of unrelated businesses below the 20% significance level individually, but aggregating in excess of the 50% level of significance. Individual acquisition (or multiple acquisitions of related businesses, as described above) in excess of the 40% significance level, but below the 50% level. Individual acquisition above the 50% significance level. Securities being registered in an offering to stockholders of the acquired company (such as a stock-for-stock merger). Reporting requirement No requirement to include audited financials. Audited financials for the most recent fiscal year and unaudited financials for any interim periods will be required, as specified in S-X Rules 3-01 and Audited financials for the most recent fiscal year and any interim periods required for a substantial majority of the individually insignificant acquisitions required Audited financials for the two most recent fiscal years (including one balance sheet) and any interim periods required. Three years of audited financial statements (including two balance sheets) and any interim periods required for all completed and probable acquisitions at this level of significance. However, financial statements for the earliest of the three fiscal years required may be omitted if net revenues reported by the acquired business in its most recent fiscal year are less than $25 million. Three years of financial statements (including two balance sheets) of the business to be acquired in the transaction are generally required and in most cases the most recent fiscal year must be audited. 88 One notable exception to these rules is that below the 50% significance level, no audited financial statements are required in a registration statement for probable acquisitions or for completed acquisitions consummated up to 74 days before the date of the offering. 89 However, industry practice is to include financials for any acquisition above the 20% threshold as soon as it has become probable and the commitment committees of most investment banks will probably require at least a one-year audit, even if the 74- day grace period has not yet expired. Compliance with these rules is also facilitated by the S-X Rule 3-06 exception that allows a single audited period of nine to 12 months to count as a year for an acquired business. Staff Accounting Bulletin Number 103 (SAB 103) provides a special interpretation of S-X Rule 3-05 for initial public offerings involving businesses that have been built by the aggregation of discrete businesses that remain substantially intact after acquisition (that is, industry roll-ups). (SAB 103 recodifies, with slight modifications, prior Staff Accounting Bulletin 80.) SAB 103 allows firsttime issuers to consider the significance of businesses recently acquired or to be acquired based on the pro forma financial information for the issuer s most recently completed fiscal year. While compliance with this interpretation requires an application of SAB 103 s guidance and examples on a case-by-case basis, the policy is to allow currently insignificant business acquisitions to be excluded from the financial statement requirements while still ensuring that the registration statement will include not less than three, two and one year(s) of financial statements for not less than 60%, 80% and 90%, respectively, of the constituent businesses of the issuer. 90 Note that the permitted age of financial statements of acquired or soon-to-be acquired businesses is the same as for the issuer itself. 91 This means, for example, that the audited annual financial statements of the acquired business may not be more than 15 months old (with certain exceptions noted above under the section entitled Annual and interim financial statements audited annual financial statements). Notwithstanding the requirements outlined above, under S- X Rule 3-05(b)(4)(iii), separate financial statements for the acquired business do not need to be presented once the operating results of the acquired business have been reflected in the issuer s audited consolidated financial statements for a complete fiscal year (a full audit cycle) unless the financial statements have not been previously filed by the issuer or unless the acquired business is of such significance to the issuer that omission of such financial statements would materially impair an investor s ability to understand the historical financial results of the registrant. 92 Operating real estate The acquisition or probable acquisition of operating real estate is subject to an additional set of disclosure requirements under S-X Rule S-X Rule 3-14 addresses income-producing real estate such as apartment buildings and shopping malls. (In comparison, 66

11 Co-published section US financial statements: where real estate is incidental to the service provided by a business, such as a hotel, the S-X Rule 3-05 requirements would apply.) Generally, S-X Rule 3-14 requires that audited income statements must be provided for the three most recent fiscal years for any such acquisition or probable acquisition that would account for 10% or more of the issuer s total assets. S-X Rule 3-14 also prescribes certain variations from the typical form of income statement and allows for only one year of income statements to be provided if the property is not acquired from a related party and certain additional textual disclosure is made. 93 MD&A Whenever historical financial statements of an acquired business (or probable acquisition) are included in a registration statement, the issuer should consider whether a separate MD&A section discussing those financial statements is appropriate. 94 Although there is no specific line item requiring that a second MD&A be included, it is not uncommon for issuers to interpret Securities Act Rule as requiring a full discussion and analysis of the financial statements of an acquired business (or probable acquisition), particularly where it exceeds 50% on any of the three significance criteria discussed above. Pro forma financial information As noted above, whenever audited financials of an acquired business are required, S-X Article 11 requires: a combining pro forma balance sheet as of the end of the most recent period for which a consolidated balance sheet is required (unless the transaction is already reflected in that balance sheet); 96 and a pro forma income statement for the most recent fiscal year and the most recent interim period (unless the historical income statement reflects the transaction for the entire period). 97 The SEC will permit the inclusion of additional pro forma information that does not comply with S-X Article 11 if this information is required by a foreign regulator. 98 In that case, the issuer must indicate clearly what the presentation represents, state that the information does not comply with Article 11 and explain why the information is being included. 99 Guarantor financial statements A guarantee of a security (such as a guarantee of a debt or preferred equity security) is itself a security that must be registered, absent an applicable exemption. As a result, under S-X Rule 3-10(a), the general rule is that guarantors are required to present the same financial statements as the issuer of the guaranteed securities. 102 Fortunately, S-X Rules 3-10(b) (f) contain a number of important exceptions that permit issuers to disclose financial information about guarantors in a summary format using a footnote to their financial statements. 103 Although the footnote approach can involve a fair amount of effort, it is far less burdensome than providing separate audited financial statements for every guarantor, which would of course be prohibitively expensive in many cases. S-X Rules 3-10(e) and (f) go even further, dispensing with any additional information requirement for guarantors in the case of a parent company issuer that does not have independent assets or operations if all of the non-guarantor subsidiaries are minor. 104 US Gaap reconciliation is required in the footnote when the parent s financial information is prepared under a different set of accounting principles. 105 In the chart below, we review the provisions of S-X Rule 3-10 as they apply to the following five common situations: parent company issuer of securities guaranteed by one or more subsidiaries; operating subsidiary issuer of securities guaranteed by parent company; finance subsidiary issuer of securities guaranteed by parent company; subsidiary issuer of securities guaranteed by parent company and one or more other subsidiaries of parent company; and recently acquired subsidiary issuer or subsidiary guarantor. Reconciliation to US Gaap The financial statements provided for an acquired foreign business may be prepared using local Gaap or IAS, but must be reconciled to US Gaap when the acquired business is at or above the 30% level for any of the significance tests. 100 The pro forma financial information should either be prepared on a US Gaap basis, or on a local Gaap or IAS basis accompanied by a quantified reconciliation to US Gaap. 101 If financial statements for an acquired business are required, the acquired company s auditors may not be qualified (or willing) to have their audit report filed with the SEC. The auditors may also be unfamiliar with the procedures required under US Gaas. The additional work required to get those financial statements into compliant form can be a significant timing issue. 67

12 US financial statements: Co-published section Guarantee scenario 1. Parent company issuer of securities guaranteed by some or all of issuer s subsidiaries, where: the subsidiary guarantors are 100% owned 106 by the parent company issuer; the guarantee is full the amount of the guarantee may not be less than the underlying obligation; 107 the guarantee is unconditional holders must be able to take immediate action against the guarantor after a default on the underlying obligation; and the guarantees are joint and several (if there are multiple guarantors). 108 Financial statement requirements 1. No separate financial statements for subsidiaries required under S-X Rules 3-10(e) and (f) if the parent s financial statements are filed for the periods required and they include an audited footnote with condensed, consolidating financial information 109 for each such period, with separate columns for: the parent company; the subsidiary guarantor (or subsidiary guarantors on a combined basis); any non-guarantor subsidiaries on a combined basis; 110 consolidating adjustments; and total consolidated amounts. Note 2 to S-X Rule 3-10(e) and Note 1 to S-X Rule 3-10(f) allow a conditional exemption from providing the footnote if the parent company has no independent assets or operations, the nonguarantor subsidiaries are minor, and there is a footnote to this effect in the parent financial statements that also notes that the guarantees are full and unconditional and joint and several. Under S-X Rule 3-10(h)(5), a parent company has no independent assets or operations if each of its total assets, revenues, income from continuing operations before income taxes, and cash flows from operating activities (excluding amounts related to its investment in its consolidated subsidiaries) is less than 3% of the corresponding consolidated amount. 2. Operating subsidiary issuer of securities guaranteed by parent company, where: 111 the operating subsidiary issuer is 100% owned by the parent company guarantor; the guarantee is full and unconditional; and no other subsidiary of the parent is a guarantor. 2. No separate financial statements for operating subsidiary required under S-X Rule 3-10(c) if the parent s financial statements are filed for the periods required and they include an audited footnote with condensed, consolidating financial information 112 for each such period, with separate columns for: the parent company; the operating subsidiary issuer; any non-guarantor subsidiaries on a combined basis; 113 consolidating adjustments; and total consolidated amounts. This exception is also available if an operating subsidiary issuer meets these requirements except that the parent is a co-issuer with the subsidiary, rather than a guarantor. 68

13 Co-published section US financial statements: Guarantee scenario 3. Finance subsidiary issuer of securities guaranteed by parent company, where: 114 the finance subsidiary issuer is 100% owned by the parent company guarantor; the guarantee is full and unconditional; and no other subsidiary of the parent is a guarantor. Financial statement requirements 3. No separate financial statements for finance subsidiary required under S-X Rule 3-10(b) if the parent s financial statements are filed for the periods required and they include an audited footnote with: a statement that the finance subsidiary issuer is a 100% owned finance subsidiary of the parent and the parent has fully and unconditionally guaranteed the securities; and additional disclosure under S-X Rule 3-10(b)(4) relating to limitations on the ability of the issuer and guarantor to obtain dividends and loans from their subsidiaries. This exception is also available if a finance subsidiary issuer meets these requirements except that the parent is a co-issuer with the subsidiary, rather than a guarantor. 4. Subsidiary issuer of securities guaranteed by parent company and one or more other subsidiaries of parent company applies to both operating and finance subsidiaries, where: the issuer and all subsidiary guarantors are 100% owned by the parent company guarantor; the guarantees are full and unconditional, joint and several; 115 and no other subsidiary of the parent is a guarantor. 4. No separate financial statements for subsidiaries required under S-X Rule 3-10(d) if the parent s financial statements are filed for the periods required and they include a footnote with condensed, consolidating financial information 116 for each such period, with separate columns for: the parent company; the subsidiary issuer; the guarantor subsidiaries on a combined basis; any non-guarantor subsidiaries on a combined basis; 117 consolidating adjustments; and total consolidated amounts. This exception is also available if a subsidiary issuer meets these requirements except that the parent is a joint and several co-issuer with the subsidiary, rather than a guarantor. 5. Recently acquired subsidiary issuer or subsidiary guarantor, where: the subsidiary has not been included in the audited consolidated results of the parent company for at least nine months of the most recent fiscal year; and the purchase price or net book value (as of the most recent fiscal year end prior to the acquisition), whichever is greater, of the subsidiary (or group of subsidiaries that were related prior to the acquisition) is 20% or more of the principal amount of the securities being registered. 5. Separate financial statements required under S-X Rule 3-10(g) for each such subsidiary, including: audited financial statements for the subsidiary s most recent fiscal year prior to the acquisition; and unaudited financial statements for any required interim periods. 118 Requirements apply even if (1) the recently acquired subsidiary would otherwise be eligible for the use of condensed consolidating footnote presentation or (2) S-X Rule 3-05 would not require financial statements. 69

14 US financial statements: Co-published section Investments accounted for under the equity method S-X Rule 3-09 generally requires that registration statements and annual reports include audited financial statements for significant investments in less-than-majority-owned investees that are accounted for under the equity method. S-X Rule 3-09 applies whether the investee is held by an issuer, a subsidiary or another investee. 119 Significance for these purposes is evaluated under S-X Rule 1-02(w) based on the following two criteria: the amount of the issuer s investment in and advances to the investee compared to the total assets of the issuer and its subsidiaries on a consolidated basis; and the equity of the issuer and its other subsidiaries in the pretax income from continuing operations of the equity investee compared to that income of the issuer and its subsidiaries on a consolidated basis. 120 These tests are performed as of the end of each year presented in the issuer s financial statements. Full audited financial statements as of the same dates and for the same periods as the audited consolidated financial statements of the issuer are required where the equity investee meets either of the two criteria above at the 20% or greater significance level. 121 For equity investees or non-consolidated subsidiaries which meet any of the three S-X Rule 1-02(w) criteria at the greater than 10% but not more than 20% significance level, S-X Rule 4-08(g) requires the presentation of summary financial information as described by S-X 1-02(bb). Financial statements of equity investees that are prepared under local Gaap or IAS do not have to be quantitatively reconciled to US Gaap unless either of the two criteria is greater than 30% (calculated on a US Gaap basis). 122 A description of the differences in accounting methods is required, however, regardless of the significance levels. 123 Industry guides and other transactionspecific guidance Industry guides Pursuant to Item 801 of Regulation S-K, the SEC publishes the following six industry guides which require enhanced disclosure of financial and operational metrics for issuers in certain industries: 124 Guide 2 Disclosure of Oil and Gas Operations: requires disclosure of reserve estimates, sales and production costs per unit, numbers of productive wells, developed and undeveloped acreage, drilling activity, and delivery commitments. Guide 3 Statistical Disclosure by Bank Holding Companies: requires disclosure of analyses of interest earnings, investment and loan portfolios, loan loss experience, deposit types, returns on equity and assets, and short-term deposits. Guide 4 Prospectuses Relating to Interests in Oil and Gas Programs: requires enhanced disclosure relating to the offering terms and participation in costs and revenues among investors and others, as well as a 10-year financial summary of any drilling programs by the issuer and its associates, including recovery on investment for investors in those programs. Guide 5 Preparation of Registration Statements Relating to Interests in Real Estate Limited Partnerships: requires a summary of the financial performance of any other real estate investment programmes sponsored by the general partner and its affiliates. Guide 6 Disclosure Concerning Unpaid Claims and Claim Adjustment Expenses of Property-Casualty Insurance Underwriters: requires disclosure of details of reserves and historical claim data if reserves for unpaid property casualty claims and claim adjustment expenses of the issuer, its consolidated and unconsolidated subsidiaries and equity investees exceed 50% of the common stockholders equity of the issuer and its consolidated subsidiaries. Guide 7 Description of Property by Issuers Engaged or to be Engaged in Significant Mining Operations: requires disclosure of information relating to each of the mines, plants and other significant properties owned or operated (or intended to be owned or operated) by the issuer, including location of the property, brief description of the title, claim or lease to the property, a history of previous operations, and a description of the present condition and operations on the property. Compiling the information required by these industry guides may be a significant undertaking, and the auditors should coordinate with the issuer s financial and operating management early in the process if an industry guide applies to an offering. Supplemental schedules for certain transactions S-X Rule 5-04 requires a number of supplemental schedules for particular industries and circumstances. Each schedule contains additional financial information that must be audited and provided with the registration statement or annual report. The schedules include: Schedule I Condensed Financial Information of Registrant (known as parent-only financial statements): requires condensed balance sheets and statements of income and cash flows on a non-consolidated basis if as of the end of the latest fiscal year the amount of restricted net assets of subsidiaries exceeds 25% of the issuer s consolidated assets. Restricted net assets are the issuer s proportionate share of net assets of consolidated subsidiaries (after intercompany eliminations) which as of the end of the most recent fiscal year may not be transferred to the parent company by subsidiaries in the form of loans, advances or cash dividends without the consent of a third party (for example, lender, regulatory agency or foreign government). 125 Schedule II Valuation and Qualifying Accounts: requires an analysis of each valuation and qualifying account (for example, allowance for doubtful accounts, allowance for obsolescence). 70