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The Lowdown on Carve-Out Financial Statements
As you probably already know, US GAAP doesn't have much to say about carve-outs or carve-out financial statements. And by much, we mean nothing. Not a peep. So what should you do when there's a divestiture on the horizon and you need some guidance?
The SEC has provided a few scant crumbs here and there, but for the most part, financial organizations are on their own. That is, unless you have some hands-on, boots-on-the-ground experience guiding the way. And wouldn't you know it, that's exactly what Embark’s about to provide with some much-needed insights on carve-out financials. So let's dive right in.
What Are Carve-Out Financial Statements?
Regulatory bodies, investors, sellers, buyers – they all have legitimate needs for accurate, timely, and detailed insights into divestitures.The compliance folks, of course, need to verify everything goes by the books, while investors want to make fully informed investment decisions.
But it's the buyers and sellers that sit in the transactional front row, needing to evaluate a potential divestiture as part of the due diligence process or even financing activities. That's what makes carve-out financial statements so essential for all of these parties and in all of these instances.
Simply put, when a potential seller divests a part of operations, it's essentially carving it out from the organization. However, outsiders need to understand how it operates within the larger entity to gauge the viability and financial position of the carved-out piece, not to mention if there are benefit plans, pension plans, warranties, leases, or other possible complications involved.
Carve-out financial statements are a window into that divested piece. Their job is to present the historical operations of the carve-out entity as well as the cost of doing business. So while the seller might derive the carve-out financials from the parent company's consolidated financial statements, the carve-out financials put the potentially divested entity under a specific spotlight.
The result is a focused set of financials that gives users and investors all of the relevant information they need, which, at least on paper, seems pretty straightforward. However, the carve-out doesn't have to be a legal entity – corporations, partnerships, LLCs, trusts, etc. – or group of legal entities, making the process far more complicated than most of the business combinations in the M&A sphere. That is, depending on what exactly constitutes the carve-out business in the first place.
Further, carve-outs themselves can come in many shapes and sizes, including:
- A specific subsidiary or group of subsidiaries
- An operating unit or division
- Specific product lines or brands
Divestitures & Exit Strategies Requiring Carve-Out Statements
Now that we have the 101-level insights behind us, let's take a closer look at some of the more common transactions requiring carve-out financial statements.
An entity wanting to divest a portion of its assets might prepare carve-out financials to help a potential buyer evaluate the prospective transaction as part of their due diligence.
When a public entity either acquires or likely will acquire a portion of another entity's business – and the acquisition is "significant" to the acquirer under SEC Regulation S-X, Rule 3-05 – the acquiring entity will need to file an 8-K and include the acquiree's carve-out financial statements.
Carve-out financials are required when a public entity plans to distribute a portion of its total assets – that constitute a business – by spinning it off to shareholders as a separate public company with its own equity structure. Spinoffs do not raise capital for their parent or the spun-off entity.
Instead, after the spinoff is complete, the shareholders own shares in two entities. The spun-off entity's newly-issued shares are registered with the SEC by filing Form 10 and including carve-out financial statements for the newly spun-off entity.
Initial Public Offering (IPO)
Let's say an entity wants to segregate a portion of itself to effect an IPO of a newly created subsidiary. In this case, the SEC registration statement connected to the IPO must include carve-out financial statements of the operations segregated and transferred to the newly formed subsidiary.
Special Purpose Acquisition Company (SPAC)
In a SPAC transaction, an entity wants to segregate a portion of itself as a target and become a public business – via reverse merger transaction – upon acquisition by a SPAC entity. Thus, the SPAC proxy – and possibly joint registration statement – must include carve-out financial statements of the carve-out entity's operations per the SEC.
Granted, this isn't an exhaustive list of applications since plenty of other circumstances require carve-out statements as well. However, these are the five most common types of transactions you’ll run into requiring carve-out financials.
Preparing Carve-Out Financial Statements
Now we're ready to roll up our sleeves and actually prepare carve-out financials. But where do we even start?
The first step is identifying the businesses that will comprise the carve-out financial reporting entity. This is what drives all the necessary judgments you need to prepare the financial statements, including the identification of assets and liabilities as well as the allocation of costs.
In practice, two common approaches are used to identify the carve-out entity – the legal entity approach and the management approach.
Legal Entity Approach
The legal entity approach is generally reserved for instances when the divestiture aligns with a company's legal entity structure. This is common when, for example, the sale is all or substantially all of the legal entity – or entities – divested.
A Legal Entity Approach Curveball
Now let's throw in a curveball and assume a divested legal entity stems from the transaction, but the parent retains a nonsignificant portion of the business. In other words, they contribute it back to the parent before the sale.
Under these circumstances, from a basis of presentation perspective, what happens with the portion not sold depends on the approach you use. If you determine the legal entity approach is most appropriate, you would present all historical results of operations for the legal entity in the historical financial statements through the date of transfer, at least in most cases. This would include those retained by the parent.
However, companies might also need to consider if the portion of the business the parent retains might qualify as a discontinued operation. If so, they would need to present it as such.
Also, the portion of a legal entity the parent retains contemporaneously with the transaction is an adjustment to any pro forma financial information possibly required as part of the transaction. All that said, if the management approach was used instead of the legal entity approach, all of these would generally be excluded.
Speaking of the management approach, it's most common when the divestiture does not represent a legal entity or group of legal entities. Instead, the divestiture of various net assets will constitute the basis for the transaction.
However, there can even be cases in which a legal entity is divested, yet the management approach provides more meaningful information to financial statement users. For example, think of an instance where a legal entity to be divested contributes significant parts of the business back to its parent right before being sold through a common control transaction.
The approach management ultimately takes will impact the basis of presentation, which is obviously pertinent information the carve-out financial statements should disclose to the users. Specifically, they should include transparent disclosures that describe:
- The composition of the carve-out entity
- How the financial statements were prepared
- If the financial statements are combined or consolidated
Drilling down a bit further:
- Consolidated financial statements: When the financial statements constitute a legal entity with controlling financial interest in all other entities in the financial statements.
- Combined financial statements: When there are multiple legal entities in the financial statements that aren't under the control of a single legal entity included in the carve-out financials
A company might also present combined financials when they aggregate assets and operations representing components of multiple legal entities.
Carve-Out Entity Accounting Policies
In most cases, the carve-out entity should base its accounting policies on the entity it's carved from. In other words, the parent's policies usually carry over.
In some cases, however, the carve-out entity might need to change its accounting policies. For example, an accounting policy may have been immaterial to the parent entity but would be material to the carve-out entity requiring evaluation. A change resulting from an immaterial conclusion by the parent wouldn't be considered a change in accounting principle for the carve-out entity under ASC 250.
Accounting Standard Adoption for Carve-Out Entities
Issues can and do arise on the accounting standard front for carve-out entities, particularly when preparing for an IPO. Such problems are especially prevalent when the parent entity is a private company that hasn't adopted certain accounting standards because they aren't effective yet.
If the carve-out entity meets the definition of a public business entity, it must apply new accounting standards guidance in line with other public business entities (PBEs). Them's the rules.
There's an exception, though, for carve-out entities considered a smaller reporting company (SRC) or an emerging growth company (EGC), allowing them to adopt in line with private companies under the extended transition provisions.
Remember, a carve-out entity preparing for an IPO is not considered a PBE. That designation doesn't kick in until the registration statement is effective. Therefore, the carve-out statements included in the registration don't have to reflect the new standard adoption dates for other PBEs.
However, once the initial registration statement is declared effective, the carve-out entity will need to apply adoption dates of PBEs to its financial statements in its next filing, unless it elects the adoption deferral of new accounting standards provided to qualifying EGCs and SRCs.
Carve-Out Balance Sheets: Insights and Best Practices
To begin, the carve-out balance sheet should include the assets and liabilities relating to the operations of the carve-out business. However, there could be additional factors involved in determining which assets and liabilities to attribute to the carve-out business, including:
- Whether the asset or liability will be transferred in the transaction
- Which entity holds the legal title to the asset or has the legal obligation for the liability
The good news, however, is that assessing which assets and liabilities the carve-out entity recognizes is usually more straightforward when legal entities exist within the carve-out entity. But there’s not-so-good news, too – the assessment is often more complex and requires more judgment if the carve-out entity doesn't have a well-defined legal structure.
Assessing Which Assets or Liabilities to Include
When assessing the fair value of what's involved and what isn't, you'll usually begin by going through the parent's balance sheet line by line – cash, accounts receivable, fixed assets, etc. For items inherently related to the carve-out entity, however, you can usually attribute them to the carve-out financial statements.
Unfortunately, it's not always that easy and straightforward. For instance, things can get a bit confusing when a balance sheet item is a mixture of the portion of operations you include in the carve-out transaction, along with the portion you exclude.
Also, note that it's usually not appropriate to partially allocate assets or liabilities. Instead, you'll need to determine if there should be a full attribution or exclusion of these items from the carve-out financials.
Further, suppose a shared asset used by the carve-out business isn't included on its balance sheet. In that case, the carve-out entity should still recognize an appropriate allocation of the associated income statement impact. Using real estate as an example, if a corporate office building isn't attributed to the carve-out balance sheet but considered used in their operations, the carve-out entity would still inherit a portion of the depreciation expense. This ensures all costs of doing business are included.
Carve-Out Balance Sheet Pain Points
When we say long-lived assets, we're primarily referring to fixed assets and intangibles. Yes, when either is used solely by the carve-out entity, all is right with the world. You simply include the carrying amount in the carve-out financial statements.
But things can get squirrely when multiple entities under the parent – or the entire parent as a whole – use the fixed and intangible assets. When shared, you usually don't allocate portions of them to the carve-out entity since the asset itself is the unit of accounting. Thus, separating portions of that asset undermines the unit of account.
However, if a carve-out entity still uses a shared long-lived asset or intangible, as we previously mentioned, the carve-out entity should still include a portion of the expense related to the asset. Although we'll focus on this concept more in just a bit, including these expenses means you're reflecting all of the costs of doing business.
Determining if the carve-out entity reflects goodwill on the balance sheet depends on whether it reflects the parent's stepped-up basis for those assets and liabilities achieved through purchase accounting.
If so, you should include any goodwill the parent records relating to the carve-out entity. Other circumstances, however, can be a lot more complex. In many cases, management must determine a reasonable allocation if, for example, the carve-out entity represents a portion of a larger acquisition by the parent. As such, a piece of the goodwill the parent records would likely relate directly to the carve-out entity and, thus, should be allocated.
Side Note – Impairment
For long-lived assets like fixed assets and certain intangibles, a carve-out entity needs to consider any impairment indicators that might have existed in the historical periods. Management just needs to be careful not to use hindsight, something that's sometimes easier said than done when making these evaluations.
Likewise, asset grouping will also be different for the carve-out entity. When there's an indicator in any historical period, management needs to test for impairment at the carve-out entity asset group levels.
Further, just as we said regarding hindsight on the indicators, management must also ensure the cash flows it uses to test recoverability or measure an impairment loss are based on information they would've had at the historical impairment assessment date.
For goodwill, there's a requirement to test for impairment annually in each historical period. Therefore, a carve-out entity must first determine its reporting units just to understand where to test for goodwill impairment. Once again, if cash flows are used in the impairment assessment, do not include hindsight assumptions.
Also, don't forget that, for the earliest historical period presented, management must also test for impairment in the opening goodwill balance as part of its opening balance sheet procedures. This is in addition to the subsequent recurring annual impairment tests, and maybe even trigger-based interim tests as well.
As a best practice, our advice is to ensure you have the right resources lined up – internally and externally – when thinking about valuations and everything else needed. Suffice it to say, simply pulling all the different moving parts together can be a Herculean task, and certainly not something you should underestimate.
Other Possible Sticking Points
Although long-lived assets and goodwill are the chief troublemakers, other items can also be head-scratchers. But to avoid this already hefty mountain of insights from becoming even heftier, we're going to narrow it all down to debt and income taxes.
Obviously, any debt the carve-out entity issues itself goes on its balance sheet. This should also include any related interest expense and discounts associated with the debt. Thankfully, if the parent entity holds the debt and the carve-out entity doesn't guarantee it, you can usually exclude it from the balance sheet.
Are income taxes ever not a pain? Because, as a surprise to no one, they tend to be one of the more complex areas in carve-out financial statements. That said, if the carve-out entity is a taxable entity or includes taxable entities in its makeup, it will be necessary to reflect certain tax balances in the carve-out statements. However, if the carve-out entity is not or does not contain a taxable entity, no income tax payable or receivable tax assets will be reflected on the balance sheet as they aren't the legal obligor.
From a tax provision perspective, ASC 740 mandates allocating the consolidated current and deferred tax expense when a consolidated tax return is filed for a group of taxable entities that prepare separate financial statements. Also, a carve-out entity itself may be a taxable entity or include one. When this is true, the allocation of tax expense is most often achieved through the use of the separate return method.
Equity on a Carve-Out Entity's Balance Sheet
It wouldn't be a discussion on the balance sheet if we failed to mention equity, right? To that point, the form and content of a carve-out entity's equity statement depend on its structure. For instance, if it's a legal entity that prepares full financial statements, the statement of changes in equity would reflect the full equity structure of that legal entity. And yes, that’s a mouthful.
On the other hand, when the carve-out entity is a portion of one or a group of net assets rather than a full legal entity, the traditional equity captions that everyone is accustomed to seeing won't cut the mustard. Instead, all equity components – not included in other comprehensive income (OCI) – are generally presented in an equity line item described as "net investment of parent."
Also, changes in equity where a traditional full equity structure isn't present are usually limited to:
- Net investment of parent
- Changes in accumulated OCI
- Any non-controlling interest (NCI) that might be present
So what exactly is this net investment of parent we speak of? Well, it's usually comprised of:
- Financing received from the parent entity to fund its operations not requiring repayments
- Cash dividends to the parent
- The net effect of cost allocations from transactions with the parent entity
- Accumulated earnings of the carve-out entity
- Settlement of intercompany transactions with the parent
Carve-Out Income Statements: Insights and Best Practices
Moving on to the income statement, it should be pretty easy to identify what relates to the carve-out entity for big line items like revenue and cost of sales, even when the carve-out entity isn't a specific legal entity. Other expense types can be more confusing, though, often requiring a bit more judgment to determine what to include, or if allocating certain cost items is necessary.
Remember when we mentioned the SEC guidance way up top? Well, that's where the framework for determining what costs to include comes from. Specifically, SAB Topic 1.B.1 states a carve-out entity's income statement must reflect all the costs of doing business. This includes certain expenses the parent may have incurred on behalf of the carve-out entity.
Regarding that last point on costs a parent may incur, the SEC guidance provides some specific examples, including:
- Officer and employee salaries
- Rent, depreciation, amortization
- Advertising costs
- Professional service costs – i.e., legal and accounting
- Other selling, general, and administrative expenses (SG&A)
The SAB Topic also addresses how management should allocate these costs, acknowledging it might be tough to directly identify how much to include. But since some type of allocation process is needed, carve-out entities will include disclosure around the use of allocations, methodologies employed, and the reasonableness of the allocations.
Also, note that all costs should be reflected when fully attributable to the carve-out entity. When costs are shared, allocation methods to use may include things like:
- Percentage of revenue
- Percentage of square footage
- Proportional usage
Like we said, there's quite a bit of judgment involved in figuring out which costs to reflect in all the historical periods, as well as how much.
Carve-Out Statement of Cash Flows: Insights and Best Practices
Finally, we get to cash flows. And as you might've guessed, you base the cash flows on the carve-out entity's balance sheet, a process that can prove to be much more challenging than management often thinks.
Remember, a carve-out entity might not even have any cash or cash equivalents on its balance sheet, especially when the cash accounts aren't in its name. Instead, there may be due to or from parent entity balances reflected on the balance sheet to demonstrate cash movements.
But even with no cash on the balance sheet, they're still required to present a cash flow, a large piece often being intercompany activity between the parent – or other affiliated entities – and the carve-out entity. The nature of these intercompany transactions will determine the cash flow classification.
Further, many such intercompany transactions become related party transactions in the carve-out financial statements and should be disclosed accordingly. In fact, many of the transactions a parent would ordinarily eliminate now get reflected in the carve-out entity's financial statements. Therefore, management should take the time to ensure they've identified and reflected all those transactions in the financials, and that they're properly disclosed.
Other Insights and Best Practices
We're in the home stretch now. But we wouldn't feel good about ourselves if we wrapped things up without providing a few other tips and insights that don't necessarily fit into the categories above. So here we go.
Earnings per Share (EPS)
Questions around EPS are common when talking about requirements for carve-out entities. This is especially true when the entity is not a legal entity and equity is primarily just net investment of the parent. In these situations, EPS is not reported in the historical carve-out financial statements.
Subsequent Event Assessments
It’s usually a bit of a struggle when management tries to determine which period they need to evaluate through. For starters, they need to consider events occurring after the most recent balance sheet that's included in the carve-out statements. Since the carve-out financial statements are derived from the parent's financial statements, the carve-out financial statement disclosures may simply be a subset of the parent's subsequent-event disclosures.
Also, as we previously discussed on accounting policies, there are likely different materiality lenses applied to subsequent events for the carve-out entity and the parent. Thus, there may have been immaterial events at the parent level now requiring disclosure for the carve-out statements.
Still, there are often questions about evaluating subsequent events, especially when the carve-out statements are issued after the parent entity issues its own financial statements. In practice, the cut-off date for subsequent event evaluations depends on whether the event would be recognized or disclosed.
When determining recognized events, the cut-off date is the same date the parent used in its subsequent event evaluation for its previously issued financial statements. However, when evaluating events for potential disclosure, the carve-out entity should consider events through the dates the carve-out statements are issued.
For any new events identified, the carve-out entity would generally only disclose such matters and not recognize any impacts of the events by analogy to ASC 855 on reissuances.
Don't forget about the need to reevaluate conclusions made at the parent level in light of a lower materiality threshold for the carve-out entity. As we discussed, this could relate to accounting policy judgments as well as past audit adjustments in the historical periods.
Likewise, keep in mind that lower materiality thresholds during the audit will likely lead to incremental testing being performed. This even includes testing areas that weren't previously touched as part of the parent entity audit due to immateriality.
Documentation Over Significant Judgments
When an audit of the carve-out entity is required, management shouldn't skimp on the documentation around key judgments made in preparing the carve-out entity financial statements. In fact, the more robust, the better.
This is particularly important for cost allocations where, oftentimes, a technical memo outlines the judgments made – account by account – in determining what ultimately burrows its way into the carve-out statements.
Don't Underestimate the Effort You'll Need
We said it before, and we'll say it again – preparing carve-out statements can be complex. Really complex. And the pressure only mounts when you're trying to prepare the statements and get them audited for various capital market needs.
Therefore, don't hesitate to involve experienced outside help if you don't have the bandwidth or skill sets internally. Preferably, you'll want to bring such experts in as early as possible, including tax and valuation specialists.
Don't Forget the Auditors
Like the point above, you'll want to involve auditors early and often as you go. It will be important to have auditor buy-in on key judgments you make during the carve-out process. As always, you'll want to understand the auditor's supporting documentation needs and maintain an open dialogue throughout to ensure an efficient process.
Yes, that was a mountain of information we just chucked your way. But there are a lot of nooks and crannies to carve-out financial statements and, given their importance, an extremely bright spotlight on the end result. So, if you walk away from these insights overwhelmed and thirsty for a cold one, you're not alone. Just remember, your financial accounting specialists here at Embark are ready to make life easier for you at a moment's notice.