1.2 Identifying the Form and Content of the Carve-Out Financial Statements and the Operations of the Carve-Out Entity
1.2.1 Form and Content of the Carve-Out Financial Statements
The form and content of the carve-out financial statements depend on the needs or requirements of the users of the financial statements and any regulatory requirements applicable to the transaction for which the carve-out financial statements are being prepared.
The most common types of carve-out financial statements include:
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Public-entity financial statements:
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Registrant, predecessor, or Rule 3-05 — A registrant and its predecessor1 may need to prepare carve-out financial statements for an initial registration statement filed with the SEC as well as in Forms 10-K and 10-Q filed after the initial registration statement. If so, the financial statements must comply with the general financial statement requirements in SEC Regulation S-X, Rules 3-01 through 3-04. Carve-out financial statements may also be required for a significant acquired or to be acquired business in accordance with Rule 3-05 in certain SEC filings. See Sections 5.1 and 5.2 for additional information about the financial statement requirements applicable to a registrant and its predecessor and financial statements of businesses acquired or to be acquired in an SEC filing.
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Abbreviated financial information — In accordance with Rule 3-05, abbreviated financial information may at times be provided for significant acquired or to be acquired businesses in certain SEC filings. These abbreviated financial statements typically consist of a statement of revenues and direct expenses (in lieu of a full statement of operations) and a statement of assets acquired and liabilities assumed (in lieu of a full balance sheet). Abbreviated income statements for acquired or to be acquired real estate operations in accordance with SEC Regulation S-X, Rule 3-14, may also be provided. See Sections 5.2.3 and 5.3 for more information about when abbreviated financial information may be appropriate.
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Nonpublic-entity financial statements — Certain U.S. GAAP presentation and disclosure requirements do not apply to nonpublic entities. In addition, nonpublic entities may elect to apply reporting alternatives developed by the PCC. Nonpublic-entity carve-out financial statements in which PCC accounting alternatives have been elected may be appropriate when the financial statements are not included or expected to be included in an SEC filing.
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Special-purpose financial information — A user may ask for financial information in a specific form or for it to be prepared in accordance with another comprehensive basis of accounting. While such information may be prepared to suit the user’s request, there will most likely be restrictions on the use of such information as well as the level of attestation available. Further, since the form and content of financial statements to be included in SEC filings are prescribed, the financial information prepared under a special-purpose framework may not be usable for SEC filings.
In addition, preparers of carve-out financial statements should discuss with
their auditor the level of assurance that may be provided for the planned form
and content. If the carve-out financial statements are reissued, the auditor may
be required to reissue its opinion(s) or other form of attestation. Changes in
the intended users of the carve-out financial statements or in the planned form
and content of the carve-out entity’s financial information may change the level
of assurance sought or that can be provided. Accordingly, any such changes
should be monitored throughout the carve-out transaction process.
1.2.2 Basis of Presentation: Identifying the Carve-Out Entity’s Assets, Liabilities, and Operations
The business or activities associated with a carve-out
transaction provide the basis for identifying the assets, liabilities, and
operations to be included in the carve-out financial statements. Since a
carve-out entity is a subset of a larger parent, there may be complexities
associated with the preparation of the carve-out entity’s financial statements.
Such complexities are particularly likely when the business of the carve-out
entity has not been organized separately within the larger parent entity and
when significant assets, liabilities, and operations are shared with other
businesses (see Chapters
2, 3, and 4 for related accounting considerations).
Carve-out financial statements should include disclosures that
give users the information they need to understand the basis of presentation
(e.g., a description of the business or activities included in the carve-out
financial statements; an explanation of how assets, liabilities, and operations
of the carve-out entity were identified; and an indication of whether the
carve-out financial statements are consolidated or combined).2
Entities typically use one of two approaches to prepare
carve-out financial statements. These approaches, which are sometimes referred
to as the “legal entity” approach and the “management” approach, are discussed
in additional detail below.
Before filing carve-out financial statements with the SEC, an
entity may wish to discuss its proposed basis for presenting such statements
with both its accounting advisers and the SEC staff. Doing so may help alleviate
questions concerning the basis of presentation and facilitate any subsequent SEC
staff reviews.
1.2.2.1 Legal Entity Approach
If an entity selects the legal entity approach, it includes
in the carve-out financial statements all of the legal entities
(subsidiaries) that have historically been part of the carve-out entity,
even if some of the legal entities or some of the assets, liabilities, or
operations will not be transferred as part of the carve-out transaction
(i.e., the retained operations). Under the legal entity approach, the
retained operations are included in the carve-out financial statements until
the transfer to the parent occurs, which may not be until the effective date
of the carve-out transaction. Once the transfer occurs, management must
determine whether the retained operations meet the criteria to be classified
as a discontinued operation in the carve-out financial statements.
Therefore, carve-out financial statements prepared under this approach may
reflect assets, liabilities, and operations that will not be divested by the
parent as part of the transaction.
SAB Topic 5.Z.7 provides a modification to the “pure” legal entity approach
described above for an entity that files an initial registration statement
as long as all of the following criteria are met:
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Financial statements that include the spun-off subsidiary have not been widely distributed.
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The spin-off occurs before the applicable registration statement is effective.
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The carve-out entity and retained operations are in dissimilar businesses, and the differences in the nature of the business are substantially greater than the differences that would normally be used to distinguish reportable segments. See Chapter 3 of Deloitte’s Roadmap Segment Reporting for details about evaluating segments.
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The carve-out entity and retained operations have historically been managed and financed autonomously.
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The carve-out entity and retained operations have no more than incidental common facilities and costs, will be operated and financed autonomously after the spin-off, and will not have material financial commitments, guarantees, or contingent liabilities with each other after the spin-off.
If all the above conditions are met, SAB Topic 5.Z.7 permits
the removal of the retained operations from the carve-out financial
statements for all periods presented even if the legal entities included in
the carve-out financial statements controlled the retained operations during
those prior periods. This accommodation reflects the transfer of the
retained operations as a change in reporting entity along with retrospective
revision of the historical financial statements of the carve-out entities as
if the retained operations had never been controlled by such entities.
Example 1-1
Identifying the
Financial Statements of the Registrant — Carve Out
of an Existing Legal Entity
Registrant R’s reporting structure
includes four direct consolidated subsidiaries. One
of the subsidiaries, B, has a consolidated
subsidiary, E. As part of a strategic review of its
operations, R determines that a spin-off of B and C
would provide additional value to shareholders.
Accordingly, R creates a new company, NewCo, and
prepares carve-out financial statements by using the
historical results of B and C. While E is a
subsidiary of B for financial reporting purposes, R
intends to retain E. Before the contribution of B
and C to NewCo, which is expected to occur shortly
before the spin-off, B will transfer its ownership
interest in E to its parent, R. The charts below
show the existing and intended organizational
structure.
Structure
Before Reorganization
Structure
After Reorganization
When preparing the carve-out
financial statements to be included in NewCo’s Form
10 registration statement, management has concluded
that it will apply the legal entity approach and
that the criteria in SAB Topic 5.Z.7 have not been
met. Accordingly, the carve-out financial statements
would reflect the operations of B and C, including
B’s consolidated subsidiary E, which R will retain.
NewCo would reflect the transfer of E in the pro
forma financial information presented in the Form 10
and evaluate whether E meets the criteria to be
reported as discontinued operations in the carve-out
financial statements. Alternatively, if management
had concluded that the conditions of SAB Topic 5.Z.7
had been met, the carve-out financial statements
would reflect the operations of B and C but would
exclude E for all periods presented.
1.2.2.2 Management Approach
Under the management approach, the carve-out financial
statements only include those assets, liabilities, and operations that will
ultimately comprise the new reporting entity as of the effective date of the
transaction. Therefore, if certain assets, liabilities, subsidiaries, or
operations will be retained by the parent, or transferred to the parent in a
common-control transaction as of the effective date of the transaction, such
net assets and operations would not be included in the historical carve-out
financial statements. This basis of presentation reflects the carve-out
entity in the form management expects to run the business rather than the
legal entities included in the transaction. The management approach is
commonly used when the transaction will be executed by transferring assets,
liabilities, and operations, rather than by transferring legal entities, or
when the legal structure does not reflect the carve-out business.
Example 1-2
SEC Registrant Z has four reportable
segments. As part of a strategic review of its
operations, Z determines that a spin-off of Segment
2 would provide additional value to shareholders.
Accordingly, Z creates a new company, NewCo, and
prepares carve-out financial statements by using the
historical results of Segment 2. Rather than
transferring legal entities, Z intends to transfer
the assets, liabilities and operations of Segment 2
to NewCo in advance of the spin-off. Under the
management approach, the carve-out financial
statements would reflect the operations of Segment
2, for all periods, irrespective of which legal
entities held those assets, liabilities, and
operations during the historical periods.
1.2.3 Spin-Offs and Reverse Spin-Offs
ASC 505-60 defines a spin-off as follows:
The transfer of assets that
constitute a business by an entity (the spinnor) into a new legal spun-off
entity (the spinnee), followed by a distribution of the shares of the
spinnee to its shareholders, without the surrender by the shareholders of
any stock of the spinnor.
However, in some spin-offs, the substance of the transaction
does not align with its legal form. ASC 505-60 defines a reverse spin-off as
follows:
A spinoff of a subsidiary to an entity’s
shareholders in which the legal form of the transaction does not match its
substance such that the new legal spun-off entity (the spinnee) will be the
continuing entity.
ASC 505-60-25-7 states:
Reverse spinoff
accounting is appropriate if treatment of the legal spinnee as the
accounting spinnor results in the most accurate depiction of the substance
of the transaction for shareholders and other users of the financial
statements. The determination of whether reverse spinoff accounting is
appropriate is a matter of judgment that depends on an evaluation of all
relevant facts and circumstances. The following paragraph provides guidance
on making the required determination.
Entities should consider the guidance in ASC 505-60 for
determining whether, for accounting purposes, the transaction should be
accounted for as a spin-off (sometimes called a “forward spin”) or a reverse
spin-off. Specifically, ASC 505-60-25-8 provides the following indicators for
determining the accounting spinnor and spinnee:
In order to
determine the required accounting and reporting in a spinoff transaction, an
entity needs to determine which party is the accounting spinnor and which is
the accounting spinnee. In determining whether reverse spinoff accounting is
appropriate, a presumption shall exist that a spinoff be accounted for based
on its legal form, in other words, that the legal spinnor is also the
accounting spinnor. However, that presumption may be overcome. An evaluation
of the following indicators shall be considered in that regard.
Nevertheless, no one indicator shall be considered presumptive or
determinative. The following are indicators that a spinoff should be
accounted for as a reverse spinoff:
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The size of the legal spinnor and the legal spinnee. All other factors being equal, in a reverse spinoff, the accounting spinnor (legal spinnee) is larger than the accounting spinnee (legal spinnor). The determination of which entity is larger is based on a comparison of the assets, revenues, and earnings of the two entities. There are no established bright lines that shall be used to determine which entity is the larger of the two.
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The fair value of the legal spinnor and the legal spinnee. All other factors being equal, in a reverse spinoff, the fair value of the accounting spinnor (legal spinnee) is greater than that of the accounting spinnee (legal spinnor).
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Senior management. All other factors being equal, in a reverse spinoff, the accounting spinnor (legal spinnee) retains the senior management of the formerly combined entity. Senior management generally consists of the chairman of the board, chief executive officer, chief operating officer, chief financial officer, and those divisional heads reporting directly to them, or the executive committee if one exists.
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Length of time to be held. All other factors being equal, in a reverse spinoff, the accounting spinnor (legal spinnee) is held for a longer period than the accounting spinnee (legal spinnor). A proposed or approved plan of sale for one of the separate entities concurrent with the spinoff may identify that entity as the accounting spinnee.
The determination of whether a
transaction is a spin-off or a reverse spin-off will significantly affect the
financial statement presentation after the transaction. For example, assume that
Entity C is a holding company that owns Operations A and B and has no other
operations. Entity C determines that it will form Entity D, contribute B to D,
and then distribute shares of D to its shareholders. The following table
outlines the content of the financial statements for C and D once the separation
has occurred on the basis of whether the distribution is determined to be a
spin-off or reverse spin-off:
|
Forward Spin-Off
|
Reverse Spin-Off
| |
|---|---|---|
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Financial statements of C, the existing
registrant and legal spinnor
|
|
|
|
Financial statements of D, the new
registrant and legal spinnee
|
|
|
At the 2014 AICPA Conference on Current SEC and PCAOB Developments, the SEC
staff addressed reporting considerations related to a spin-off that is
determined to be a reverse spin-off under ASC 505-60. The staff stated:
[W]hen the spinoff is determined to be a reverse spin under
Subtopic 505-60, some registrants have assumed that this conclusion dictates
the financial statements that are presented in a registration statement that
is filed to effect the spinoff. Specifically, some registrants have
concluded that when a transaction is accounted for as a reverse spin, the
financial statements of the existing registrant (i.e. — the legal spinnor)
can be used to satisfy the financial statement requirements of the entity
that will be spun off (i.e. — the accounting spinnor/ legal spinnee). On
this point, our colleagues in the Division of Corporation Finance view this
as an assessment that is based on the unique facts and circumstances of each
transaction, and there may be situations in which carveout financial
statements are required for the accounting spinnor/legal spinnee in a
registration statement relating to a reverse spin. Overall, the separation
of an existing registrant into two or more registrants in a spinoff
transaction may present a number of reporting questions, both with respect
to the registration statement as well as the subsequent Exchange Act reports
for each continuing entity. Given the significant judgments involved in
determining the accounting spinnor as well as the appropriate financial
statement presentation, the staff encourages registrants to continue to
consult on their accounting and reporting conclusions relating to spinoffs,
particularly when the transaction is expected to be accounted for as a
reverse spin.
If management has concluded that a spin-off transaction is expected to be
accounted for as a reverse spin-off, or if the determination involves a high
degree of judgment, management should consider (1) consulting with its auditors
and other professional advisers and (2) preclearing its conclusions about the
accounting and reporting requirements with the SEC staff if the carve-out
financial statements are expected to be included in an SEC filing.
1.2.4 Common-Control Transactions
In preparing for a carve-out transaction, an entity may engage in common-control transactions to
reorganize its internal structure and move net assets among its subsidiaries. In a common-control
transaction, the receiving entity recognizes the transferred assets and liabilities at their carrying
amounts on the date of transfer. However, the carrying amounts of the assets and liabilities transferred
in the parent’s consolidated financial statements sometimes differ from those in the transferring entity’s
separate financial statements (e.g., if the transferring entity has not applied pushdown accounting).
ASC 805-50-30-5 states that in such cases, the receiving entity’s financial statements must “reflect
the transferred assets and liabilities at the historical cost of the parent of the entities under common
control.” An entity should consider this guidance when determining the historical cost basis of the
assets and liabilities of a carve-out entity that were received by the carve-out entity in a common-control
transaction.
For additional guidance on accounting for and reporting common-control
transactions, see Appendix
B of Deloitte’s Roadmap Business Combinations.
Footnotes
1
It is important to determine the
appropriate predecessor in an SEC filing since
this determination will affect which financial
statements must be included in an SEC filing, as
well as other considerations. In certain
circumstances, there could be more than one
predecessor.
2
The ASC master glossary defines consolidated financial
statements as “[t]he financial statements of a consolidated group of
entities that include a parent and all its subsidiaries presented as
those of a single economic entity” and combined financial statements as
“[t]he financial statements of a combined group of commonly controlled
entities or commonly managed entities presented as those of a single
economic entity. The combined group does not include the parent.” While
carve-out financial statements are either consolidated or combined, in
situations involving the contribution of operations under common control
to a newly formed holding company (i.e., no change in basis), the
financial statements might be (1) combined for the period(s) before the
contribution of the operations and (2) consolidated for the period(s)
after the contribution of the operations.