1.3 Considerations for Management | DART – Deloitte Accounting Research Tool

1.3.1 Identifying the Carve-Out Entity and the Carve-Out Financial Statements

The preparation of carve-out financial statements is often a complex process. The form and content of the financial statements will depend on several considerations, including the users of the financial statements and the purpose for which the financial statements are being prepared. Integral to the preparation of carve-out financial statements is the identification of the carve-out entity and the assets, liabilities, and operations of the carve-out entity to be included in the historical periods presented. Management is encouraged to engage its auditors during the planning of the carve-out transaction and before the preparation of the carve-out financial statements; such proactive engagement may help management identify issues and complexities earlier.

1.3.2 Assembling the Right Team

Involving the appropriate personnel is an integral step in preparing carve-out financial statements. Management should evaluate which employees could help provide the information needed to prepare accurate and complete financial statements. Such employees may include those outside accounting (e.g., in operations or human resources). In addition, management may need to engage external specialists (e.g., tax or valuation specialists).

1.3.3 Materiality and Evaluating Misstatements

Because the materiality thresholds related to the carve-out financial statements will most likely be lower than those related to the consolidated parent entity, management may need to assess the carve-out entity’s accounts and balances in even more detail than they may have been subjected to during the preparation of the parent entity financial statements. Accordingly, the parent entity’s historical corrected or uncorrected misstatements and disclosures related to the carve-out entity that were previously considered immaterial to the parent’s financial statements would need to be reconsidered on the basis of materiality thresholds applicable to the carve-out financial statements.

1.3.4 Internal Controls

Management should design and implement processes and controls for preparing the carve-out financial statements (e.g., management may need to design, implement, and execute controls related to the appropriate determination and recording of income statement and balance sheet allocations to the carve-out financial statements). Although an entity may often be able to leverage existing financial statement preparation controls, management should evaluate whether it needs to modify such controls to accommodate process changes related to preparing the carve-out financial statements.

1.3.5 Supporting Documentation

Management should consider the type of documentation necessary to support the assumptions made and results achieved in preparing carve-out financial statements. In some cases, the supporting documentation may already exist (e.g., compensation expense is usually calculated and allocated on an employee-by-employee basis). However, management may need to develop and maintain new documentation for the allocations made for the carve-out financial statements (e.g., a rational and systematic method for allocating selling, general, and administrative expenses).

Management may choose to use existing accounting systems as much as possible when preparing carve-out financial statements. However, the ability to use such systems may be limited depending on the level of detail at which the account balances are maintained as well as the structure of the carve-out entity (e.g., whether the carve-out represents a segment of the parent or only part of a segment). If the carve-out entity represents a segment or component for which discrete financial information is readily available, management may be able to readily extract information from its existing accounting records. However, if the carve-out entity includes portions of different segments, further involvement of IT specialists may be required.

1.3.6 Significant Judgments and Estimates

In preparing carve-out financial statements, management will often need to make significant accounting judgments and estimates related to allocating account balances and activities to the carve-out financial statements and determining the appropriate disclosures to include in these financial statements. Such judgments and estimates may include the following:

The allocation of goodwill to the carve-out financial statements and the assessment of goodwill for impairment in the periods presented in such financial statements (see Chapter 2).
The identification of the carve-out entity’s operating and reportable segments and the preparation and presentation of segment disclosures in the periods presented in the carve-out financial statements (see Chapters 2 and 4).
The allocation of pension and postretirement expenses, obligations, and plan assets, as well as share-based compensation expense, to carve-out financial statements (see Chapter 2).
The allocation of expenses for shared assets and facilities or corporate functions to carve-out financial statements (see Chapter 3).
The preparation of the income tax provision and the allocation of deferred tax assets and deferred tax liabilities to carve-out financial statements (see Chapter 3).
The identification of subsequent events applicable to the carve-out entity and the determination of whether the effects of subsequent events need to be recorded and disclosed in the carve-out financial statements (see Chapter 4).

1.3.7 Working With Auditors

If, as part of the preparation of carve-out financial statements, external auditors need to perform an audit and issue an audit opinion, the auditors will need to understand the process undertaken by management for collecting and maintaining all supporting documentation used in the preparation of the carve-out financial statements. For balances in which judgment or complex estimates are required, management should ensure that its documentation contains enough detail for auditors to reach conclusions about the reasonableness of the amounts allocated to, and balances presented in, the carve-out financial statements.

Topics on which up-front and regular dialogue with auditors may help facilitate an efficient and effective audit of the carve-out financial statements include the following:

Identifying the carve-out entity and the carve-out financial statements — Understanding the purpose, as well as the form and content, of the carve-out financial statements is important in determining the nature of the audit and the type of report to be issued. Management’s early engagement of its auditors may also help the auditors develop their risk assessment and procedures for the audit of the carve-out financial statements in a timely manner. Under certain circumstances, management may need to prepare carve-out financial statements for only a portion of an entity that is not considered a stand-alone business. Accordingly, the carve-out financial statements could be designated as special-purpose financial statements that would be prepared in accordance with a special-purpose framework instead of under U.S. GAAP. Auditor reporting implications, such as restrictions on the use of the report by third parties, could be associated with such financial statements. Further, the audit report for carve-out financial statements may include an emphasis-of-matter paragraph to, for example, stress that the financial statements (1) were derived from the financial statements and accounting records of the carve-out entity’s parent, (2) include expense allocations for certain corporate functions historically provided by the carve-out entity’s parent, (3) may not reflect the actual costs that the carve-out entity would have incurred as a separate entity apart from its parent, and (4) include significant transactions with related parties.
Materiality and evaluating misstatements — Although management will need to consider materiality when evaluating uncorrected misstatements in the carve-out financial statements, the auditor will often need to calculate a separate materiality to assess risk and plan further procedures for auditing these financial statements. Materiality influences many of the auditor’s decisions about its audit strategy and scope, including the determination of which locations and accounts are within the audit’s scope as well as the extent of the testing it needs to perform. Materiality is based on both quantitative and qualitative factors, including the needs of the expected users of the financial statements. The materiality thresholds determined for audits of the carve-out financial statements are usually lower than those used for audits of the parent-entity financial statements from which the carve-out financial statements are derived, and amounts considered immaterial or not tested by the auditor at the parent-entity level may be considered material to the carve-out entity’s operations. For example, an auditor may need to test (1) account balances that were not tested historically as part of the parent-entity audits or (2) previously tested account balances by using a lower materiality threshold. In addition, management may need to include certain disclosures in carve-out financial statements that were previously immaterial and undisclosed in the parent-entity financial statements. Auditors will need to perform incremental procedures to test the accuracy and completeness of the disclosures included in the carve-out financial statements.
As a result of the auditor’s use of a lower materiality threshold, uncorrected misstatements and omitted disclosures previously considered immaterial to the parent entity’s financial statements may be considered material to the carve-out financial statements. Management should evaluate uncorrected misstatements and omitted disclosures identified during the audit of the parent-entity financial statements and should consult with its auditors in determining whether those are applicable to the carve-out financial statements.
If, as part of the audit of the carve-out financial statements, audit misstatements are identified, the auditor may need to consider the implications of those misstatements with respect to the parent entity’s prior or current-period audits. The identification of such misstatements may also result in incremental control deficiencies that will need to be evaluated from an audit scope perspective. Depending on the severity of these misstatements, they may need to be communicated to management and those charged with governance.
Internal control over financial reporting (ICFR) — The auditor will need to consider and evaluate controls over the preparation and review of carve-out financial statements as well as the business processes relevant to financial reporting for the carve-out entity, regardless of whether these are existing controls that are modified for the carve-out entity or newly created ones. If the auditor concludes that such controls are relevant to the audit, the auditor must perform incremental procedures to test the design and implementation, and potentially the operating effectiveness, of these controls. The extent of such procedures will vary depending on the precision and frequency of the existing or new controls. Management and the auditor may have to invest a significant amount of time and effort to evaluate the new or modified controls. If the carve-out financial statements will be included in a registration statement filed with the SEC, management is strongly advised to consult with legal counsel and auditors to determine the ICFR reporting requirements of management and the independent auditor. While newly public companies do not need to provide management’s report on ICFR in an SEC registration statement or in the first Form 10-K filed after the registration statement is declared effective, management is required to evaluate its internal controls on a quarterly basis and disclose material changes in ICFR. Further, key executives will be required to certify that they have maintained effective disclosure controls and procedures. These certifications must be provided in the first Form 10-Q filed by the newly public entity. Auditors are not required to audit or issue an opinion on the effectiveness of ICFR during the registration statement process but could be required to do so in future periodic filings with the SEC. For additional guidance on internal controls and procedures after a registration statement is declared effective, see Deloitte’s Roadmap Initial Public Offerings.
Significant management judgments and management estimates — The auditor will request detailed documentation that supports the judgments and estimates used in preparing the carve-out financial statements.