3.1 Expenses Clearly Applicable | DART – Deloitte Accounting Research Tool

The identification and allocation of expenses directly related to the carve-out entity’s revenue-producing activities (e.g., cost of goods sold) may be straightforward and readily available from the entity’s historical records through specific identification with the related revenues.

Because there is limited authoritative guidance issued by the FASB on the allocation of other expenses not directly related to the carve-out entity’s revenue-producing activities in the carve-out financial statements, entities typically apply the SEC guidance in SAB Topic 1.B.1 (codified in ASC 220-10-S99-3) directly or by analogy when performing such allocations. Questions 1 and 2 of SAB Topic 1.B.1 state:

Facts: A company (the registrant) operates as a subsidiary of another company (parent). Certain expenses incurred by the parent on behalf of the subsidiary have not been charged to the subsidiary in the past. . . .

Question 1: Should the subsidiary’s historical income statements reflect all of the expenses that the parent incurred on its behalf?

Interpretive Response: In general, the staff believes that the historical income statements of a registrant should reflect all of its costs of doing business. Therefore, in specific situations, the staff has required the subsidiary to revise its financial statements to include certain expenses incurred by the parent on its behalf. Examples of such expenses may include, but are not necessarily limited to, the following (income taxes and interest are discussed separately below):

Officer and employee salaries,
Rent or depreciation,
Advertising,
Accounting and legal services, and
Other selling, general and administrative expenses.

When the subsidiary’s financial statements have been previously reported on by independent accountants and have been used other than for internal purposes, the staff has accepted a presentation that shows income before tax as previously reported, followed by adjustments for expenses not previously allocated, income taxes, and adjusted net income.

Question 2: How should the amount of expenses incurred on the subsidiary’s behalf by its parent be determined, and what disclosure is required in the financial statements?

Interpretive Response: The staff expects any expenses clearly applicable to the subsidiary to be reflected in its income statements. However, the staff understands that in some situations a reasonable method of allocating common expenses to the subsidiary (e.g., incremental or proportional cost allocation) must be chosen because specific identification of expenses is not practicable. In these situations, the staff has required an explanation of the allocation method used in the notes to the financial statements along with management’s assertion that the method used is reasonable.

In addition, since agreements with related parties are by definition not at arms length and may be changed at any time, the staff has required footnote disclosure, when practicable, of management’s estimate of what the expenses (other than income taxes and interest discussed separately below) would have been on a stand alone basis, that is, the cost that would have been incurred if the subsidiary had operated as an unaffiliated entity. The disclosure has been presented for each year for which an income statement was required when such basis produced materially different results.

Question 1 of SAB Topic 1.B.1 indicates that a subsidiary’s historical financial statements “should reflect all of its costs of doing business,” including costs incurred on the subsidiary’s behalf by its parent. For those costs incurred on the subsidiary’s behalf by its parent, Question 2 of SAB Topic 1.B.1 states that “any expenses clearly applicable to the subsidiary [should] be reflected in its income statements.” The SEC staff did not provide any further guidance on the determination of which expenses are “clearly applicable” to a subsidiary, and management must use judgment in making such a determination.

For expenses that are “clearly applicable” but for which specific identification is not practicable, management should develop a reasonable allocation method that can be used to allocate the expenses to the carve-out entity. Methods used historically, such as a recurring management fee, are typically not adjusted in the preparation of carve-out financial statements.

Different allocation methods may be determined to be reasonable on the basis of different types of common expenses. Depending on the nature of the expense to be allocated, the following factors may be helpful in an entity’s determination of an appropriate allocation:

Number of employees.
Square footage used.
Percentage of inventory.
Percentage of production.
Percentage of revenue.
Percentage of operating income.

Other factors may also be appropriate. An entity should carefully consider its specific facts and circumstances when determining the basis for allocating an expense. For example, head count may be viewed as a reasonable basis of allocation for certain employee costs, while square footage may be viewed as a reasonable basis of allocation for certain occupancy costs.

Historical costs included in the carve-out entity may not be an accurate indicator of the future costs of the carve-out entity. However, any attempt to adjust historical costs in the carve-out entity to reflect future estimated costs is inappropriate.