Deloitte's Roadmap: Carve-Out Financial Statements

This Roadmap provides financial reporting, accounting, and auditing considerations to help companies navigate challenges related to preparing 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 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).

ASC 505-60 defines a spin-off as follows:

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.

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.

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).

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.

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.

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).

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).

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.

The carve-out entity’s operating segments may differ from those identified in the parent entity’s reporting structure. As defined by ASC 280-10-50-1, an operating segment has the following characteristics:

• The segment recognizes revenue and incurs expenses from participating in business activities.
• The chief operating decision maker (CODM) regularly reviews operating results to assess performance and makes decisions about resources to be allocated to the segment.
• Discrete financial statement information about the segment is available.

When goodwill allocated to the carve-out entity is derived from the goodwill balances of the parent, as discussed in Section 2.2, we believe that such goodwill carries with it the results of the parent’s previously performed goodwill impairment tests. Accordingly, upon allocation, an entity is not required to perform impairment testing for historical periods in the carve-out financial statements even if different reporting units are identified going forward for the carve-out entity. This approach is consistent with the view that the formation of the carve-out entity is akin to a reorganization of the parent entity’s reporting units for which retrospective testing of goodwill under the reorganized structure is not required by U.S. GAAP. Future goodwill impairment testing should be performed for the carve-out entity on the basis of its reporting unit structure as of the date of each subsequent test.

A carve-out entity’s financial statements that include goodwill must meet the disclosure requirements in ASC 350-20-50-1 for presenting changes in the carrying amount of goodwill. Under these requirements, an entity must separately disclose:

When the parent entity divests of the carve-out entity, it must determine the amount of goodwill to include with the disposal by using the guidance in ASC 350-20-40-1 through 40-6, which may require a relative fair value allocation. Differences may exist between (1) the allocation method used by the parent entity in determining the amount of goodwill to attribute to the net assets disposed of and (2) the method used to identify and attribute goodwill to the financial statements of the carve-out entity. As a result of the use of these two methods, there may be differences between the amount of goodwill that the parent entity (1) derecognizes from its financial statements when it divests of a carve-out entity and (2) includes in the carve-out financial statements (see Section 2.2). In addition, ASC 350-20-40-7 states:

Use of a multiemployer approach is based on analogy to the guidance in ASC 715-80-35-1 on multiemployer plans, as further described in ASC 715-30-55-62 through 55-64. This guidance describes accounting similar to the accounting a subsidiary would use in its stand-alone financial statements if it participates in a defined benefit plan sponsored by the parent entity for which the plan assets are not segregated and restricted for each participating subsidiary. This approach would not reflect the carve-out entity’s share of the benefit obligation, plan assets, and related AOCI amounts in the carve-out financial statements. An intercompany payable or receivable may be included in the carve-out financial statements depending on the historical approach an employer has used when allocating benefit costs or funding the plan. Under this approach, if the carve-out entity will assume responsibility for a portion of the plan’s benefit obligation, the financial statements should disclose either the benefit obligation and plan assets to be assumed by the carve-out entity or, if that information is not available, the information available for the plan’s aggregate benefit obligation and plan assets before the carve-out transaction.

Under an allocation approach, the carve-out entity would reflect its portion of the benefit obligation, plan assets, and any related AOCI amounts in the carve-out financial statements. This approach may be more helpful to financial statement users if the carve-out entity will assume part of the benefit obligation because the carve-out financial statements would include the amount of the benefit obligation to be assumed by the carve-out entity (and, hence, to be carried forward into future financial statements and operating results). In accordance with ASC 845-10-55-1, if a pension obligation is being transferred as part of a spin-off, an entity must account for such a transfer similarly to how it accounts for a division of a pension plan that was previously part of a larger pension plan. For both pension and other postretirement defined benefit plans, it is appropriate for an entity to analogize to this guidance when preparing the carve-out financial statements.

The purpose and the timing of the preparation of carve-out financial statements may be relevant to the evaluation of which method of accounting for defined benefit plans is most appropriate in a given set of facts and circumstances. For example, the allocation approach might be considered more appropriate when there already is an agreement in place between a buyer and seller of a business that clearly delineates which part of the parent entity’s benefit obligation will be assumed by the buyer. In other situations, historical carve-out financial statements may be prepared in advance of a transaction agreement to assist the parent entity in marketing and selling the carve-out business. In the absence of contractual terms between a buyer and seller that support the structure of the transaction and related treatment of the benefit obligation, the multiemployer approach might be considered more appropriate.

The parent entity should also consider whether, in connection with the potential sale of a business, a curtailment has occurred that should be reflected in the parent’s income statement. In addition, if the parent entity determines that a defined benefit plan will be settled or terminated as a result of the carve-out transaction, the accounting impact of such settlement or termination should be included in the parent’s financial statements when it occurs.

Companies often have centralized cash management functions involving “sweep” accounts or “cash pools.” The classification of any deposits by a carve-out entity in a cash pool as cash or a cash equivalent depends on the terms of the arrangement and whether the deposit represents a demand deposit in the carve-out entity’s name at a bank or financial institution. See Section 4.3 of Deloitte’s Roadmap Statement of Cash Flows for more information.

For deferred compensation plans, management must determine whether to allocate those balances or a portion thereof to the carve-out entity. The deferred compensation balances generally should “follow the employee” to whom they are related. Management should consider where the employee provided services within the consolidated entity as well as where the employee will be employed once the carve-out transaction is completed. Often, these factors align (e.g., when the carve-out entity represents a reportable segment of the parent, and the employee for that reportable segment will be transferred with the carve-out entity). Careful consideration is necessary to ensure that costs are properly reflected in the carve-out financial statements in situations in which the employee provided services to the carve-out entity but will not be transferred with it.

Self-insurance accrual allocations can be complex and generally require the involvement of an actuary. If the parent entity maintains sufficient claim detail, management may be able to identify the specific claims attributable to the carve-out entity. For example, if a parent entity is carving out five plants, management may be able to use “plant identifiers,” such as a company code, to identify the specific claims associated with the five plants. However, if a parent entity does not have sufficient detail in its claims data to identify the claims attributable to the carve-out entity, management would need to determine an appropriate allocation method to estimate the amount. Allocation methods may take into account such factors as payroll exposure data and percentage of head count associated with the carve-out entity.

When preparing carve-out financial statements, entities should consider whether to include the right-of-use (ROU) assets and lease liabilities of the parent entity and, if so, in what amounts. Regardless of whether the carve-out entity recognizes the ROU assets and lease liabilities, it should include lease expense that clearly applies to it (see Section 3.1 for further discussion) in its financial statements, which must reflect all of its costs of doing business.

To the extent that there are intercompany transactions between the carve-out entity and parent, management should consider whether the controls in place are sufficiently precise to cover the transactions at an intercompany level. For example, if management uses certain transaction codes to identify intercompany sales, it should consider whether there are controls over the master data inputs and changes to the transaction code field that would ensure that the identification of intercompany amounts is complete and accurate. Further emphasis should be placed on whether the transactions are appropriately reflected within and among the relevant entities so that management can evaluate whether the transactions are completely and accurately stated in the carve-out financial statements. In addition, management should consider granular transaction-level detail in the preparer’s systems of record (as opposed to “batched” information, which may not retain all detail related to certain intercompany transactions) to ascertain the nature of certain intercompany balances from a cash flow perspective (e.g., if intercompany cash transfers are recorded in a net intercompany payables account, there may be no visibility into gross borrowings and payments).

In contemplation of a carve-out transaction, management may choose to modify stock compensation awards. In addition, such awards may have a provision in which their vesting is accelerated because of the carve-out transaction’s completion. Management should consider how much of (1) the incremental compensation costs from a modification and (2) the costs associated with the acceleration of vesting (if any) should be allocated to the carve-out entity.

The carve-out entity’s statement of cash flows typically will be similar to that of the parent entity. However, differences may arise as a result of the presentation of the cash flow effects of intercompany transactions. As discussed in Section 3.2, although intercompany transactions are eliminated in consolidation of the parent entity’s financial statements, they generally should not be eliminated from the carve-out financial statements unless they are transactions that take place exclusively within the carve-out entity. Once management determines whether intercompany activities should be reflected in the carve-out entity’s statement of cash flows, it must classify cash receipts and cash payments related to each activity as operating, investing, or financing on the basis of the nature of that activity in accordance with the guidance in ASC 230.

When the financial statements of the carve-out entity reflect a disposal of a component of the carve-out entity, management must determine whether it should present the disposal as a discontinued operation in the carve-out financial statements even if the disposal did not qualify for discontinued-operations presentation in the parent entity’s consolidated financial statements. Specifically, management would consider the guidance in ASC 205-20-45-1B on reporting a discontinued operation, which states, in part:

Under ASC 205-20, the parent entity is required to evaluate whether the effect of a disposal resulting from a carve-out transaction should be presented as a discontinued operation. Depending on the form of the carve-out transaction, this evaluation may occur when the carve-out entity (1) meets the criteria in ASC 205-20-45-1E to be classified as held for sale, (2) is disposed of by sale, or (3) is disposed of other than by sale in accordance with ASC 360-10-45-15 (e.g., by abandonment or in a distribution to owners in a spin-off). If the disposal meets the conditions to be reported as a discontinued operation by the parent entity, it would be unlikely that amounts presented as discontinued operations for the disposal in the parent-entity financial statements would equal the operations reflected in the carve-out entity’s financial statements (e.g., because of differences between how expenses may have been allocated in the carve-out financial statements and how expenses associated with the discontinued operation are determined).

Under ASC 855, SEC filers are defined as including only entities that are required to file financial statements with the SEC (or with another appropriate agency in accordance with the Securities Exchange Act of 1934 [the “Exchange Act”]). Because an entity that files financial statements in an initial registration statement is not required to file its financial statements with the SEC until the registration statement is declared effective, it does not meet the definition of an SEC filer under ASC 855 and therefore must disclose the date through which management evaluated subsequent events in the financial statements. Similarly, the definition of an SEC filer in ASC 855 does not encompass an entity whose financial statements are included in an SEC registrant’s filing. Accordingly, when an SEC registrant’s filing includes financial statements of an entity that is not considered an SEC filer under ASC 855 (e.g., financial statements of a significant acquiree under Rule 3-05), the non-SEC filer must disclose the date through which subsequent events have been evaluated and whether that date was the date of issuance or the date on which the non-SEC filer’s financial statements were available to be issued.

While the determination of the number of audited financial statement periods to be presented for an acquiree is based on the level of significance, the form and content of the acquiree’s carve-out financial statements are generally the same as if the acquiree were a registrant and must meet the relevant requirements of SEC Regulation S-X9 and U.S. GAAP.10 Supplemental schedules under SEC Regulation S-X, Articles 5 and 12, are not required.

The definition of a PBE in the ASC master glossary includes a business entity that is required by the SEC “to file or furnish financial statements, or does file or furnish financial statements (including voluntary filers), with the SEC (including other entities whose financial statements or financial information are required to be or are included in a filing)” (emphasis added). Therefore, PBEs include entities whose financial statements or financial information is required under Rule 3-05, and such carve-out financial statements must address the PBE requirements in U.S. GAAP.

There may be situations in which it is not practicable for management to prepare full carve-out financial statements of an acquiree, such as when the acquiree is a small portion or a product line of a much larger business and separate financial records were not maintained. In such instances, the SEC staff allows registrants to file abbreviated financial statements — that is, audited statements of assets acquired and liabilities assumed (in lieu of a full balance sheet) and audited statements of revenues and direct expenses (in lieu of a full statement of operations) — to satisfy the financial statement requirements of Rule 3-05, provided that certain qualifying conditions as well as presentation and disclosure requirements are met. In addition, Rule 3-05(f) allows a registrant to provide a form of abbreviated financial statements for an acquired or to be acquired business that includes significant oil-and-gas-producing activities. For additional information, see Section 2.6.4 of Deloitte’s Roadmap SEC Reporting Considerations for Business Acquisitions.

When audited financial statements of an acquiree are provided under Rule 3-05, the audit must be performed in accordance with AICPA standards but compliance with PCAOB standards is not required.12 SEC regulations generally do not require registrants to obtain an audit or review of interim financial statements provided under Rule 3-05. However, a company’s underwriters will often require that a review of interim information be performed by its independent auditors for due-diligence or comfort purposes.

There are two categories of required pro forma adjustments:

• Transaction accounting adjustments — These adjustments are limited to those that reflect the accounting for the transaction in accordance with U.S. GAAP or IFRS® Accounting Standards, as applicable. For an acquisition, such adjustments may include, among other items, the recognition of goodwill and intangible assets and adjustments of assets and liabilities to fair value on the balance sheet, as well as the related impacts on the statement of comprehensive income.
• Autonomous entity adjustments — These adjustments, which are only required if the registrant was previously part of another entity, reflect incremental expenses or other changes necessary to reflect the registrant’s financial condition and results of operations as if it were a separate stand-alone entity. (See Section 5.4.2.)