Chapter 2 — Identifying the Required Financial Statements for the Registration Statement

2.3 Predecessor Financial Statements

If a registrant has not had substantive operations for all periods presented in an IPO registration statement, it is important to consider whether the registrant has a “predecessor” company or business.

Section 1170 of the FRM indicates that the designation of an acquired business as a predecessor is based on both of the following criteria:

The registrant “succeeds to substantially all of the business (or a separately identifiable line of business) of another entity (or group of entities).”
“[T]he registrant’s own operations before the succession appear insignificant relative to the operations assumed or acquired.”

A predecessor’s historical financial information is considered important to an investing decision. As a result, the registrant’s financial statements and those of its predecessor together should typically cover all periods required by Regulation S-X, with no lapse in audited periods. Further, the predecessor financial statements must be audited in accordance with PCAOB, not solely AICPA, standards and will be required not only in the IPO but also in subsequent periodic reports.

The SEC staff believes that when a newly formed company (i.e., a “newco”) is formed to acquire multiple entities in conjunction with an IPO, instances in which there is no predecessor would generally be rare, even if the newco is substantive and was deemed the accounting acquirer. The staff highlighted a number of factors for registrants to consider in determining the predecessor, including (but not limited to) (1) the order in which the entities are acquired, (2) the size of the entities, (3) the fair value of the entities, and (4) the historical and ongoing management structure. No one item is determinative on its own. In addition, the staff has encouraged registrants to evaluate their determination of predecessors in light of how management intends to discuss its business in the IPO registration statement as well as whether financial information in its subsequent Forms 10-K would provide sufficient information to investors.1 The staff noted that while there may be situations in which more than one predecessor exists, it would be rare for no predecessor to be identified unless the registrant is a start-up business. Carve-outs and entities in roll-up transactions frequently meet the criteria to be identified as predecessors and are discussed below in more detail.

2.3.1 Carve-Out Financial Statements

As described in Section 2.5.3.2, “carve-out financial statements” is a generic term used to describe separate financial statements that are derived from the financial statements of a larger parent company. A carve-out situation occurs when a parent company segregates a portion of its operations and prepares a distinct set of financial statements for the segregated portion in anticipation of a sale, spin-off, or IPO of the “carve-out business.” Examples of a carve-out business include an operating segment or multiple segments, all or part of a subsidiary, and even a division or line of business of a larger parent company. The carve-out business may not be in a separate, preexisting legal entity and thus is often merged into a recently organized entity in an IPO.

In an IPO, it is critical that carve-out financial statements reflect the appropriate assets and operations of the registrant or its predecessor so that the financial statements include all the costs of doing business. Frequently, a carve-out business will involve multiple legal entities and include operations that have not historically been reported separately. In determining the composition of the carve-out financial statements, an entity should consider its specific facts and circumstances and may need to use significant judgment. Carve-out financial statements should present information about all aspects of the carve-out business’s historical results and operations (i.e., provide balanced and transparent financial information that reflects all of the operation’s historical successes and failures). As a result, the carve-out financial statements may even include certain assets or operations that are not part of the IPO transaction. These financial statements may therefore reflect more than the entity in which the investor ultimately invests. However, in this situation, a registrant would provide pro forma financial information to adjust the historical carve-out financial statements to reflect only the net assets and operations included in the IPO.

The SEC staff has acknowledged that the determination of which carve-out financial statements to include in a registration statement can be complex. Registrants therefore need to use judgment in making this determination, particularly because (1) there may not be directly applicable SEC guidance on this topic and (2) the accounting guidance (e.g., the guidance in ASC 505-60 on determining the accounting spinnor and spinnee) may not be completely consistent with the SEC’s reporting requirements. The SEC staff has also indicated that financial reporting differences may arise depending on the legal form of the transaction. Therefore, the form and content of these financial statements may vary depending on the circumstances.

In determining what to include in the carve-out financial statements, registrants may need to consider issues such as the parent’s existing reporting structure (e.g., segments and reporting units), the nature and size of the operations being carved out compared with the operations being retained by the parent, and the legal structure of the carve-out. Registrants should also consider the information in the “description of business” and MD&A sections of their registration statements and whether such information, along with the financial statements, gives investors a consistent, full, and transparent picture.

Carve-out entities in an IPO will need to consider their compliance with regulations governing other entities’ financial statements, including those in Regulation S-X, Rules 3-05 and 3-09, related to acquisitions and equity method investments, respectively. Such regulations will have to be considered on a stand-alone basis because the level of significance of acquisitions and the equity method investments to the carve-out entity may differ significantly from the level of significance to its parent.

For additional considerations related to carve-out transactions, see Deloitte’s Roadmap Carve-Out Financial Statements.

2.3.2 Put-Together or Roll-Up Transactions

Regulation S-K, Item 901(c)(1), defines a “roll-up” transaction as “a transaction involving the combination or reorganization of one or more partnerships, directly or indirectly, in which some or all of the investors in any of such partnerships will receive new securities, or securities in another entity.” A “put-together” is not specifically defined by the SEC but is discussed in paragraph 2025.12 of the FRM as a transaction in which more than two previously unrelated businesses combine concurrently with an IPO. Such a transaction normally occurs when a shell company is formed to purchase two or more businesses or an operating entity acquires several entities at once. The proceeds from the IPO are generally used to fund the acquisitions.

The terms “put-together” and “roll-up” are also sometimes used generically for other transactions in which two or more smaller companies are combined to form a larger company before an IPO transaction. One common example would be a scenario in which investors (often private equity firms) acquire multiple smaller companies within the same market and combine them to form a larger company, with a goal of achieving economies of scale or combining companies with complementary capabilities. Regardless of the form of the transaction, there are many unique considerations related to an IPO of an entity created through a “put-together” or “roll-up” transaction. Such considerations may include:

The timing of the mergers, which can range from acquisitions over a multiyear period before an IPO to acquisitions concurrent with, and contingent on, the closing of an IPO.
Any preexisting commonality of ownership between the combining entities.
Whether the combining entities are considered “related businesses” under SEC guidance.2
Who the accounting acquirer is and how the mergers will be accounted for.
Identifying the registrant and whether there is a predecessor (or potentially multiple predecessors).
Whether financial statements of any combining entities may be required under Regulation S-X, Rule 3-05, in addition to the financial statements of the registrant and its predecessor(s). (See Section 2.5.4 for more information.)

Footnotes

If a business is not identified as a predecessor, it would generally be evaluated under Regulation S-X, Rule 3-05. Therefore, in an IPO registration statement, the financial statements of nonpredecessor entities may be provided under Rule 3-05. However, for subsequent Forms 10-K, only the financial statements of the registrant and its predecessor(s) would be required.

Businesses are related if (1) they are under common control or management or (2) their acquisitions depend on each other or on a single common event or condition. See paragraph 2015.12 of the FRM for more information.