For most entities, there is significant complexity involved in the preparation of carve-out financial statements. Because transactions requiring these statements occur infrequently, they often necessitate the use of specialists versed in the subject matter.
Carve-out financial statements are a section of an entity, such as a segment, business unit, or product line, and are derived from the parent’s historical financial information. They are usually needed when a section is divested, such as through a sale to investors, spin-off to existing shareholders, or an initial public offering. Entities prepare carve-out financial statements in order for investors to gain a better understanding of the business, which may then be used during due diligence, in marketing material for the sale of the business, building valuation models, as well as to satisfy public financial reporting requirements.
Here, we highlight four common misconceptions encountered when preparing carve-out financial statements and how to deal with them.
1. Preparing carve-out financial statements is straight-forward.
The preparation of carve-out statements will always present certain complexities that may require input from multiple stakeholders involved in a proposed transaction. These reasons include:
- The limited accounting guidance available on the preparation of carve-out financial statements;
- Decisions made for a parent entity will need to be evaluated through a different lens for the carve-out entity (e.g., sufficiency of historic accounting policies and disclosures);
- Financial information previously audited as part of the parent entity may need to be reexamined at lower materiality thresholds for the carve-out entity; and
- Performance of an in-depth analysis to determine what additional costs may need to be burdened on the carve-out financial statements is required even for an entity or segment that is operating separately from its parent.
In practice, preparers refer to the Securities and Exchange Commission guidance requiring carve-out financial statements to reflect all of the costs of doing business, including directly-attributable costs and an allocable share of other corporate costs, as well as carve-out guidance published by some of the Big Four accounting firms. However, given the limited guidance available, there is often divergence in the treatment of individual items.
The ease in which such financial information can be extracted from the entity’s historical financial information depends on how it was captured. For example, is information for the business discrete from or heavily commingled with the parent entity? The more commingled they are, the more time required to perform an analysis of the discrete financial information to be included in the carve-out financial statements.
2. Historic financial reporting alone is sufficient to determine the carve-out balance sheet and income statement.
Historic financial reporting is the basis for preparing carve-out financial statements. Nevertheless, preparing these statements require a detailed analysis to determine which assets and liabilities, and profits and losses to include.
When determining the assets and liabilities (which are generally recognized entirely or not at all) to include on the balance sheet, consideration is given to legal rights and obligations - such as ownership of the asset or requirement to settle the liability - as well as the entity’s shared use of an asset or liability.
Because the income statement should reflect all of the costs of doing business, when determining the profits and losses to include, consideration is given to items that are specific to the carve-out entity, as well as an expense allocation for corporate or shared service costs.
3. Historical allocation methods for shared costs are appropriate.
It is common for companies to internally allocate corporate costs incurred by the parent to their segments, subsidiaries or product lines. The methodologies employed for historical internal allocations reflect those that management considered were the most appropriate at the time. However, these methodologies should be analyzed to ensure that they reflect the true standalone costs of the carve-out entity.
4. Inter-company transactions must be presented in the carve-out financial statements.
The practice of intercompany transactions is one area where there is a significant degree of divergence. In consolidated financial statements, these transactions are eliminated, but should be analyzed to determine whether and how they should be reflected in the carve-out financial statements. Extensive effort may be required to identify inter-company transactions that were historically eliminated or not allocated to the carve-out entity.
The preparation of carve-out financial statements creates additional work streams for finance teams to be responsible for, and typically require delivery in a condensed timeframe. A well thought out project plan to prepare carve-out financial statements is essential to appropriately present the historical performance position of the entity, and minimize rework and challenges during the audit process.