When a parent entity prepares for a carve-out transaction for the spin-off, sale, or initial public offering (IPO) of a business or division, or wishes to separate the company into multiple strategic business units to facilitate a reorganization, the success of the carve-out will be central to the success of the underlying transaction. Carve-outs are complex undertakings with a myriad of hidden risks and opportunities. Navigating those two extremes while managing, planning, and executing a carve-out transaction requires a capable team and significant experience.
This post shares insights based on CFGI’s experience into potential carve-out accounting pitfalls and how they can be avoided.
Management needs to use judgment and carefully plan when preparing carve-out financial statements since the process can be challenging initially for the parent entity and on an ongoing basis for the carve-out entity.
Materiality
The threshold for materiality in carve-out financial statements can be significantly lower than the parent entity’s consolidated financial statements, given that the carve-out business is often only a fraction of the parent entity’s size.
Accordingly, the parent entity’s historical corrected or uncorrected misstatements and disclosures related to the carve-out entity that may previously have been considered immaterial to the consolidated financial statements need to be reconsidered based on materiality thresholds applicable to the carve-out entity.
In planning for the carve-out, management should carefully review the reconciliation of critical accounts of the carve-out entity by applying a lower materiality threshold. That and the subsequent application of analytics to explain the variances between key financial statement accounts and metrics can help avoid an actual or perceived diminishment of the value of the carve-out entity relative to the underlying transaction thesis.
Basis of presentation
The basis of presentation disclosures for the carve-out entity should clearly explain the methodology and rationale for how the assets, liabilities, profits, and losses were identified and carved-out from the parent to create the carve-out financial statements. Describing and implementing a carve-out methodology and rationale can be challenging if the parent’s historical records did not clearly segregate the carve-out entity’s business activities. As such, when preparing carve-out financial statements, it is critical to undertake a detailed analysis to determine how to allocate profits and losses to the carve-out entity that were not clearly tagged directly to the carve-out entity in the parent’s historical records. Relatedly, it is important to consider how assets and liabilities that may represent benefits and obligations of multiple components (including the carve-out entity) of the parent, should be attributed to the carve-out entity.
Changes to reporting frameworks
Especially relevant in cross-border transactions, converting carve-out financial statements to a new standard such as IFRS or U.S. GAAP may create the potential need for dual reporting or multiple reporting frameworks on an ongoing basis for monthly, quarterly, and annual reporting periods.
This can create resource and knowledge gaps not only during the planning and execution of the carve-out itself but also create an ongoing burden on the post-carve-out entity’s accounting, finance, and regulatory compliance functions. The need to convert financial statements into different accounting and reporting frameworks in multiple jurisdictions to accommodate local financial reporting requirements will magnify the complexity and effort required. In planning to prepare the carve-out financial statements and evaluate the operational aspects of the carve-out entity, it is essential to identify all such standards and jurisdictional changes carefully to ensure that any potentially significant ramifications to the carve-out entity and transaction thesis are considered.
Accounting and reporting considerations related to a planned carve-out transaction
A planned carve-out transaction can create a myriad of accounting considerations for the parent entity including discontinued operations and assets held for sale reporting, changes in reporting units and segments, and impairment considerations related to goodwill and other long-lived assets. Involving carve-out accounting specialists early in the process who can identify and manage potential reporting complexities can improve efficiency and reduce reporting costs on the back-end.
Internal controls
If the carve-out transaction involves an IPO or a sale of the carve-out entity to a public company, the carve-out entity may face several challenges.
In many cases, the carve-out entity will benefit from the parent entity’s internal audit and regulatory compliance functions, which are unlikely to be conveyed as part of the carve-out transaction. As a result, the carve-out entity (in the case of an IPO) or the buyer (in the case of a sale to another public company) may need to pivot quickly to replace the services of those parent functions. While a parent entity may be able to continue providing these functions to some extent under a transition services agreement with the parent, there may be limitations in the nature and duration of such services after the transaction. Similarly, the carve-out entity may have relied upon processes and technology associated with internal controls that are not conveyed as part of the carve-out.
Frequently overlooked, special care should be taken to include internal controls within the perimeter of the carve-out and as part of carve-out management, planning, and execution.
Working with auditors
Given the inherent complexity of preparing carve-out financial statements, it will be essential to have timely auditor involvement in key accounting judgments made during the process. As always, it is essential to understand the auditor’s supporting documentation needs and to maintain an open dialogue throughout to ensure an efficient process.
Meet the authors
Jean-Pierre Henderson has over 17 years of experience providing accounting advisory and consulting services to the technology, media & entertainment and consumer business industries (with a focus on consumer products and retail & distribution). Prior to joining CFGI, Jean-Pierre spent 13 years with Deloitte. He started his career in South Africa and was transferred to New Zealand for a 3-year assignment prior to arriving in New York City. Jean-Pierre was a Senior Manager for 6 years in Deloitte’s Audit Practice in New York City serving large multi-national clients across media & entertainment and the consumer business industries. Get in touch at jphenderson@cfgi.com.
Shawn Assad is the leader of the firm’s Washington, DC office overseeing strategy, business and practice development, and client service delivery in the Mid-Atlantic market. Shawn has more than 23 years of experience providing accounting, management advisory, and transaction services to public and private companies ranging from high growth, venture capital, and private equity-backed to Fortune 500. Shawn has extensive experience advising clients in the areas of SEC reporting, initial public offerings, M&A diligence and integration, technical accounting, finance transformation, process improvement, and enterprise risk management. Get in touch at sassad@cfgi.com.