Carve-out transactions can take many forms and are often an inevitable part of a company’s life cycle. Such transactions occur when a parent company separates a portion of its operations (referred to as the “carve-out entity”) and prepares a distinct set of financial statements for the carve-out entity in anticipation of a sale or spin-off, aiming for an IPO or SPAC transaction. The preparation of carve-out financial statements can be challenging, and both buyers and sellers of carve-out entities may be subject to additional SEC reporting requirements if they are SEC registrants. Executives should be prepared for these additional SEC reporting obligations and the complexities that arise from these transactions.
Basis of presentation and materiality considerations for carve-out financial statements
The carve-out entity can take the form of an entire or partial operating unit, product line, brand, subsidiary, etc., set to be divested from the parent company. Describing and implementing a carve-out methodology and rationale for use as the basis of presentation disclosures can be challenging if the parent’s historical records did not clearly segregate the carve-out entity’s business activities. Therefore, when preparing carve-out financial statements, it is crucial to define the carve-out entity and determine how to allocate revenues and expenses that were not tagged directly to the carve-out entity in the parent’s historical records. Similarly, judgment is required to decide whether assets and liabilities that may be applicable to multiple components of the parent should be attributed to the carve-out entity. In addition, the carve-out financial statements should clearly indicate in the basis of presentation disclosures whether the statements should be labeled as consolidated, combined, or both, depending on the structure.
During the preparation of carve-out financial statements, management may need to make significant accounting judgments and estimates, including:
- Identifying the carve-out entity’s operating and reportable segments, and preparing and presenting segment disclosures in the carve-out financial statements;
- Allocating goodwill to the carve-out entity and assessing goodwill for impairment in the periods presented.
Concerning cave-out financial statement preparation, it’s essential to note that materiality thresholds related to the carve-out entity will likely be lower than those associated with the parent. This could necessitate additional scrutiny of the carve-out entity’s account balances and historical uncorrected misstatements previously deemed immaterial at the parent level.
Due to the complexities and subjective judgments required to determine the appropriate basis of presentation, pre-clearance with the SEC regarding basis of presentation decisions may be required or advisable for some carve-out transactions.
Common examples of carve-out transactions and associated SEC reporting requirements
In a sale scenario, if the carve-out entity meets the SEC’s definition of a business, carve-out financial statements may need to be filed for up to three years preceding the carve-out transaction. The number of years required will depend on the results of the SEC’s significance tests for how significant the acquisition is to the acquirer. If the results of any of the SEC’s three significance tests (i.e., asset, investment, or income) exceed 20%, at least one year of carve-out financial statements will be required. When carve-out financial statements are mandated by the SEC, pro forma financial information under Article 11 of Regulation S-X will also be necessary, and management’s discussion and analysis of financial position and results of operations under Regulation S-K may also be required.
The four types of transactions listed below are common examples where carve-out transactions may trigger SEC reporting obligations.
- A public entity may need to prepare carve-out financial statements to effect an IPO of a newly created subsidiary.
- A public entity may carve-out a portion of its business to create a new public subsidiary and distribute the shares in the new entity to the parent entity’s shareholders on a pro-rata basis, otherwise known as a “spin-off.”
- A public entity may acquire, or it is probable that it will acquire, a carve-out entity meeting the SEC’s definition of a business that is significant to the public entity based on the results of the SEC’s significance tests.
- A public entity may dispose of an asset or a business that is significant to the public entity based on the results of the SEC’s significance tests.
How CFGI can help
CFGI has experts with a wide range of knowledge and experience to help you through the complexities of your next carve-out transaction. With the various SEC requirements that arise from carve-out transactions, it is critical to have a team of specialists with the skills and expertise to navigate you through each step of your transaction. If you have questions or would like to learn more, please reach out to Matthew Podowitz (mpodowitz@cfgi.com) or Greg Taylor (gtaylor@cfgi.com).