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To prepare carve-out financial statements, management must first determine what is being divested. This determination impacts the operations and assets and liabilities included in the financial statements and the costs to be allocated.
There are generally two approaches used to prepare carve-out financial statements: a legal entity approach and a management approach. Determining which approach to apply depends on the facts and circumstances of the transaction.
Factors that impact how the carve-out financial statements are prepared include:
  • the purpose of the transaction,
  • the legal structure of the transaction (e.g., whether shares of a legal entity or the net assets of a business are being divested),
  • the form of the transaction (e.g., spinoff or sale),
  • whether or not certain net assets and results of operations retained by the parent can be excluded on a retroactive basis (i.e., a "depooling") from the historical financial statements, and
  • The portion of the legal entity that is being acquired/divested relative to the portion that is not being acquired/divested.
If the form of the transaction has not been determined, the reporting entity may need to consider each of the possible outcomes, and the reporting requirements of each outcome.

2.1.1 Legal entity approach

The legal entity approach is often appropriate in circumstances when the transaction structure is aligned with the legal entity structure of the divested entity. One example would be when shares of a legal entity or a consolidated group of legal entities are divested.
If it is determined that the legal entity approach is appropriate, all historical results of the legal entity, including those that are not ultimately transferred, should be presented in the historical financial statements through the date of transfer. If the historical results of operations of the carve-out entity include legal entities that will not ultimately be divested, the operations remaining with the parent company should be assessed under ASC 205-20, Discontinued Operations. See Example CO 6-2 for an example of how a carve-out business assesses the discontinued operations criteria related to operations that are part of the historical results of the carve-out business but will remain with the parent.
A legal entity approach is typically used when (1) the transaction is a spinoff or IPO and the “depooling” criteria of SAB Topic 5.Z.7, Accounting for the spin-off of a subsidiary, codified as ASC 505-60-S99-1, are not met (see CO 2.1.3) or (2) the transaction is a sale of substantially all of the legal entity (see CO 2.1.4).

2.1.2 Management approach

In some circumstances, utilizing a legal entity approach may not be appropriate or may not provide the most meaningful presentation of financial information to the users of the carve-out financial statements. This may be the case when net assets that constitute a business, rather than a legal entity, are being divested, or when the legal structure of an entity does not align with the business being sold. The management approach takes into consideration the assets that are being transferred to determine the most appropriate financial statement presentation.
A management approach may also be appropriate when a parent entity needs to prepare financial statements for the sale of a legal entity, but prior to divestiture, certain significant operations of the legal entity are contributed to the parent in a common control transaction.
A management approach is typically used when (1) the transaction is a spinoff or IPO and the “depooling” criteria of SAB Topic 5.Z.7 are met (see CO 2.1.3), (2) the transaction is a sale that does not represent substantially all of the legal entity (see CO 2.1.4) or (3) the transaction is the divestiture of net assets (or a combination of net assets and legal entities).
Example CO 2-1 illustrates the application of the management approach.
EXAMPLE CO 2-1
Applying the management approach
Parent Entity operates in the construction industry through two subsidiaries, Residential Building Company Inc. and Commercial Building Company Inc., each of which is a separate legal entity. Residential Building Company Inc. and Commercial Building Company Inc. are comprised of several divisions. Parent Entity plans to sell the supply divisions of Residential Building Company Inc. and Commercial Building Company Inc. to a buyer.
What operations should be included in the historical financial statements of the carve-out business?
Analysis
The planned transaction is not a divestiture of legal entities. Accordingly, a management approach in which the presentation of the operations and net assets of the residential and commercial building supply divisions are combined would be appropriate. The resulting financial statements will be labeled combined. See CO 5.2 for guidance on whether an allocation of corporate costs from Residential Building Company Inc., Commercial Building Company Inc., and/or Parent Entity would need to be reflected in the financial statements.

2.1.3 Depooling a dissimilar business

If the transaction is an IPO or spinoff of a preexisting legal entity, whether to use the legal entity or the management approach is based on whether or not certain net assets and results of operations retained by the parent can be excluded on a retroactive basis (i.e., a "depooling") from the historical financial statements. SAB Topic 5.Z.7 provides the criteria for this evaluation. If the criteria are met, the entity may elect to apply the management approach, presenting only the net assets and operations included in the IPO or spinoff. If the criteria are not met, the entity should apply the legal entity approach.
For the retained business to be separated, or depooled, from the business that will be spun-off, one requirement in SAB Topic 5.Z.7 is that they are “dissimilar.” Our experience is that to meet this requirement, the businesses must be significantly different, such as when one business is a car wash and the other is a bank. If the reporting entity cannot separate the two businesses because they are not sufficiently dissimilar, then the business that will not be included in the transaction are included in the carve-out financial statements. Notwithstanding, the business that is not part of the IPO or spinoff transaction may be reflected as a discontinued operation under ASC 205-20 if those criteria are met. See FSP 27.4.3.1.
In addition to being in dissimilar businesses, SAB Topic 5.Z.7, requires the reporting entity to consider if each of the following criteria are met:
  • The businesses have been managed and financed historically as if they were autonomous;
  • The businesses have no more than incidental common facilities and costs;
  • The businesses will be operated and financed autonomously after the transaction; and
  • The businesses will not have material financial commitments, guarantees, or contingent liabilities to each other after the transaction.
Example CO 2-2 provides an example of the application of SAB Topic 5.Z.7 when part of the legal entity is retained by the Parent entity.
EXAMPLE CO 2-2
Applying the legal entity approach when part of the legal entity is retained
Company X is a diversified financial services company with operations in a number of lines of business. Company X operates its insurance business (life insurance and auto insurance) through its wholly-owned subsidiary, Subsidiary S. The life insurance and auto insurance divisions each have their own customer base and distribution channel.
Subsidiary S intends to file a registration statement in connection with an IPO. Prior to completing the IPO, Company X intends to transfer the automobile insurance operations from Subsidiary S's legal structure to another legal entity within the Company X group.
Can Subsidiary S present its financial statements in the IPO prospectus as if Subsidiary S had never legally owned the automobile insurance company (i.e., "depool" the automobile insurance business and recast all prior periods)?
Analysis
Given the transaction is an IPO of a preexisting legal entity, the use of the legal entity or the management approach is based on whether the net assets and results of operations retained by the parent can be excluded on a retroactive basis (i.e., a "depooling") from the historical financial statements. SAB Topic 5.Z.7 provides the criteria for this evaluation and all the criteria should be evaluated. Although the businesses are dissimilar with respect to the nature of the customer risks being insured and the marketing channels utilized, the underlying business of both entities involve insurance. Because they are both in the insurance business, they would likely be viewed as similar for purposes of applying SAB Topic 5.Z.7. As such, Subsidiary S would reflect the ownership of the automobile insurance company in its financial statements and should not depool these operations. If the criteria for discontinued operations presentation are met, the automobile insurance company would be reflected as a discontinued operation.

2.1.4 Substantially all of the legal entity

If the transaction is a sale of a preexisting legal entity, and is not an IPO or spin transaction, then the determination of whether the legal entity or management approach should be used is based on whether the divested business represents “substantially all” of the legal entity. SEC FRM 2065.1 through SEC FRM 2065.2 provide the guidance for this evaluation. If the divested business represents “substantially all” of the legal entity, the entity should apply the legal entity approach. If the divested business does not represent “substantially all” of the legal entity, the entity should apply the management approach.

SEC FRM 2065.1 Acquire Substantially All of an Entity –

If the registrant acquires or succeeds to substantially all of the entity's key operating assets, full audited financial statements of the entity are presumed to be necessary in order to provide investors with the complete and comprehensive financial history of the acquired business. In these circumstances, elimination of specified assets and liabilities not acquired or assumed by the registrant is depicted in pro forma financial statements presenting the effects of the acquisition.

SEC FRM 2065.2 Acquire Less than Substantially All of an Entity –

In some circumstances, a registrant does not acquire or succeed to substantially all of the assets and liabilities of another entity. For example, the selling entity may retain significant operating assets, or significant operating assets that comprised the seller may continue to be operated by an entity other than the registrant. In these circumstances, financial statements of the larger entity of which the acquired business was a part may not be informative. In that case, audited financial statements usually should be presented for the acquired component business, excluding the continuing operations retained by the larger entity. Registrants should evaluate their facts and circumstances to determine whether to apply the guidance in Section 2065.3 (carve-out financial statements) or in Sections 2065.4 through Section 2065.12 (abbreviated financial statements).

There is not a bright line test to make the substantially all assessment. Rather, it requires judgment and is based on the particular facts and circumstances. The analysis might consider a comparison of financial metrics (such as total assets, revenue, operating income, pre-tax income, operating cashflows being disposed versus remaining) and operating metrics, like total stores.
Example CO 2-3 illustrates the appropriate approach when a sale constitutes substantially all of a legal entity.
EXAMPLE CO 2-3
An acquisition of “substantially all” of a legal entity
Company A, an existing SEC registrant, owns and operates a national chain of convenience stores. Company A will acquire the shares of Acquiree B (a legal entity) in February 20x1 in a transaction that will be accounted for as an acquisition of a business in accordance with ASC 805, Business Combinations. Acquiree B owns and operates a national chain of 100 convenience stores. In January, prior to its acquisition by Company A, Acquiree B transfers 5 stores that are not being acquired by Company A to Acquiree B’s shareholder. The 95 stores remaining in Acquiree B represent approximately 95% of the key operating assets of Acquiree B prior to its acquisition. The acquisition of Acquiree B and the remaining stores is significant to Company A and requires financial statements under Regulation S-X Rule 3-05.
How should the 5 stores not being acquired be reflected in Acquiree B’s 20x0 financial statements?
Analysis
In preparing financial statements under Regulation S-X Rule 3-05, Company A would present separate financial statements of Acquiree B including all 100 stores in its Form 8-K because Company A has acquired “substantially all” of Acquiree B’s key operating assets. The elimination of the remaining assets and liabilities not acquired (i.e., the 5 stores transferred prior to the acquisition by Company A) would be depicted in pro forma financial information in accordance with Regulation S-X Article 11.

Example CO 2-4 illustrates the determination of the appropriate approach when a sale does not constitute substantially all of a legal entity.
EXAMPLE CO 2-4
An acquisition of “less than substantially all” of a legal entity
Company A, an existing SEC registrant, owns and operates a national chain of convenience stores. Company A will acquire the shares of Acquiree B (a legal entity) in a transaction that will be accounted for as an acquisition of a business in accordance with ASC 805. Acquiree B owns and operates a national chain of 100 convenience stores. Prior to its acquisition by Company A, Acquiree B will transfer 60 stores that are not being acquired by Company A to Acquiree B’s shareholder. The 40 stores remaining in Acquiree B represent approximately 40% of the key operating assets of Acquiree B prior to its acquisition. The acquisition of Acquiree B and the remaining stores is significant to Company A and requires financial statements under Regulation S-X Rule 3-05 or Regulation S-X Rule 8-04.
How should the 60 stores not being acquired be reflected in Acquiree B’s financial statements?
Analysis
Given that the 60 stores not acquired by Company A represent significant operating assets retained by the seller, Company A would likely determine that the full financial statements of Acquiree B including all 100 stores would not be meaningful to the users of the financial statements. Rather, in preparing financial statements under Regulation S-X Rule 3-05 or Regulation S-X Rule 8-04, Company A would present carve-out financial statements for the 40 stores of Acquiree B. The footnotes to the financial statements should disclose that they represent the financial statements of the acquired component of Acquiree B (i.e., the 40 stores acquired). The financial statements would not represent that they consist of the consolidated financial statements of legal Acquiree B since the consolidated financial statements of legal Acquiree B would include all 100 stores.
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