1. September 2010
Mergers & Acquisitions
—A snapshot
Change the way you think about tomorrow’s deals*
Stay ahead of the new accounting and reporting standards for M&A
Summary Carve-out Financial Statements: A
Purpose of Carve-out challenging process
Financial Statements
In many M&A transactions, companies looking to dispose of non-core
Treatment of Certain
businesses or to generate cash may sell only a portion of their operations
Assets, Liabilities & (e.g., a subsidiary or a business unit). As part of these transactions, a seller
Expenses may need, or want, to prepare separate financial statements of the operations
Non-financial Asset being sold, commonly referred to as carve-out financial statements.
Impairments
The preparation of these financial statements can be challenging as there is
Other Reporting limited guidance covering their composition. This volume of Mergers &
Considerations Acquisitions - A snapshot, focuses on some of the issues companies may face
Conclusion when preparing carve-out financial statements, how those statements may
differ from their own financial statements, and how the M&A Standards 1 may
impact the accounting for transactions that are reported in the carve-out
financial statements.
1
Accounting Standards Codification Topic 805, Business Combinations, is the US Standard on M&A, and Accounting Standards Codification
Topic 810, Consolidation, is the US Standard on consolidations (collectively the "M&A Standards").
*connectedthinking
2. Purpose of Carve-out Financial Statements Tangible and Intangible Assets
Carve-out financial statements refer to the separate Carve-out Entity
financial statements of a business that are derived or
"carved-out" from the financial statements of a larger Depending on the circumstances, assets may be attributed
entity. The purpose of the carve-out financial statements is to the carve-out entity based on legal ownership, usage, or
to reflect the historical operations of the carve-out entity on through an intercompany sharing arrangement, such as an
a stand-alone basis. The separate financial statements operating or lease agreement. It is not always easy to
may be used to comply with a buyer's requirement for determine which assets should be included in the carve-
audited financial statements of an acquired business, out financial statements. This could be the case when
appear in an initial public offering of securities, or serve as numerous divisions within a consolidated entity share the
the basis for final purchase price discussions in an M&A use of an asset.
transaction.
Applying the Guidance - Shared Intangible Assets
Oftentimes, separate financial statements have never Facts: The carve-out entity and several other business
been prepared for the results of a company's operations units utilized the selling company's brand name. The
below the consolidated level, and those operations may brand name is legally owned by the selling company and
not be fully burdened with the total cost of doing business. will not be sold to the buyer.
Thus, preparing carve-out financial statements for the first
time can be challenging. Adding to the challenges is the Analysis: It would not be appropriate to reflect a portion of
fact that no accounting definition of a carve-out transaction the historical cost of the brand name as an asset on the
exists, and there is limited accounting guidance related to carve-out entity's balance sheet since the brand will not be
the preparation of carve-out financial statements. Further, sold to the buyer. The carve-out income statement should
judgments may need to be made in many areas, including reflect an expense representative of the cost to use the
impairment and valuation allowance assessments, and brand name, such as a hypothetical royalty that might be
those judgments may differ from the judgments made in charged by the owner of the brand. On the other hand, if
preparing the seller's financial statements. Any judgments the buyer were to acquire the brand name along with the
and assessments that are needed will likely be needed for carve-out entity, it would generally be appropriate to
all relevant periods presented. Moreover, the seller's include a brand name asset on the balance sheet of the
financial statements and the carve-out financial statements carve-out entity. The income statement would then reflect
may treat the same item differently. As a result, the the full cost of the amortization of the brand name, offset
preparation of carve-out financial statements requires in part by intercompany credits reflecting any use of the
special attention to ensure that all of the assets and brand name by the other business units.
liabilities of the separate business have been properly
identified, and that all relevant costs of doing business
have been reflected in the carve-out financial statements. Selling Company
Treatment of Certain Assets, Liabilities and Expenses The tangible and intangible assets included in the carve-
out financial statements should be assessed by the selling
The assets and liabilities that are assigned to the carve-out company for appropriate presentation. Most likely, these
entity will reflect, for the most part, the same basis of assets will be reflected as assets held for sale in the
accounting as that used by the selling company. This is the selling company's financial statements once the held-for-
case even though an entity that acquires the carve-out sale criteria are met. At that time, depreciation or
entity will record its assets and liabilities at fair value in amortization would cease in the seller's financial
accordance with acquisition accounting requirements. Thus, statements, even though the assets would continue to be
while the purpose of carve-out financial statements is to used and depreciated or amortized by the carve-out entity.
reflect the historical operations of the carve-out entity,
acquisition accounting reflects the investment made by the Debt
acquiring entity.
Carve-out Entity
However, determining which asset, liability, or expense
items should be included in the carve-out financial
statements may be challenging. Some of the more Determining if debt arrangements should be reflected in
challenging items are discussed below in the context of both the carve-out financial statements requires careful
the carve-out entity and the selling company, as applicable. consideration. Third-party debt issued directly by the
2 Mergers & Acquisitions—A snapshot
3. carve-out entity would be included in the carve-out curtailment accounting for the pension plan is required.
financial statements. In addition, if the proceeds from the Such accounting could result in a charge/credit to the selling
sale of the carve-out entity will be used to retire debt company's income statement, which would not be reflected
issued by the selling company or the carve-out entity by the carve-out entity. In addition, if the carve-out entity's
guarantees or pledges its assets as collateral, the debt operations were significant, a seller may decide to terminate
and an allocation of interest expense may also need to be the pension plan. In this case, the seller's financial
included in the carve-out financial statements. There may statements would reflect accounting for the termination of its
be other arrangements in which the debt may need to be pension plan.
reflected in the carve-out financial statements. In making
these determinations, consideration should be given to the Income Taxes
presentation that is most meaningful to users of the carve-
out financial statements. Carve-out Entity
Selling Company Income tax accounting is usually not straight forward, and
the accounting for income taxes in carve-out financial
The selling company will need to consider the appropriate statements is no exception. Generally, a carve-out entity
presentation and disclosure of the debt in its financial must prepare a tax provision as if it was a separate stand-
statements. For example, third-party debt issued directly alone entity. Appropriate consideration at the carve-out
by the carve-out entity and that will be assumed by the entity level must be given to tax attributes such as tax-
buyer would be reflected as part of the assets and sharing agreements, net operating losses and tax credits,
liabilities held for sale by the selling company. However, uncertain tax positions, deferred tax asset valuation
debt that is reflected in the carve-out financial statements allowances, and assertions that cash will be held and used
because the proceeds of a debt or equity offering of the outside of the US.
carve-out entity will be used to retire debt issued by the
selling company may need to be reflected as a liability by For example, historically a consolidated entity may not
the selling company. have recorded a valuation allowance as future projections
of consolidated income or tax planning strategies allowed
Pension (and other benefit arrangements) for realization of deferred tax assets. However, an
assessment of operations at the carve-out entity level
Carve-out Entity could result in the need for a valuation allowance in the
carve-out financial statements. These assessments should
On first glance, the assignment of pension balances and reflect the facts and circumstances as they existed at
allocation of pension expense to the carve-out entity may historical dates and should not incorporate the benefits of
seem straight forward - a liability for accrued contributions hindsight.
or an asset for prepaid contributions, and a reasonable
allocation of pension expense for each year presented. Selling Company
However, depending on either the agreement in place
between the seller and buyer, or statutory requirements, a A sale of the carve-out entity will affect the selling
selling company may legally transfer a portion of its company's income taxes. A gain or loss recognized on the
pension plan to the carve-out entity. In this scenario, a net sale of the carve-out entity will have direct tax effects.
pension liability or asset taking into account the projected Appropriate consideration must also be given to other tax
benefit obligation and plan assets for the transferred effects of the sale. For example, profit from the carve-out
portion of the plan, not just accrued or prepaid entity may have supported the future use of the selling
contributions, may need to be reflected in the carve-out company's net operating loss. No longer benefiting from
financial statements. This may require a separate actuarial the carve-out entity profit may require the selling company
valuation for the projected benefit obligation related to the to record an adjustment to its income tax valuation
carve-out entity's employees and consideration of allowances.
underlying assumptions. The asset transfer may also
require approval by the regulator of the pension plan. Expenses
Selling Company Carve-out Entity
Pension items may also impact the seller's financial Similar to income tax accounting, expense allocation in
statements. In situations where employees of the carve-out carve-out financial statements may not be straight forward.
entity will no longer accrue benefits under the seller's Determining which expenses should be included in the
pension plan, the seller would need to determine if carve-out entity financial statements and the appropriate
Change the way you think about tomorrow's deals 3
4. methodologies to allocate those expenses are critical and The reporting unit or asset group level at which impairment
can be challenging. testing is performed is determined based on the structure
and management of the carve-out entity's operations.
Some companies may perform cost allocations as part of
their internal management reporting. For example, the Goodwill
selling company may have charged the carve-out entity a
management fee for general management services (e.g., Carve-out Entity
executive salaries or administrative processing, such as
accounting and payroll).
If the carve-out business was acquired by the selling
company, goodwill is generally included in the financial
When preparing the carve-out financial statements, it is
statements of the carve-out entity.
important to understand the components and methodology
used in determining and allocating the management fee to
The amount of goodwill included is the total amount of
assess whether the costs reflect a reasonable allocation to
goodwill recorded by the selling company related to the
the carve-out financial statements. Some expenses
carve-out entity when it was acquired. This amount of
included within the management fee would generally be
goodwill and level at which goodwill is tested by the carve-
allocated to the carve-out entity based on time spent while
out entity may differ from that of the selling company.
others may be allocated based on sales levels,
profitability, headcount, or other appropriate metrics. The Applying the Guidance - Goodwill Impairment
carve-out entity will need to determine which expenses
Facts: Company X has one reporting unit (level of
included in the management fee should be included in its
goodwill impairment testing) that consists of two
financial statements and if the allocation methodology
businesses (Business A and Business B). Company X
utilized was appropriate.
plans to sell Business A and to prepare carve-out financial
statements for Business A.
Other companies that do not perform cost allocations as
part of their internal management reporting would typically
Business A had been previously acquired by Company X
need to assess the range of costs and services provided
which resulted in the recognition of $100 of goodwill.
by the selling company to the carve-out entity to identify a
Business B was not acquired and no goodwill directly
reasonable allocation of such costs in the carve-out
related to Business B has been recorded by Company X.
financial statements.
Analysis: In Business A's carve-out financial statements,
Selling Company
$100 of goodwill would be assigned to Business A. This
equals the total goodwill that relates to the acquisition of
Expense allocation in the carve-out financial statements
Business A by Company X.
may not always follow how those same expenses are
reflected in the selling company's financial statements. For
example, a portion of the CEO's salary may be allocated to The carve-out entity will need to determine its reporting
the carve-out entity in the carve-out financial statements. units to test goodwill included in the carve-out financial
However, if the selling company reflects the carve-out entity statements for impairment at least annually. For example,
as a discontinued operation, general corporate overhead, if the carve-out entity was an equipment rental company
which includes the CEO's salary, is not reported as part of that is managed as two lines of business (in-store and
discontinued operations in the selling company's financial online), this could result in two reporting units at the carve-
statements. out entity level. Whereas, the selling company may
manage the business as one operation, equipment rental,
Non-financial Asset Impairments and determine that there is only one reporting unit. While
from an overall perspective, the equipment rental
Reflecting non-financial asset impairments in the carve-out operations may have supported the combined goodwill
financial statements is not as simple as merely allocating balance, slumping operations in either the in-store or
to the carve-out entity a portion of any impairment charge online operations may not support goodwill in the separate
that may have been taken at the selling company level. reporting units from the carve-out entity's perspective.
To appropriately reflect impairments in the carve-out
entity's financial statements, long-lived asset impairments Selling Company
must be evaluated based on the actual assets assigned to
the carve-out entity. This includes goodwill (if the carve-out A portion of the goodwill of the reporting unit that included
entity had been previously acquired by the seller), the carve-out entity (assuming it is a business) is included
indefinite-lived intangibles, and other long-lived assets. in the calculation of any gain or loss on the sale of the
4 Mergers & Acquisitions—A snapshot
5. carve-out entity in the selling company's financial Other Reporting Considerations
statements. However, the amount of goodwill included in
the gain or loss calculation may not be the same amount In a typical carve-out transaction, most reporting items
of goodwill that was assigned to the carve-out entity in the carryover from the selling company. However, when the
carve-out financial statements. This is because the carve-out entity will be involved in an initial public offering
goodwill balance used by the selling company in (IPO), the carve-out entity will have a number of reporting
determining any gain or loss on the sale of the carve-out decisions to make, including determination of its year-end
entity is based on the relative fair value of the carve-out reporting date and selection of its accounting principles. In
entity to the remaining businesses in the selling company's addition, the selling company must also consider the impact
reporting unit.
that the carve-out transaction may have on its reporting
requirements.
Applying the Guidance - Goodwill Impairment
Facts: Same facts as above. Additionally, Business A has
Gain or Loss
a fair value of $1,000 and Business B has a fair value of
$3,000.
Carve-out Entity
Analysis: In determining Company X's gain or loss on the
sale of Business A, Company X would allocate the $100 of The carve-out entity will not report a gain or loss on its sale.
goodwill between Business A and Business B based on This gain or loss is reflected in the selling company's
financial statements.
their relative fair values. Company X would allocate 25%
($1,000/$4,000), or $25, to Business A in calculating its
Selling Company
gain or loss on the sale of Business A.
The M&A Standards require deconsolidation and a gain or
loss to be recognized when an entity loses control of a
business. In determining the amount of gain or loss to be
Long-lived Assets Other than Goodwill recognized on the sale of the carve-out entity, taxes, the
allocation of goodwill, amounts included in other
Carve-out Entity comprehensive income, and continuing relationships need
to be considered. Examples of continuing relationships
Similar to determining its reporting units for goodwill include guarantees on contracts or lines of credit of the
impairment testing, the carve-out entity will need to carve-out entity, or long-term contracts between the seller
determine its asset groups for impairment testing of its other and the carve-out entity that will survive the sale. Any
long-lived assets. The carve-out entity will need to proceeds that represent consideration for such
separately assess if any events have occurred to its stand arrangements must be separately accounted for. As a
alone operations that would trigger the need to perform a result, the net assets included in the calculation of the gain
long-lived asset impairment test for each period covered by or loss by the seller may differ from the net asset balances
included in the carve-out financial statements.
the carve-out financial statements. Again, this assessment
would be made without the benefit of hindsight.
Materiality
Selling Company
Carve-out Entity
Consideration of long-lived asset impairment is also
important for the selling company. Similar to determining The carve-out entity will need to assess materiality for its
reporting units for goodwill impairment testing, a selling separate financial statements. Consideration should be
given to immaterial misstatements at the selling company
company's asset groups may differ from the asset groups
level that may be material to the carve-out entity, as well as
of the carve-out entity. In addition, because the carve-out
any misstatements noted at the carve-out entity level.
entity's operations will be held by the selling company for
only a short period of time prior to sale, the selling
Selling Company
company may need to recognize a long-lived asset
impairment charge. This could be the case even if an
Any misstatements found at the carve-out entity level also
impairment charge is not recognized by the carve-out need to be assessed for materiality in the selling company
entity in the carve-out financial statements. financial statements.
Change the way you think about tomorrow's deals 5
6. Cash flows those disclosed at a consolidated level in the selling
company's financial statements.
Carve-out Entity
A carve-out entity that is undertaking an IPO and will be
The presentation of the carve-out entity's statement of cash publicly traded will need to consider the disclosure of
flows can be challenging. For example, intercompany historical earnings per share for all income statement
transactions that would not have been reflected in the periods presented.
consolidated statement of cash flows at the selling company
level will need to be reflected in the cash flow statement at Additionally, in certain situations, the SEC requires that the
carve-out financial statements include operations that will
the carve-out entity level. These intercompany transactions
not become part of the carve-out entity going forward, but
need to be carefully scrutinized for proper classification.
which will remain with the selling company. When these
requirements are met, the carve-out financial statements
Selling Company
would generally reflect the operations that will remain with
the selling company as discontinued operations.
The selling company will also need to consider the cash
flows of the carve-out entity. For example, if the carve-out Selling Company
entity qualifies as a discontinued operation, the selling entity
will need to consider how to reflect those cash flows in its A seller that is a public company must also change its
cash flow statement. accounting principle, and obtain and file a preferability letter
related to the change, if there is a change in accounting
Disclosures principle at the carve-out entity level and the seller will
continue to reflect the carve-out entity in consolidation or on
Carve-out Entity the equity method after the sale.
In addition to the required financial statement disclosures, Conclusion
the carve-out financial statements should include
comprehensive disclosure of the basis of presentation, As you can see, the preparation of carve-out financial
accounting policies unique in attributing or allocating statements is far from straight-forward. We have
balances (e.g., income taxes or pensions), expense discussed only some of the challenges that may arise in
allocation methodologies and related party transactions. understanding differences between carve-out and selling
company financial statements. Companies preparing
Selling Company carve-out financial statements may find that a significant
investment in time and resources will be necessary to
Disclosure considerations for subsequent events or any meet these challenges. With the limited specific guidance
continuing relationship with the carve-out entity should be covering carve-out financial statements, being aware of
assessed for inclusion in the selling company's financial current practice will help you navigate through the
statements. process.
SEC considerations
Carve-out Entity
If there is a change in accounting principle at the carve-out
entity level from what it was at the selling company level,
the carve-out entity should disclose the nature of the
change in accounting principle and justification for it in the
carve-out financial statements. The carve-out entity should
clearly explain why the newly adopted accounting principle
is preferable.
The carve-out entity will also need to include required
segment disclosures in its financial statements. Most
likely, the segments of the carve-out entity will differ from
6 Mergers & Acquisitions—A snapshot
7. PwC has developed the following publications related to PwC clients who would like to obtain any of these
business combinations and noncontrolling interests, publications should contact their engagement partner.
covering topics relevant to a broad range of constituents. Prospective clients and friends should contact the managing
partner of the PwC office nearest you, which can be found at
10 Minutes on Mergers and Acquisitions—for chief www.pwc.com. For more information on this publication
executive officers and board members please contact one of the following individuals:
What You Need to Know about the New Accounting Martyn Curragh
Standards Affecting M&A Deals—for senior executives U.S. Transaction Services Leader
and deal makers (646) 471-2622
martyn.curragh@us.pwc.com
Mergers & Acquisitions—A snapshot—a series of
publications for senior executives and deal makers on
emerging M&A financial reporting issues Lawrence N. Dodyk
U.S. Business Combinations Leader
Business Combinations and Consolidations…the new (973) 236-7213
accounting standards—an executive brochure on the lawrence.dodyk@us.pwc.com
new accounting standards
John R. Formica Jr.
A Global Guide to Accounting for Business National Professional Services Group Partner
Combinations and Noncontrolling Interests: Application (973) 236-4152
of U.S. GAAP and IFRS Standards—for accounting john.r.formica@us.pwc.com
professionals and deal makers
Donna L. Coallier
DataLine 2008–01: FAS 141(R), Business Transaction Services Partner
Combinations—for accounting professionals and deal (646) 471-8760
makers donna.coallier@us.pwc.com
DataLine 2008–02: FAS 160, Noncontrolling Interests Dimitri B. Drone
in Consolidated Financial Statements—for accounting Transaction Services Valuation Partner
professionals and deal makers (646) 471-3859
dimitri.b.drone@us.pwc.com
DataLine 2008–30: Key Considerations for
Implementing FAS 141(R) and FAS 160—for accounting
Jay B. Seliber
professionals and deal makers
Business Combinations Implementation Leader
DataLine 2008–35: Nonfinancial Asset Impairment (408) 817-5938
Considerations—for accounting professionals and deal jay.seliber@us.pwc.com
makers
DataLine 2009–16: New Guidance for Acquired
Contingencies —for accounting professionals and deal
makers
DataLine 2009–34: Accounting for Contingent
Consideration Issued in a Business Combination —for
accounting professionals and deal makers
6 Mergers & Acquisitions—A snapshot
