US GAAP combined and/or carve-out financial statements have long been used in the United States for capital market transactions, including in filings with the SEC. But the uptick in demand for such financial statements under IFRS is a newer development. Likewise, cross-border private M&A transactions involving foreign or US-based businesses often require the preparation of IFRS financial information.
In May 2015, the IASB reinforced in Exposure Draft, Conceptual Framework for Financial Reporting, its acknowledgment that combined and/or carve-out financial statements can comply with IFRS. One aspect of compliance is that the combined and/or carve-out financial statements need to be relevant, useful and representationally faithful. However, judgment is required in a number of areas, because there is no specific IFRS literature defining or providing guidance related to such financial information.
We have observed diversity in practice; this makes the preparation of combined and/or carve-out financial statements challenging for a company’s processes and can require considerable judgment by management.
Here we highlight key accounting areas requiring judgment when a company is preparing combined and/or carve-out financial statements. These and more are covered in greater detail in KPMG’s recently published guide, Combined and/or carve-out financial statements, which summarizes common practices as well as the main issues and challenges in preparing such financial statements under IFRS.
- Boundaries of the combined and/or carved-out entity. The entity is tailored to meet the specific purpose for which the financial statements are prepared. Management needs to identify all relevant economic activities that form part of the combined and/or carved-out entity. For example, the purpose of the combined and/or carve-out financial statements could be to display management’s track record in conjunction with conducting an IPO for a portion of a larger business. Applying these principles also requires consideration of local regulatory requirements.
- Top-down vs. bottom-up approach. The combined and/or carve-out financial statements can be compiled using either:
— a ‘top-down approach’, in which the information is extracted from the consolidated financial statements of the larger reporting entity; or
— a ‘bottom-up approach’, in which the financial statements for the carved-out entity are built up entirely from the legal entity’s ledgers.
In selecting one or the other, consideration should be given to whether the information can be reliably and efficiently extracted from the larger reporting entity, as well as the requirements and preferences of local regulators.
- Related party transactions. The accounting for transactions between the larger reporting entity and the combined/carved-out entity – e.g. leases, shared services centers, intra-group financing – needs to reflect the perspective of the combined and/or carved-out entity rather than the group as a whole. Those transactions may be charged at fair value. Alternatively, the price may be based on an intra-group formula that is not on an arm’s-length basis. IAS 24, Related Party Disclosures, does not establish any measurement requirements for related party transactions. In our experience, a company chooses one of two approaches: (1) applying the relevant standard or, where a transaction with shareholders is identified, the transaction might be measured at fair value; or (2) allocating the actual costs incurred by the larger reporting entity on a systematic and rational basis to the combined/carved-out entity, regardless of whether an amount is charged or whether the actual costs reflect fair value.
- Financing. Combined and/or carve-out financial statements prepared using the planned financing structure usually constitute pro forma information because the financing is not in place prior to closing of the proposed transaction. Rather, the financial statements should reflect the historical financing of the combined and/or carved-out entity. Internal financing between the larger reporting entity and the combined/carved-out entity is assessed under the relevant financial instruments standard, IAS 39 or IFRS 9. Classification as liability or equity may require judgment when there are no stated repayment terms.
- Shared assets. Intangible assets, property, plant and equipment, etc. may be shared between the combined and/or carved-out entity and the larger reporting entity. Judgment is required to determine whether those shared assets should be recognized entirely, partially or not at all in the combined and/or carve-out financial statements.
- Bonus payments. Bonus payments conditioned upon a successful carve-out related to management or employees working at the level of the combined/carved-out entity may need to be reflected in the combined and/or carve-out financial statements. If these cost are directly attributable to the combined/carved-out entity, IFRS 2,Share-based Payment, or IAS 19, Employee Benefits, may apply depending on the facts and circumstances.
- Transaction costs. Some transaction costs may be specifically attributable to the combined and/or carved-out entity. Examples of costs to assess include issuance costs for financial instruments, costs for legal advice and consulting fees.
- Subsequent events. Generally, the ‘first-time adopter approach’ is applied in conjunction with IFRS 1, First-time Adoption of IFRS. Under this approach, estimates made under previous GAAP are generally not revised for information received at a later date.
- Income tax. Income tax in a tax-consolidated group may be allocated as follows:
— current and deferred income taxes are recognized by each entity in the group, regardless of who has legal liability for settlement/recovery of the tax; or
— each entity recognizes current income taxes based on the amounts actually paid by the individual legal entities.
Further consideration is needed when components of the combined and/or carve-out activity are not considered separate entities for tax purposes.
Preparing IFRS combined and/or carved-out financial statements is a complex undertaking that can create practical challenges for management from project management, IT systems and data gathering, central and shared services, to internal controls. Talk to your KPMG professional to understand specific considerations relevant to your situation.