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The European Federation of Accountants (FEE) has recently published a paper entitled Combined and Carve-out Financial Statements: Analysis of Common Practices. It summarises common practices as well as the main issues and challenges in preparing combined and carve-out financial statements in compliance with International Financial Reporting Standards (IFRS).
At present, IFRS does not have a specific standard governing the preparation of combined and carve-out financial statements and none of the existing IFRSs provides principles for their preparation. As a result, diverse practices in preparing such financial information have developed.
Combined and carve-out
Carve-out financial statements are the separate financial statements of a business that are derived or ‘carved out’ from the financial statements of a larger entity. Combined financial statements are financial statements that present the historical financial information of a number of entities or parts of entities that do not comprise a group for which consolidated financial statements can be prepared.
For example, an economic activity may be carved out from a group into a separate entity to present the historical financial information for the activity for the purpose of sale. Alternatively, a group may demerge a significant part of its economic activities and may wish to present the historical financial information for its remaining economic activities to investors independently of the whole group.
Both consolidated and combined financial statements present historical financial information. The only significant difference between them is that consolidated financial statements require the consolidation of the parent company and all its subsidiaries in accordance with IAS 27 and IFRS 10.
In contrast, combined financial statements present the historical financial information of an area of economic activities for which it is not possible to present consolidated financial statements because a full parent-subsidiary relationship does not exist among all component entities being combined. In many cases, it is not just entities but also portions of entities that are included in combined financial statements.
A fundamental condition for preparing combined financial statements is there must be an element that has ‘bound’ the constituent elements together throughout the accounting period. Normally, the three main categories of what constitutes a binding element are:
A There has been common control.
B There has been common management.
C There has been a common business.
No accounting definition of these transactions exists, and there is limited accounting guidance. Judgments may need to be made in many areas, with special attention paid to ensuring that all assets and liabilities of the new business have been properly identified, together with the relevant costs.
Under IFRS there are a number of definitions that may help in developing a definition of the area of economic activities in the context of combined financial statements.
The 2010 exposure draft issued by the International Accounting Standards Board (IASB) on the conceptual framework for financial reporting declares: ‘A reporting entity is an area of economic activities whose financial information has the potential to be useful to existing and potential equity investors, lenders and other creditors who cannot directly obtain the information they need in making decisions about providing resources to the entity and in assessing whether management and the governing board of that entity have made efficient and effective use of the resources provided.’
Additionally, IFRS 3, Business Combinations, defines ‘a business’. IFRS 5, Non-current Assets Held for Sale and Discontinued Operations, covers a component of an entity. And IFRS 8, Operating Segments, defines an operating segment.
The following key elements could define ‘area of economic activities’ when derived from the definitions in the above IFRSs and conceptual framework exposure draft:
A The economic activities encompass a set of assets and liabilities that can be clearly distinguished from those that are linked to other economic activities.
B The economic activities of such integrated set of assets and liabilities were conducted, or could have been separately conducted, for the purpose of providing a return in the form of dividends, lower costs or other economic benefits.
Based on that key principle of applying all requirements under IFRS, the principles of consolidation accounting are applied when preparing combined financial statements. As a result, the entities and parts of entities within the area of economic activities being reported on are after eliminating intercompany balances and transactions. As a principle, combined financial statements may include only income and expenses, assets and liabilities that are clearly identifiable.
In the vast majority of cases, the elements of the financial statements above should be easily identifiable as belonging to the area of economic activities for which combined financial statements are to be prepared. However, it may sometimes be necessary to allocate amounts as attributable to the area of economic activities concerned where such amounts have historically not been allocated in such a way.
In the vast majority of cases, audited financial statements will have been prepared at the group level. However, the degree of financial statement preparation for subsidiaries and divisions may vary. These financial statements are often inadequate and as a result the preparation of a more comprehensive set of financial statements is often required.
Usually, separate financial statements will not have been prepared for the results of a company’s operations below the group level, so preparing combined financial statements for the first time can be difficult.
In both combined and carve-out financial statements, there are key principles to bear in mind. Generally, the allocation of finance costs should reflect the allocation historically used by the group concerned and the substance of the group’s overall financing, Thus, if the overall group has financed its operations with debt, then a portion of the debt with accrued interest and a related finance expense would be accounted for when preparing the financial statements.
The assets and liabilities should be recorded at fair value in accordance with acquisition accounting principles. However, determining which items should be included in the financial statements can be challenging. Assets may be attributed based on legal ownership, usage or through such arrangements as operating or lease agreements. There may also be problems when numerous divisions in an entity share the use of an asset.
If there is a change in accounting principle from previous practice, its nature should be disclosed and justified in the financial statements.
Complexity can arise when considering how to allocate the cost of a defined benefit pension plan. If a contractual agreement or adequate allocation policy exists that allocates the cost, this should be followed. If there is no contractual basis or policy for allocation, particularly in the situation of an area of economic activities being carved out of a larger group, a solution could be to revert to a contributions basis of accounting, which will result in the allocation of the costs equal to the contribution of the participants in the pension plan to the area of economic activities.
A separate actuarial valuation for the projected obligation may be required and the asset transfer may have to be approved by the pensions regulator. If the carve-out entity’s operations are significant, the vendor may decide to terminate the pension plan and reflect this in its financial statements.
The allocation of tax charges in preparing combined financial statements depends on whether the entities carrying out the economic activities for which the combined financial statements are to be prepared have filed separate tax returns or have their tax affairs dealt with as part of a larger tax entity. If separate tax returns do not exist, a basis for allocating overall tax charges must be determined.
The accounting for income taxes in carve-out financial statements is difficult and normally a carve-out entity must create a tax liability provision as if it were a separate entity.
Non-financial asset impairment allocations must be based on actual assets assigned, which may include goodwill. The asset grouping level at which impairment testing takes place is determined based on the structure of the entity’s operations. IAS 33, Earnings Per Share, assumes a listed company with a share capital, which is the basis for calculating the earnings per share ratio. As this is not necessarily so in a combined or carve-out situation, such information does not have to be presented. However, earnings per share ratio can be determined on the basis of the targeted structure for the purposes of an initial public offering (IPO).
The key elements
Fundamental to understanding combined and carve-out financial statements is a description of the basis on which they have been prepared. The key elements will be the purpose for which the combined financial statements are prepared, the entities or parts of entities that comprise the area of economic activities and the accounting policies and basis of allocation applied, including the reason for applying them.
The combined or carve-out entity will need to assess materiality for its financial statements. Consideration should be given at the selling company level to immaterial misstatements that may be material to the carve-out entity and vice versa.
Graham Holt is an ACCA examiner, and associate dean and head of the accounting, finance and economics department at Manchester Metropolitan University Business School