5 accounting considerations for divestitures and carveouts
Organizations may pursue a divestiture, a spinoff, or a partial divestiture (also referred to as a carveout) for any number of reasons.
From an accounting perspective, each of these terms means something a little different. For instance, a divestiture typically refers to a company disposing of an entire line of business or separate subsidiary that will usually be defined as a business. A carveout usually entails the disposition of a portion of a business that will need to be carved out of a separate subsidiary or line of business.
A spinoff constitutes a transfer of assets that make up a business by one entity into a new legal spun-off entity, followed by a distribution of the shares of the new entity to its shareholders without those shareholders having to surrender any stock of the original entity. While the ultimate outcome and the accounting treatment for each may differ, the goal is somewhat consistent. This discussion looks to identify the accounting consequences of each.
As noted, a company may choose to pursue one of these options for a number of valid business reasons. Perhaps an acquisition came with excess lines of business, or leadership is seeking a new strategic direction for the business or wants to exit a particular area. Maybe the organization has seen a recent increase in shareholder activism that is pushing the business in a different direction, or additional capital is needed for growth opportunities.
COVID-19 has amplified and, in some cases, accelerated these decisions, causing organizations to rethink strategic directions and streamline their assets to focus on those with the most significant long-term value. Sectors most affected by the pandemic — including retail, travel, hospitality, entertainment, and oil and gas — may also be increasingly leveraging divestitures to gain quick access to capital and avoid bankruptcy amid uncertainty.
When considering a divestiture or carveout, business leaders must first decide what they are carving out or divesting of. Contemplating the following accounting aspects from the start will allow for a more seamless process and avoid delays down the line.
Once a company has decided to pursue a divestiture, carveout, or spinoff, some key determinations must be made to assess the accounting impacts associated with the transaction. Namely, conclude whether you are disposing of a set of assets or a business — more simply put, does what is being disposed of constitute a business under FASB ASC Topic 805, Business Combinations, or the SEC rules? This distinction will lead down different accounting and reporting paths as you go through the process.
Updated FASB guidance from January 2017 on clarifying the definition of a business will affect this assessment. For a carveout entity to be designated as a business, it must contain three elements: inputs, processes, and outputs. More specifically, the guidance notes that “a business is an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants.”
Therefore, a business must, at the very least, include an input and a substantive process that together significantly contribute to the ability to create outputs. Without this, the carveout must be dealt with as a set of assets rather than a business. Refer to the appropriate guidance to make that determination before moving on to the next step in the decision-making process, as it will heavily affect the accounting ramifications as the transaction moves forward.
Once you define the divestiture, you must specify whether you are selling wholesale or spinning off a piece of the business as a pro rata distribution to shareholders. The accounting in each is different: If selling, you will have some type of gain or loss, but if you are spinning off, the process becomes an equity transaction.
As defined above, in a spinoff, the parent may transfer assets to a new legal entity and distribute the shares of the spun-off entity to its shareholders, so they now hold stock in two businesses. This process avoids any shareholder loss of stock in the original entity. It also allows the newly formed company to have its own governance structure and to be organized to meet its stakeholders’ needs.
A sale is more straightforward and does what the name suggests — the original entity separates from the assets entirely, selling them to a third party. In this case, shareholders lose stock in the parent company due to the sale, and there are also additional tax considerations pursuant with a sale.
There are no right or wrong answers when choosing between a sale or a spinoff — each transaction is unique, and the business leader must ultimately make the decision that is best for the parent company and its shareholders. However, the down-the-line tax implications of a sale can be larger than those of a spinoff, so financial professionals must ensure this is accounted for before embarking on the transaction.
When considering the impact a carveout or divestiture will have on a business, tax considerations must be taken into account at the beginning of the transaction rather than left as an afterthought.
Whether a carveout or divestiture, the parent organization must ensure that tax processes are set up to enable each entity to operate successfully after the transaction is over. Spinoffs and sales also each have unique tax consequences in both the short and long term. In some situations, a spinoff may end up being a tax-free transaction to both shareholders and the parent company, while a sale almost always has taxes imposed upon it.
Additionally, if a transition service agreement is in place whereby the parent organization agrees to provide support until the secondary entity is able to manage its own operations, the specific tax-related implications should be established from the onset to avoid complications when fully disentangling the entities.
While there is no one-size-fits-all approach to tax considerations in a sale or carveout, there is one common goal: ensuring the decisions made are in the shareholders’ best interests.
It will also be necessary to dive deeper into the specific pieces that comprise the business or assets you are divesting.
If you are divesting a business, certain allocations to the carveout entity must be made. Establish whether portions of the business, like revenues and expenses, are going away due to the transaction. Additionally, identify whether there are fixed assets, intangibles, or other corporate assets utilized within this business that are ultimately shared with the parents. If so, those may have to be replaced or established through some type of financial arrangement. Good will must also be allocated to a business that is being disposed of.
Ultimately, there are no set FASB rules for formulating carveout financial statements. The purpose of developing carveout financial statements is to present how the balance sheet, income statement, cash flows, and equity of the carveout entity would have been presented, historically, if it were its own stand-alone entity. Doing so will demonstrate either the carveout’s viability as an independent entity or prove the attractiveness of the sale to a potential buyer. It is also necessary to go through the process of allocating and attributing balances and activity to the carveout entity when building the financial statements.
Finally, the organization disposing of or spinning off assets must consider whether the removal of the assets or business will change reporting units or operating segments of the remaining entity. The chief operating decision-maker (CODM) is responsible for selecting how the business is evaluated for management assessment and financial reporting purposes. If the portion of the business being divested is already a stand-alone segment, it is typically removed, and the others remain in place. However, if the business being divested is commingled with and a material part of one or multiple segments, the business’s removal could cause significant shifts in overall operations. This would then compel the CODM to reevaluate what segments they have in place, including how to remove the activity of the divested business from the remaining company financial statements.
Further, if the organization has concluded that it is disposing of a business or a significant portion of the operations, they will need to consider whether the disposition rises to the level whereby presenting as a discontinued operation is required.
In addition to the internal reporting impacts, public companies must consider various SEC rules. The considerations made above about the nature of the transaction and resulting business will inform the specific filing the SEC will require a business to present. This will be done not only upon the announcement of the transaction but also when presenting what the divestiture is, how it is structured, and what the business looks like moving forward.
As we look ahead to 2021, the popularity of divestitures and carveouts will be affected by several factors, including the ongoing COVID-19 pandemic and overall consumer behavior.
If the pandemic continues long into the year and companies continue to face bankruptcy threats, we could see more sales between distressed organizations looking to shore up capital, with stronger players taking advantage of an opportune market.
No matter the outcome, organizations should ensure they thoroughly consider the accounting and tax implications of a divestiture or carveout prior to embarking on this journey.
— Michael Stevenson, CPA, is national practice leader and Jon Eilertsen, CPA, is a managing director for BDO’s Accounting & Reporting Advisory Services Group. To comment on this article or to suggest an idea for another article, contact Ken Tysiac, the JofA’s editorial director, at Kenneth.Tysiac@aicpa-cima.com.
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