Turning to spin-offs
Many power and utilities (P&U) companies are turning to spin-offs to optimize portfolios, maximize returns and control costs. But these complex divestments bring many accounting challenges. Dennis Deutmeyer reports.
As reported in our latest Global Capital Confidence Barometer: power and utility (April-October 2013), 71% of P&U companies that are planning divestments expect to pursue the carve-out of one or more business units.
These transactions, whether structured as an outright sale, spin-off, initial public offering or contribution to a joint venture, can be an effective way of releasing capital to shareholders or better aligning an asset portfolio with broader strategic goals.
However, spin-offs are highly complex and involve numerous decisions. Companies need a decision-making process guided by well-informed management and backed by third-party specialists.
Key financial reporting challenges
While there are currently no International Financial Reporting Standards that deal specifically with spin-off transactions, most - though certainly not all - will fall under IFRIC 17, Distribution of Non-cash Assets to Owners. However we are seeing diversity in the application of these guidelines, highlighting the need for management to consider the significant judgements that arise when applying accounting requirements and to call on third-party advisers when in doubt.
This highlights the need for management to consider the significant judgments that arise when applying accounting requirements and to call on third-party advisers when in doubt.
We are helping companies across many industries, including power and utilities, to consider the five key areas under IFRIC 17:
- How to account for a spin-off transaction initially
- How to account for a spin-off transaction in subsequent reporting periods
- How to account for a spin-off transaction at transaction settlement
- What to do with the associated transaction costs
- What to disclose in the footnotes to financial statements
It is important to note that IFRIC 17 does not apply to spin-offs when the assets distributed are ultimately controlled by the same party (or parties) before or after the distribution.
Timing is everything
The first key challenge in accounting for a spin-off is determining when to recognize the transaction. This frequently requires judgment to determine when the spin-off decision has been appropriately authorized and the obligation is no longer at the entity’s discretion.
As it will also be subject to local regulations and laws, management needs to consider its jurisdiction.
The next challenge is to measure the spin-off. Without exception, all spin-off transactions within the scope of IFRIC 17 are initially measured at the fair value of the assets to be distributed. This is particularly challenging if shareholders must approve the spin-off and be satisfied that a proper value has been ascribed to the business.
The valuation of a power and utilities' assets is a complex process, beyond the skill sets of most companies’ management. We work with P&U companies to develop methodologies that determine the fair value of assets, considering the individual assets, customer relationships, contracts, leases and the like.
Timing is a key consideration because of the advantages of settling the spin-off in the same reporting period as its initial recognition. If a P&U company has to account for a spin-off transaction in a subsequent reporting period, it may need to remeasure the fair value of the distribution liability.
An entity has to account for the spin-off when the transaction is settled by remeasuring the distribution liability to fair value as at that date. It then de-recognizes the assets (and liabilities, if any) being distributed. Any difference is recognized in profit and loss.
If the period between initial recording and settlement straddles multiple reporting periods, utilities may face a valuation mismatch on their balance sheet, particularly when energy contracts are subject to fluctuating commodities and price changes.
Speedy settlement also allows the company to move ahead with its strategy and sends positive messages to the market.
Costs and disclosures
When considering how to account for the transaction costs associated with a spin-off, companies should be aware that these are generally accounted for as a deduction from equity if they are considered to be directly related to the spin-off transaction. Any costs not considered directly related to the spin-off are to be expensed as incurred.
What needs to be disclosed on financial statements, particularly surrounding the carrying amount and fair value of assets, will depend on whether the spin-off distribution liabilities have been declared and recognized before or after the reporting period.
Importance of local knowledge
Local knowledge is critical to the success of spin-offs. The tax implications of these transactions can be complicated and requires specific knowledge of the national jurisdiction and local rules prior to and during the spin-off process.
Utilities also need to consider specific dividend rules, which may impact their ability to pay cash dividends, especially if they must be distributed from positive retained earnings.
It is critical that management address and understand the key financial reporting challenges of spin-off transactions. Special attention should be paid to valuations and the prompt settlement of spin-offs in order to maximize the benefits of these transactions.
How we can help
We work with P&U entities on a variety of divestments, including spin-offs, and can support you throughout the life cycle of a transaction. We can provide guidance on the key financial reporting areas in a spin-off, including IFRIC 17, valuations and tax implications.
For more information
Read our full paper, Spin-off transactions: addressing the key financial reporting challenges.