Discontinued operations

What Are Discontinued Operations?

Discontinued operations represent a component of an entity that either has been disposed of or is classified as held for sale, and whose disposal represents a strategic shift that has (or will have) a major effect on an entity's operations and financial results. This concept is a crucial aspect of financial reporting within corporate accounting. The income or loss from discontinued operations is presented separately on the income statement, distinct from a company's continuing operations, to provide a clearer view of the ongoing business performance. This separate presentation allows users of financial statements to better understand the sources of a company's net income and evaluate its future prospects by isolating the financial impact of a disposed or soon-to-be-disposed business segment. The objective is to provide relevant information for assessing a company's sustainable earnings per share.

History and Origin

The accounting and reporting standards for discontinued operations have evolved significantly over time to enhance transparency and provide more relevant information to financial statement users. Initially, guidance was provided by Accounting Principles Bulletin (APB) 30, which established requirements for reporting the effects of business segment disposals. Under APB 30, discontinued operations were reported as a separate, net-of-tax line item on the income statement, but not as an extraordinary item.¹⁰

A major shift occurred with the adoption of Statement of Financial Accounting Standards (SFAS) 144 in 2002. This pronouncement broadened the scope of transactions that could qualify for discontinued operations accounting. However, SFAS 144 led to concerns among preparers and users that its application was too broad, often resulting in minor, recurring asset disposals being treated as discontinued operations, which could diminish the usefulness and comparability of financial statements.⁹

In response to these concerns, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-08 in April 2014, which is now codified primarily in Accounting Standards Codification (ASC) 205-20, "Presentation of Financial Statements — Discontinued Operations." This update narrowed the definition of a discontinued operation, requiring that the disposal of a component must represent a "strategic shift" with a major effect on the company's operations and financial results to qualify for separate presentation. This strategic shift criterion aimed to ensure that only significant divestitures or disposals were reported separately, providing a more focused view of a company's continuing core business.,
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7## Key Takeaways

• Discontinued operations represent a part of a business that has been sold or is being held for sale, and its disposition significantly alters the company's strategic direction and financial results.
• The financial results of discontinued operations are presented separately on the income statement, net of tax, below the results from continuing operations.
• This separate presentation enhances the predictability of a company's ongoing financial performance by segregating one-time events.
• Both assets and liabilities associated with discontinued operations classified as held for sale must also be presented separately on the balance sheet for current and prior periods.
• The criteria for classifying an operation as "discontinued" are stringent, requiring a "strategic shift" that has or will have a major effect on the entity's operations.

Interpreting Discontinued Operations

The separate presentation of discontinued operations is crucial for financial statement users because it provides a clearer picture of a company's ongoing business activities and their financial performance, aiding in more accurate forecasting. When a company reports discontinued operations, it signals a significant change in its business composition. Investors and analysts can use this segregated information to:

• Assess Core Performance: By isolating the revenues, expenses, gains, and losses from operations that are no longer part of the core business, users can better evaluate the profitability and sustainability of the remaining, continuing operations.
• Understand Future Cash Flows: The reclassification helps in projecting future cash flow statement generation from the ongoing business, as cash flows from discontinued operations are often disclosed separately.
• Evaluate Management's Strategic Decisions: The reporting of discontinued operations indicates a deliberate management decision to divest or dispose of a segment, which can be analyzed for its strategic implications and potential impact on long-term value creation.

When reviewing financial statements, it is important to analyze the income or loss from discontinued operations in conjunction with the asset and liability disclosures on the balance sheet to understand the full scope of the divested component.

Hypothetical Example

Consider "Tech Innovations Inc.," a diversified technology company with three main segments: Software Development, Hardware Manufacturing, and Consumer Electronics. In late 2024, the management of Tech Innovations Inc. decides to sell its Consumer Electronics division, which has consistently underperformed and is no longer aligned with the company's long-term strategic goals. This sale represents a strategic shift for the company, as the Consumer Electronics division was a significant portion of its overall revenue and employee base.

Here's how this might impact their financial reporting for the year ending December 31, 2024:

1. Decision to Sell: On October 1, 2024, Tech Innovations Inc. formally commits to a plan to sell the Consumer Electronics division, and it meets the criteria to be classified as "held for sale."
2. Reporting Prior to Sale: For the periods presented in the 2024 annual report, the results of the Consumer Electronics division (its revenues, operating expenses, and profit or loss) would be reclassified and presented separately as "Discontinued Operations" on the income statement. This would apply not only to 2024 but also to any prior periods presented for comparative purposes.
3. Income Statement Presentation:
   • Income from Continuing Operations: This section would reflect only the results of the Software Development and Hardware Manufacturing segments.
   • Discontinued Operations: A single line item, "Income (Loss) from Discontinued Operations, Net of Tax," would appear after Income from Continuing Operations. This line would include:
     • The operating results (revenue, expenses, depreciation, etc.) of the Consumer Electronics division from January 1, 2024, until the date it was classified as held for sale (or the sale date, if completed within the period).
     • Any impairment loss recognized if the carrying value of the division's assets exceeded its fair value less costs to sell.
     • Any gain or loss on the actual sale of the division.

For example, if the Consumer Electronics division had a pre-tax operating loss of $5 million and a gain on sale of $2 million (both before tax effects), and the company's tax rate was 20%, the discontinued operations line would reflect:

Pre-tax Loss: $5,000,000 (operating loss) - $2,000,000 (gain on sale) = $3,000,000 loss
Tax Benefit (20%): $3,000,000 * 0.20 = $600,000
Net Loss from Discontinued Operations: $3,000,000 - $600,000 = $2,400,000

This $2.4 million net loss would be shown as a single line item, "Loss from Discontinued Operations, net of tax: $2,400,000."

Practical Applications

Discontinued operations reporting has several practical applications across various financial disciplines:

• Investment Analysis: Investors and analysts widely use the separate reporting to derive a more accurate picture of a company's sustainable earnings power. By excluding the non-recurring impact of discontinued operations, they can better compare a company's performance year-over-year and against peers, focusing on the core business that will generate future returns. This is particularly important for models that project future financial performance.
  *⁶ Credit Analysis: Lenders and creditors analyze continuing operations to assess a borrower's ability to generate consistent cash flows for debt repayment. The clarity provided by separating discontinued operations helps in evaluating the ongoing solvency and liquidity of the entity.
• Regulatory Compliance: Companies are mandated by accounting standards, such as Generally Accepted Accounting Principles (GAAP) in the U.S. (specifically ASC 205-20), and International Financial Reporting Standards (IFRS 5 internationally), to report discontinued operations separately. This ensures transparency and comparability across financial reports. The Securities and Exchange Commission (SEC) also provides specific guidance on the retrospective reclassification of prior periods for discontinued operations when financial statements are reissued.
  *⁵ Mergers and Acquisitions (M&A): When a company acquires or divests a business, the accounting for discontinued operations becomes critical for properly presenting the financial impact of the transaction. For example, METRO AG, a wholesale and food specialist company, reported its hypermarket business as discontinued operations in its 2018/2019 annual report due to its decision to sell this segment, clearly separating its financial results from the ongoing wholesale business.

⁴## Limitations and Criticisms

While the reporting of discontinued operations aims to improve transparency, it is not without its limitations and criticisms:

• Complexity: The criteria for classifying an operation as "discontinued" can be complex, requiring judgment regarding what constitutes a "strategic shift" and a "major effect" on operations. This complexity can sometimes lead to inconsistencies in application across different companies or industries.
• Potential for Earnings Management: Critics argue that the classification of operations as "discontinued" could potentially be used for earnings management. Firms might have incentives to shift certain operating expenses or losses from continuing operations into discontinued operations, thereby presenting a more favorable picture of their core business performance. Research indicates that firms with loss-making discontinued operations may engage in such classification shifting. H³owever, changes in accounting standards, such as ASU 2014-08, were partly motivated by concerns over the prior standard's broadness contributing to this.
  *² Difficulty in Forecasting: Even with separate reporting, analysts can face challenges in forecasting future earnings accurately, especially when a portion of permanent earnings is eliminated, or when the future effect on continuing operations is unclear. The subsequent performance of the remaining entity after a significant disposal can sometimes be difficult to predict.
  *¹ Restatement Burden: Companies are required to restatement prior period financial statements to reflect the discontinued operations, which can be an administrative burden and sometimes confuse users if not clearly explained.

Discontinued Operations vs. Non-recurring Items

The terms "discontinued operations" and "non-recurring items" are both related to events that are not expected to happen regularly, but they have distinct meanings and reporting treatments in financial statements.

Discontinued operations specifically refer to a major component of an entity that has been disposed of or is held for sale, representing a significant strategic shift. Their financial results (revenue, expenses, gains, and losses, net of tax) are presented in a dedicated section of the income statement, separate from continuing operations, and prior periods are typically reclassified. The intent is to provide a clean view of the ongoing business.

Non-recurring items, on the other hand, is a broader category that includes various unusual or infrequent gains and losses that are not part of a company's normal business activities but do not meet the strict criteria for discontinued operations. Examples include significant asset sales (that are not part of a strategic shift), gains or losses from litigation, large impairment charges on long-lived assets (not associated with a component being sold), or restructuring charges. These items are typically reported within the continuing operations section of the income statement, though often highlighted separately or disclosed in the notes. Unlike discontinued operations, prior period financial statements are generally not reclassified for non-recurring items. The key distinction lies in the "strategic shift" and the separate presentation requirements for discontinued operations, which provide a more fundamental resegmentation of a company's financial reporting.

FAQs

Q1: Why are discontinued operations reported separately on the income statement?

A1: Discontinued operations are reported separately to give users a clearer picture of a company's ongoing business performance. By removing the financial impact of segments that are no longer part of the core business, investors and analysts can better assess the profitability and cash flow generation of the activities that will continue into the future. This helps in more accurate forecasting and valuation.

Q2: How do discontinued operations affect a company's financial statements?

A2: Discontinued operations primarily affect the income statement and balance sheet. On the income statement, their results are shown as a single line item, net of tax, below continuing operations. On the balance sheet, the assets and liabilities of the discontinued component (if held for sale) are presented separately. Companies are also required to restate prior period financial statements to reflect the discontinued operations for comparative purposes, ensuring consistency in presentation.

Q3: What is the difference between an asset held for sale and a discontinued operation?

A3: An asset held for sale is a long-lived asset or group of assets that management plans to sell. A discontinued operation is a component of an entity that has been disposed of or is classified as held for sale, and whose disposal represents a strategic shift with a major effect on the entity's overall operations and financial results. All discontinued operations are, by definition, considered "held for sale" or already disposed of, but not all assets held for sale qualify as discontinued operations.