Accounting: The Language of Business - Vol 2 (Intermediate: Part 53)

The income tax is the biggest single intrusion suffered by the American people. It forces every worker to be a bookkeeper, to open his records to the government, to explain his expenses, to fear conviction for a harmless accounting error. Compliance wastes billions of dollars. It penalizes savings and creates an enormous drag on the U.S. economy. It is incompatible with a free society, and we aren’t libertarians if we tolerate it.

Harry Browne

Statements of Net Income and Comprehensive Income (Part K)

by

Charles Lamson 

Discontinued Operations

Discontinued operations are portions of the business that a company has disposed of or is in the process of disposing of. The discontinued operations section of the statement of net income includes any income from components of an entity or a group of components of an entity that have been disposed of, abandoned during the reporting, or are classified as held for sale as of the end of the reporting period. A discontinued operation may also be composed of a business or nonprofit activity. We will identify the characteristics of discontinued operations before examining the reporting requirements.

Characteristics of a Discontinued Operation

A component of an entity has three main characteristics: it is (1) a portion of the entity (2) comprising operations and cash flows (3) that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. A component of an entity can be:

• a reportable segment,

• an operating segment,

• a reporting unit,

• a subsidiary, or

• an asset group.

That is, a company must be able to separate the discontinued component's operations and cash flows from the continuing operations' earnings and cash flows. It should also be able to separately report discontinued operations in its financial statements.

After a company has determined that a portion of a business is a component of an entity or a group of components of an entity, the company must also demonstrate that the disposal represents a strategic shift that has or will have a major effect on the entity's operations and financial results. For example, the disposal of a major line of business would constitute a strategic shift that would have a major impact on the entity.

Discontinued Operations Reporting Requirements

Companies report income from discontinued operations and continuing operations separately. The separate reporting provides financial statement users with a measure of income from continuing operations, which is a preferred basis for predicting future performance. Clearly, a discontinued portion of a business will no longer generate future earnings and cash flows. Companies report three main types of income, gain, or loss under discontinued operations on the income statement:

1. Income or loss from operations of discontinued segment, unit or group, net of tax.

2. Loss on initial remeasurement of net assets held for sale to fair value less disposal costs, net of tax. In subsequent measurements, a loss or gain up to previously recognized losses can be repeated.

3. Gain or loss on disposal of assets or disposal group(s) constituting the discontinued operation, net of tax.

Companies present the operating income, loss, or gain from the discontinued operation and income from continuing operations separately. If the company has sold the discontinued operation, it includes the operating income from the beginning of the reporting period to the date of disposal in the discontinued operations section of the statement of net income. If the company is holding the discontinued operation for sale as of the end of the reporting period, it presents the operating income from the entire reporting period in the discontinued operations section of the statement of net income. For example, assume a company earned $22 million of net income of which three million dollars was from a loss on discontinued operations. The company would report income from continuing operations of $25 million and a $3 million loss from discontinued operations.

When a company decides to discontinue an operation, it remeasures the assets and liabilities of that operation for their fair values less selling costs if this amount is lower than their carrying value. Because the assets and liabilities are being held for sale, their value in the market is the most relevant value to financial statement users.

In the first period that the company remeasures the assets and liabilities of the operation, only a loss is permitted. If a write-down is necessary, the loss is equal to the difference between the book value of the net assets and their fair value net of selling costs. If the company writes down the net assets to fair value net of selling costs in one period and still holds the net assets in the next period, the company will report again in the subsequent period if the fair value net of selling costs increased. However, the write-up cannot result in a carrying value greater than the carrying value of the net assets before the write-down (See FASB ASC 205-30-65-3 and FASB ASC 360-10-35-40 for the related authoritative literature. Also, we discuss this issue in more detail in a later post.)

When the company sells the discontinued operation, there could be a realized gain or loss [The realized gain/loss is the difference between the cost and the proceeds from the sale or redemption of a security. A gain occurs when the proceeds from the security sold are greater than your cost basis. A loss occurs when the proceeds are less than your cost basis (rwbaird.com).] on the sale. Companies present all amounts on the income statement related to discontinued operations net of tax. Net of tax means that the amount of income, gain, or loss, reported includes any income tax effects. As noted earlier, the income tax expense (or benefit) related to discontinued operations is not included in the tax provision related to continuing operations.

Companies are also required to disclose the following other income and expense items related to discontinued operations in the footnotes to the financial statements:

1. Free text income (loss)

2. Pre-tax income (loss) attributable to the company's shareholders

3. Major line items to arrive at pre-tax income (loss) such as revenue and cost of sales, depreciation, and interest expense

4. Reconciliation of the major items making up the pre-tax profit (loss) disclosed in the notes to financial statements to the after-tax profit (loss) presented in the income statement

5. Carrying amounts of the major classes of assets and liabilities included as part of a discontinued operations and classified as held for sale

6. Gain or loss on remeasurement of net assets held for disposal

7. Reconciliation of the carrying amounts of major classes of assets and liabilities disclosed in the notes to financial statements to total assets and liabilities classified as held for sale on the balance sheet

8. Either total operating and investing cash flows related to the discontinued operation, or the depreciation, amortization, capital expenditures, and significant operating and investing non-cash items associated with the discontinued operation.

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 187-189*

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