Nothing lasts forever. Well, maybe that can of ravioli in your pantry will, but let’s call that an outlier. Everything else, including once vital components of your operations, has a finite lifespan. Unfortunately, when you have discontinued operations, it’s not as easy as letting it fade into the ether. In fact, the fine folks at FASB outright say your discontinued operations can’t go gentle into that good accounting night.
That isn’t to say that discontinued operations are a migraine waiting to happen, though. Like most things in the big ol’ financial accounting world, when you understand the guidance behind them, you make your accounting team’s collective life much easier. So let’s take a closer look at those pesky discontinued operations, throw in a few best practices for good measure, and let your accounting function show off those pearly whites.
What Are Discontinued Operations?
Sometimes the name says it all. Discontinued operations are exactly what they sound like – a business or part of a business that a company has either discontinued or plans to. That could include a group of components or a non-profit activity as well. The overriding point, however, is that something within your operations is going the way of the dinosaurs.
Accounting For Discontinued Operations: Get to Know ASC 205-20
ASC 205-20 is the discontinued operations gospel, IFRS 5 for our international brethren. But like most guidance, despite an overhaul to simplify things a few years ago, it can still read like the ingredients on the back of a shampoo bottle. Therefore, a quick, high-level review of the relevant accounting principles is well in order. And as luck would have it, a quick review also functions as a walk-through to help determine what qualifies as a discontinued operation, what doesn’t, and how it impacts your financial statements.
Begin the process by figuring out if the disposal represents a strategic shift that either already has had or will have a major effect on your operations and financial results. Sounds kind of subjective, right? Thankfully, the guidance provides some criteria that shed a bit more light on what it means by strategic shift:
- A major geographical area.
- A major line of business.
- A major equity method investment.
- Other major parts of an entity
From there, you must determine if you actually have a discontinued operation on your hands, as discussed in ASC 205-20-45-1B. This will identify components either held for sale, disposed of by sale, or by other means like abandonment or a spinoff to owners via a distribution. Thankfully, there’s additional guidance for each of these classifications that will inevitably impact different areas of your reporting.
Taking a deeper dive, ASC 205-20-55 even provides a few examples of disposals that qualify as strategic shifts that result in a major effect on your operations, financial results, or both.
- A product line that represents 15% of your total revenues.
- A geographical area accounting for at least 20% of your total assets.
- You’re selling all of your mall locations to focus exclusively on your superstore sites that have historically provided 30% - 40% of your total net income, and 15% of your current total net income.
- A component that’s an equity method investment and represents 20% of your total assets.
- An 80% interest in one of your two product lines that accounts for 40% of your total revenue.
Discontinued Operations Examples
We understand that even a conversational review of guidance can still cause a person to drift off to their happy place, so a couple of real-world scenarios should help flesh out the important strategic shift and major effect concepts.
An Expanding Hotel Operator
Let’s start with something simple to better define the concept of a strategic shift. You’re a hotel operator that’s expanding your footprint through acquisitions, targeting a smaller chain of economy-class hotels spread across the lovely Southwestern United States. It’s a fast entry into a market you’ve long wanted to explore, and this acquisition is too tempting to pass up.
However, the company you acquire also has a construction line of business, allowing them to build their own hotel properties rather than hiring an endless line of contractors and subcontractors. Your executive team rightfully feels that the construction business is well outside of your core competencies and chooses to sell it. The sale would represent a discontinued operation in the period you sell the business because retaining it would qualify as a strategic shift in your operations. In other words, you’re a hotel operator, not a builder.
A Toy Company
Now let’s take a look at a strategic shift that has a major effect on operations or financial results, this time using metrics as our guide. You’re a toy company that is trying to stay ahead of shifts in demand. You have a subsidiary that manufactures a line of sci-fi action figures that has always performed well, but the licensing fees you pay for character rights have been consistently rising in recent years. Management sees the subsidiary’s eroding margins and decides to sell it.
You look at the latest reports and see that the subsidiary’s total revenue is greater than 15% of the consolidated revenue for the parent company as a whole. Further, the subsidiary’s assets also represent more than 20% of the parent’s total assets. According to the examples we provided from ASC 205-20-55, the sale of the action figure subsidiary represents a discontinued operation by both the total revenue and asset metrics.
Financial Reporting: Disc Ops on the Income Statement
Now that you have a better idea of what constitutes a discontinued operation, let’s take a look at what to do with them in your financial statements. First and foremost, remember that it’s crucial to separate your discontinued operations from your ongoing operations with new line items on your income statement. This way, anyone looking at your financials can easily distinguish between the cash flows and profits from your continuing operations and those from the disposals.
Your discontinued operation will result in a gain or loss during the accounting period it flew the accounting coop. Naturally, you have to report that gain or loss as well as the relevant taxes. However, since many discontinued operations are disposed of at a loss, you could very well realize a future benefit on your corporate income taxes.
Also, when calculating your total net income, combine the gain or loss from the discontinued operation with that from your ongoing operations. Sure, you might have to make a few adjustments here and there due to contingent liabilities or contract terms, benefit plan obligations, or other items, but you get the idea.
Other Considerations & Best Practices
Aside from that high-level look at discontinued operations and your income statement, there are a few other considerations to keep in mind that, once again, can be helpful to the folks in your accounting department.
- In the case of a sale where the buyer assumes debt associated with the discontinued operation, be sure to allocate any interest expense on that debt to the disposal and not your ongoing operations.
- Expanding on the previous point, GAAP doesn’t let you assign general corporate overhead to your discontinued operation and limits items like depreciation, amortization, and impairment to the date of disposal or held for sale.
- Disclosures play an important role when you have discontinued operations, where what you include in your disclosures will depend on the nature of the disposal – sale, held for sale, or by other means. Your disclosures also let you explain particular items in your financials, like your income statement, to provide the reader a better idea of what’s going on.
- It’s highly unlikely a discontinued operation will blindside you. Plan ahead and track transaction costs related to the component you’re disposing of, maybe even using a separate GL code to make that tracking easier. This will prevent a mad scramble for the pertinent data down the road.
- Likewise, when you know there’s a discontinued operation coming up, issue a memo that documents all of the considerations. You’ll thank us come audit time.
Although this high-level look at discontinued operations and accepted accounting principles should be a tremendous help, always remember to review the actual guidance itself for any nooks and crannies that might pertain to you. And as always, if you need a helping hand to guide the way, Embark is at the ready to lend you our expertise.