ASC 360 has changed the qualifying conditions for reporting discontinued operations, as well as the standards on reporting for long-lived assets to be disposed of. Reporting of discontinued operations was originally set forth by ASC 225. ASC 225 required that a discontinued operation be a segment of the business in order to qualify for the special financial statement presentation afforded to such operations. By contrast, under ASC 360 the reporting requirements apply to a “component of an entity“. A component of an entity is distinguishable from the rest of the entity because it has its own operations and cash flows. A component may be a reportable segment, an operating segment, a reporting unit, a subsidiary, or an asset group.
Through this post I bring you to a closer look on reporting discontinued operations on the income statement, as well as disposal of long-lived assets: requirements for reporting discontinued operations [what conditions to be met to be qialified to report for discontinued operations], how to compute gain or loss on disposal, discontinued operation in the Future Periods. To make this post even richer, a determination example whether to report discontinued operations or not is revealed, and example of income statement presentation for discontinued operations is also provided. Enjoy!
Qualifying Conditions for Reporting Discontinued Operations
If a component of an entity is either classified as held-for-sale or has been disposed of during the period, the results of its operations are reported in discontinued operations, if both of the following conditions are met:
- The operations and cash flows of the component have been or will be removed from the ongoing operations of the entity as a result of the disposal transaction; and
- The entity will have no significant continuing involvement in the operations of the component after the disposal transaction.
ASC 205-20-55 provides guidance in applying these two criteria. The determination of whether the operations and cash flows of a disposed component have been or will be eliminated from the ongoing operations of the entity depends on (1) whether continuing cash flows have been or are expected to be recognized and, if so, (2) whether those continuing cash flows are direct or indirect.
Continuing cash flows are cash inflows or outflows that are recognized by the ongoing entity and are associated with activities involving a disposed component. If continuing cash flows are recognized, the determination as to whether those continuing cash flows are direct or indirect is based on their nature and significance. If any continuing cash flows are determined to be direct, the cash flows have not been eliminated and the operations of the component are not to be presented as a discontinued operation.
ASC 205-20-55 also concluded that continuing involvement in the operations of the disposed component would provide the ongoing entity with the ability to influence the operating and (or) financial policies of the disposed component. The retention of risk or the ability to obtain benefits associated with the ongoing operations for the disposed component might indicate that the ongoing entity has the ability to influence the operating and (or) financial policies of the disposed component, resulting in a finding of continuing involvement.
The determination as to whether the continuing involvement is significant would be based on quantitative and qualitative assessments from the perspective of the disposed component. The assessment is to consider all types of continuing involvement, individually and in the aggregate.
The assessment period commences when the component initially meets the criteria for classification as held for sale or is actually disposed of. The assessment period ends one year from the date of the actual disposal.
During this assessment period, each time it issues financial statements, management of the ongoing entity is to consider whether any significant events or circumstances had occurred that might cause its original assessment with respect to whether both criteria for classification as discontinued operations are expected to be met.
If a significant event or circumstance occurs during the assessment period that results in management assessing that both criteria are no longer expected to be met by the end of the assessment period, the operations of the component are not to be presented as discontinued operations. Consequently, it is possible that, during the assessment period, amounts may be classified into and out of discontinued operations based upon reassessments necessitated by the occurrence of events or circumstances.
Examples of Determination Of Whether To Report Discontinued Operations
Software Solutions Plus develops and sells software for several markets. It has a children’s educational line, a children’s game line, a business office line, and a desktop publishing line. The product line is the lowest level at which the operations and cash flows can be clearly distinguished by management. Thus, each product line is an operating segment and a component of the entity.
- Case 1 – Software Solutions Plus decides to exit the game business and commits to a plan to sell the children’s game line. The assets and liabilities of the product line are classified as held-for-sale at that date. Software Solutions Plus will have no continuing involvement with the children’s game software after the sale is closed. In addition, Software Solutions Plus has decided that it will not develop any new computer games for the children’s market. In this case, the conditions are met to report the children’s game line as a discontinued operation.
- Case 2 – Instead of exiting the children’s game business entirely as in Case 1, Software Solutions Plus decides to keep its game programmers on its staff and have them develop new children’s games. However, instead of selling the games to the home market via distributors as it had been doing, each existing and newly developed game will be marketed and sold to other software game companies. Software Solutions Plus will not provide technical support for any particular game software after it is sold. In this case, although Software Solutions Plus will not have any continuing involvement with the games after they are sold, it will continue to have revenues and expenses related to the children’s game product line. Thus, the first of the two conditions required for discontinued operations treatments is not met. The change in the manner of marketing the line cannot be reported in discontinued operations.
- Case 3 – Software Solutions Plus decides to discontinue developing and selling its graphics drawing program product, which is part of the desktop publishing product line. In this case, because the graphics drawing program product is not a component of the entity on its own, but instead is part of the component desktop publishing product line, the sale of the graphics drawing program cannot be reported in discontinued operations.
- Case 4 – Software Solutions Plus commits to a plan to sell the desktop publishing line to another software company. The assets and liabilities of the product line are classified as held-for-sale at that date. As part of the sales agreement, Software Solutions Plus will receive a sizable royalty for each program sold and will provide technical support to the buyer’s programming staff and to customers for the next three years. In this case, because Software Solutions Plus will continue to receive cash flows from the product line and will continue to have significant involvement with the product line after the product line is sold, the sale of the desktop publishing product line cannot be reported in discontinued operations. In the third year after the sale, Software Solutions Plus should reassess whether the conditions necessary to report the activity in discontinued operations have been met.
In the period in which a component of an entity is either classified as held-for-sale or has been disposed of, the results of operations of that component and any gain or loss recognized on disposal is reported as a separate component of income, before extraordinary items and the cumulative effect of accounting changes (if any). The income statements of any prior periods being presented should be restated to also reflect the results of operations of the component as discontinued operations. All amounts should be reported less applicable income taxes (benefits), as shown in the example below.
Example Of Income Statement Presentation For Discontinued Operations
Below example shows the loss on disposal on the face of the income statement. Alternatively, the amount can be shown in the notes to the financial statements, as long as the disclosure identifies the caption in the income statement in which the loss is included.
General corporate overhead may not be allocated to discontinued operations. Interest expense, however, is to be allocated to discontinued operations if, as a result of a disposal transaction, the buyer assumes debt of the seller/reporting entity or, as a result of the disposal transaction, the reporting entity is required to repay debt (ASC 205-20-45). Allocation to discontinued operations of other consolidated interest is permitted but not required. If the corporation decides to allocate other consolidated interest, ASC 205-20-55 provides guidance regarding the maximum amount and methods of allocation.
How to Compute Gain or Loss On Disposal?
To compute the loss (or gain) on disposal, the entity must first compute the fair value of the component; less the cost to sell it. Costs to sell are the incremental direct costs to transact the sale. In other words, costs to sell result directly from the decision to sell the component, are essential to the sales transaction, and would not have been incurred by the entity absent the decision to sell the component.
Examples of costs to sell are broker commissions, legal fees, title transfer fees, and closing costs. In the limited situations in which the sale will occur more than one year after the component is classified as held-for-sale, the costs to sell should be discounted to present value.
Next, the entity must compute the carrying value of the component. The carrying amounts of assets (other than long-lived assets) and liabilities are first adjusted in accordance with GAAP, and any adjustments are excluded from the gain or loss from disposal. For example, if trade accounts receivable are being sold as part of a component, the adequacy of the valuation allowance would be assessed as of the date the component is classified as held-for-sale, and any adjustment needed to bring the allowance to the proper balance would be included in bad debt expense. Similarly, if the sale of the component includes assumption of bonds payable, the accumulated amortization of any premium or discount on those bonds would be brought up to date, and this adjustment would be included in interest expense.
The gain or loss on disposal is computed by comparing the total carrying amount to the fair value net of costs to sell. A loss is recognized in the period in which the component is classified as held-for-sale if the total carrying amount exceeds the fair value less costs to sell.
On the other hand, if the fair value less costs to sell exceeds the carrying amount (that is, there is a gain on disposal), the gain is not recognized until the actual sale occurs. Fair value, as defined in ASC 820, is essentially the price the seller would receive on the open market for a product.
Under ASC 360, losses from operations of the component subsequent to the date the component is classified as held-for-sale are to be recognized in the period in which they are incurred. That is, expected future losses are not accrued prior to being incurred, since doing so would result in the creation of a liability (reserve) which fails to meet the definition in CON 6.
Example of Computing the Gain or Loss on Disposal
Today’s Telecommunications has decided to close its pager division, which is a component of the reporting entity. It has committed to a plan to sell the assets and liabilities of the division and has properly reclassified the division as held-for-sale at that date. The following conditions apply:
- The division has incurred $1,750 losses from operations from the beginning of the year to the date it was reclassified as held-for-sale.
- The fair value of the assets and liabilities of the division are $10,775.
- Broker’s commissions and other costs to sell are estimated to be $1,650.
- The carrying value of the assets and liabilities of the division is $12,525 before the GAAP adjustments (depreciation, amortization, adjustment of valuation accounts, and similar periodic adjustments) are made:
- The GAAP adjustments reduce the carrying value of the assets and liabilities by $125.
- Losses from operations of the division from the date it is classified as held-for-sale to the end of the fiscal year are $580. (This loss does not include the GAAP adjustments noted above).
- Anticipated future losses from operations of the division from the end of this fiscal year to the expected sales date are $1,999.
- The tax rate is 40%.
The income statement presentation of discontinued operations would be:
Discontinued operations (Note ___)
Loss from operations of discontinued division, net of tax of $982 = $1,473
Loss on disposal of discontinued division, net of tax of $1,310 = $1,965
Loss on discontinued operations = $3,438
The loss from operations of the discontinued pager division is the sum of the $1,750 loss incurred prior to the date the assets and liabilities were classified as held-for-sale, plus the $125 GAAP adjustments that were recorded, plus the $580 loss incurred from the date the division was classified as held-for-sale to the end of the fiscal year. The sum ($2,455) less the tax effects of $982 ($2,455 × 40%) is the loss from operations of $1,473.
The loss on disposal is the difference between the carrying value of the division and its fair value less costs to sell. The carrying value of the division is $12,400 ($12,525 less the GAAP adjustments of $125). The fair value of the division less costs to sell is $9,125 ($10,775 fair value less costs to sell of $1,650). The difference of $3,275 less the tax effects of $1,310 ($3,275 × 40%) is the loss on disposal of $1,965. The anticipated future losses from operations of the division will be reported in discontinued operations in the future period in which they occur. They are not included in the loss on disposal in the current fiscal year.
Discontinued Operation in the Future Periods
Subsequent to the fiscal year in which the assets and liabilities of a component are classified as held-for-sale, the discontinued operations section of an income statement includes:
. Results of operations of the discontinued component
. Certain adjustments that are directly related to the disposal of a component of an entity, such as:
a. Resolution of contingencies associated with the terms of the disposal transaction, such as purchase price adjustments and indemnification issues with the purchaser.
b. Resolution of contingencies associated with the operations of the component prior to its disposal, such as environmental or product warranty obligations retained by the seller.
c. Settlement of employee benefit plan obligations directly associated with the disposal transaction that occur no later than one year after the disposal transaction.
When adjustments of this nature occur, they should be classified separately in discontinued operations of the current period and the notes to the financial statements should disclose the nature and amount of these adjustments.
Example of Discontinued Operations In A Future Period
Continuing the previous example, the sale of Today’s Telecommunications’ pager division, which is a component of the entity, closed in the year subsequent to the fiscal year in which the assets and liabilities were classified as held-for-sale:
- The actual sales price less costs to sell was $9,725.
- The net carrying value of the assets and liabilities on the date of sale was $12,225.
- The loss from operations from the end of the fiscal year to the date of sale was $2,045.
- The tax rate is 40%.
The income statement presentation of discontinued operations would be:
Discontinued operations (Note ___)
Loss from operations of discontinued division, net of tax of $818 = 1,227
Gain on disposal of discontinued division, net of tax of $310 = 465
Loss on discontinued operations = 762
The loss from operations of the discontinued pager division is the $2,045 less the tax effects of $818 ($2,045 × 40%).
The loss on disposal is the difference between the carrying value of the division and its sales price less the loss recognized in the prior period. The carrying value of the division was $12,225; the sales price less costs to sell was $9,725, for an actual loss of $2,500. The loss recognized in the prior period was $3,275, so an adjustment of $775 ($2,500 less $3,275) is necessary. The tax effects on the adjustment are $310 ($775 × 40%), so the net adjustment is a gain of $465 ($775 – $310).
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