Companies will likely report fewer discontinued operations in financial statements as they transition to a new accounting standard, although they will have more judgment to exercise over whether a particular disposal constitutes a discontinued operation or not.
The Financial Accounting Standards Board recently adopted Accounting Standards Update No. 2014-08 to give companies new criteria to follow when determining whether it is necessary to break out a disposed or shuttered business and present it in financial statements as a discontinued operation. FASB developed the new standard, it says, in response to concerns that existing requirements led to too many disposals of small groups of assets, sometimes recurring events, being reported as discontinued operations.
“Broadly speaking, we expect the new standard will result in fewer disposals being presented as discontinued operations across many industries,” Larry Dodyk, a partner with PwC, says.
The new requirements may also be easier to apply. “Often showing something as a discontinued operation and breaking out prior periods to show the reclassifications can be problematic,” Dodyk says. “The board was trying to simplify the accounting.” The new standard provides for footnote disclosures to help users of financial statements understand where asset disposals have occurred that are no longer presented as discontinued operations, he explains.
Under the new standard, a company would report a disposal as a discontinued operation if it represents a “strategic shift” and it “has, or will have, a major effect” on operations and financial results. The standard provides examples of events that would be considered discontinued operations, including the disposal of a major geographical area, a significant line of business, major equity method investment, or other major parts of an entity. A business or non-profit activity, upon acquisition, may also meet the criteria.
At first, the standard appeared to be good news because it reduced the complexity of reporting for relatively small asset disposals, Mark Winiarski, senior manager for the CPA firm Mayer Hoffman McCann, says. In a deeper dive, however, it’s clear the new standard will require new judgments, particularly around what constitutes a strategic shift or a major effect. “You have to evaluate whether it meets this new criteria,” he says. “There’s no strict definition for a strategic shift or a major effect. Before it was relatively clear when you met the criteria and when you didn’t. Now, there’s more judgment, so you’ll have to do a little more documentation around that.”
The discontinued operations treatment will be reserved for significant events, says Kelley Wall, a director at consulting firm RoseRyan. “If you’re just closing a store, that doesn’t count,” she says. “You have to be closing a whole region of stores or selling off one of your products. It needs to represent a strategic shift in the business. It has to be something big.” Under the existing standard, if a company tracked separate cash flow or financial results for a group of assets, their disposal generally would constitute a discontinued operation. “Now it has to be something big,” she says.
Often showing something as a discontinued operation and breaking out prior periods to show the reclassifications can be problematic. So the board was trying to simplify the accounting.
Larry Dodyk, Partner, PwC
Applying the new guidance will lead to differences in the financial statement presentation of income and assets, although it won’t change the bottom line, Scott Lehman, a partner with accounting and consulting firm Crowe Horwath, says. “When you report something as a discontinued operation, it’s clearly identified as such,” he explains. “You have income from continuing operations and from discontinued operations, so they are separate on the income statement. Net income isn’t going to change; you’re just showing the reader that going forward this income is going to go away. Now, you’re not going to have that as much.” That is welcome relief, he says, both to preparers and auditors: “The existing standard really pulls in, in many cases, some small, recurring disposals.”
The National Association of Real Estate Investment Trusts is very pleased with the new guidance, George Yungmann, senior vice president of NAREIT, says. “Because of the definition in the previous standard, the sale of even a single investment property was treated as a discontinued operation,” he says. “Many REITs had to reclassify earnings from continuing operations to discontinued operations regularly as they sold properties. This was very disruptive to many of our industry sell-side analysts.”
Below, PwC provides the new definition of a discontinued operation and the disclosures introduced under the new standard.
Under the new guidance, a discontinued operation is defined as a disposal of a component or group of components that is disposed of or is classified as held for sale and “represents a strategic shift that has (or will have) a major effect on an entity’s operations and financial results.”
The standard states that a strategic shift could include a disposal of (i) a major geographical area of operations, (ii) a major line of business, (iii) a major equity method investment, or (iv) other major parts of an entity. Although “major” is not defined, the standard provides examples of when a disposal qualifies as a discontinued operation.
A business or nonprofit activity that upon acquisition qualifies as held for sale will also be a discontinued operation.
The standard no longer precludes presentation as a discontinued operation if (i) there are operations and cash flows of the component that have not been eliminated from the reporting entity’s ongoing operations, or (ii) there is significant continuing involvement with a component after its disposal.
The standard introduces several new disclosures, some of which are described below.
An entity is required to present in the statement of cash flows or disclose in a note either (i) total operating and investing cash flows for discontinued operations, or (ii) depreciation, amortization, capital expenditures, and significant operating and investing noncash items related to discontinued operations.
Additional disclosures are required when an entity retains significant continuing involvement with a discontinued operation after its disposal, including the amount of cash flows to and from a discontinued operation.
For disposals of individually significant components that do not qualify as discontinued operations, an entity must disclose pre-tax earnings of the disposed component.
The new guidance also requires companies to take a fresh look at their continuing involvement with an operation that it divests, Wall says. Companies often strike transition agreements that constitute a continuing involvement when they dispose of a business. This involvement can include an equity investment, a supply arrangement, commitment to help with research and development, or assisting with customer agreements throughout the transition to new ownership. “Under existing GAAP, if you have a lot of those transition agreements, it would often preclude companies from being able to report the disposal as a discontinued operation,” she says. “Now with the new rules, the transition agreements don’t get considered in whether or not you’re going to have to report.”
The standard also comes with tax implications companies will want to consider as they adopt the new requirements, Reto Micheluzzi, a partner at PwC, says. “While the new guidance is not changing the accounting for the related income tax effects, the presentation of discontinued operations has significant tax implications,” he says. Companies will want to assure that the intraperiod tax allocation model is taken into account.
When operations are discontinued, prior periods are restated for the sake of comparability and taxes must be allocated to both continuing and discontinued operations. That can be challenging, Micheluzzi says.
On balance, the new standard is an improvement over existing requirements, John Hepp, a partner with the international accounting firm Grant Thornton, says. “This is going to simplify the accounting and it’s going to reduce the number of transactions that have to be separately disclosed and accounted for as discontinued operations,” he says.
Companies are working through some transition issues, Hepp says, because the standard was issued in April, takes effect at the end of the year, but allows for early adoption. That led to some questions about how to treat operations that were discontinued or treated as held for sale in early 2014. “But from what I’ve seen so far with the issues that have come to my attention in the national office, it’s a better answer under the new guidance,” he says.