GAAP Accounting for Discontinued Operations

When a company decides to sell or shut down a distinct portion of its business, this event is known as a discontinued operation. U.S. Generally Accepted Accounting Principles (GAAP) provide specific rules for how companies must account for and present these disposals. The primary goal is to separate the financial results of a company’s ongoing activities from the results of the part of the business that has been or will be disposed of. This separation provides stakeholders with a clearer view of the company’s sustainable profitability and future cash flow potential.

Criteria for Classification as a Discontinued Operation

For a disposal to be classified as a discontinued operation under GAAP, as detailed in Accounting Standards Codification (ASC) 205-20, it must meet specific criteria. A component is defined as having operations and cash flows that can be clearly distinguished, both operationally and for financial reporting purposes, from the rest of the company. This means the company can track the revenue, expenses, and cash movements of that specific part of the business separately.

The disposal must also represent a “strategic shift” that has or will have a major effect on the company’s operations and financial results. This is not met by routine sales of assets or smaller business lines. Examples of a strategic shift include disposing of a major geographical area of operations, selling a major line of business, or getting rid of a significant equity method investment. A national retail chain selling all of its stores in a particular region would likely qualify, whereas selling a single underperforming store would not.

A component must also meet the detailed criteria to be classified as “held for sale.” Management, at the appropriate level of authority, must be committed to a formal plan to sell the component. The component must be available for immediate sale in its present condition. Furthermore, the company must have initiated an active program to locate a buyer and be taking other necessary actions to complete the plan. The sale must be probable, and the transfer of the component is expected to be completed within one year from the date of classification. If all these conditions are met, the component is classified as held for sale.

Financial Statement Presentation

Once a component is classified as a discontinued operation, GAAP dictates a specific presentation on the financial statements. The objective is to present the results of continuing operations separately from the results of the operations being discontinued.

On the income statement, the results of the discontinued operation are reported in a single, separate line item. This line appears after the subtotal for income from continuing operations. It consolidates the income or loss from the component’s operations during the reporting period and any gain or loss recognized from the disposal itself. This amount is presented net of its related income tax effects.

On the balance sheet, the assets and liabilities of the component classified as held for sale must be presented separately from the company’s other assets and liabilities. The assets of the disposal group are aggregated and presented as a single line item, such as “Assets held for sale,” and the liabilities are similarly grouped. These assets and liabilities are not offset against each other. The balance sheet is retrospectively adjusted to show this separate classification for all prior periods.

The statement of cash flows also requires separate presentation. The net cash flows generated by or used for the discontinued operation’s operating, investing, and financing activities must be disclosed. This can be done either by presenting the amounts separately on the face of the statement of cash flows or by providing a disclosure in the footnotes.

Measurement and Subsequent Adjustments

When a disposal group is first classified as held for sale, it is measured at the lower of its carrying amount or its fair value less any costs to sell. Fair value represents the price that would be received to sell the asset in an orderly transaction, while costs to sell are the direct, incremental costs associated with the disposal, such as broker commissions and legal fees.

A consequence of classifying a component as held for sale is the treatment of its long-lived assets. From the date of classification, the company must cease recording depreciation or amortization on these assets, as their value is now expected to be recovered through sale rather than through continued use.

If management decides not to proceed with a sale and the criteria for held for sale are no longer met, the component must be reclassified as “held and used.” The new carrying value will be the lower of two amounts: their fair value at the date of the decision not to sell, or their carrying amount before they were classified as held for sale, adjusted for any depreciation that would have been recognized.

Any required adjustment to the asset’s carrying amount upon reclassification is included in income from continuing operations in the period of the decision. The operations of the component are also reclassified from discontinued operations back to continuing operations for all periods presented.

Required Disclosures

Beyond the specific presentation on the face of the financial statements, GAAP requires extensive disclosures in the footnotes to provide a comprehensive understanding of the discontinued operation. These disclosures are meant to give financial statement users a picture of the disposal’s nature and financial impact.

The company must provide a narrative description of the facts and circumstances that led to the disposal, including the expected manner and timing of the disposal. A disclosure is also required for a breakdown of the major classes of assets and liabilities of the component classified as held for sale.

For the income statement, the notes must disclose the major line items constituting the pretax profit or loss of the discontinued operation. This could include details like the revenue, cost of sales, and depreciation for the discontinued part of the business. The gain or loss recognized on the disposal must also be disclosed.

Finally, if the information is not presented separately on the statement of cash flows, the notes must disclose the net cash flows attributable to the operating, investing, and financing activities of the discontinued operation. These detailed disclosures work together to ensure transparency regarding the strategic shift undertaken by the company.