What Are Discontinued Operations in Accounting?

When a business sells off a portion of its operations, financial statements must reflect these shifts. Discontinued operations refer to a component of an entity that has either been disposed of or is classified as held for sale. Separately presenting these operations enhances transparency and comparability for financial statement users. By segregating the results of discontinued activities from those of ongoing business segments, stakeholders can better understand a company’s current performance and its future earning potential. This distinct reporting ensures that decisions made based on financial data accurately represent the entity’s continuing core business.

Understanding Discontinued Operations

Under U.S. Generally Accepted Accounting Principles (GAAP), a “component of an entity” is defined as operations and cash flows that are clearly distinguishable, both operationally and for financial reporting purposes, from the rest of the company. This component can range from an operating segment or a reportable segment to a subsidiary or even an asset group. This classification applies when the entity will no longer have significant continuing involvement in that specific operation after its disposal. For instance, if a company sells a major product line, the income, expenses, and cash flows from that product line would be reported as discontinued operations. Without this distinction, the financial performance of a divested segment could distort the perceived performance of the remaining business, leading to misinformed investment or lending decisions. It ensures that the financial statements reflect the company’s true operational trajectory after a strategic change. This transparency supports investors, creditors, and other stakeholders in making more accurate assessments of the entity’s financial health and prospects.

Criteria for Classification

For an operation to be classified as discontinued under U.S. GAAP, specifically ASC 205-20, strict criteria must be met. The disposal of a component or a group of components must represent a “strategic shift” that has, or will have, a major effect on an entity’s operations and financial results. This “strategic shift” criterion significantly narrows the scope of what qualifies as a discontinued operation. Once a disposal is determined to be a strategic shift, the component must either have been disposed of by sale, disposed of other than by sale (e.g., abandonment), or meet the criteria to be classified as “held for sale.” The “held for sale” classification requires several conditions to be satisfied. There must be a commitment to a plan to sell the component, and the asset or group of assets must be available for immediate sale in its present condition, subject only to usual and customary terms. An active program to locate a buyer must be initiated, and the sale must be considered probable, with an expectation of completion within one year from the date of classification. Furthermore, for an operation to be classified as discontinued, the entity must not have any significant continuing involvement in its operations after the disposal transaction. This means the company cannot retain substantial operational ties or responsibilities that would blur the distinction between the divested part and the continuing business. The operations and cash flows of the component must be clearly distinguishable from the rest of the entity. This ensures that the reported discontinued operations genuinely represent a clean break from the company’s ongoing activities, providing financial statement users with a clear view of the remaining core business.

Financial Reporting of Discontinued Operations

On the income statement, the results of discontinued operations are presented as a single amount, net of tax, appearing after income from continuing operations. This single line item typically includes both the income or loss from the operations of the discontinued component for the period and any gain or loss recognized on the disposal of the component itself. If comparative income statements are presented, the results for all prior periods shown must be reclassified to segregate discontinued operations from continuing operations, ensuring consistency across reporting periods. For balance sheet presentation, the assets and liabilities of a discontinued operation that are classified as held for sale are presented separately from other assets and liabilities. These assets are measured at the lower of their carrying amount or fair value less costs to sell. This separate classification provides transparency regarding the assets and liabilities that are no longer part of the company’s long-term operational structure. The major classes of assets and liabilities of the discontinued operation are typically disclosed either on the face of the balance sheet or in the notes to the financial statements. Regarding the cash flow statement, cash flows related to discontinued operations are generally classified within the standard categories of operating, investing, and financing activities. While not always presented as a separate line item on the face of the statement, companies are required to disclose the net cash flows attributable to the operating, investing, and financing activities of discontinued operations. This disclosure can appear either within the cash flow statement itself or in the notes to the financial statements, allowing users to understand the cash impacts of the divested operations. The proceeds from the sale of a discontinued operation, for example, would be presented as cash related to investing activities of discontinued operations.