What Belongs in Your Discontinued Ops?

FASB will rework the definition of discontinued operations in its upcoming exposure draft.
Marie LeoneJuly 25, 2008

One small step at a time, the Financial Accounting Standards Board is tightening up the criteria for what qualifies as a discontinued operation on a corporate income statement. This time the board has targeted a subset of discontinued operations: newly acquired subsidiaries that are classified as “held for sale on acquisition.” Those are business units that are earmarked for a quick sell-off after a merger.

On Wednesday FASB voted to move forward with an exposure draft that would amend the definition of discontinued operations to include these held-for-sale acquisition. This is significant because if the businesses don’t meet the stringent criteria already set up for held-for-sale subsidiaries, they won’t be classified as discontinued operations.

Generally, companies like to report discontinued operations separately from continuing operations to enable investors to strip out sold, or soon-to-be-sold, assets from current and future earnings when they judge the worth of the company. Such reporting has been known to brighten company profit pictures. Case in point: on Thursday Scholastic Inc. — the U.S. publisher of the famously popular Harry Potter book series — reported earnings from continuing operations of $2.82 for the 2008 fiscal year, compared with a $0.57 net loss for the year when it included discontinued operations in its calculation.

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Similarly, acquiring companies are keen on immediately classifying assets that they intend to jettison as held for sale, to communicate the company’s view of what’s driving the transaction. For example, consider an entertainment conglomerate that spends $1 billion (half stock, half debt) to buy a company that owns theme parks, a bottling group, and a rail-car operation. If the conglomerate’s executives want investors to know that the theme parks were the primary target and that within a short time the bottling and rail-car units will be sold to help pay down the debt and buy back some stock, they can book the bottling and rail-car units as held for sale.

The held-for-sale criteria are strictly defined to prevent companies from dumping too many items into that financial-statement category, however. For an asset or subsidiary to qualify as held for sale, management must commit to sell the item off within one year of recording it, the asset or business unit must be available for immediate sale in its present condition, management must be actively seeking a buyer, and the sale price must be “reasonable in relation to its current fair value.” The asset or subsidiary is measured at its fair value — less the cost to sell the item — as of the acquisition date.

In 2001 FASB issued FAS 144, the rule that defines discontinued operations and instructs companies how to account for the items. At the time, the new rule broadened the scope of the definition so more items qualified for such accounting treatment. And although separating out discontinued operations doesn’t change net income, companies say the partitioning makes it easier for executives to tell their earnings story without addressing unwanted assets and liabilities.

What’s more, companies that classify a subsidiary as a held-for-sale business can sometimes get a mild boost to earnings because the assets held by the subsidiary aren’t depreciated. That’s because, by definition, assets will be sold, and proceeds will be collected, in less than a year. Typically, companies depreciate assets over at least three years. In addition, any adjustment to the subsidiary’s asset value on the acquisition date is considered part of goodwill. Adjustments made after the acquisition date are run through the income statement, and ultimately affect earnings.

FASB also decided at its Wednesday meeting to propose changing some requirements for disclosing assets and liabilities classified as held for sale. The disclosure amendments, and the FAS 144 changes, all will be incorporated in an exposure draft that’s being crafted in tandem with the International Accounting Standards Board. At its June meeting, IASB approved all the recommendations that FASB approved last week.

Under the disclosure proposal, if newly acquired businesses meet the criteria for held-for-sale, then the parent company is exempt from a handful of footnote disclosure requirements that pertain to individual components of the business. For example, companies wouldn’t have to disclose information about recognized gains or losses related to the fair value of the asset. They also wouldn’t have to reveal information about major classes of assets and liabilities, income and expenses, and cash flows. Instead, parent companies would only have to describe the facts and circumstances leading to the expected disposal of the assets, the expected manner and timing of the disposal, and, if applicable, the segment within which the subsidiary belongs — three requirements that are currently in place.

For acquiring companies that have sold or own held-for-sale subsidiaries that don’t meet the held-for-sale criteria, four specific footnote disclosures are still required: major classes of revenues and expenses — including impairments, interest, depreciation, and amortization; net income attributed to the parent company; major classes of cash flows; and major classes of assets and liabilities.

A fifth disclosure describing how the company used the cash proceeds spawned by selling off the held-for-sale assets is currently required. But both FASB and the IASB decided to eliminate that requirement because the information is already described in cash-flow statements and the management’s discussion and analysis section of the annual report.