What happens when a company discontinues a product line or a sales office? These operations must still be recorded in any relevant financial records. Learn how to report income from discontinued operations for accounting on the income statement and tax purposes with some examples below.
What are Discontinued Operations?
A ‘discontinued operation’ is a part of a firm that has been sold or is being held for sale. It could be a subsidiary bought solely for sales, a main line of business, or a significant geographical area of operations.
A corporation that has disposed of or classified a component of its entity as held for sale will classify it as discontinued operations.
A corporation can declare discontinued operations if the disposal transaction results in the elimination of the component’s operations and cash flows from the company’s operations. Another criterion that must be met is that the company will have no ongoing involvement in the component’s operations once the disposal transaction is completed.
Recognizing Discontinued Operations
Discontinued operations are presented separately on the income statement because it is critical for investors to be able to discern profits and cash flows from ongoing operations from those from discontinued operations.
This distinction is especially valuable when corporations merge, as determining which assets are being divested or folded provides a more accurate picture of how a company will produce money in the future.
On a company’s income statement, discontinued operations are separated from continuing operations so that investors can readily understand how much money is coming in from current operations vs those that have ceased.
Reasons for Discontinued Operations
Parts of a firm’s business or product line are often categorized as discontinued if they are no longer operating, have been withdrawn from the corporation, or have been or will be sold (referred to as being “held for sale”). It should be noted that the discontinued activity must be a separate primary line of business or geographical area of operation.
During the normal course of a company’s life, its business structure will frequently change, including the cancellation of product lines deemed obsolete or no longer lucrative, the disposition of aging equipment, sales of various market segments, and alterations in its business model. All of the adjustments indicated above will result in discontinuation and must thus be declared on financial statements as discontinued operations.
They must be recognized separately in accordance with accounting regulation requirements such as GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards). The reason that discontinued operations are recorded separately from continuing operations (the product lines or business areas that are still in operation) is to prevent external stakeholders – such as shareholders or potential investors – from becoming confused and incorrectly evaluating the business’s profitability.
Income Statement Disclosure
When a company’s operations are discontinued, it must disclose various line items on its financial accounts. Despite the fact that the company component is being shut down, it may nevertheless make a profit or loss in the current accounting period.
Thus, the overall gain or loss from the operations is recorded, followed by the applicable income taxes. Because discontinued operations frequently generate losses, this tax is frequently a future tax advantage. To calculate the company’s total net income (NI), the gain or loss from discontinued operations is added to the gain or loss from ongoing operations.
To avoid confusion, a firm may classify modifications to the financial statements that relate to previously reported discontinued operations separately in the discontinued operations part of its financials. Benefit plan responsibilities, contingent liabilities, or contingent contract terms may all necessitate adjustments.
If the buyer of a discontinued operation absorbs the operation’s debt, all interest expenditure incurred prior to the sale is assigned to discontinued operations. General corporate overhead cannot be allocated to discontinued operations under generally accepted accounting principles (GAAP).
What are the Accounting Principles for Discontinued Operations?
GAAP is an abbreviation for “Generally Accepted Accounting Principles.” In the United States, GAAP is the accounting authority that defines accounting concepts, assumptions, and techniques. GAAP establishes regulation in a wide range of areas, including assets and liabilities, foreign currency, and financial statement format. This uniformity makes financial statements considerably easier to understand for business owners, investors, and government agencies.
GAAP requires the following events to occur in order for an American company to classify something as a “Discontinued Operation”:
#1. Operations and cash flow must come to a halt.
Discontinued must truly mean discontinued. In Ned’s instance, this means that no new income can be generated after the station is sold, and all expenses associated with transitioning the operation to the buyer must halt soon after the sale date.
#2. There must be no further involvement in the future.
The activity that has been discontinued or sold must be kept distinct from the original business. For example, if Ned sold the station but stipulated that his sales crew continue to sell commercials for the new owner, the transaction cannot be regarded as a discontinued operation.
Examples of Discontinued Operations
Here are some examples of accounting for discontinued operations:
- Due to a lack of sales, Armadillo Industries intends to discontinue one of its pressurized container products. The product is part of a wider product group whose cash flows are monitored. Because Armadillo does not track cash flows at the particular product level, it is unnecessary to categorize activities connected to a single product as discontinued.
- After further thought, Armadillo chooses to sell the entire container product group. Armadillo should identify this broader group as a discontinued operation because financial flows are related to it.
- Armadillo sells one of its retail outlets to a distributor and engages in a supply agreement with the new store owner. As a result, despite the change in ownership, the majority of cash flows from the store will remain. It is not proper to identify the store as a discontinued operation in this circumstance.
- One of Armadillo’s product lines is for sale. The buyer will pay Armadillo a 5% royalty on any sales connected to the product line for the following three years, according to the terms of the selling agreement. Armadillo will no longer be involved in the product line’s operations. Because Armadillo will have no ongoing engagement and the ensuing cash flows are indirect, the product line should be reported as a discontinued operation.
Read Also: SINGLE STEP INCOME STATEMENT: What you need to know
If the foregoing conditions are met and a component is held for sale, the company must report the component’s current and prior period results of operations in a separate discontinued operations part of the income statement. Under the same criteria, but if the component has been sold, the company must report the component’s results of operations for the current and prior periods, as well as any gain or loss on disposal, in a separate discontinued operations part of the income statement.
For example, Armadillo Industries has opted to sell its money-losing body armor segment, resulting in the following reporting in the lower portion of its income statement:
| Income from continuing operations before income taxes | $15,000,000 | |
| Income taxes | (5,250,000) | |
| Income from continuing operations | $9,750,000 | |
| Discontinued operations | ||
| Loss from activities of the discontinued business component | (6,000,000) | |
| Income tax benefit | 2,100,000 | |
| Loss of discontinued operations | (3,900,000) | |
| Net income | $5,850,000 |
IFRS Discontinued Operations
International financial reporting standards (IFRS) reporting regulations differ slightly from GAAP reporting guidelines. A discontinued operation must meet two criteria:
First, the asset or company component must be sold or recognized as being on the market.
Second, the component must be recognizable as a separate firm that is being voluntarily shut down or a subsidiary of a component that is being held with the intent to sell.
In contrast to GAAP reporting requirements, IFRS rules allow equity method investments to be classed as held for sale. Furthermore, under IFRS, firms may continue to be involved in the discontinued operation. Discontinued operations, like GAAP, are presented in a separate section of the income statement.
Financial Analysis and Discontinued Operations
Discontinued operations are reported separately in the income statement and are not included in ongoing operational activities. As a result, income from these operations is excluded from operating profit and EBIT.
There may be complications in calculating EBITDA and adding D&A expenses back to computed EBIT. In this regard, the most typical concern is D&A that has been assigned to the discontinued activity. Income from discontinued activities is shown at the bottom of the income statement and consequently has no influence on operating profit; therefore, D&A from discontinued activities should not be included in the operating profit add-backs.
Discontinued Operations Taxation
The taxes of discontinued operations can be a difficult problem to navigate. Discontinued operations frequently produce a profit or a loss in the accounting period in which the decision to terminate operations was made. As a result, the gains or losses must be reported to the IRS.
However, it is normal for discontinued operations to no longer generate money and to be operating at a loss, resulting in their demise. It means that while some money may be realized via taxes, the losses associated with the discontinued activity must be balanced against all of the other product lines that are still in operation and generating income.
Companies will almost certainly continue to pay taxes if the proceeds from their revenue-generating operations outweigh the proceeds from their discontinued operations.
Additional Rules for Discontinued Operations Disclosure
If there were previously reported adjustments for disposal-related amounts for discontinued operations, they should be classified separately in the income statement’s discontinued operations section in the current quarter. Here are some examples of these modifications:
Obligations under a benefit scheme Contingencies relating to employee benefit plan responsibilities, such as post-employment benefits, are resolved. This type of adjustment is normally limited to being classed as discontinued operations if it occurs no later than one year after the disposal transaction unless it is delayed due to circumstances beyond the company’s control.
Liabilities that are contingent Contingencies connected to liabilities associated with a disposal transaction, such as site remediation liabilities held by the seller, are later handled.
Terms that are contingent. Contingencies linked to the terms under which a disposal deal was executed, such as changes to the initial price paid, are later resolved.
If the buyer absorbs the debt connected with a discontinued operation, any interim interest expense incurred by the seller should be attributed to discontinued operations. GAAP expressly prohibits the transfer of general corporate expenses to discontinued operations.
Discontinued Operation FAQs
How do you record discontinued operations?
In order to comply with accounting regulatory standards such as GAAP, the discontinued operations must be recorded individually (Generally Accepted Accounting Principles)
How do you account for loss from discontinued operations?
Determine the profit or loss from the discontinued operation, which is equal to revenues less expenses. Revenues are calculated by deducting sales returns and allowances from product and service sales.
Where does discontinued operations go on the income statement?
Income and expenses from discontinued operations can be noted on a company’s income statement as line items below “Continuing Operations Income” and above “Net Income.”
How do you show discontinued operations on a balance sheet?
The assets and liabilities of a discontinued operation must be displayed separately in the asset and liability sections of the statement of financial position throughout the period(s) in which it is categorized as held for sale, as well as for all earlier periods provided.
Why are discontinued operations shown net of tax?
The “net of tax” presentation for discontinued operations indicates that the effect of income tax on the net income of the entire firm is pro-rated on the income statement between its effect on income from continuing operations and its effect on gain or loss on discontinued activities.
