What are Discontinued Operations?
Discontinued operations is an accounting term for parts of a firm’s operations that have been divested or shut down. They are reported on the income statement as a separate entry from continuing operations.
Discontinued operations is a term used in accounting to refer to parts of a company’s business that have been terminated and are no longer operational. In accounting, discontinued operations are listed separately on financial statements from continuing operations.
Reasons for Discontinued Operations
Parts of a company’s business or product line will typically be classified as a discontinued operation if they are no longer operational, have been removed from the company, or have been, or will be sold (referred to as being “held for sale”). It is important to note that the discontinued operation needs to represent a separate major line of the business or geographical area of operations.
During the regular course of a company’s life, it will often undergo changes in its business structure, including the cancellation of product lines deemed obsolete or no longer profitable, the disposition of aged equipment, sales of various market segments, and shifts in their business model. All of the changes described above will lead to discontinuation, and therefore must be reported as discontinued operations on financial statements.
Discontinued operations must be recorded separately in compliance with the accounting regulatory standards, 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 still in operation) is to ensure that external stakeholders – such as shareholders or potential investors – do not become confused and inappropriately evaluate the profitability of the business.
Discontinued Operations Under GAAP
A company may report discontinued operations under GAAP as long as two conditions are met:
First, the transaction to shut down the divested business will result in eliminating the operations and cash flows of the divested business from company operations.
Second, once it has been discontinued, the closed business must have no significant ongoing involvement with its operations. If these two conditions are met, then a company may report discontinued operations on its financial statements.
Discontinued Operations Under IFRS
The reporting rules under international financial reporting standards (IFRS) differ slightly from GAAP. A discontinued operation must meet two criteria:
First, the asset or business component must be disposed of or reported as being held for sale.
Second, the component must be distinguishable as a separate business that is being removed from operation intentionally or a subsidiary of a component being held with the intent to sell.
Unlike GAAP reporting requirements, IFRS rules permit equity method investments to be classified as held for sale. Moreover, under IFRS, entities may continue involvement with the discontinued operation. As with GAAP, discontinued operations are reported in a special section of the income statement.
Is income from discontinued operations taxable?
We’ve touched on the income statement discontinued operations rules above, but how must this type of transaction be reported for tax purposes? The situation will depend on the timing of the sale. For example, if the component ceases operations at the end of an accounting period, it will still yield a gain or loss which needs to be reported.
One thing to take into account is that discontinued operations often operate at a loss, which is why they’re discontinued in the first place. This might lead to tax relief, but be sure to weigh the losses against the company’s continuing, revenue-generating operations. As long as the company’s still generating revenue overall, this will probably balance out the loss of discontinued operations. Be sure to consult with an accounting professional if in doubt.
Example of Discontinued Operations
Ned owns and runs Ned’s Networks, a company consisting of six television channels. One channel, a specialty network devoted to everything fitness, has been a money loser. In the 18 months it has been on the air, it has only generated a profit once, and it was a small one. There’s just not enough interest from the viewing public to generate the advertising revenues Ned needs. He decides, after going over the latest financial reports and meeting with his senior team, to shut down the channel.
Eight people work specifically for this channel, four in content, two in programming and two in sales. Ned is able to assign four of them to other channels that need help, but four of the staff are let go.
Ned instructs accounting to discontinue operations for this channel. This means that any income or expenses related to the channel’s operation will now fall under “Discontinued Operations” on the income statement (the one that will be generated for the same quarter he sold the station in). In Ned’s case, these amounts include sale revenues from ads, the cost of the severance packages, taxes, licensing fees, programming charges, interest expenses, etc.
Now let’s try another scenario. Ned decides to simply sell the channel.
Upon selling it, Ned instructs accounting to discontinue operations for this channel. There will still be the same income and expenses as per the first scenario, but there will also be charges related to the physical transfer of some of the channel’s equipment to the new location, as per the agreement he has in place with the buyer. These costs will also be reflected under “Discontinued Operations” on the next income statement.