Your Ask Joey ™ Answer

Discontinued Operations on the FAR CPA Exam

Overview of Discontinued Operations

In financial reporting, discontinued operations refer to a component of a company’s core business or product line that have been divested or shut down. Discontinued operations will be reported (net of tax) separately from continuing operations on the income statement. The reason that discontinued operations are reported separately is so that primary external financial statement users (e.g., investors, creditors, and lenders) can distinguish the profits and respective cash flows are being received from activities that have ceased to exist.

Important terms to know:

In order for the transaction to be classified as a discontinued operation, the asset being divested/shut-down needs to meet the definition of a component. In addition, the transaction needs to be considered a “strategic shift”. If both of these conditions are met, then the component being divested/shut-down would be classified as “held-for-sale”. From the moment the component is classified as “held-for-sale”, the company would classify any impairment losses, operating profits/losses, and gain/losses on disposal as discontinued operations in the income statement.

Component – A component that is deemed discontinued describes components of an organization or a group of components. Generally, these components will be consistent of reportable segments, operating segments, reporting units, or subsidiaries. Components of an entity are those that are disposed of by sale or classified as “held-for-sale”.

Strategic shift – In order for a component to qualify as a discontinued operation, the component has to represent a “strategic shift”. Examples of strategic shifts are outlined below:

Held-for-Sale – Components of businesses are considered “held-for-sale” in a given period that they meet all of the following criteria:

Reporting period – Components will be reported on the income statement under discontinued operations in the period in which the component is either disposed of or is held-for-sale.

Valuation and impairment loss – Components classified as held-for-sale will be measured at the lower of its net book value or fair market value (less cost of disposal). If the carrying amount or book value is greater than the fair value less cost to sell (recoverable amount), the company would record an impairment loss in the period. The impairment analysis would typically be performed when the company first classifies the component as “held-for-sale”.

Mental Map for Discontinued Operations

The series of steps in the mental map below will cover the types of questions the exam will cover on discontinued operations:

Step 1) Check for impairment

When a component is classified as “held-for-sale”, the company would typically assess the fair value less cost to sell to determine what the sale proceeds might be. At this point, if the fair less cost to sell is below the book value/carrying value of the component, then the company would record an impairment loss. As long as the component is “held-for-sale”, the company should continue to compare the fair vales less cost to sell to the current book value of the component on the balance sheet.

Step 2) Calculate gain or loss on disposed component

To determine the gain or loss on discontinued operations, you will take the proceeds from the sale of the component/division and subtract the current net book value (carrying value). If the sale proceeds are greater than the net book value, the company would record a gain. If the sale proceeds are less than the net book value, the company would record a loss. The calculated gain or loss does not reflect the impact of taxes.

Step 3) Determine total impact for each year (in the income statement)

Under U.S. GAAP, once the component/division is classified as discontinued, any subsequent results of the component would be excluded from income from continuing operations. Therefore, income from discontinued operations would include the operating results, any impairment losses recorded during the period (step #2), and any gain or loss on the disposal of the component/division (step #3).

Step 4) Impact of tax on gain or loss of discontinued operations

Under U.S. GAAP, the company must record the gain or loss on discontinued operations net of tax. Therefore, you would take the total impact from step #3 and multiply by “1 – tax rate” to calculate the amount net of tax. You may also calculate each gain or loss net of tax separately.

Discontinued Operations Example

The series of steps in the mental map below will cover the types of questions the exam will cover on discontinued operations:

Impact to Year 5 Income Statement

The Board of Directors classified the aircraft division as held-for-sale on August 31, Year 5, so this is when the company would start accounting for the component as a discontinued operation. Since the fair value less cost to sell was less than the book value (carrying value) of the component, the company would record a $50,000 impairment less (step #1). Since the component was not sold until Year 6, we can skip step #2. For steps #3 and #4, we combine the impairment loss with the operating loss of $75,000 the component generated, which totals to a loss of $125,000 before tax. Since the company has a tax rate of 30%, we multiple $125,000 x 70%, which equals a loss net of tax of $87,500. This will result in a tax benefit for the company.

Impact to Year 6 Income Statement

The component was sold for $440,000 on March 31, Year 6. No impairment is mentioned, so we can skip step #1. For step #2, the company would record a gain on disposal of $40,000 since the proceeds were $440,000 and the adjusted net book value after impairment was $400,000. When we combine the gain on disposal of $40,000 with an operating loss of $10,000, the net gain before tax is $30,000. After factoring in a tax rate of 30%, the company would record a gain on discontinued operations (net of tax) of $21,000 for Year 6.

Back To All Questions

You might also be interested in...

  • How to Write a Research Essay in Accounting

    Writing a research paper will take the student from the start of the process through structuring and mapping your ideas, properly organising your research, exploring writing strategies, and networking- practice that will guarantee the creation of a successful research paper in accounting. No other discipline handling money is as panoramic as accounting for a reason;...

  • Write For Us

    Write For Us Submit your guest blog post! Universal CPA Review welcomes contributors to submit articles for publication on our website. Please review the following guidelines before submitting your article. Due to the high volume of submissions we receive daily, we cannot respond to each one individually. If your article is selected for publication, you...

  • Exams With Essays: How to Prepare Effectively

    “A good essay must have this permanent quality about it; it must draw its curtain round us, but it must be a curtain that shuts us in not out.” Virginia Woolf The essay is the main challenge for students during the exam. When faced with an essay, students most often panic, not knowing how to...