Accounting for Discontinued Operations

Companies will need to sharpen their pencils soon when calculating income from continuing operations. This line item on the income statement is important to many users of financial statements as a critical element of financial analysis, and it is affected by a consensus reached by the EITF in 2004 on accounting for discontinued operations.

EITF Issue No. 03-13, "Applying the Conditions in Paragraph 42 of FASB Statement No. 144 in Determining Whether to Report Discontinued Operations," takes effect in 2005 and can be adopted early. This Issue can trigger questions from auditors and analysts about how disposals are reported in 2004 financial statements.

Do the financial statements accurately reflect income from continuing operations?

The overall trend in recent years has been to classify more disposals as discontinued operations. This trend began in 2001 when the FASB issued Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Statement 144 expanded the definition of a unit that qualifies as discontinued operations.

Under prior standards, the disposal unit had to be an entire business segment or class of customers. Under Statement 144, it can be a smaller component with distinguishable activities, (e.g., a reportable segment, operating segment, reporting unit, subsidiary, or asset group).

However, under Statement 144, a disposal is not treated as a discontinued operation if the seller has a continuing business relationship, defined as the existence of either of the following conditions:

• Continuing cash flows related to the disposed component.
• Any significant continuing involvement by the seller in the operations of the disposed component.

Issue 03-13 continues the trend to broader use of the discontinued operation classification by narrowing the conditions for a continuing relationship. It clarifies that:

• Only those continuing cash flows that are direct cash flows preclude discontinued operations treatment.
• Direct cash flows can arise when revenues or costs migrate, that is, if the seller continues to sell similar products or services to similar customers of a disposed unit, (e.g., a migration from a disposed bricks-and-mortar store to an e-commerce Internet site.)
• Direct cash flows also can result from a continuation of activities between the seller and the disposed component. Examples include purchase/supply agreements, outsourcing agreements and franchise agreements with a disposed of retail operation.
• The test for a continuing involvement is whether the seller retains the ability to influence the operating and/or financial policies of the disposed component.
• A franchise agreement would generally meet the criterion of influence, but neither a financing arrangement nor a cost-method investment would, by itself, provide sufficient evidence of an ability to influence operating or financial policies.

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