Discontinued Operations – Definition, Reasons, and Tax Considerations

Discontinued operations are parts of a business that have been sold, shut down, or classified as “held for sale.”  In accounting, since these operations no longer contribute to revenue, they must be reported separately in financial statements to clarify the results of ongoing operations.

What is Discontinued Operations?

Discontinued operations are specific segments of a business that a company may choose to close down or dispose of. From an accounting perspective, operations and disposal must satisfy certain conditions so that they are recognized as being in the “discontinued operation” category.

Usually, the operations refer to a large segment of the business that may encompass a product division, a geographical market, or an affiliate that is no longer strategic or relevant to the business.

When operations are discontinued, the assets, liabilities, income, and expenses associated with the discontinued line of operation are shown separately from other operations. This provides a high level of visibility: investors and other stakeholders want to know how much of the current business outlook is based on operations and performance distinct from the nearing end of a particular business line.

Why Do Businesses Discontinue Certain Operations?

Companies decide to cease some operations for many reasons, which may include enhancing the profits, reducing costs, or restructuring to reflect on the new vision.

Here are some common reasons for discontinuing operations, along with real-world examples:

1. Poor Financial Performance

When a business unit or product line draws negative resonant more often than not, management will seek to stop it so that it stops draining the company’s cash.

Example:

As Ford Motor Company’s sales plummeted in the United States, the company declared that it would stop manufacturing and selling a range of passenger cars by the end of 2020. These models were low-margin vehicles, poorly suited for a market dominated by SUVs and pickup trucks. 

Ford managed to cut these vehicles knowing that the company was also free to tap into other well-lucrative markets, such as trucks and electric vehicles.

2. Strategic Shift

It is common for firms to stop operations because of their strategic plan or shift the direction of their activities in their main competency areas.

Example:

GE Lighting: General Electric (GE) had its lighting division, which was wholly owned because Edison invented the light bulb invention for GE, but in 2021, it sold the GE Lighting division. 

Empowering a new generation of smart light: GE’s strategic move to free itself from its historic lighting division was to concentrate on its industrial segments, like aviation and healthcare. The company no longer saw the lighting business as its strategic core business and did not form part of its long-term strategic plan.

3. Mergers and Acquisitions

In mergers and acquisitions, businesses may shut down some operations due to the sale of products by one company to another, reducing duplication of operations or services or absorbing new assets.

Example:

When Disney bought 21st Century Fox in 2019, it shut down most of the smaller Fox movie divisions, like Fox 2000 Pictures. The objective was to streamline operations and minimize redundancies while shifting Disney’s value proposition of content production, mainly fictional movie franchises such as Marvel and Star Wars.

4. Regulatory Pressure

Businesses can shut down their operations due to regulation or environmental legislation.

Example:

In 2019, Johnson & Johnson stopped selling the talc-based product in North America due to several cases and investigations regarding the presence of asbestos in the product. This was done in a bid to minimize further losses and reputational damage, though the company was still selling other baby care products.

5. Divestiture for Cash Flow

Thus, it is possible to divest a company to increase cash, and this is normally done to clear debt or to invest in other better business lines.

Example:

In 2021, AT&T spun off its WarnerMedia division, merging it with Discovery Inc. AT&T had bought Time Warner to enter the media content business but shifted its attention back to telecommunication services. 

When AT&T divested WarnerMedia, it generated proceeds and paid down its balance sheet, which in turn helped to bolster its 5G and fiber optic networks.

6. Technological Obsolescence

If a change in technology renders a particular product or service irrelevant, some businesses may unilaterally withdraw from it to avoid being left behind.

Example:

Microsoft pulled the Internet Explorer web browser from the market in 2020. With browsers such as Google Chrome, Mozilla Firefox, and Microsoft Edge taking over, Internet Explorer became irrelevant. 

Continuing this process was no longer feasible because it allowed Microsoft to concentrate on the Edge browser, which is more optimized for performance and enhanced security to work with modern web standards.

7. Changing Consumer Preferences

Whenever consumer demand or the use of a particular product or service changes, it is often possible for the business world to close down that operation in order to conform to current demands.

Example:

In 2017, McDonald’s also pulled out the McWraps line of premium sandwiches in the United States due to a shift in customer preferences.

The company understood that clients favored convenience food with a short preparation time, such as burgers and nuggets. Thus, McDonald’s unique selling proposition aligned with the fast food industry’s values.

How Do We Report Discontinued Operations in Income Statements?

In the income statements, companies are required to report information on discontinued operations, as it is essential in explaining the continuous performance of the enterprise.

Here’s how businesses typically report discontinued operations in their income statements:

1. Separate Presentation

Discontinued operations cannot be reported in the same statement as continuing operations, where they are presented as a single operating segment. This guards against users of financial statements having to guess which operations will continue in the future and which operations in the past or the future will not be continuing.

2. Income Statement Structure

The income statement should include the following sections:

1. Continuing Operations

This section provides the revenues, expenses, and net income from ongoing operations that will continue to be conducted in the future.

It includes:

• Revenue
• Cost of Goods Sold (COGS)
• Gross Profit
• Selling, General and Administrative expenses or Selling, Administrative, and Other expenses
• Other Income and Expenses
• Income Tax Expense
• Net Income from Continuing Operations

2. Discontinued Operations

After the continuing operations section, the income statement includes a separate section for discontinued operations, which typically consists of two main components:

• Income or Loss from Discontinued Operations: This line displays the earnings from the disposed-of operations, including revenue and expenditure related to those items.
• Gain or Loss on Disposal of Discontinued Operations: This line records any increase or decrease arising from the disposal of the discontinued operation.

3. Example

Here’s an example of how discontinuing operations might reflect in your income statement:

Discontinued Operations Under GAAP (Generally Accepted Accounting Principles)

Discontinued operations should be reported in the income statement during the operation‘s discontinuation or disposal, even when physical disposal does not occur during the same reporting period.

Post GAAP Discontinued Operations

Discontinued operations in financial reporting are governed under GAAP, which has some specific rules regarding their presentation. This framework makes it easier for business organizations and their stakeholders to distinguish between running processes and programs that were once relevant at the company but are irrelevant at present.

Here’s an overview of how discontinued operations are treated under GAAP:

Definition of Discontinued Operations Under GAAP

In GAAP, discontinued operations refer to those parts of an entity that have been divested or are available for sale. They are a strategic process that will affect or has already affected the company’s operations and earnings. A component could be a division, a subsidiary, or even a product line.

Nature of the Discontinued Operations Classification

To classify a part of the business as a discontinued operation under GAAP, it must meet specific criteria:

The Component Must Be Disposed If Or If Held For Sale

The component is either:

• Conveyed, transferred, abandoned, or disposed of, or
• This is classified as held for sale in the financial statements.

The Disposal Was a Strategic Move

The disposal has to entail a strategic change in the nature of operations in the business organization.

It could be a sale of:

• A major geographical area.
• A major business line.
• Large investments or large subsidiary companies are some examples of significant items.

Disposal must be such that it can significantly impact the markets in terms of its effect on the company’s performance.

The Operations and Cash Flows Must Be Clearly Distinguishable

The separation of the line between discontinued operations and the rest of the organization group is necessary both for business functioning and for presenting financial statements.

Financial Reporting for Discontinued Operations Under GAAP

Discontinued operations can be defined as the legal disposal of assets or business activities of a company that has not been completed through the sale of the asset or business activities or other related operations. Reporting discontinued operations is relevant to show the users of the financial statements how the business operations are faring other than the effects of operations that are no longer relevant.

Income Statement

• Discontinued operations are reported below and separately from continuing operations on the income statement. This enables investors and shareholders to compare the financial performance of the entity’s current operations without involving a one-off effect resulting from the sale or disposal of the component being disposed of.
• The results of discontinued operations are typically shown in two lines on the income statement:

• Income or loss from discontinued operations: This refers to the revenues and costs incurred by the component before it was sold or closed.
• Gain or loss on disposal of the discontinued operation: This line displays any profit or loss that could emanate from the sales of the business unit or its complete disposal.

Balance Sheet

When a component is recognized as held for sale, the existence of the assets and liabilities are reported in the balance sheet under such captions as “Assets to be sold” or “Assets held for disposal” and “Liabilities related to the disposal of the component.”

Cash Flow Statement

cash flows from operations of discontinued activities are also presented separately on the statement of cash flows. By making this distinction, users of the financial statements can determine the effect that the discontinued operations have had on the cash flows and will be able to concentrate on the cash flows of the operations that are continuing.

Impairment and Measurement Considerations

When a component is categorized as held for sale, it is stated at the lower of its carrying value and net realizable value. This implies that if the fair value of the net selling costs is less than the component’s book value, the company should recognize an impairment loss.

Tax Considerations

Suitably, discontinued operations have to be reported on a net-of-tax basis. Therefore, income, expenses, gains, and losses of the discontinued operations should include an effect of taxation on the organization’s final result. The tax effect of operating to discontinued operation is often shown on the income statement as the line below operation profit or loss from discontinued operation.

Disclosure Requirements

Discontinued operations need to be presented with great details under GAAP in order to provide users with clear information.

Companies must provide the following information:

• A description of the operation that is no longer in existence.
• The broad categories include the generation of revenues and usage of expenses.
• The reason for halting the use of products and the process in which they are disposed of (sold, left to eliminate themselves, etc.).
• The nature and amount of those adjustments classify substantial adjustments made to amounts reported in previous periods.
• Where in inventory is the expected period of using the asset?

Examples of Discontinued Operations

1. Divesting a Major Business Line: If a company involved in different businesses, such as technology, healthcare, and financial services, sells off its financial services segment, this will be categorized as a discontinued operation if the segment contributes a significant portion of its revenue.

2. Abandoning a Geographical Segment: A multinational company may decide to stop operations in a certain country or region, for instance, due to changes in regulations or changes in the market. Such operations would be considered discontinued operations.

Discontinued Operations Under IFRS Guidelines

According to IFRS 5, “Non-current Assets Held for Sale and Discontinued Operations,” the standard contains specific criteria for the identification of discontinued operations.

Here are the key aspects:

1. Criteria for Classification: If there is a distinct product line, geographic area, or separate line of operation, or is part of a single plan, or is a subsidiary bought for its purpose to sell, then it is considered as a discontinued operation.

2. Measurement of Assets: When a company decides to stop operation, then the assets and liabilities of the discontinued operation must be stated at the lower of the carrying amount and net realizable value. This ensures that the financial statements in the consolidated statement present the current value of the disposed operations.

3. Disclosure Requirements: Reporting of discontinued operations involves the provision of elaborate information in the companies’ statements.

This includes:

• An outline of the fact that the business has ceased to operate.
• Total revenues, total expenses, and tax effects of the discontinued operation.
• Any profit or loss identified at the disposal of the operation.
• All company cash flows are related to a line of business that has been divested during the reporting period.

4. Presentation in Financial Statements: Discontinued operations should also be separately presented from continuing operations in the income statement. This allows stakeholders to evaluate the company’s continuous performance unleveled by discontinued operations.

Tax Implication of Discontinued Operations

There are also tax effects to discontinued operations, which creates pressure on the company’s financial arrangement.

1. Capital Gains and Losses: In simple terms, any gains that are developed if and when a company sells a discontinued operation are recognized as capital profits and, therefore, are taxed. If the sale results in a loss, this wholly too may be claimed as a capital loss. The tax regime varies depending on the period of operation before the closure and the financial result of the sale.

2. Operating Loss Carryforward: If a company has operating losses before the sale or abandonment of a discontinued operation, such losses can be employed to reduce future taxable income. This is called net operating loss (NOL) carryforward, which assists in minimizing future taxes to stakeholders.

3. Depreciation Recapture: Where the discontinued operation contains depreciable assets like buildings and equipment, the IRS deems that the deprecations must be reclaimed when the assets are sold. This implies that any depreciation deductions that may have been claimed in the past are recovered and charged to tax as if they were income.

4. Tax Treatment for Abandoned Operations: Even if a company stops an operation and does not sell it, there can be tax advantages. In some situations, businesses simply charge off the abandoned assets to an ordinary loss on their income tax return, which means that the businesses will have lower taxable income.

5. Reporting and Compliance: The IRS requires site improvements to be reported separately in both the financial statements and the tax return. This will promote transparency and accuracy in consolidating the business’s continuing and discontinued operations.

Best Practices for Managing Discontinued Operations

Providing practical advice can add value for readers who may be involved in similar decisions:

• Conduct Thorough Analysis: Before shutting down the business, it is important to evaluate the efficiency of previous financial activity, current market tendencies, and further effects upon the enterprise.

• Engage Stakeholders: Communicate with the stakeholders and take them into confidence. Ideas experts might provide ideas for further risks and opportunities to fix in order to enhance the execution of the given discontinuation strategy.

• Create a Transition Plan: Create a well-thought-out plan that outlines the measures needed, the probable time needed for the above actions, and the message to be passed on to the employees and customers.

• Monitor and Adjust: In case of discontinuation, evaluate the effects and outcomes – on the outcomes of business operations. Take note that there will be a need to make some changes depending on feedback and changing market situations.

The Bottom Line

Discontinued operations play a very important role in an organization’s financial reports, especially when the organization changes its structure. Businesses provide accurate information that is helpful to investors in deciding whether to continue operations based on the information provided by discontinued operations.

Whether one is an investor, an accountant, or a business owner, knowing how these discontinued operations are reported might provide important insights.