In April 2014, FASB issued Accounting Standards Update (ASU) 2014-08, Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity, which is effective for fiscal years beginning after December 15, 2014. Its primary effect is to tighten the requirements for treating the disposal of a component of a business as a discontinued operation. It also increases disclosure requirements for discontinued operations and for other disposals of significant components of a business that do not otherwise qualify for treatment as a discontinued operation. This article examines how changes in the accounting for discontinued operations have impacted reporting in the past and proposes how ASU 2014-08 may impact accounting for discontinued operations in the future.
The Road to ASU 2014-08
As described in its summary and basis for conclusions sections, complaints from preparers and users of financial statements were a large motivation for FASB to issue ASU 2014-08. Some stakeholders argued that the prior standard, Statement of Financial Accounting Standards (SFAS) 144, was unnecessarily complex and difficult to apply; others argued that application of SFAS 144 too frequently resulted in small, recurring asset disposals being treated as discontinued operations. Some preparers also believed that the examples provided in the existing standard were not sufficiently helpful in applying the rules to their own situations. Following from these points, some users of financial statements argued that overuse and inconsistent application of the discontinued operations treatment was reducing the usefulness and comparability of the resulting statements.
Prior to 2002, the rules for discontinued operations were described in Accounting Principles Bulletin (APB) 30. This pronouncement established formal reporting requirements for various events, including the effects of a disposal of a business segment. APB 30 required that discontinued operations be reported as a separate line item on the income statement, net of tax effects, but not as an extraordinary item. In 2002, FASB adopted SFAS 144, which greatly expanded the scope of transactions that might qualify for discontinued operations accounting. No longer were companies limited to dispositions of business segments when evaluating the discontinued operations treatment; SFAS 144 required that dispositions of component operations also be considered.
Given this expanded criterion, it should come as no surprise that the number of companies reporting discontinued operations rose significantly in the post-SFAS 144 period.
As defined, a component of an entity “comprises operations and cash flows that can clearly be distinguished, operationally and for financial reporting purposes, from the rest of the entity.” Arguably, at least in the real estate industry, individual buildings could qualify as a component since real estate companies frequently track cash flows and operational performance on a building-by-building basis.
Given this expanded criterion, it should come as no surprise that the number of companies reporting discontinued operations rose significantly (based on traditional measures of statistical significance) in the post-SFAS 144 period. This trend is depicted in Exhibit 1. In 1995, 232 companies reported discontinued operations. Of these, 56% reported discontinued losses, and 44% reported discontinued gains (not tabulated). The number of companies reporting discontinued operations did not grow significantly from 1995 to 2001 (i.e., before SFAS 144), nor did the ratio of companies reporting gains versus losses change. Six percent of all companies reported discontinued operations at least once in this period.
The number of companies reporting discontinued operations jumped significantly, however, with the adoption of SFAS 144 in 2002, to 589—a 95% increase—and has remained at a higher level. Although the ratio of companies reporting gains versus losses has not changed significantly since 2002, the percentage of all companies reporting discontinued operations doubled to 12%.
SFAS 144 required that companies restate prior years’ financial statements for the impact of discontinued operations. Consistent with the above-described complaints, doing so was not only costly, it also reduced the usefulness of comparative financial statements. The example provided in Exhibit 2 illustrates how the requirement impairs comparability. The retailer in this example had base sales of $18 million and base profits of $1 million in 2013 and the following asset disposals: 1) in 2013, the closing of six underperforming rented stores with sales of $2 million and annual income of $200,000; 2) in 2014, a company-owned distribution center with no direct sales and annual operating costs of $300,000, sold for a profit of $1,000,000; and 3) in 2015, the closing of four underperforming rented stores with sales of $1 million and an annual loss of $100,000.
Example of Restatement of Previous Years’ Earnings under ASU 2014-08
As Exhibit 2 shows, the requirement to continuously restate historical earnings for what many consider routine asset sales can distort the comparability of financial results from year to year. In addition, there is at least some empirical evidence that companies may have used SFAS 144 to, at least in the near-term, manipulate the presentation of earnings (Monica I. Stefanescu, “The Effect of SFAS 144 on Managers’ Income Smoothing Behavior,” August 2006, http://bit.ly/1LQOp1f). Holding constant all other inputs, the restated 2013 and 2014 results of continuing operations are identical in both 2014 and 2015. Furthermore, if certain long-lived assets (e.g., stores, divisions, geographic locations) were unprofitable, management could adopt a plan to sell the assets—subject to the provisions of SFAS 144—and be able to present the loss associated with the assets as discontinued operations in both the current and historical financial statements.
FASB has almost come full circle in terms of reporting special items below income from continuing operations.
Exhibit 3 presents the percentage of companies (by industry) reporting discontinued operations in the pre- and post-SFAS 144 periods. In nearly every industry segment, the percentage of companies reporting discontinued operations doubled after the passage of SFAS 144.
U.S. Companies Reporting Discontinued Operations by Industry Segment
Furthermore, in the pre-SFAS 144 period, manufacturing and services companies accounted for 60% of all discontinued operations, while post-SFAS 144, they accounted for 50% of all discontinued operations. On the other hand, real estate companies went from only 3% of all discontinued operations in the pre-SFAS 144 period to 13% post-SFAS 144.
Comment letters to FASB describing the impacts of SFAS 144 help to explain this change. Host Hotels and Resorts said that under SFAS 144, “we classify the sale of an individual property as a discontinued operation, regardless of its significance to our portfolio.” Similarly, Taubman Centers, Inc., a publicly traded real estate investment trust, noted that under SFAS 144, each of their 25 properties would constitute a discontinued operation. Taubman further said that, “we have historically restated our financial statements for the sale of individual centers to provide for discontinued operations presentation.”
Discontinued Operations under ASU 2014-08
In the authors’ opinion, the adoption of ASU 2014-08 will likely lead to a significant decrease in reported discontinued operations. The new standard requires that a disposal represent a “strategic shift that has (or will have) a major effect on an entity’s operations and financial results.” While ASU 2014-08 does not define “major,” it offers as examples the disposition of a line of business or a significant geographic area. Thus, the criteria are more similar to those of APB 30, which limited discontinued operations treatment to those portions considered a business segment.
Two changes will allow some disposals to qualify as discontinued operations that would not have qualified under prior guidance, offsetting any reduced frequency in reporting. First, ASU 2014-08 allows for greater continuing involvement with the disposed components than was previously allowed. Under SFAS 144, companies were restricted from applying discontinued operations treatment to disposals in which the company continued to have significant involvement, including cash transfers. In practice, this meant that outsourcing part of a company’s operations was unlikely to qualify as a discontinued operation, since the company would likely continue to have significant transactions and cash flows involving the disposed component. ASU 2014-08, however, permits such continued involvement as long as the disposal meets other criteria. For example, if a company chooses to outsource its manufacturing process to a third party, the costs associated with transferring or disposing of related equipment, employees, and other assets may now qualify for discontinued operations treatment.
Second, SFAS 144 did not allow the sale of equity investments to qualify for treatment as discontinued operations. ASU 2014-08 reverses this and allows for disposals of equity investments to be treated as discontinued operations if they otherwise represent a strategic shift.
Although ASU 2014-08 retains the requirement that prior period financial statements be restated to reflect the impact of discontinued operations, the authors believe that, collectively, these changes will greatly reduce the burden of having to continuously restate earnings.
FASB has almost come full circle in terms of reporting special items below income from continuing operations. For many years, three items required special reporting, net of tax: 1) discontinued operations, 2) extraordinary items, and 3) cumulative effects of changes in accounting principles. FASB eliminated reporting the cumulative effect of a change in accounting principles in 2005. The number of companies reporting extraordinary items became so small that the reporting was eliminated in 2015; these items are now included as a component of income from continuing operations. Finally, although the reporting of discontinued operations has not been eliminated, ASU 2014-08 has significantly narrowed its scope.
As more and more unusual items are classified as part of income from continuing operations, the ability for managers to opportunistically classify items and smooth earnings will be reduced. The decision of what information is useful is left to the user of the financial statements.