5.2 Criteria for Reporting a Discontinued Operation

ASC 205-20

What Is a Discontinued Operation?

45-1A A discontinued operation may include a component of an entity or a group of components of an entity, or a business or nonprofit activity.

A Discontinued Operation Comprising a Component or a Group of Components of an Entity

45-1B A disposal of a component of an entity or a group of components of an entity shall be reported in discontinued operations if the disposal represents a strategic shift that has (or will have) a major effect on an entity’s operations and financial results when any of the following occurs:

The component of an entity or group of components of an entity meets the criteria in paragraph 205-20-45-1E to be classified as held for sale.
The component of an entity or group of components of an entity is disposed of by sale.
The component of an entity or group of components of an entity is disposed of other than by sale in accordance with paragraph 360-10-45-15 (for example, by abandonment or in a distribution to owners in a spinoff).

45-1C Examples of a strategic shift that has (or will have) a major effect on an entity’s operations and financial results could include a disposal of a major geographical area, a major line of business, a major equity method investment, or other major parts of an entity (see paragraphs 205-20-55-83 through 55-101 for Examples).

The operations related to a disposal of assets (and liabilities) are reported in discontinued operations in the statement of operations if all of the following criteria are met:

The disposed-of assets (and liabilities) together represent a component of an entity (or a group of components of an entity) (see the next section).
The component (or group of components) (1) meets the criteria to be classified as held for sale (see Chapter 3), (2) has been sold, or (3) has been disposed of other than by sale (see Chapter 4).
The disposal of the component “represents a strategic shift that has (or will have) a major effect on an entity’s operations and financial results” (see Section 5.2.2).

In addition, a newly acquired business or nonprofit activity that meets the held-for-sale classification criteria in ASC 205-20-45-1E upon acquisition qualifies for reporting in discontinued operations regardless of whether the other discontinued-operations reporting criteria are met. (See Section 5.6 for further discussion.)

5.2.1 Component of an Entity

The ASC master glossary defines a component of an entity as follows:

A component of an entity comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. A component of an entity may be a reportable segment or an operating segment, a reporting unit, a subsidiary, or an asset group.

Connecting the Dots

A discontinued operation may represent one or more components of an entity. For convenience, the term “component” is used throughout this publication.

The legal form of a component is not relevant, as demonstrated by the inclusion of a subsidiary or a reporting unit in the definition. However, we do not believe that a component can be at a lower level than an asset group. Further, a disposal group represents the assets and liabilities that will be disposed of together in a single transaction. Because a component does not have to be disposed of in a single transaction, a component may consist of multiple disposal groups.

Because the operations and cash flows of the component must be clearly distinguishable from the rest of the entity, the financial information of the component must be available. A disposal group can be a component even if the parent retains certain assets associated with or used by the component to be disposed of, such as cash, accounts receivable, other working capital, or specific assets (e.g., IT systems, intellectual property, a manufacturing facility, or headquarters). Entities must sometimes use judgment in determining whether a disposal group constitutes a component.

Example 5-1

Sale of a Component to Multiple Buyers

Company C manufactures and markets men’s shoes and coats. Company C discloses that it operates two segments under ASC 280-10 and two lines of business — the Shoe Group and the Coat Group. The operations and cash flows of the Shoe Group can be clearly distinguished, operationally and for financial reporting purposes, from the rest of C. Therefore, the Shoe Group is a component of the entity. In the fourth quarter of 20X6, C initiates and closes on a transaction to sell the majority of the Shoe Group’s manufacturing and distribution operations to Company E. In addition, management, having the appropriate level of authority, commits to a formal plan to sell the remaining assets of the Shoe Group.

ASC 205-20 does not require that a component be sold in a single transaction. If the Shoe Group’s remaining assets and liabilities continue to meet the requirements for held-for-sale classification, C may continue to classify them as a discontinued operation. See Section 5.3 for considerations related to disposals that occur over multiple reporting periods.

Example 5-2

Sale of an Entire Entity

The owners of Company A, a manufacturing entity, enter into an agreement to sell A in its entirety to Company B. Because the operations being sold represent the entire entity (and therefore are not distinguishable from the rest of the entity), A does not meet the definition of a component of an entity. Therefore, the operations of A cannot be presented as discontinued operations.

5.2.2 Strategic Shift That Has (or Will Have) a Major Effect

To report a discontinued operation, the disposal must represent “a strategic shift that has (or will have) a major effect on an entity’s operations and financial results.” ASC 205-20 does not define the terms “strategic shift” and “major effect” but provides the following examples of dispositions that represent strategic shifts that have (or will have) a major effect on an entity’s operations:

A major geographical area.
A major line of business.
A major equity method investment.
Other major parts of an entity.

In addition, ASC 205-20-55 includes five examples of dispositions that are strategic shifts that have or will have a major effect on the entity’s operations and financial results:

The sale of a product line that represents 15 percent of the entity’s total revenues.
The sale of a geographical area that represents 20 percent of the entity’s total assets.
The sale of all the entity’s mall stores (which historically have provided 30 to 40 percent of the entity’s total net income and 15 percent of its current total net income) so that the entity can focus solely on its supercenter stores.
The sale of a component that is an equity method investment that represents 20 percent of the entity’s total assets.
The sale of an 80 percent interest in one of two product lines that accounts for 40 percent of total revenue.

The examples indicate that the assessment of whether a disposal should be reported as a discontinued operation is both qualitative and quantitative. A strategic shift implies that the disposal must result from a change in the way management had intended to run the business. For example, if management has a history of closing retail locations that operate at a loss, the decision to close a number of stores operating at a loss in a given period might have a major effect on an entity’s operations and financial results but would not represent a strategic shift. The determination of whether a disposal represents a strategic shift will be based on the entity’s specific facts and circumstances.

Likewise, ASC 205-20 offers no bright lines regarding whether the disposal has or will have a “major” effect on an entity’s operations and financial results. However, the examples from ASC 205-20-55 indicate that a disposal would have a major effect if it represents (1) 15 percent of the entity’s total revenues, (2) 20 percent of the entity’s total assets, or (3) 15 percent of the entity’s total net income. Thus, we believe that “major” is a quantitatively high threshold, especially when considered alongside the disclosure requirements added to ASC 360-10 related to disposals of individually significant components that do not qualify for discontinued operations (see Chapter 6). According to the examples, the disposal only has to have a major effect on one metric (i.e., revenue, net income, or assets), not necessarily all three.

In addition, ASC 205-20 does not state which metrics must be considered. ASC 205-20 does not preclude consideration of the impact on other metrics such as operating cash flows or EBITDA if they are relevant to investors and have been used by management to communicate operating and financial results. We do not believe that the assessment should be based on whether a sale results in a significant one-time gain or loss to the entity but on whether eliminating the operations and assets of the component will have a major effect on an entity’s ongoing operations and financial results. Similarly, an entity may need to use judgment in evaluating metrics when those metrics include the effects of events considered to be nonrecurring, such as impairments.

In prepared remarks at the 2015 AICPA Conference on Current SEC and PCAOB Developments, Barry Kanczuker, an associate chief accountant in the SEC’s Office of the Chief Accountant, provided the following insights regarding the staff’s views on strategic shift and major effect:

So how does one determine what represents a strategic shift that has or will have a major effect? I would observe that the standard requires judgment to determine whether a disposal meets the revised definition for a discontinued operation. ASC 205-20 provides several examples of what may constitute a strategic shift that will have a major effect on operations and financial results. The examples include a sale of a product line that represents 15% of total revenue; the sale of a geographic area that represents 20% of total assets; and the sale of all stores in one of two types of store formats that historically provided 30–40% of net income and 15% of current net income. We have heard suggestions that the quantitative factors included in the examples are meant to create thresholds by which to determine whether a disposal represents a strategic shift that has a major effect on the entity’s operations and financial results. In my view, the thresholds are illustrative and do not establish bright lines or safe harbors.

A question also arises as to what constitutes a financial result? I believe that judgment is required to determine which financial results are indicative of a strategic shift that has a major effect. I think there are certain “primary” metrics that are prominently presented in the financial statements and communicated to investors. For example, revenue, total assets and net income are items that I would clearly consider to be relevant metrics. However, the identification of other financial results may require judgment, with an eye toward what is relevant from an investor’s perspective. It also may be helpful to understand alternative measures, as certain operating metrics may also be relevant, particularly where the Company has used the measure on a consistent basis for communicating operating and financial results. I also believe that it is prudent to consider the effect of the relevant financial metric on the entity from the perspective of current, historical and forecasted results. In my view, the guidance indicates a need to evaluate the totality of the evidence, and there is no single financial metric that is determinative in concluding that a disposal had a major effect on the entity’s operations and financial results.

While the guidance does not provide quantitative bright lines in determining whether a disposal is a strategic shift that has a major effect, the less significant a financial impact the disposal has on an entity, the stronger the qualitative evidence would need to be. In evaluating whether the qualitative evidence supports a strategic shift that has a major effect, I think it is important to consider the prominence and consistency with which the disposed component and related qualitative factors have been discussed within periodic filings.

We believe that disposal of a reportable segment will often qualify for presentation as a discontinued operation, while an entity will need to use judgment when the disposal consists of an operating segment, reporting unit, or other parts of the entity. An entity will also want to consider the extent to which information about the component has been provided publicly (e.g., via the entity’s Web site, earnings releases, or MD&A) in assessing whether a disposal represents a strategic shift. Further, we believe that an entity should separately evaluate the criteria for reporting discontinued operations at each level of financial statement reporting and that the conclusions reached at the level of the stand-alone subsidiary may differ from those reached at the level of the consolidated parent.

The examples of a strategic shift that has (or will have) a major effect on an entity’s operations include the disposal of “other major parts of an entity,” not just a major line of business or geographical region. In the 2013 proposal on which ASU 2014-08 was based, the FASB contemplated limiting the definition of a discontinued operation to a separate major line of business or a major geographical area of operations. Paragraphs BC13 and BC14 of ASU 2014-08 offer some insight into why the Board ultimately decided not to limit the definition:

BC13 Some respondents questioned whether disposals that include several different parts of an entity other than an entire major line of business or major geographical area of operations would qualify for discontinued operations reporting if they represent a strategic shift. Some of those respondents noted that in their experience it is rare that an entity ever disposes of an entire major line of business or a major geographical area of operations. Additionally, those respondents noted that a disposal transaction that includes several different parts of an entity often could have a greater effect on an entity’s operations and financial results than a disposal of an entire major line of business or major geographical area of operations.

BC14 The Board concluded that the nature of the disposal and its effect on an entity’s operations and financial results matter more than the composition of the transaction. Therefore, the Board decided that a discontinued operation could include different parts of an entity other than an entire major line of business or a major geographical area of operations as long as those parts are a disposal group that together represents a strategic shift that has a major effect on an entity’s operations and financial results.

The following examples in ASC 205-20-55 illustrate disposals that would qualify for discontinued-operations presentation:

ASC 205-20

Example 1: Consumer Products Manufacturer

55-84 An entity manufactures and sells consumer products that are grouped into five major product lines. Each product line includes several brands that comprise operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. Therefore, for that entity, each major product line includes a group of components of the entity.

55-85 The entity has experienced high growth in its discount cleaning product line that has lower price points than its premium cleaning product line. Total revenues from the discount cleaning product line are 15 percent of the entity’s total revenues; however, the discount cleaning product line will require significant future investments to increase its profits. Therefore, the entity decides to shift its strategy of selling cleaning products at multiple price points and focus solely on selling cleaning products at a premium price point. As a result, the entity decides to sell the discount cleaning product line.

55-86 Because the entity shifts its strategy of offering discount cleaning products to consumers and because the discount cleaning product line is one of five major product lines that is a major part of the entity’s operations and financial results, the disposal represents a strategic shift that is reported in discontinued operations.

Example 2: Processed and Packaged Goods Manufacturer

55-87 An entity manufactures and sells food products that are grouped into five major geographical areas (Europe, Asia, Africa, the Americas, and Oceania). Each major geographical area includes several brands that comprise operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. Therefore, for that entity, each major geographical area includes a group of components of the entity.

55-88 The entity has experienced slower growth in its operations located in the Americas, which accounts for 20 percent of the entity’s total assets. Therefore, the entity decides to shift its strategy of selling food products in that geographical area and focus its resources on manufacturing and marketing food products in its other four higher growth geographical areas. As a result, the entity decides to sell its operations in the Americas.

55-89 Because the entity’s operations in the Americas is one of five major geographical areas that is a major part of the entity’s operations and financial results, the disposal represents a strategic shift that is reported in discontinued operations.

Example 3: General Merchandise Retailer

55-90 An entity that is a general merchandise retailer operates 1,000 retail stores in 2 different store formats — malls and supercenter stores — throughout the United States. The entity divides its stores into five major geographical regions: the Northwest, Southwest, Midwest, Northeast, and Southeast. For that entity, each retail store comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. Therefore, for that entity, each retail store is a component of the entity.

55-91 The entity has experienced declining net income at its 200 stores located in malls across all 5 major geographical regions. Historically, net income from the 200 stores in malls has been in a range of 30 to 40 percent of the entity’s total net income. Total net income from the 200 stores in malls is down to 15 percent of the entity’s total net income because of declining customer traffic in malls. Therefore, the entity decides to shift its strategy of selling products in malls and sell the 200 stores located in malls.

55-92 Because the entity decides to shift its strategy of selling products in malls and focus solely on its supercenter stores and because the 200 stores located in malls are a major part of the entity’s operations and financial results, the disposal represents a strategic shift that is reported in discontinued operations.

Example 4: Oil and Gas Entity

55-93 This Example provides an illustration of the guidance in paragraphs 205-20-45-1B through 45-1C. In this Example, the entity disposes of a component of an entity that is an equity method investment representing a strategic shift that has a major effect on the entity’s operations and financial results and is reported in discontinued operations.

55-94 An entity that follows the successful-efforts method of accounting produces oil and gas in two major geographical areas (Europe and Africa) that are each divided into several regions. Each region comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. Therefore, for that entity, each major geographical area includes a group of components of the entity.

55-95 In its operations located in Africa, the entity operates through a joint venture with another entity that is accounted for by the reporting entity as an equity method investment. The entity’s carrying amount of its investment in the joint venture is 20 percent of the entity’s total assets. Because of significant investments needed in its operations in Europe, the entity decides to shift its strategy of operating in Africa to focus on its operations in Europe and sell its stake in the joint venture.

55-96 Because the entity shifts its strategy of operating a joint venture to focus on its operations in Europe where it maintains full control and because its operations in Africa are a major part of the entity’s operations and financial results, its disposal represents a strategic shift that is reported in discontinued operations.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.