What Belongs in Your Discontinued Ops?

FASB will rework the definition of discontinued operations in its upcoming exposure draft.

One small step at a time, the Financial Accounting Standards Board is tightening up the criteria for what qualifies as a discontinued operation on a corporate income statement. This time the board has targeted a subset of discontinued operations: newly acquired subsidiaries that are classified as “held for sale on acquisition.” Those are business units that are earmarked for a quick sell-off after a merger.

On Wednesday FASB voted to move forward with an exposure draft that would amend the definition of discontinued operations to include these held-for-sale acquisition. This is significant because if the businesses don’t meet the stringent criteria already set up for held-for-sale subsidiaries, they won’t be classified as discontinued operations.

Generally, companies like to report discontinued operations separately from continuing operations to enable investors to strip out sold, or soon-to-be-sold, assets from current and future earnings when they judge the worth of the company. Such reporting has been known to brighten company profit pictures. Case in point: on Thursday Scholastic Inc. — the U.S. publisher of the famously popular Harry Potter book series — reported earnings from continuing operations of $2.82 for the 2008 fiscal year, compared with a $0.57 net loss for the year when it included discontinued operations in its calculation.

Similarly, acquiring companies are keen on immediately classifying assets that they intend to jettison as held for sale, to communicate the company’s view of what’s driving the transaction. For example, consider an entertainment conglomerate that spends $1 billion (half stock, half debt) to buy a company that owns theme parks, a bottling group, and a rail-car operation. If the conglomerate’s executives want investors to know that the theme parks were the primary target and that within a short time the bottling and rail-car units will be sold to help pay down the debt and buy back some stock, they can book the bottling and rail-car units as held for sale.

The held-for-sale criteria are strictly defined to prevent companies from dumping too many items into that financial-statement category, however. For an asset or subsidiary to qualify as held for sale, management must commit to sell the item off within one year of recording it, the asset or business unit must be available for immediate sale in its present condition, management must be actively seeking a buyer, and the sale price must be “reasonable in relation to its current fair value.” The asset or subsidiary is measured at its fair value — less the cost to sell the item — as of the acquisition date.

In 2001 FASB issued FAS 144, the rule that defines discontinued operations and instructs companies how to account for the items. At the time, the new rule broadened the scope of the definition so more items qualified for such accounting treatment. And although separating out discontinued operations doesn’t change net income, companies say the partitioning makes it easier for executives to tell their earnings story without addressing unwanted assets and liabilities.

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