Discontinued Operation

These lecture cover CPA practice questions covering discontinued operation, intraperiod tax allocation and income from continuing operations.

Discontinued Operation

  • Discontinued Operations

    A discontinued operation occurs when two things happen:

    • 1.A company eliminates the results of operations of a component of the business. A component comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes.
    • 2.The elimination of a component that represents a strategic shift, having a major effect on the company’s operations and financial results. A strategic shift generally includes the disposal of (1) a major line of business, (2) a major geographical area, or (3) a major equity method investment.

    To illustrate, Softso has the following product lines that it manufactures and sells—beauty care, health care, and baby care. Within these product lines, it has a total of 18 brands. Each brand is considered a separate component because each brand comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes. Each product line represents a major line of business. Softso decides to eliminate the baby-care product line because it is suffering substantial losses. Softso should report the elimination of the baby-care product line as a discontinued operation because the baby-care line represents a major line of business and its disposal represents a major part of Softso’s operations (a strategic shift).

    On the other hand, assume that Softso decides to remain in the baby-care business but will discontinue one brand in this product line because it is very unprofitable. Softso should not report the elimination of this brand as a discontinued operation because it does not represent a major part of Softso’s operations (disposing of it is not considered a strategic shift).

    As indicated, the reporting of a discontinued operation involves strategic shifts that are substantial in nature. Here are some additional examples:

    • 1.The sale of a product line that represents 15 percent of a company’s total revenues.
    • 2.The sale of a geographical area that represents 20 percent of a company’s total assets.
    • 3.The sale of a component that is an equity investment that represents 20 percent of a company’s total assets.

    Companies report as discontinued operations (in a separate income statement category) the gain or loss from disposal of a component of a business. In addition, companies report the results of operations of a component that has been or will be disposed of separately from continuing operations. Companies show the effects of discontinued operations net of tax as a separate category, after continuing operations.

  • Intraperiod Tax Allocation

The allocation of tax to this item is called intraperiod tax allocation, that is, allocation within the income statement of a period. It relates the income tax expense (sometimes referred to as the income tax provision) of the fiscal period to the specific items that give rise to the amount of the income tax provision.

Intraperiod tax allocation helps financial statement users better understand the impact of income taxes on the various components of net income. For example, readers of financial statements will understand how much income tax expense relates to “Income from continuing operations” and how much to discontinued operations. This approach helps users to better predict the amount, timing, and uncertainty of future cash flows. In addition, intraperiod tax allocation discourages statement readers from using pretax measures of performance when evaluating financial results, and thereby recognizes that income tax expense is a real cost.

Companies use intraperiod tax allocation on the income statement for (1) income from continuing operations and (2) discontinued operations. The general concept is “let the tax follow the income.”

To compute the income tax expense attributable to “Income from continuing operations,” a company computes the income tax expense related to both the revenue and expense transactions as well as other income and expense used in determining this income subtotal. (In this computation, the company does not consider the tax consequences of items excluded from the determination of “Income from continuing operations.”) Companies then associate a separate tax effect for discontinued operations.