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Common errors in accounting for discontinued operations

Common errors in accounting for discontinued operations

Common errors in accounting for discontinued operations

Accounting for discontinued operations is an area that by its nature not (needed) to be applied regularly by entities, but given the current economic climate is becoming more relevant.

In this article we highlight some of the application areas of NZ IFRS 5 Non-current Assets Held for Sale and Discontinued Operations that we see entities applying incorrectly.

Background

The objective of NZ IFRS 5 is to enable users to understand the performance of the continuing business, by carving out parts of the business that won’t be continuing going forward.

That is, “to compare apples with apples”.

According, NZ IFRS 5 provides the criteria and requirements regarding the presentation of:

Income and expenses from discontinued operations.
Assets (and disposal groups) that are classified as held for sale.

There may be an inherent incentive for entities with loss-making businesses to classify them as discontinued operations, so as to carve these out and present a much better set of results from continuing operations.

Similarly, showing an asset (or disposal group) as held for sale can give an unrealistically positive view of an entity’s liquidity position – as the asset (disposal group) is presented as current.

Some of the common errors in NZ IFRS 5 application, discussed further below, include:

1. Classification as held for sale when the asset fails to meet the held for sale criteria

Assets and disposal groups can be classified as held for sale if, and only if, permitted under NZ IFRS 5.

The key requirements to be met include:

The carrying amount will be recovered principally through a sale transaction, rather than continuing use
The asset or disposal group must be available for immediate sale in its present condition,
The sale must be highly probable, requiring that:
- The appropriate level of management must be committed to a sale plan.
- The asset must be being actively marketed.
- Ther sale price must be reasonable, in relation to its current value (i.e., so as to facilitate a sale).
- The sale should be expected to be completed within one year from classification as held for sale.

Common errors - that can lead to an entity incorrectly classifying an asset or a business as held for sale

The asset is not saleable in its current state.
The asset is not being actively marketed.
It is not highly probable that the asset will be disposed of within the next twelve months because, for example:
- The asking price is unrealistically high, and it is not highly probable that a buyer will be found at that price, or
- There simply is not a market for that asset/business in the current economic cycle
The asset is to be abandoned rather than sold (NZ IFRS 5, paragraph 13).
The asset(s) or disposal group is to be used and then closed down.

2. Disposal of an interest in a subsidiary

If an entity plans on losing control of a subsidiary, paragraph 8A requires that the assets and liabilities of that subsidiary be classified as held for sale when the criteria outlined above are met. This applies regardless of whether the entity will retain a non-controlling (minority) interest in the subsidiary after the sale.

Common error - An entity intends to sell an interest in a subsidiary but retain control.
It incorrectly classifies a portion of the assets as held for sale when none of the assets should be classified as held for sale because there is no loss of control

Common error - An entity intends to dispose of a controlling stake in a subsidiary but will continue to hold a non-controlling interest in the entity.
It incorrectly classifies only the subsidiary holding to be disposed of as an asset held for sale, rather than the entire holding.

3. Measuring a non-current asset (or disposal group) immediately before classification as held for sale

Immediately before an asset or disposal group is classified as held for sale, the carrying amount of the asset (or of all the assets and liabilities in the group) must be measured in accordance with applicable NZ IFRS.

A common error occurs when management fails to do this at the time the non-current asset or disposal group is classified as such.

Common error - For example, if the entity intends to dispose of its land and buildings:

Scenario 1: Revaluation model is applied:
All land and buildings should be revalued at the date that they are classified as held for sale

Scenario 2: Cost model is applied
All buildings should be depreciated up to the date they are classified as held for sale

Scenario 3. Cost model is applied, and impairment indicator is present
Any impairment losses should be recognised up to the date they are classified as held for sale.

4. Measuring a non-current asset (or disposal group) once classified as held for sale

Once a non-current asset or disposal group is classified as held for sale, it must be measured at the lower of its:

Carrying amount, and
Fair value less costs to sell (FVLCTS).

In addition, depreciation or amortisation is suspended on these assets.

Common errors

Entities incorrectly revaluing (upwards) an asset held for sale to its expected FVLCTS when the cost model accounting policy has been applied, and the carrying amount is less than FVLCTS.
Being over-optimistic in determining the FVLCTS.
Continuing to depreciate or amortise the asset after it has been classified as held for sale.

5. Measuring a non-current asset not covered by the measurement provisions of NZ IFRS 5

While the classification and presentation requirements of NZ IFRS 5 apply to all non-current assets and disposal groups, the measurement requirements do not apply to the following assets, which are covered by other standards:

Deferred tax assets (NZ IAS 12 Income Taxes)
Assets arising from employee benefits (NZ IAS 19 Employee Benefits)
Financial assets within the scope of NZ IFRS 9 Financial Instruments
Non-current assets that are accounted for in accordance with the fair value model in NZ IAS 40 Investment Property
Non-current assets that are measured at FVLCTS in accordance with NZ IAS 41 Agriculture
Groups of contracts within the scope of NZ IFRS 17 Insurance Contracts.

Common errors
Common measurement errors occur when management applies the lower of carrying amount and FVLCTS measurement rule, particularly to:

Financial instruments, and
Investment property.

This results in these assets being measured at FVLCTS rather than fair value.

6. Identifying discontinued operations

The basic aim of NZ IFRS 5 is to restrict discontinued operations to a major component that represents a major line of business or geographical area.

This is because the results of discontinued operations are classified in the statement of profit or loss separately from those continuing operations.

But, what is the definition of a discontinued operation?

A discontinued operation is a component of an entity that either has been disposed of or is classified as held for sale, and

Represents a separate major line of business or geographical area of operations.
Is part of a single coordinated plan to dispose of a separate major line of business or geographical area of operations, or
Is a subsidiary acquired exclusively with a view to resale.

Common errors

Treating a closure of a single store as a discontinued operation (closing a single store is unlikely to be a major line of business)
- The entity is likely to still be operating in that particular sector with its remaining stores.
Treating the disposal of a single tenement or exploration area as a discontinued operation.
- A junior explorer’s business is to evaluate various tenements/areas of interest, very likely across a number of continents, and typically an entity will be exploring for a number of minerals, gold, copper, nickel, silver, etc., at the same time.
- The explorer’s business is exploring.
- Closing a particular exploration project is unlikely to mean the explorer ceases to be in the exploration business, unless the particular exploration project represents one whole geographical area of operations.
Treating the closure of a particular facility (factory, warehouse, data centre, etc.) as a discontinued operation, when the entity is still involved in that line of business in other locations.
- This most likely represents a simple reorganisation of the entity’s continuing business, rather than the discontinuing of a major component of its business.
Treating the disposal of an operation in an outsourcing arrangement as a discontinued business.
- Also, where an entity disposes of assets or a business to an outsourcing business, e.g. an entity disposes of its servers and data storage facilities to an outsourcing operation, but will then engage that outsourcer to provide data storage services, this type of arrangement would most likely not represent a discontinued operation.

Typically, these ‘common errors involve a discontinued loss-making operation.

Therefore, the entity has incorrectly separated out, in its statement of profit or loss, the results of this loss-making operation, completely distorting the reported performance of the continuing operation, including gross margin, operating expenses, impairment, etc.

7. Asset or disposal group abandonment

An asset or disposal group that the entity intends to abandon (rather than sell) cannot be classified as held for sale because its carrying amount will be recovered principally through continuing use, rather than sale.

However, if a disposal group to be abandoned meets the criteria for a discontinued operation, the entity presents the results and cash flows of the disposal group as discontinued operations as of the date it ceases to be used.

Common errors

Incorrectly classifying assets to be abandoned as discontinued operations in the statement of profit or loss from the date the decision to abandon the asset or disposal group is made.
Incorrectly classifying assets to be abandoned as held for sale in the balance sheet (as part of current assets and liabilities), when the asset or disposal group is to be recovered through continuing use rather than sale.
Not including the results as discontinued operations on the date the disposal group is abandoned.

8. Treating the disposal of the entire business as a discontinued operation

Where an entity decides to sell all of its business operations, a common error is classifying the results of the entire business as discontinued operations in the statement of profit or loss.

This can also arise when an offshore parent decides to sell its Australian operations.

In the Australian subsidiary’s books, it cannot classify its results as a discontinued operation.

The disposal of the whole business would not meet the definition of a discontinued operation because the whole business is not a separate line of business or geographic area of operations (i.e., it is not a ‘component’ of the entity, it is the entity in its entirety).

However, in the case of the foreign parent, it may be able to classify the Australian subsidiary as a discontinued operation if it meets the criteria, but the Australian entity cannot classify itself as a discontinued operation.

In addition, separating the results for the whole business in the statement of profit or loss as ‘discontinuing’ would serve no purpose, as there would be no residual continuing operations.

Common error

Incorrectly classifying the whole business as a discontinued operation in the statement of profit or loss.

9. Classifying the assets and liabilities on the winding down of a company as held for sale

Where the entity decides to wind down its operations:

Assets and liabilities cannot be classified in the balance sheet as ‘held for sale’ (i.e., and present these as current assets and current liabilities) because the criteria for held for sale classification are not met (i.e., the assets will be used until the end of the useful life or abandoned, rather than sold).
The definition of a discontinued operation is not met (because there is no sale of the business as a whole as part of a single coordinated plan.

Common errors

Incorrectly classifying the whole business as a discontinued operation in the statement of profit or loss
Incorrectly classifying the assets and liabilities in the balance sheet as ‘held for sale’ as current assets and current liabilities.

10. Presenting discontinued operations and assets or disposal groups held for sale

Non-current assets and the assets of a disposal group classified as held for sale must be shown separately in the balance sheet from other assets (the same applies to the liabilities of a disposal group).

This is done by consolidating all relevant assets and liabilities into a single line item within the current assets and current liabilities sections. Prior year comparatives are not restated in the balance sheet.

On the other hand, the results of discontinued operations are presented separately from continuing operations in the statement of profit or loss, and comparatives must be restated for all operations discontinued by the end of the reporting period.

Common errors

Entities incorrectly restating the balance sheet from the prior year to show assets and disposal groups held for sale separately
Entities failing to restate the statement of profit or loss to show the results of discontinued operations separately in the prior year.

11. Discontinued operations with deferred consideration adjustments

Because the results of discontinued operations are shown separately in the statement of profit or loss, there is a tendency to assign losses and costs to the discontinued operation, and to recognise profits and credits as part of continuing operations.

NZ IFRS 5 requires that adjustments in the current period to amounts previously presented in discontinued operations that are directly related to the disposal of a discontinued operation in a prior period must be classified separately in discontinued operations.

Examples of this include:

The resolution of uncertainties that arise from the terms of the disposal transaction, such as the resolution of purchase price adjustments and indemnification issues with the purchaser
The resolution of uncertainties that arise from and are directly related to the operations of the component before its disposal, such as environmental and product warranty obligations retained by the seller
The settlement of employee benefit plan obligations, provided that the settlement is directly related to the disposal transaction.

A simple example of a common error is an entity disposing of a business on contingent/deferred payment terms and incorrectly classifying adjustments to the deferred consideration as part of continuing operations.

Example

In the 2026 financial year, Entity A disposes of Business B on deferred payment terms. Based on a three-year post-disposal earnings before interest and taxation (EBIT) calculation, Entity A will receive somewhere between $0 and $5 million in 2029.

When preparing its 2026 financial statements, Entity A takes a very ‘conservative’ view and recognises no receivable in respect of the deferred consideration, therefore recording a significant loss from discontinued operations.

Subsequently, in 2027, Entity A reassesses the likelihood that the EBIT target will be met and determines it is likely to be $1 million. It credits this revised estimate to continuing operations.

In 2029, Entity A actually receives the full $5 million.

It then makes three errors:

It continues to recognise all the $5 million gain as a gain from continuing operations
It shows the $5 million cash inflow as an operating cash flow, or fails to disclose this as a discontinued operation, and
It includes the $5 million gain in its segment note as a profit from a continuing segment.

Judgement is required

It is important to understand that judgement is often required to apply aspects of NZ IFRS 5, including:

Whether, and at what point, the sale is highly probable
The expected timing of the sale transaction (and whether it will be within one year)
Whether the disposal group is a discontinued operation.

Need help?

Please contact our Financial Reporting Advisory team for further assistance on the navigating the application of NZ IFRS 5 with respect to discontinued operations and/or assets (and disposal groups) held for sale.

For more on the above, please contact your local BDO representative.

This article has been based on an article that originally appeared on BDO Australia, read the original article here.