Blind Freddy – Common errors in accounting for discontinued operations
Our ‘Blind Freddy’ series focuses on errors where the preparer has typically not read, or applied, requirements that are very clear in accounting standards. In this month’s article we look at ‘Blind Freddy’ errors relating to AASB 5 Non-current Assets Held for Sale and Discontinued Operations.
The aim of AASB 5 is to enable users to understand the performance of the continuing business. In reality, the thrust of the standard is intended to restrict which assets can be classified as held for sale, and which operations can be shown as being discontinued.
There is obviously a great incentive for entities with loss making businesses to classify them as discontinued operations and to present a much better set of results from continuing operations. Similarly, showing an asset as held for sale can give an unrealistically positive view of an entity’s liquidity position if the asset is presented as current when it is not highly probable that it will be disposed of in the next 12 months.
Historically under US GAAP, prior to the issuance FAS 144 (ASC 205-20), US businesses would report the same loss making business as a ‘discontinued operation’ year after year because a buyer was being sought for a business nobody wanted, or the business was being marketed at a price that could not attract a buyer. FAS 144 introduced a set of very tight rules to stop this abuse, and AASB 5 follows these same rules.
Some of the major Blind Freddy errors, discussed further below, include:
- Classification as held for sale when the asset fails to meet the ‘held for sale’ criteria
- Classification of disposals of interests in subsidiaries
- Measurement of a non-current asset (or disposal group) classified as held for sale
- Presentation and disclosure of results from continuing and discontinuing operations.
‘An entity shall classify a non-current asset (or disposal group) as held for sale if its carrying amount will be recovered principally through a sale transaction rather than through continuing use. ’
AASB 5, paragraph 6
‘For this to be the case, the asset (or disposal group) must be available for immediate sale in its present condition subject only to terms that are usual and customary for sales of such assets (or disposal groups) and its sale must be highly probable.’
AASB 5, paragraph 7
‘For the sale to be highly probable, the appropriate level of management must be committed to a plan to sell the asset (or disposal group), and an active programme to locate a buyer and complete the plan must have been initiated. Further, the asset (or disposal group) must be actively marketed for sale at a price that is reasonable in relation to its current fair value. In addition, the sale should be expected to qualify for recognition as a completed sale within one year from the date of classification, except as permitted by paragraph 9….’.
AASB 5, paragraph 8
Classification as held for sale
There are a number of ‘Blind Freddy’ errors that can result in an entity incorrectly classifying an asset or a business as held for sale. These include:
- 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 12 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 (AASB 5, paragraph 13)
- The asset(s) or disposal group is to be used and then closed down.
Disposal of an interest in a subsidiary
‘An entity that is committed to a sale plan involving loss of control of a subsidiary shall classify all the assets and liabilities of that subsidiary as held for sale when the criteria set out in paragraphs 6–8 are met, regardless of whether the entity will retain a non-controlling interest in its former subsidiary after the sale.’
AASB 5, paragraph 8A
‘Blind Freddy’ errors that can occur here include:
- Showing a partial disposal in a subsidiary (but still having control of the subsidiary) as an asset held for sale
- When an entity is to dispose of a controlling stake in a subsidiary, but will continue to hold a non-controlling interest in the entity, only showing the holding in the subsidiary to be disposed of as an asset held for sale, rather than the entire holding.
Measurement of a non-current asset (or disposal group)
‘An entity shall measure a non-current asset (or disposal group) classified as held for sale at the lower of its carrying amount and fair value less costs to sell.’
AASB 5, paragraph 15
‘An entity shall not depreciate (or amortise) a non-current asset while it is classified as held for sale or while it is part of a disposal group classified as held for sale…’
AASB 5, paragraph 25
‘Blind Freddy’ measurement errors of non-current assets and disposal groups held for sale include:
- Entities incorrectly revaluing (upwards) an asset held for sale to its expected fair value less costs to sell (FVLCTS)
- Being over-optimistic in determining the fair value less cost to sell (FVLCTS)
- Continuing to depreciate/amortise the asset after it has been classified as held for sale.
AASB 5, paragraph 15’s requirements are clear that measurement is at the lower of carrying amount and FVLCTS. Therefore upward revaluations cannot be made unless a revaluation policy is being applied to the asset class.
Presentation and disclosure
‘An entity shall present and disclose information that enables users of the financial statements to evaluate the financial effects of discontinued operations and disposals of non-current assets (or disposal groups).’
AASB 5, paragraph 30
‘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 co-ordinated 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.’
AASB 5, paragraph 32
The basic aim of AASB 5 is to restrict discontinued operations to a major component that represents a major line of business.
‘Blind Freddy’ errors might therefore include:
- Treating a closure of a single store as a discontinued operation (closing a single store is unlikely to be a major line of business)
- Treating the disposal of a single tenement or exploration area as a discontinued operation
- 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
- Treating a disposal of an operation in an outsourcing arrangement as a discontinued business.
Closing a single store is unlikely to be a major line of business because the entity is likely to still be operating in that particular sector.
In the case of junior explorers, 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 represent the explorer ceasing to be in the exploration business unless the particular exploration project represents one whole geographical area of operations.
When an entity closes a single facility, e.g. a factory or a warehouse, again this most likely represents a simple reorganisation of the entity’s continuing business, rather than discontinuing a major component of its 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.
FAS 144 (ASC 205-20 ) contains a number of examples that demonstrate the subtle differences as to how various specific facts and circumstances impact whether an operation is determined to be a discontinued operation. Set out below is Example 14 of this standard.
An entity that manufactures sporting goods has a bicycle division that designs, manufactures, markets, and distributes bicycles. For that entity, the bicycle division is the lowest level at which the operations and cash flows can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. Therefore, the bicycle division is a component of the entity. The entity has experienced losses in its bicycle division resulting from an increase in manufacturing costs (principally labor costs).
- The entity decides to exit the bicycle business and commits to a plan to sell the division with its operations. The bicycle division is classified as held for sale at that date. The operations and cash flows of the division will be eliminated from the ongoing operations of the entity as a result of the sale transaction, and the entity will not have any continuing involvement in the operations of the division after it is sold. In that situation, the conditions for reporting in discontinued operations the operations of the division while it is classified as held for sale would be met.
- The entity decides to remain in the bicycle business but will outsource the manufacturing operations and commits to a plan to sell the related manufacturing facility. The facility is classified as held for sale at that date. Because the manufacturing facility is part of a larger cash-flow-generating group (the bicycle division), and on its own is not a component of the entity, the conditions for reporting in discontinued operations the operations (losses) of the manufacturing facility would not be met. (Those conditions also would not be met if the manufacturing facility on its own was a component of the entity because the decision to outsource the manufacturing operations of the division will not eliminate the operations and cash flows of the division [and its bicycle business] from the ongoing operations of the entity.)
Typically these ‘Blind Freddy’ errors involve a discontinued loss-making operation. Therefore the entity has incorrectly separated out from its income statement the results of this loss making operation, completely distorting the reported performance of the continuing operation, including gross margin, operating expenses, impairment, etc.
Other ‘Blind Freddy’ errors
There is a tendency to put all losses and costs to the discontinued operation, and to take all profits and credits to continued operations.
A simple example of a ‘Blind Freddy’ error would be instances where an entity disposes of a business on contingent/deferred payment terms.
In the 2016 financial year, Entity A disposes of Business B on deferred payment terms, whereby based on a 3 year post disposal EBIT calculation, Entity A will receive somewhere between $0 and $5 million in 2019.
When preparing its 2016 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 2017, Entity A reassesses the likelihood of the EBIT target being met and determines that it is likely to be $1 million. It credits this revised estimate to continuing operations.
In 2019 Entity A actually receives the full $5 million. It then makes three ‘Blind Freddy’ errors:
- Continues to recognise all of the $5 million gain as a gain from continuing operations
- Shows the $5 million cash inflow as an operating cash flow, or fails to disclose this as a discontinued operation, and
- Includes the $5 million gain in its segment note as a profit from a continuing segment.
In next month’s Accounting News we continue the series with a discussion on impairment issues.