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:
‘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
‘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:
‘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:
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.
‘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:
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:
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.
Example 14An 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).
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.
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:
In next month’s Accounting News we continue the series with a discussion on impairment issues.