Discontinued operations and other comprehensive income (OCI)

Discontinued operations

A discontinued operation is:

• A component of an entity that either has been disposed of or is classified as held for sale, when the disposal represents a strategic shift that has (or will have) a major effect on the entity’s operations and financial results - for example, the disposal of a major line of business or a major geographical area
• A business or nonprofit activity that, on acquisition, is classified as held for sale.

A “component of an entity” comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. A component of an entity may be any of the following:

• Reportable segment
• An operating segment
• A reporting unit
• A subsidiary
• An asset group.

When an entity has a component that is classified as a discontinued operation, it must present the income statement in a slightly different format.

Presentation of income statement with discontinued operations

When discontinued operations exist, the income statement separates results into two sections. The upper portion shows income from continuing operations - all revenues, expenses, gains, and losses expected to continue - and the lower portion shows income from discontinued operations, net of tax, on a single line. Net income is the sum of both sections. A few guidelines follow:

Income from discontinued operations. All revenues, expenses, gains, and losses of the discontinued component - including the gain or loss on the actual disposal, once it occurs - are combined and reported net of tax on a single line. This is the basis of the income from discontinued operations line: it’s never presented in detail, but it inherently includes everything belonging to the component for the period.

Prior period presentation. For sake of comparability, the prior period income statements are restated to present the discontinued operations of the component. This process removes the net income related to the discontinued operations from the income from continuing operations for all prior periods presented so that users of the financial statements are able to view a comparable set of statements of comprehensive income.

Income from continuing operations. The income from continuing operations section of an income statement pertains to all gain or loss items that are expected to continue in the foreseeable future, as opposed to the discontinued operations section which pertains to the portion of net income that is not expected to recur in the future. This helps users of financial statements assess the amount, uncertainty and timing of future cash flows. Income from continuing operations is different from operating income - operating income excludes items such as interest and taxes, while income from continuing operations is an after-tax subtotal that includes all items except those attributable to the discontinued component. For example, a gain or loss on the disposal of property, plant, and equipment that doesn’t meet the discontinued-operations criteria remains part of income from continuing operations.

Example: income statement with discontinued operations

An entity reports income from continuing operations before tax of $500,000 and income tax expense of $120,000 on that income. During the year, it also disposed of a component, resulting in a loss from operations and disposal of the component totaling $80,000 before tax, with a related tax benefit of $20,000.

• Income from continuing operations before tax: $500,000
• Income tax expense: $(120,000)
• Income from continuing operations: $380,000
• Loss from discontinued operations, net of tax benefit of $20,000: $(60,000)
• Net income: $320,000

Answer: Net income of $320,000 is the sum of income from continuing operations ($380,000) and the net-of-tax loss from discontinued operations ($(60,000)).

Criteria for classifying a component as discontinued operations

Strategic shift is required. Meeting the held-for-sale criteria alone is NOT sufficient for discontinued-operations classification. The disposal must also represent a strategic shift that has (or will have) a major effect on the entity’s operations and financial results. For a component of an existing entity, both conditions - a qualifying triggering event AND a strategic shift - must be present. A business or nonprofit activity that is classified as held for sale on acquisition is a discontinued operation without the strategic-shift test.

Any of the following triggering events, combined with that strategic shift, results in discontinued-operations reporting:

1. The component of an entity or group of components of an entity meets the criteria to be classified as held for sale: a. Management commits to a plan to sell the component or group of components. b. The component(s) are available for immediate sale. c. An active program to locate a buyer or buyers and other actions required to complete the sale have been initiated. d. The sale is probable within one year, unless events beyond the company’s control occur. e. The component(s) are being actively marketed at a reasonable price in relation to their fair value. f. Actions required to complete the plan to sell the component(s) make it unlikely that the plan will be withdrawn or significantly changed.
2. The component of an entity or group of components of an entity is disposed of by sale.
3. The component of an entity or group of components of an entity is disposed of other than by sale, for example, by abandonment or in a distribution to owners in a spinoff.

Purpose and limitations of the income statement

The income statement assists users:

• In assessing the cash flows that the company may generate in the future.
• In estimating the market value of an entity through financial analysis of the company’s future earning ability.
• In understanding how equity has changed during the period other than from investments or distributions to owners. This further allows resource providers (owners and lenders) to assess how well management was able to use the company’s assets and liabilities to generate revenue.

The following are some of the limitations of the income statement:

• Preparation of the income statement involves the use of estimates and judgements which may make it less comparable across entities.
• Similar to above, variations in accounting policies such as the use of different depreciation methods or inventory valuation methods (FIFO, LIFO weighted average method) can make income statements across different entities less comparable.
• There are some events that cannot be reliably measured in the income statement such as loss of key employees, increases in values of internally generated brands, etc.
• The income statement is prepared using the accrual basis and does not reflect the cash impact of transactions. This makes it not easily usable for users who want information about the cash impact of transactions.

Sidenote

LIFO is a US GAAP-only method

The LIFO inventory valuation method is permitted under US GAAP but is prohibited under IFRS. This means that companies reporting under IFRS cannot use LIFO, which further limits comparability between entities following different accounting frameworks.

Other comprehensive income (OCI)

As mentioned previously, the comprehensive income is composed of:

1. Net income; and
2. Other comprehensive income.

Net income has been thoroughly discussed in the previous section. This section focuses on the second composition of comprehensive income.

There are two terms to learn in this section:

• Other comprehensive income (OCI) - this is the amount of movements in the current period that appears in the statement of comprehensive income
• Accumulated other comprehensive income (AOCI) - this is the amount of OCI accumulated in the equity section of the balance sheet. It is composed of the current period OCI and all previous period movements, hence the term accumulated. AOCI is reported separately from the share capital, APIC and retained earnings.

The AOCI account in the equity section of the balance sheet is where the other comprehensive income during the period flows when the accounts are closed at the end of the reporting period. In contrast, net income accounts are closed to retained earnings at the end of the reporting period.

OCI consists of revenues, expenses, gains, and losses that US GAAP specifically excludes from net income and reports instead in other comprehensive income.

What transactions are included in OCI?

The items that are considered as OCI are expressly stated in the standards and you do not need to memorize all of them. The most common items in this group include:

• Foreign currency translation gain or loss from translating the financial statements of a foreign subsidiary into the presentation currency of the parent
• Pension adjustments that are not recognized immediately as a component of net periodic benefit cost
• Unrealized gains or losses from available-for-sale debt securities
• Gains or losses from derivatives designated as cash flow hedges

It’s worth noting that many OCI items are temporary - they are held in AOCI until a future event triggers reclassification (sometimes called “recycling”) into net income. For example, an unrealized gain on an available-for-sale debt security recorded in OCI is reclassified to net income when the security is sold.

Each component of the OCI should be reported either:

1. Net of the related tax effects; or
2. Before related tax effects with one amount shown for the aggregate income tax effect of all OCI items.

Example: comprehensive income and AOCI

An entity reports net income of $320,000 for the year. It also records two items in OCI, both net of tax: an unrealized gain on available-for-sale debt securities of $10,000, and a foreign currency translation loss of $(4,000). The entity’s beginning AOCI balance was $15,000.

• Other comprehensive income: $10,000 - $4,000 = $6,000
• Comprehensive income: $320,000 + $6,000 = $326,000
• Ending AOCI: $15,000 + $6,000 = $21,000

Answer: Comprehensive income is $326,000, and the ending AOCI balance reported in equity, separate from retained earnings, is $21,000. If the available-for-sale security is later sold, its $10,000 gain is reclassified out of AOCI and into net income at that time.