The consequences of using discontinued operations

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From the Case study given, we found the additional issues that synchronize with the discontinued operations. The another issues arise is, most of managers in current situation manage their earning by using the discontinued operations. How, Why and What the consequences by doing so are will be explained and elaborate in details as the below paragraphs:

When making firm-valuation decisions, investors place a higher value on items of income expected to be determined in the future. To assist investors making valuation decisions, GAAP generally requires that material nonrecurring items be separately disclosed in the financial statements. However, the separation of net income into recurring and non-recurring components also gives managers the opportunity to mislead investors, by misclassifying income and expense items. For example, a manager want to increase firm valuation can misclassify recurring expenses as non-recurring, misleading investors as to the determination of the income increase. In the accounting literature this type of earnings management is called classification shifting Classification shifting involves reporting revenues, expenses, gains and losses on different lines on the income statements than they should properly appear under GAAP, for instance, allocating operating expenses to discontinued operations. Managers engage in this form of earnings management most probably because investors value recurring earnings more than non-recurring earnings.

From the previous research, McVay (2006) discusses two reasons why classification shifting been choose by managers to manage their earnings, First, not like accrual management or

real activity manipulation, there is no “settling-upâ€Â in the future for past earnings management. If a manager decides to increase earnings using positive (income increasing) accruals, at some point in the future these accruals must reverse. The reversal of these accruals reduces future reported earnings. If a manager decides to increase earnings by managing real activities, such as reducing research and development expenditures, this may lead to fewer income producing projects and reduced earnings in the future. In contrast, classification shifting involves simply reporting recurring expenses in a non-recurring classification on the income statement, having no implications for future earnings. Second, because classification shifting does not change net income, it is potentially subject to less inspection by auditors and regulators than forms of earnings management that change net income (Nelson, Elliot, and Tarply, 2002).

Classification shifting using discontinued operations involves two managerial

decisions. The first is the decision to discontinue the operations, while the second is to

shift operating expenses to this classification. In other words, researchers believe the two decisions are independent of each other. Base on the researchers belief on the following findings generated: First, discontinued operations are an important real activity decision requiring board of director approval. as a result, the manager needs forceful economic reasons to make a case to the board. Second, because discontinued operations are a real activity decision, the company will incur real expenses disposing of the operation. The company will pay expenses such as separation pay, appraisal fees, legal fees, and other expenses, from the cash flows of continuing operations. Third, there may be a possibility of improvement in the operating results of the discontinued operation. If so, the manager will be trading future earnings to increase current period earnings.

From the research done by Abhijit Barua, Steve Lin and Andrew M. Sbaraglia (2009) found there are the positive association between income-decreasing discontinued operations and unexpected core earnings in the year a firm reports discontinued operations, a result consistent with managers shifting operating expenses to discontinued operations, Together, these results provide evidence that managers shift core expenses to discontinued operations to increase core earnings. Results also show that the degree of classification shifting using a discontinued operation has declined after the introduction of FASB (Statement No. 144) . Two

explanations for this finding are been found, First, FASB (Statement No. 144) broadened the definition of discontinued operations by replacing the business segment requirement under Accounting Principles Board (APB) Opinion No. 30 with the component of an entity concept. This allowed firms to report smaller asset dispositions as discontinued operations, increasing the reporting frequency. In addition, allowing smaller asset dispositions to qualify as discontinued operations, potentially reducing the amount of operating expenses that can be shifted to the disposition. Second, the Sarbanes-Oxley Act was enacted around the same time as FASB (Statement No. 144) and may have led to a decrease in classification shifting due to increased regulation and misunderstanding.

In conclusions, accounting treatment for discontinued operations is also a global accounting

issue. Similar to APB 30, IFRS 5, Non-current Assets Held-for-sale and Discontinued

Operations, defines a discontinued operation as a separate major line of business or

geographical area of operations. IFRS 5 also requires detailed disclosure of revenue,

expenses, pre-tax profit or loss, and the related income tax expense, either in the notes or

on the face of the income statement. Currently, both the FASB and the IASB are working

toward a unite accounting definition and treatment for discontinued operations, with

both boards issuing proposals amending FASB (Statement No. 144) and IFRS 5, respectively, hopefully the final decisions by FASB and IASB will benefit the investors, analysts, auditors and regulators by alerting them to the potential earnings management using classifications shifting when a firm report discontinued operations.