Kestrel Manufacturing: Is the Kestrel Europe Sale a Discontinued Operation?
Kestrel Manufacturing has three reporting segments. On September 30, 20X5 its board approved and committed to a plan to sell Kestrel Europe, its only non-North American subsidiary, engaged an investment bank, and considers a sale within twelve months probable. Kestrel Europe contributed 8% of consolidated revenue, 6% of consolidated assets, and 5% of consolidated pre-tax income in 20X5 and in prior years. Management's stated strategy is to exit all markets outside North America. As part of the deal, Kestrel signed a five-year agreement to supply the buyer with components equal to roughly 30% of Kestrel Europe's historical output. At December 31, 20X5 the disposal group's carrying amount is $62.0 million, including $9.0 million of allocated goodwill; fair value is $58.0 million and estimated costs to sell are $3.0 million. Kestrel Europe's 20X5 pre-tax operating loss was $4.0 million.
1. Does the planned sale qualify for discontinued-operations presentation? Identify the criteria and the specific facts that drive your conclusion, including the effect of the supply agreement.
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Criterion 1 - Component of an entity: met. Kestrel Europe is a subsidiary whose operations and cash flows are clearly distinguished operationally and for financial reporting purposes.
Criterion 2 - A strategic shift with a major effect: judgment. The guidance gives three examples of a strategic shift: a major line of business, a major equity-method investment, and a major geographic area of operations. Exiting every market outside North America fits the geographic example even though the unit is not a 'major' line of business in dollar terms.
The 8% / 6% / 5% profile is the hard part. GAAP sets no percentage threshold, and practice often treats roughly 10-15% as a marker of significance. Taken alone, these percentages are borderline. What tips the conclusion is the qualitative story: this is the entity's entire non-North American footprint, it is a reportable segment, and it is being exited deliberately rather than trimmed.
The supply agreement is not a disqualifier. The 'no significant continuing involvement' condition was eliminated from the discontinued-operations definition; the only gating test today is the strategic shift / major effect. A 30% supply relationship no longer forces the unit to stay in continuing operations. It is, however, relevant evidence to weigh and a required disclosure.
Conclusion. Report as discontinued operations, with the percentages disclosed and the judgment explained. A conclusion either way is defensible; an unexplained conclusion is not.
2. Compute the held-for-sale write-down and show the December 31, 20X5 income statement presentation of all amounts related to Kestrel Europe, assuming discontinued-operations treatment applies.
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Measurement. Fair value less costs to sell = $58.0M - $3.0M = $55.0M. Carrying amount = $62.0M. Write-down = $62.0M - $55.0M = $7.0M.
The disposal group is measured at the lower of carrying amount and fair value less costs to sell from the date the held-for-sale criteria are met. The $7.0M is a valuation allowance allocated pro rata to the group's long-lived assets, with no individual asset written below its own fair value less costs to sell; the $9.0M of allocated goodwill is part of the carrying amount that produced the loss and cannot support a separate recoverable amount.
Income statement presentation, year ended December 31, 20X5
| Line | Amount |
|---|---|
| Income from continuing operations | as computed |
| Discontinued operations: | |
| Loss from operations of Kestrel Europe | $(4.0)M |
| Impairment loss to adjust to fair value less costs to sell | $(7.0)M |
| Loss before income taxes | $(11.0)M |
| Income tax benefit | per applicable rate |
Key presentation rules: the $4.0M operating loss stays in discontinued operations even though it was earned before the held-for-sale date; taxes are allocated and shown on the face; no depreciation is recorded on the group's long-lived assets while held for sale, which itself increases the 20X6 loss relative to 20X5.
3. Assume instead that the held-for-sale criteria were not met until February 20X6. How would the 20X5 statements differ, and what happens to the $4.0 million operating loss?
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20X5 becomes an ordinary year. With no held-for-sale classification at December 31, 20X5:
- Kestrel Europe's $4.0M pre-tax loss remains in continuing operations, reported within its segment.
- The $7.0M write-down is not recorded. The disposal group is still measured under the held-and-used model, so the entity tests the long-lived assets (and goodwill) only if a triggering event exists at December 31. The decision to sell may itself be a triggering event, but the measurement is an undiscounted-cash-flow recoverability test, not fair value less costs to sell, and it is performed at the asset group level.
- The board's February action is a nonrecognized subsequent event: disclose it if material, because the plan arose after the balance sheet date.
20X6 consequences. In 20X6, once the criteria are met, the results of Kestrel Europe are reclassified into discontinued operations, and the 20X5 comparative income statement is restated so that 20X5 also shows Kestrel Europe in discontinued operations. That restatement is the awkward part: 20X5's as-originally-issued statements showed the loss in continuing operations, and the comparative column in the following year's annual report will not agree to those issued statements. Disclosure of the reclassification is required, and it is precisely the outcome the September board decision was designed to reach a year earlier.