Disposition of Assets and Businesses
The disposition of assets and businesses are non-recurring events that create either gains or losses on disposition. If the asset is scrapped, then the loss would include the undepreciated cost of the asset plus any costs of removal. If the asset is sold, then the gain or loss from the sale would be the sale proceeds less costs of disposition and undepreciated cost of the asset.
Any gain or loss arising from the disposition is booked in the period of the transaction. Such transactions are typically considered unusual charges on the income statement before extraordinary items, unless the gain or loss is for an entire business segment, e.g., subsidiary, division, or major line of business.
Economics of Dispositions
All assets possess two economic attributes: operating value and opportunity cost of sale. Operating value is the discounted cash flow that the asset is expected to generate over its life. Opportunity cost of sale is what the asset would net if sold to the highest outside bidder*.
While each of these factors may be difficult to quantify, management can only maximize value if they seek to find opportunities to dispose of assets that are worth more to others than they are to keep. This type of identification is usually the outcome of strategic planning.
Common candidates for sale or disposition include antiquated equipment that slows productivity and requires a lot of maintenance, or underutilized machines or buildings. However, even highly productive assets can be worth selling if they could be even more productive to an outside buyer.
A value creating deal could result in either an accounting gain or loss on sale. The only relevant criteria to value creation is whether the present value of the cash flows from holding and operating the asset exceed its net realizable value on disposition.
Behavioral Impact
Operating income never matches the gains or losses on assets within any accounting period. For example, over a period of decades, one may be indifferent between getting $100 now or $10 per year--these may perceived as economically equivalent benefits. Within a single year, however, that $100 is no longer "matched" to the $10 per year--the period is now too short. A rational person would choose $100 now. Even the most far-sighted manager is typically in his or her position for only a few years, far too short a period to benefit from a long-term income stream.
This mismatch between "income" and "gains" within an accounting period can create a couple of perverse incentives.
First, management may hold assets that should be sold. Selling a poorly performing asset, even for a good price, may force management to recognize a loss on sale. This would hit Basic EP (which is not adjusted for such unusual or non-recurring items), not to mention sales, income, market share, or any of a number of metrics that may be on management's "scorecard."
Second, if the asset is highly productive, management may have an incentive to sell what should be held. If one is faced with declining operating profit on several lines of business, the gain on the sale of a productive asset or line could be used to disguise the operating shortfall.
Of course, management has only so many productive assets it can sell off, but a store of unrealized gains can be used to hide operating shortfalls for several years.
Obviously, investors have an interest in separating non-recurring gains from improvements in ongoing operations. If gains or losses are material, they are noted separately as an "extraordinary" item on the financial statements. However, even when these items are separated in reporting, they do not lend themselves to easy comparison between the value of the sale relative to the foregone value of operations. To achieve this, we need to an adjustment that essentially makes $100 now look like $10 per year.
Alternative Treatments
The sale of assets or operations suggests one of three accounting treatment alternatives, depending on the circumstances of the disposition:
Option 1: Treat as an operating item
