What are Discontinued Operations?
The Discontinued Operations line item on the income statement represents the parts of a company that were either divested or shut down (i.e. classified as held-for-sale).
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Discontinued Operations – Income Statement Accounting
The term “discontinued operations” refers to the business divisions or assets of a company that were formerly part of its operations until being either divested or terminated.
- Divestiture → The company conducted a partial or outright sale of the segment (and the associated assets).
- Held-for-Sale → The company has shut down part or the whole of a business division so that it is no longer operational and classified as held-for-sale.
The discontinued operations represent unnecessary segments that a company divests or shuts down to dispose of at a later date.
A business division can be discontinued because of a wide variety of reasons, such as closing a division that cannot turn or consistently sustain a profit or a redundant division following a merger.
If divested, the assets of the discontinued operations are sold off – while in the case of a termination, the assets can be held-for-sale.
Once the operations are disposed of, the income stemming from those operations must be eliminated from the company’s future financial statements (and adjustments are necessary for historical financial reports to facilitate an “apples to apples” comparison).
But in either case, the discontinued operations are reported separately from a company’s core, recurring operations.
Gains / (Losses) on Asset Sales
The gains or losses from a non-recurring event are recognized separately on the company’s income statement below the performance of its core operations so that investors can easily distinguish between continuing vs. discontinued operations.
The effects of the sale, whether positive or negative, must not impact operating profit (EBIT).
Common Reasons for Discontinued Operations
The following are common reasons for a company to divest or terminate a business division.
- Closure of Redundant Division Post-Merger
- Cutting Off Unprofitable Division
- Discontinuation of Product/Service with Limited Market Demand
- Fire Sale for Liquidity (i.e. Urgent Need for Cash)
- Mismatch of Business Division with Core Operations
GAAP Accounting Rules for Discontinued Operations
Under U.S. GAAP reporting standards, a public company can classify an item as “Discontinued Operations” if the following conditions are met:
- Removal of Operations and Cash Flows: The cash flows from the discontinued operations – whether it be a gain or a loss – must cease shortly after the sale (or termination) date.
- No Continuing Involvement in Operations: The discontinued operation must remain separate from the original company, i.e. no more influence or continued business dealings post-disposal.
In the accounting period when operations are ceased, the gain (or loss) can still occur and thus must be recorded and reported.
Since discontinued operations are usually operating at a loss – which is why they’re often discontinued in the first place – the decision to dispose of a segment can often bring about a tax benefit.
Discontinued Operations Calculator – Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Discontinued Operations Example Calculation
Suppose a company’s continuing operations generated $25 million in pre-tax income for the fiscal year ending 2021.
If the company’s tax rate is 21%, the income tax owed is $5.3 million.
- Pre-Tax Income from Continuing Operations
- Tax Rate = 21.0%
- Income Taxes = 21% × $25 million = $5.3 million
The net income from continuing operations – i.e. the core, recurring operations of our company – comes out to be $19.8 million.
- Net Income from Continued Operations = $25 million – $5.3 million = $19.8 million
However, let’s say that the company decided to divest an underperforming segment because it was unprofitable and weighing down its margins.
For simplicity, we’ll assume there was no income generated from the discontinued segment, which the company was just waiting to dispose of.
If we assume the pre-tax gain / (loss) related to the sale of the divested business division was a loss of $2 million, the tax benefit equals the loss multiplied by the tax rate.
- Tax Benefit = $2 million × 21% = $420k
Upon netting the loss from the sale against the income tax benefit, the net income from discontinued operations is a loss of $1.6 million.
- Net Income from Discontinued Operations = –$2 million + $420k = –$1.6 million
In closing, the net income of our hypothetical company after the disposal is $18.2 million.
- Net Income = $19.8 million – $1.6 million = $18.2 million.