Discontinued Operations

What Are Discontinued Operations?

Discontinued operations refer to a component of an entity that either has been disposed of or is classified as held for sale, and represents a strategic shift that will have a major effect on an entity's operations and financial results. This definition, primarily guided by accounting standards such as ASC 205-20 (formerly SFAS 144) under U.S. Generally Accepted Accounting Principles (GAAP) and IFRS 5 under International Financial Reporting Standards, emphasizes the significance of the event. It's not merely the sale of an asset or a minor business segment; rather, it must constitute a major strategic shift, such as disposing of a major geographical area of operations, a major equity method investment, or a major line of business.

Key Characteristics and Criteria

For an operation to be classified as discontinued, it must meet specific criteria, ensuring that only truly significant events are afforded this distinct reporting treatment. These criteria are designed to provide investors with clear, segregated information about an entity's ongoing core business versus its divested or soon-to-be-divested components.

• Strategic Shift: The disposal must represent a major strategic shift for the entity. This could involve exiting a significant market, discontinuing a major product line, or selling a substantial portion of its real estate portfolio that was central to a specific business model.
• Component of an Entity: The operations must be a clearly distinguishable component, meaning its assets, liabilities, and operations can be separately identified from the rest of the entity. In real estate, this often means a specific property, a portfolio of properties, or a distinct business unit like a hotel chain within a larger real estate investment trust (REIT).
• Elimination of Cash Flows: The entity will not have any significant continuing involvement in the operations of the component after the disposal. This implies that the cash flows and operational results of the discontinued component will be entirely eliminated from the entity's ongoing activities.
• Held for Sale Classification: If not yet disposed of, the component must meet the criteria to be classified as held for sale. This typically means management is committed to a plan to sell, the asset is available for immediate sale, an active program to locate a buyer has been initiated, the sale is probable within one year, and the asset is being marketed at a reasonable price relative to its fair value.

Accounting Treatment and Financial Reporting

The distinct accounting treatment for discontinued operations is paramount for financial statement users. It ensures that the results of ongoing operations are not distorted by the effects of segments that are no longer part of the core business. This separate presentation allows investors to better predict future performance and assess the quality of earnings.

Presentation on Financial Statements

• Income Statement: The results of discontinued operations, including the gain or loss on disposal, are reported separately from continuing operations, net of tax. This appears after income from continuing operations, often as a single line item. For example, a REIT might report 'Income from continuing operations' followed by 'Loss from discontinued operations, net of tax'.
• Balance Sheet: Assets and liabilities of a component classified as held for sale are presented separately from other assets and liabilities. They are typically shown as 'Assets held for sale' and 'Liabilities held for sale' and are not depreciated or amortized once classified as held for sale.
• Cash Flow Statement: Cash flows from discontinued operations are generally presented separately within the operating, investing, and financing sections, or disclosed in the footnotes to the financial statements.
• Footnotes and Disclosures: Extensive disclosures are required, detailing the major classes of assets and liabilities, the segment's revenues and expenses, the gain or loss on disposal, and the expected manner and timing of disposal. These footnotes are critical for investors to understand the full context.

Measurement and Valuation Considerations

Assets classified as held for sale are measured at the lower of their carrying amount or fair value less costs to sell. Any impairment loss is recognized immediately. This valuation adjustment is crucial for investors assessing the financial health of the entity, as it can significantly impact reported earnings in the period of classification or disposal.

Strategic Implications for Real Estate Investors

For real estate investors, understanding discontinued operations is vital for accurate financial analysis and informed investment decisions, particularly when evaluating REITs or large real estate development companies. The presence of discontinued operations can significantly alter key financial metrics and future projections.

Impact on Due Diligence

During due diligence, investors must carefully scrutinize the nature and magnitude of discontinued operations. This involves reviewing financial statements, particularly the footnotes, to understand:

• The reasons for disposal: Was it underperformance, a strategic pivot, or regulatory pressure?
• The financial impact: What was the gain or loss on disposal? How did it affect net income and earnings per share?
• Future implications: How will the disposal affect the remaining entity's cash flows, revenue streams, and risk profile?
• Contingent liabilities: Are there any ongoing liabilities or guarantees associated with the discontinued segment that could impact the continuing entity?

Valuation and Investment Decisions

When valuing a real estate company or REIT, investors should typically exclude the results of discontinued operations from their projections of future earnings and cash flows. This is because these operations are no longer part of the ongoing business. Key metrics like Net Operating Income (NOI), Funds From Operations (FFO), and Adjusted Funds From Operations (AFFO) should be analyzed for continuing operations only to get an accurate picture of the core business's performance.

Step-by-Step Analysis of Discontinued Operations

Analyzing discontinued operations requires a systematic approach to ensure all relevant financial impacts are understood and properly accounted for in an investment thesis.

1. Identify Discontinued Operations: Locate the 'Discontinued Operations' section on the income statement and any related disclosures in the footnotes. Note the specific segments or assets involved and the effective date of disposal or classification as held for sale.
2. Segregate Financial Data: Extract the revenues, expenses, gains, and losses attributable to discontinued operations. Ensure these are net of tax. For historical analysis, recalculate key metrics (e.g., EPS, FFO) for continuing operations only, restating prior periods if necessary, as companies often do this retrospectively.
3. Assess Strategic Rationale: Understand why the operations were discontinued. Was it to shed underperforming assets, focus on core competencies, or raise capital? This provides insight into management's strategic direction and the quality of the remaining business.
4. Evaluate Financial Impact: Analyze the gain or loss on disposal and any impairment charges. Determine if these are one-time events or indicative of deeper issues. Consider the impact on the balance sheet, particularly 'Assets held for sale' and 'Liabilities held for sale'.
5. Adjust Valuation Models: When projecting future performance, exclude all historical contributions from discontinued operations. Base future revenue, expense, and cash flow forecasts solely on the continuing operations. This provides a more accurate forward-looking valuation.
6. Consider Post-Disposal Risks: Assess any residual risks, such as environmental liabilities, litigation, or contractual obligations related to the divested segment that could still affect the continuing entity.

Real-World Examples in Real Estate

Example 1: Divestiture of a Non-Core Asset Portfolio

A diversified REIT, 'Global Properties Inc.', decides to exit the retail shopping center market to focus exclusively on industrial logistics properties. They classify their entire portfolio of 15 retail centers as discontinued operations. The carrying value of these centers is $850 million. After an active marketing period, they sell the portfolio for $800 million, incurring $15 million in selling costs. The retail centers generated a net loss of $20 million (net of tax) in the year leading up to the sale.

• Carrying Value: $850,000,000
• Sale Price: $800,000,000
• Selling Costs: $15,000,000
• Net Loss from Operations (Year of Sale): $20,000,000

Calculation of Loss on Disposal:

• Net Proceeds = Sale Price - Selling Costs = $800,000,000 - $15,000,000 = $785,000,000
• Loss on Disposal = Carrying Value - Net Proceeds = $850,000,000 - $785,000,000 = $65,000,000

On Global Properties Inc.'s income statement, under discontinued operations, they would report a total loss of $85 million (net of tax): $20 million from operations + $65 million from disposal. Investors would then analyze the remaining industrial portfolio's performance separately.

Example 2: Sale of a Struggling Development Project

A real estate development company, 'Urban Innovators LLC', has a large mixed-use project that has faced significant delays and cost overruns, leading to a strategic decision to sell the entire project. The project, which includes residential, office, and retail components, is considered a major line of business for the company. The carrying value of the project's assets is $300 million. The company classifies it as held for sale, and its fair value less costs to sell is estimated at $260 million. In the period it was classified as held for sale, it incurred an additional $5 million in operating losses.

• Carrying Value: $300,000,000
• Fair Value less Costs to Sell: $260,000,000
• Operating Losses (period held for sale): $5,000,000

Calculation of Impairment Loss:

• Impairment Loss = Carrying Value - Fair Value less Costs to Sell = $300,000,000 - $260,000,000 = $40,000,000

Urban Innovators LLC would report a total loss of $45 million (net of tax) under discontinued operations for that period, comprising the $40 million impairment loss and $5 million in operating losses. This separate reporting prevents the struggling project from obscuring the performance of the company's successful ongoing developments.

Example 3: Impact on REIT Financials and EPS

Consider 'Prime REIT', which reports Net Income of $100 million for the year. However, this includes a $20 million gain (net of tax) from the sale of a non-core office building portfolio that qualified as discontinued operations. Without this gain, the Net Income from continuing operations would be $80 million. Prime REIT has 100 million shares outstanding.

• Reported Net Income: $100,000,000
• Gain from Discontinued Operations (net of tax): $20,000,000
• Shares Outstanding: 100,000,000

Calculation of Earnings Per Share (EPS):

• Total EPS = $100,000,000 / 100,000,000 shares = $1.00 per share
• EPS from Continuing Operations = ($100,000,000 - $20,000,000) / 100,000,000 shares = $0.80 per share

An astute investor would focus on the $0.80 EPS from continuing operations, as this represents the recurring earning power of Prime REIT. The $0.20 per share from discontinued operations is a one-time event and should not be factored into future earnings projections.

Risks and Challenges

While discontinued operations aim to provide clarity, they can still present challenges. The classification itself can be complex, requiring significant judgment. Furthermore, the timing of disposal and the recognition of gains or losses can impact financial results in a way that might obscure underlying operational trends if not carefully analyzed. Investors must also be wary of companies that frequently classify operations as 'discontinued' to remove underperforming segments from ongoing results, potentially masking persistent issues within the core business.