Discontinued Operations on the Income Statement

Introduction

When a company sells or spins off a major business, its income statement is rewritten backwards. The divested business's revenue, costs and profit are pulled out of every line for every year presented and collapsed into a single figure near the bottom of the statement, below the layers described in how the income statement works. 3M did exactly this after spinning off its health care business as Solventum on April 1, 2024: in its 2024 annual report, Solventum's results for 2024, 2023 and 2022 appear on one line, and every other line excludes it.

That presentation, called discontinued operations, serves the reader who wants to know how the remaining company performs. For a banker, it does three things at once: it gives a clean history of the business that will continue, it isolates the economics of the business being sold, and it can leave behind costs that the divested business used to absorb. All three matter in a divestiture, a spin-off or a valuation of the remaining company.

Not every sale qualifies. Under Accounting Standards Codification (ASC) 205-20, as quoted in Deloitte's roadmap on the criteria for reporting a discontinued operation, the disposal of a component of an entity is reported in discontinued operations if it represents a strategic shift that has, or will have, a major effect on the entity's operations and financial results. The component must also be held for sale, disposed of by sale, or disposed of other than by sale, such as through abandonment or a spin-off.

Discontinued operations

A component of a company that has been sold, spun off, abandoned or classified as held for sale, and whose disposal represents a strategic shift with a major effect on the company's operations and results. Its results are presented separately, net of tax, below income from continuing operations, for all periods shown.

The standard's examples of a strategic shift are the disposal of a major geographic area, a major line of business or a major equity method investment, and its illustrations include a product line representing 15% of total revenues and a geographic area representing 20% of total assets. Selling a single factory or a small brand usually does not qualify; its results stay in continuing operations, and any gain or loss on the sale appears there too. The judgment can be contested: Deloitte's review of SEC comment letters on discontinued operations shows the Securities and Exchange Commission (SEC) staff questioning companies that classified, or failed to classify, a disposal as discontinued.

Held for Sale: The Trigger Before the Sale

Classification usually happens before a deal closes. A business becomes held for sale when management with the authority to approve the sale has committed to a plan, the business is available for immediate sale in its present condition, an active search for a buyer has begun, the sale is probable within a year, the business is being marketed at a price reasonable in relation to its fair value, and the plan is unlikely to change significantly. From that point, the business is measured at the lower of its carrying amount and fair value less costs to sell, which can trigger a write-down, and depreciation of its assets stops. If the business also represents a strategic shift, its results move into discontinued operations at the same time, often quarters before the sale is announced as completed. The mechanics for individual assets and smaller disposals are covered in asset sales and held-for-sale assets.

The presentation has four elements:

3M's 2024 annual report shows how the bottom of the statement looks after a spin-off:

The notes give the detail behind the single line. Solventum contributed $1,987 million of net sales to discontinued operations in 2024, only the first quarter before the spin, against $8,071 million for the full year 2023. Without the recast, 3M's reported revenue would have fallen sharply in 2024 for a reason that had nothing to do with the remaining business.

The cash flow statement is treated more loosely. Companies may present the cash flows of discontinued operations separately or combine them with continuing operations, but, as Deloitte's roadmap on discontinued operations in the cash flow statement sets out, they must disclose either the discontinued business's total operating and investing cash flows or its depreciation, amortization, capital expenditure and significant noncash items. 3M combined them: its cash flow statement includes Solventum in every period, and the notes disclose Solventum's 2023 depreciation and amortization of $554 million and capital expenditure of $227 million. Free cash flow built from a reported cash flow statement can therefore still include the divested business for the periods before the separation, and needs adjusting before it is used to value the company that remains.

The rules decide which costs leave with the discontinued business and which stay, and the answer is often unfavorable to the remaining company. PwC's guide to presenting discontinued operations explains that indirect expenses, such as allocated corporate overhead, should not be included in discontinued operations, and that costs expected to continue after the disposal generally stay in continuing operations. Interest on debt that the buyer assumes, or that must be repaid as a result of the disposal, is allocated to discontinued operations; allocating other interest is permitted but not required.

The result is stranded costs: head office, IT and shared service costs that the divested business used to help pay for remain in continuing operations, which can make the remaining company's margins look worse immediately after the separation.

Stranded costs

Corporate and shared costs that a divested business used to absorb but that remain with the seller after the separation, such as head office, IT and finance functions. They depress the remaining company's margins until they are eliminated or recovered through transition service fees.

Some of those costs are temporarily offset by fees from transition services agreements, under which the seller keeps providing services to the divested business for a period after closing. 3M charged Solventum about $0.6 billion in gross transition fees in 2024, but after deducting the costs assigned to those services, the income it recorded was only about $50 million. The fees mostly reimburse costs the seller still carries, so they cushion stranded costs while the agreements run rather than remove them.

For a banker, discontinued operations shape three pieces of work. In a sell-side divestiture, the parent's recast figures and the notes on the discontinued business are a starting point for the business being sold, though a buyer usually needs standalone carve-out financial statements with their own cost allocations, covered in carve-out financial statements. In a valuation of the remaining company, continuing operations, adjusted for stranded costs and any ongoing commercial agreements with the divested business, are the right base for forward estimates. And in trend analysis, recast history is what allows growth and margins to be compared like for like.

Discontinued operations often coincide with the one-time charges a separation produces, such as advisory fees, separation costs and debt refinancing, discussed in one-time items. Read together, the recast history, the stranded costs and those separation charges give a realistic picture of the company that remains, which is the company that will be valued after the deal.