The treatment of discontinued operations reminds me of Zaphod Beeblebrox’s Joo Janta 200 super-chromatic peril-sensitive sunglasses in Douglas Adams’ Hitchhiker’s Guide to the Galaxy.
Designed to go black at the first hint of trouble so the wearer did not see anything alarming, the glasses allowed the development of a relaxed attitude to danger. The rules for discontinued operations have a similar effect, hiding potentially bad news from interested stakeholders so they can relax rather than worry.
My view is that badly written accounting standards can encourage bad behaviour, and the rules for discontinued operations are a classic example.
Many years ago I worked for an American company that was spending millions of dollars on a doomed diversification into fibre optic communication. I vividly remember hearing the CEO declare that the board had decided to sell or close the venture and that the problem was already solved because it had been moved to discontinued operations.
As a young engineer I was baffled. Surely the unit was still haemorrhaging cash? Wouldn’t the problem remain unfixed until the bleeding had stopped? I was too naive to understand that headline earnings per share was all that mattered to some people and that the reality of cashflow was often ignored.
I have a very simple view on consolidation. If you own or control a unit, it should be consolidated; if you don’t, it shouldn’t. I understand that there are grey areas, but what possible rationale can there be for deconsolidating something you still own? Corporate reports should reflect economic reality, not a bowdlerised version with bad news buried down in the footnotes.
Useless metric
The reality of discontinued operations is actually even worse than this. The only number you are allowed to see – net income from discontinued operations – is typically useless. Assets are no longer depreciated, the tax treatment is opaque and operating performance is invisible. The value of debt and quasi-debt assets included in discontinued operations is also obscure.
I recall one example where the unit being sold had material customer advances, which had been previously treated as cash but were in effect debt. When the unit was sold, the net proceeds were well below expectations simply because outside observers couldn’t see what was actually happening. In theory, businesses being divested should stay in discontinued operations for a year at most, but I know examples where the exit has taken over two years.
I understand that the business wants to focus attention on the parts it is keeping, but requiring the parts it is selling to be buried regardless of their economic importance is just wrong
Discontinued operations can easily be a material portion of a company’s enterprise value, and yet as an investor you have absolutely no idea what is going on without additional voluntary disclosure. This reminds me of the bad old days of pension accounting. You knew there was a big liability, but the way it was calculated was so arcane that the reported number was meaningless.
I do understand that the business wants to focus attention on the parts it is keeping, but requiring the parts it is selling to be buried regardless of their economic importance is just wrong. It also creates a loophole where less scrupulous CEOs can hide unpalatable details.
Simple solution
The solution here is very simple. Units that are being sold should be fully consolidated until they are actually sold. If management wants to separate the ongoing and off-ramp businesses, then a new segment called Stuff for Sale can easily be created. After all, the hard work has already been done as discontinued operations is, in effect, a new segment with full internal reporting and no external reporting.
In a perfect world, the standard setters would recognise they have created a problem that needs fixing. In the real world, companies that care about their investors should just report discontinued operations performance in full.
