Segmental Reporting

Segmental Reporting



 OK, we’ve been looking at the

consolidation of information and the

disclosure of intangible assets. Is

consolidated data always appropriate?

What is Segmental Reporting?



 Segmental reporting is the counterpart to

consolidated information in that it involves the

disaggregation of the consolidated financial

statements.

 There is a trend to MORE segmental reporting,

particularly with regard to geographic activity,

for multinational enterprises. (How many large

US companies are MNEs?)

Why do we want segmental

information?

 Attempts to ensure that overall

performance, risks, and prospects can

be better evaluated by investors, other

users, and management and that a more

comprehensive accountability can be

achieved.

 Various studies and professional groups

have emphasized the importance of

segment information and described it as

essential, fundamental, indispensable,

and integral to the investment analysis

process (Association of Management

and Research)

Who benefits?



 Everyone seems to prefer more

information to less, tending to think of

information as a ―free good‖. This

premise seems to be accelerating in our

―electronic society‖. So who might use

segmental information? Who pays for

it???

Users and Uses of Segmental

Information

Investors

 Analysis of cash flow by Line of Business or

Geographical Area (are there different risks associated

with these two potential criteria for determining a

segment?)

 Assessment of Risk and potential future growth

 Allow comparisons of company-specific information

 Which is more important for predicting timing and nature

of future cash flows, consolidated or segmental

reporting?

 How important is diversification in

investing decisions? What do we learn

from segmental reporting?

 In addition to future cash flows, what

about roi, industries, country-specific

risk, growth, capital needs...

 (Do investors always value

diversification?)

Employees

 Evaluation of performance

 Negotiate contracts

 Comparison of intra-company compensation

and benefits

Creditors

 Assessment of Risk

 Analysis of Debt Covenants

Host Countries

 Determine economic position of country

 Allow comparisons of compensation,

working conditions, and tax base.

 Calculate tax (income, sales, franchise,

employment, equity)

Predictive Ability Test

 The purpose of accounting information, as defined in the

Conceptual Framework, is to help investors predict the

nature, timing, and uncertainty of future cash flows.

 The Conceptual Framework also states that information

must be relevant and reliable, and further states that

relevant information has predictive value (as well as

having feedback value and being timely.

 It is appropriate to evaluate information with respect to

these conditions.

 Research results indicate that predictions are more

accurate if they are based on Line of Business segmental

data than on consolidated earnings.

Stock Market Reaction Test



 Some evidence that LOB and

geographical segment data disclosure

reduce assessed risks.

 Significant relationship between

disclosure and risk in US and UK

 Not necessarily true in other markets.

Cost/Benefit



 Do costs of compiling, processing, and

disseminating information exceed

benefits?

 Internal costs

 Benefits competition

 Investor evaluation

Regulation



 International –Proper compliance—and

restatement of unsatisfactory

statements—may require significant

administrative resources.

Convergence, Cooperation, Principles-

based accounting initiative

 IAS 14 (Revised in 1996 effective for

financial reporting periods beginning on

or after 1 July 1998)

―For projects on the same subject running in a

similar time frame [SFAS No. 121 and IAS No.

14R], and in the context of the demand for

international harmonization, one might hope

that the measurement and disclosure rules

would be identical. Not so! Companies that

use International Accounting Standards and

that also have SEC reporting obligations need

to focus on these difference and ensure that full

account is taken in their filing documents.‖

 IAS 14 was issued as an exposure draft

in March, 1980 and issued as a

statement in August 1981, effective in

1983. It was revisited in 1994, and the

revised statement was issued in 1997.

Objective



 The objective of IAS 14 is to establish

principles for reporting financial

information by line of business and by

geographical area.

 (Not by internal reporting structure…)

Definitions



 Business segment: A component of an

enterprise that

 (a) provides a single product or service or

a group of related products and services

and

 (b) that is subject to risks and returns that

are different from those of other business

segments

 Geographical segment: A component of

an enterprise that

 (a) provides products and services within a

particular economic environment and

 (b) that is subject to risks and returns that

are different from those components

operating in other economic environments

 The reporting enterprise should initially

identify its business segments and

geographical segments. Business

segments are groups of related products

or services and geographical segments

are countries or groups of countries. In

particular, an enterprise must look to its

organizational structure and internal

reporting system to identify reportable

segments.

 Only if internal segments aren’t along

either product/service or geographical

lines is further disaggregation

appropriate. This is a ―management

approach‖ to segment definition.

 ―Through the eyes of management‖

Primary and Secondary

Segments

 For most enterprises, one basis of

segmentation is primary and the other

secondary, with considerably less

disclosure required for secondary

segments.

 The enterprise should determine

whether business or geographical

segments are to be used for its primary

segment reporting format based on

whether the enterprise’s risks and

returns are affected predominantly by

the products and services it produces

or by the fact that it operates in

different geographical areas.

 The basis for identification of the

predominant source and nature of risks

and differing rates of return facing the

enterprise will usually be the enterprise’s

internal organizational and management

structure and its system of internal

financial reporting to senior

management.

Basis of Segment Reporting



 Public companies must report

information along product and service

lines and along geographical lines

 One basis of segmentation is primary,

the other is secondary

Segment Disclosures



 Segments are organizational units for

which information is reported to the

board of directors and CEO unless those

organizational units are not along

product/service or geographical lines, in

which case use the next lower level of

internal segmentation that reports

product and geographical information

 Never construct segments solely for

external reporting purposes

 10% materiality thresholds

 Segments must equal at least 75% of

consolidated revenue

US



 From 1976 until the issuance of FAS

131, FAS 14 was the authoritative

pronouncement on segment disclosure.

Two primary weaknesses of FAS 14:

 failure to require an adequate degree of

disaggregation

 failure to require segment information in

interim financial statements

 CICA and FASB issued research reports

in the early 1990s, and decided to jointly

pursue a project to improve segment

reporting, which resulted in FAS 131 in

the US and a comparable standard in

Canada.

US



 FAS 131

 The objective of presenting

disaggregated information about

segments of a business enterprise is to

produce information about the types of

activities in which an enterprise in

engaged in and the economic

environment in which those activities

are carried out.

 Specifically, the FASB believes that

segment information assists financial

statement users to

 Understand enterprise performance

 Assess prospects for future net cash

flows

 Make informed decisions about the

enterprise

 The FASB does not specifically discuss

the objective of providing information to

assist in risk assessment. Risk

assessment, however, is an important

dimension o financial analysis and

underlies, to some extent, the need for

segment information.

 FAS 131 requires information about

products and services, activities in

different geographic areas, and

information about reliance on major

customers. All of these relate to areas of

significant risk to an enterprise and to

areas where risk may vary considerably

from situation to situation.

 A goal of FAS 131 was to limit

management discretion in reporting

segments.

Operating Segment

Definition:

 It is a component of the firm that engages in business

activities that earns revenues and incur expenses.

 The entity’s chief operating decision maker regularly

reviews the component’s operating results.

 Discrete financial information is available.









obj 3

Determining Operating

Segments

 Modified management approach

 focus on the way in which management

organizes segments internally to make

operating decisions and to assess

performance









obj 3

A Reportable Segment

3 Rules



1. 10% of Combined Internal &

External Revenues

2. 10% of Reported Income or Loss

3. 10% of Assets







obj 4

Aggregation Criteria

An entity is permitted to aggregate operating segments

which are similar in all the following areas:

 nature of their products or services



 nature of the production process



 types or classes of customers



 methods used to distribute products or provide

services

 nature of regulatory environment









obj 4

Common Cost Allocation -

Which?

 Common costs should be allocated to a

segment for external reporting purposes

only if they are included in the segment’s

internal profit or loss calculations









obj 5

Common Cost Allocation -

How? Steps

 Joint costs are accumulated into logical and

relatively homogeneous expense pools

 The pools are allocated to segments on the

basis of beneficial or casual relationships as

measured by activity or output of the

segments









obj 5

Common Cost Allocation -

How?

Joint

costs





Centralized

Expense Data processing warehouse

pools expenses expenses









Segments



obj 5

Segmental Disclosure

Requirements

 general information

 segment operating profit or loss

 segment assets

 bases for measurement

 reconciliation of segment amounts

and consolidated amounts for

 revenue

 profitor loss

 assets

 other significant items







obj 6

 interim disclosures

 enterprisewide disclosures

 product or service



 geographic area



 major customers - each customer representing

10% or more of total enterprise revenues

 methods of presentation

 financial statements



 footnotes to the financial statements



 separate schedule







obj 6

Quantitative Thresholds

A segment is a reportable segment if :

 its combined external and internal revenue > 10% of the

combined external and internal revenue of all reportable

segments;

 its reported profit or loss > 10% of the total gross profit

(loss) of all operating segments reporting a profit (loss);

or

 its assets > 10% of combined assets of all operating

segments







obj 4

75% Combined Revenue Test

Combined sales to

unaffiliated customers of all

reportable segments Must be



> 75%

Combined sales to

unaffiliated customers of all

operating segments





If the 75% test is not met, additional segments must be identified

obj 4

Geographic Area



 operations in foreign countries should be

grouped on the basis of

 proximity

 economic affinity

 similarities of business environments

 nature, scale, and degree of

interrelationship of the operations in the

various countries





obj 7

Major Customers

 Purpose: To provide information about dependency

on one or more major customers

 Disclosure requirement

 each customer representing 10% or more of total

enterprise revenues

 customers who are federal, state, local, or foreign

government

 amount of sales



 segment making the sales





obj 8

Costs of Segmental Reporting



 Compiling,processing, and disseminating

information

 Alerting existing or potential competitors

 Potentially misleading to third parties.

The disclosure of segmental information

implicitly assumes that the segments

reported are relatively autonomous and

independent of each other. This means

that the figures reported for any one

segment can be assessed

independently.

 If the company is highly integrated,not

only are relatively large transfers

between the segments likely, but the

segment results cannot be understood or

considered in in isolation from the rest of

the company.

 Whether this is actually a problem is

difficult to assess

Issues and Problems



 Segment identification

 Cost Allocations

 Intragroup transfers

 Transfer Pricing

 To what extent are corporate concerns

that segmental reporting will give rise to

competitive disadvantage likely to be

justified?

 If the risks of operating in a foreign

country, for example, Russia, are high,

should MNEs be required to disclose

information about the operations and

assets involved even if they comprise a

relatively minor part of the total

(e.g.,5%)?

 Is it possible to rely on international

capital markets pressures to stimulate

the disclosure of useful segmental

information by multinational enterprises

or is more focused and detailed

regulation necessary?