Segmental Reporting

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Segmental Reporting

• OK, weve been looking at the consolidation of
  information and the disclosure of intangible
  assets. Is consolidated data always appropriate?

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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?)

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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.

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• 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)

5
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???

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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?

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• 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?)

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• Employees
• Evaluation of performance
• Negotiate contracts
• Comparison of intra-company compensation and
  benefits
• Creditors
• Assessment of Risk
• Analysis of Debt Covenants

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• Host Countries
• Determine economic position of country
• Allow comparisons of compensation, working
  conditions, and tax base.
• Calculate tax (income, sales, franchise,
  employment, equity)

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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.

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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.

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Cost/Benefit

• Do costs of compiling, processing, and
  disseminating information exceed benefits?
• Internal costs
• Benefits competition
• Investor evaluation

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Regulation

• International Proper complianceand restatement
  of unsatisfactory statementsmay 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)

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• 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.

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• 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.

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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)

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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

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• 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

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• 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.

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• Only if internal segments arent along either
  product/service or geographical lines is further
  disaggregation appropriate. This is a
  management approach to segment definition.
• Through the eyes of management

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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.

22

• The enterprise should determine whether business
  or geographical segments are to be used for its
  primary segment reporting format based on whether
  the enterprises risks and returns are affected
  predominantly by the products and services it
  produces or by the fact that it operates in
  different geographical areas.

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• The basis for identification of the predominant
  source and nature of risks and differing rates of
  return facing the enterprise will usually be the
  enterprises internal organizational and
  management structure and its system of internal
  financial reporting to senior management.

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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

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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

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• Never construct segments solely for external
  reporting purposes
• 10 materiality thresholds
• Segments must equal at least 75 of consolidated
  revenue

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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

28

• 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.

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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.

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• 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

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• 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.

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• 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.

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• A goal of FAS 131 was to limit management
  discretion in reporting segments.

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Operating Segment

• Definition
• It is a component of the firm that engages in
  business activities that earns revenues and incur
  expenses.
• The entitys chief operating decision maker
  regularly reviews the components operating
  results.
• Discrete financial information is available.

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Determining Operating Segments

• Modified management approach
• focus on the way in which management organizes
  segments internally to make operating decisions
  and to assess performance

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A Reportable Segment
3 Rules

• 10 of Combined Internal External Revenues
• 10 of Reported Income or Loss
• 10 of Assets

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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

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Common Cost Allocation - Which?

• Common costs should be allocated to a segment for
  external reporting purposes only if they are
  included in the segments internal profit or loss
  calculations

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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

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Common Cost Allocation - How?
Joint costs
Centralized warehouse expenses
Data processing expenses
Expense pools
Segments
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Segmental Disclosure Requirements

• general information
• segment operating profit or loss
• segment assets
• bases for measurement
• reconciliation of segment amounts and
  consolidated amounts for
• revenue
• profit or loss
• assets
• other significant items

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• 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

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Quantitative Thresholds

• A segment is a reportable segment if
• its combined external and internal revenue gt 10
  of the combined external and internal revenue of
  all reportable segments
• its reported profit or loss gt 10 of the total
  gross profit (loss) of all operating segments
  reporting a profit (loss) or
• its assets gt 10 of combined assets of all
  operating segments

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75 Combined Revenue Test

• Combined sales to unaffiliated customers of all
  reportable segments

Must be
gt 75
Combined sales to unaffiliated customers of all
operating segments
If the 75 test is not met, additional segments
must be identified
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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

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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

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Costs of Segmental Reporting

• Compiling,processing, and disseminating
  information
• Alerting existing or potential competitors

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• 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.

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• 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

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Issues and Problems

• Segment identification

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• Cost Allocations

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• Intragroup transfers
• Transfer Pricing

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• To what extent are corporate concerns that
  segmental reporting will give rise to competitive
  disadvantage likely to be justified?

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• 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)?

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• 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?