Arthur et al. Q11.1 Case for and against segment reporting (Section 11.2)
The case for segment reporting
The core principle of AASB 8 is stated as “to enable users of financial statements to evaluate the nature and financial effects of the business activities in which it engages and economic environment in which it operates”. This information should enable users to better understand the entity’s past performance and assess the entity’s risks and returns.
Many entities provide groups of products and services or operate in geographical areas that are subject to differing rates of profitability, opportunities for growth, future prospects, and risks. Information about an entity’s different types of products and services and its operations in different geographical areas is relevant to assessing the risks and returns of a diversified or multinational entity but may not be determinable from the aggregated data. Therefore, segment information is widely regarded as necessary to meet the needs of users of financial statements.
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Similarly, Para 3 of the United States’ FAS 131 Disclosures about Segments of an Enterprise and Related Information contends that segment information helps financial statement users to:
better understand the enterprise’s performance;
better assess its prospects for future net cash flows;
make more informed judgements about the enterprise as whole.
The substance of these contentions is that “knowing the parts can lead to a better understanding of the whole”. A diversified enterprise (or group) is the sum of several parts and these parts are subject to different rates of profitability, degrees and types of risk, and opportunities for growth. Segment reporting is useful because it provides a layer of information on the risk and return characteristics of the enterprise that is otherwise subsumed in the consolidated data. Accordingly, segment information is relevant to the economic decision making of financial report users.
The case for the disclosure of segment information is supported by a body of empirical evidence that indicates that segment information:
Has improved the accuracy of consolidated sales and earnings forecasts and can reduce the cost of capital of an entity (see Mohr and Pacter, 1993);
Reduces information asymmetry (Greenstein and Sami, 2004); and
Is perceived by analysts to be relevant to forecasting (Mande and Ortman 2002).
More recent research (see Nichols et al. 2013 for a review) provides general support for these earlier findings but does indicate that the benefits of the management approach to segment reporting will vary across jurisdictions due to institutional differences (e.g., levels of enforcement, sophistication of markets) among other factors.
References
Greenstein, M and Sami, H 1994, ‘The impact of the SEC’s segment disclosure requirement on bid-ask spreads’, The Accounting Review, 69(1), pp. 179–99.
Mande, V and Ortman, R 2002, ‘Are recent segment disclosures of Japanese firms useful? Views of Japanese financial analysts’, The International Journal of Accounting, 37(1), pp. 27–46.
Mohr, R and Pacter, P 1993, ‘Review of related research’, Reporting Disaggregated Information, Financial Accounting Standards Board Research Report, FASB, Connecticut, February.
Nichols, NB,Street,DL and Tarca, A 2013, ‘The impact of segment reporting under the IFRS 8 and SFAS 13 management approach: a research review’, Journal of International Financial Management and Accounting, 24(3), pp. 261–312.
The case against segment reporting
The traditional arguments against segment reporting are summarised by Miller and Scott (1980) as follows.
Investors in the parent entity of a group do not invest in individual segments so segments are not the accounting entities of interest.
Segment data is difficult to interpret and may confuse users.
Segment data involves numerous judgements in the determination of reportable segments and arbitrary allocations in the determination of segment assets and segment expenses. Therefore, segment information fails the qualitative characteristic of reliability (refer to the AASB Framework for the Preparation and Presentation of Financial Statements paras 31 and 32).
Segment data is not comparable as different entities measure segment results in different ways. Hence, segment data fails the test of comparability (Framework paras 39–42).
Segment reporting may act to stymie corporate innovation because managers may shy away from investment in products or markets that will result in initial losses that must be separately disclosed.
Segment reporting requires the disclosure of politically or commercially sensitive information that will cause proprietary costs to the entity. For example, if a particular line of business is shown to have ‘high profits’, this may prompt new competitors to enter the industry or lead to greater wage claims from workers in that line of business.
The cost of compiling segment information outweighs any perceived benefits. Reference
Miller, MC and Scott, MR 1980, ‘Financial reporting by segments’, Discussion Paper No. 4, Australian Accounting Research Foundation, Melbourne.
Looking at the above arguments together
Investors need information on individual segments so they can properly assess the performance of the group as portrayed in the consolidated data.
Segment data may not be easily understood by lay people but is welcomed by analysts that provide investment services to lay people.
Segment data is not unique in accounting for its reliance on professional judgement in respect of classifications and cost allocations.
Investors as a group are sophisticated and look beyond short-term losses on start-up projects in their assessment of management performance.
Single-segment enterprises cannot hide the financial performance and financial position of their segment so why should multi-segment enterprises be so allowed?
The use of the internal management and reporting structure as the basis of identifying reportable segments should mean that internal segment information is often readily available and will require only minimal adjustment before being presented as the external segment information.
Notwithstanding these counterarguments, some respondents to the IASB’s post- implementation review of IFRS 8 (IASB, 2013) did continue to express concerns that the judgements made by management in determining segment disclosures resulted in difficulties in comparing segments across entities. These respondents suggested one reason for this situation was that some firms did not provide clear information about how segments were determined or measured. Regulators, such as the Australian Securities and Investments Commission, have regularly criticised the transparency of information about how the bases on which companies’ segment reporting disclosures are determined.
Comparison of the purposes of consolidation accounting and segment reporting
Consolidation accounting involves an aggregation process that reports financial information for a group of related entities as if they were a single entity. By contrast, segment reporting for diversified economic entities involves the disaggregation of consolidated financial information into business and geographical segments based on the internal reporting system.
Arthur et al. Q11.10 Segment accounting policies (Section 11.4)
What comprises segment accounting policies?
Segment accounting policies represent the basis for measuring operating performance, assets and liabilities (if applicable) for the operating segments of a business. This can include policies in relation to:
Pricing of goods and services for transactions between reportable segments;
The measure of operating performance (earnings before interest and tax [EBIT],
earnings before interest, tax, depreciation and amortisation [EBITDA] etc.);
Which expenses to allocate to operating segments;
Whether to exclude unusual or non-recurring items.
How management can use segment accounting policies to influence reported results
Given the movement to the ‘management approach’ to segment reporting, management does not have to use Generally Accepted Accounting Principles (GAAP) to measure segment operating results. Managers could use segment accounting policies in the following ways:
Combine internally reported business segments or geographical segments to minimise the level of detail provided;
Make revenue, expense, asset and liability allocations that are biased towards one or another operating segment in order to manage the financial position and financial performance reported of that segment;
Group together operating segments with similar economic characteristics to minimise the level of detail provided.
Some respondents to the IASB’s post-implementation review of IFRS 8 expressed concern that such practices were difficult to identify.
Incentives for opportunistic management behaviour
Some managers may decide that it is in the best interests of shareholders to minimise the disclosure of information with respect to the financial performance and financial position of certain operating segments or geographic regions. The main incentives are likely to be:
Detailed disclosures of revenues and profits in some lines of business or geographic regions which might attract political costs or the ire of ‘green’ investment funds (e.g., investment in tobacco growing);
The disclosure of good rates of return in certain lines of business (i.e., segment result/segment assets) may attract new market entrants leading to more price competition and the decline in those rates of return;
The disclosure of revenue and profit results in certain lines of business or geographical regions may convey strategic information to competitors about product pricing, product development or market share.
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