Segmental Reporting

1. Segmental Reporting OK, we�ve been looking at the consolidation of information and the disclosure of intangible assets. Is consolidated data always appropriate?

2. 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?)

3. 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.

4. AIMR (1993) �[segment data] is vital, essential, fundamental, indispensable, and integral to the investment analysis process.� A survey of 140 star analysts concludes that a majority considered segment performance data as the most useful data for their investment decisions.

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???

6. 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?

7. 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?)

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

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

10. 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.

11. 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.

12. Cost/Benefit Do costs of compiling, processing, and disseminating information exceed benefits? Internal costs Benefits competition Investor evaluation

13. 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)

14. �For projects on the same subject running in a similar time frame [SFAS No. 131 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.�

15. 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.

16. 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�)

17. 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

18. 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

19. 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

20. Economic and political conditions, proximity of operations, exchange controls and currency risks are among the factors used to distinguish geographic segments. IAS 14 permits firms to define geographic segments on the basis of either the location of the assets (origin of the sales) or the location of its customers (destination of the sales).

21. IAS 14 requires the firm to determine whether its risks and regards are predominantly based on business differences or geographic ones. The dominant factor is used for primary segment reporting, secondary segmentation requires fewer disclosures.

22. Reportable segments under IAS 14 are based on the same quantitative criteria that are used in SFAS 131.

23. Although the IASB expects external segment reporting to be identical to segment disclosures provided to top management, the standard has explicit risks and rewards criteria. This is intended to ensure that segment data reflect the firm�s portfolio of business activities. It is not clear that all firms can use the same disclosures to satisfy both SFAS 131 and IAS 14.

24. Required Disclosure Revenues from external customers Intersegment revenues Interest revenues and expense Depreciation, depletion, and amortization Unusual items (encouraged, not required) Equity in net income and investment in equity method investees

25. Income tax expense Extraordinary items Total segment assets *segment liabilities Additions to long-lived assets *Cash flow components (encouraged, not required) *Not required by SFAS 131

26. In contrast to SFAS 131, all disclosures are required regardless of whether they are included in the measure of profit or loss reported to the chief operating decision maker.

27. 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.

28. 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.

29. Secondary Segments When business segments are primary: Segment revenues from external customers for each geographic segment (based on customer location) Segment assets

30. When geographic segments are primary: Revenues from external customers Segment assets Additions to long-lived assets Some additional disclosures depending on specific nature of segment

31. No interim reporting required for segments.

32. 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

33. 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.

34. 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

35. SFAS 131 Issued in June, 1997. The FASB cooperated with the AcSB of Canada to issue the standard. The IASB was concurrently working on a revision of IAS 14. The two groups reached somewhat different conclusions despite identical stated objectives.

36. SFAS 131 requirements SFAS 131 requires the use of the management approach. That is, segmental information depends on the firm�s internal organization.

37. 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.

38. Operating segment: Engages in activities generating revenues and incurring expenses Whose operating results are regularly reviewed by the enterprises chief operating office For which discrete financial information is available.

39. Reportable Segments Operating segments that report any of: Revenues, including intersegment revenues, of at least 10% of total revenues for all reported operating segments Profit (loss) of at least 10% of the combined profit loss Asset of at least 10% of assets of al operating segments.

40. A reportable segment may aggregate two or more operating segments if their products and services, production processes, type of customer, distribution, and regulatory environments are similar. Reportable segments must total at least 75% of external revenues; if not, additional segments must be reported until that threshold is reached.

41. Required Disclosure 4 types of information: General information about factors used to identify reportable segments A measure of profit and loss for each reported segment. In addition, Revenues from external customers, intersegment revenues, interest revenue and expense, depreciation, depletion and amortization, unusual items, equity in net income and investment in equity method investees, income tax expense, extraordinary items, total segment assets, additions to long-lived assets.

42. Reconciliation of above items to corresponding enterprise amounts Interim period financial statements with specific reportable items

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

44. 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

45. obj 5 Common Cost Allocation - How?

46. obj 4 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

47. obj 4 75% Combined Revenue Test Combined sales to unaffiliated customers of all reportable segments

48. obj 7 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

49. obj 8 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

50. Costs of Segmental Reporting Compiling,processing, and disseminating information Alerting existing or potential competitors

51. 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.

52. 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

53. Issues and Problems Segment identification

54. Cost Allocations

55. Intragroup transfers Transfer Pricing

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

57. 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%)?

58. 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?

59. Impact of SFAS 131 on disclosure quality: Increase the number of reported segments and disaggregated information (Street et al. 1000; Herrmann and Thomas, A.H., 2000; Berger and Hann, JAR, 2003, Ettredge et al., RAST 2006)

60. Improve the information environment 1. Analysts� earnings forecast errors are reduced (Berger and Hann, 2003; Botosan and Stanford, 2005) 2. The earnings response coefficient increased (Ettredge et al. 2005, TAR)

61. Incentives and Disincentives Proprietary cost incentive to conceal Product market competition Barrier to entry

62. Agency cost incentive to conceal Avoid diversification discount

63. Capital market incentives to reveal To increase liquidity and valuation To reduce information asymmetry and lower cost of capital