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Chapter Outline
III. In response to the demand by financial analysts for improvements in segment reporting,
the FASB issued Statement 131, Disclosures about Segments of an Enterprise and
Related Information in June 1997.
A. SFAS 131 adopts a management approach in which segments are based on the way
that management disaggregates the enterprise for making operating decisions; these
are referred to as operating segments.
B. Operating segments are components of an enterprise which meet three criteria.
1. Engage in business activities and earn revenues and incur expenses.
2. Operating results are regularly reviewed by the chief operating decision-maker to
assess performance and make resource allocation decisions.
3. Discrete financial information is available from the internal reporting system.
C. Once operating segments have been identified, three quantitative threshold tests are
then applied to identify segments of sufficient size to warrant separate disclosure. Any
segment meeting even one of these tests is separately reportable.
1. Revenue testsegment revenues, both external and intersegment, are 10 percent
or more of the combined revenue, external and intersegment, of all reported
operating segments.
2. Profit or loss testsegment profit or loss is 10 percent or more of the greater (in
absolute terms) of the combined reported profit of all profitable segments or the
combined reported loss of all segments incurring a loss.
3. Asset testsegment assets are 10 percent or more of the combined assets of all
operating segments.
V. To provide investors and creditors with more timely information than is provided by an
annual report, the U.S. Securities and Exchange Commission (SEC) requires publicly
traded companies to provide financial statements on an interim (quarterly) basis.
A. Quarterly statements need not be audited.
VI. APB Opinion No. 28 requires companies to treat interim periods as integral parts of an
annual period rather than as discrete accounting periods in their own right.
VII. FASB Statement No. 154, Accounting Changes and Error Corrections, provides
guidance for reporting changes in accounting principles including those made in interim
periods.
A. Unless impracticable to do so, an accounting change is applied retrospectively, that
is, prior period financial statements are restated as if the new accounting principle
had always been used.
B. When an accounting change is made in other than the first interim period, information
for the interim periods prior to the change should be reported by retrospectively
applying the new accounting principle to these pre-change interim periods.
C. If retrospective application of the new accounting principle to interim periods prior to
the change of change is impracticable, the accounting change is not allowed to be
made in an interim period but may be made only at the beginning of the next fiscal
year.
VIII. Many companies provide summary financial statements and notes in their interim reports.
A. APB Opinion No. 28 imposes minimum disclosure requirements for interim reports.
1. Sales, income tax, extraordinary items, cumulative effect of accounting change,
and net income.
2. Earnings per share.
3. Seasonal revenues and expenses.
4. Significant changes in estimates or provisions for income taxes.
5. Disposal of a business segment and unusual items.
6. Contingent items.
7. Changes in accounting principles or estimates.
IX. Four items of information must also be disclosed by operating segment in interim financial
statements: revenues from external customers, intersegment revenues, segment profit or
loss, and, if there has been a material change since the annual report, total assets.
Learning Objectives
Having completed Chapter 8 of this textbook, Segment and Interim Reporting, students
should be able to fulfill each of the following learning objectives:
1. Identify the financial analysis problems associated with consolidated financial statements.
2. Discuss the method by which an enterprise determines its operating segments and the
factors that influence this determination.
3. Identify and apply the three tests that are used to determine which operating segments
are of significant size to warrant separate disclosure.
5. Describe the various limitations within which the number of separately disclosed operating
segments should fall.
7. Explain when and what types of information about geographic areas must be disclosed.
8. Describe the criterion by which sales to a single unaffiliated customer are measured to
determine whether disclosure is required.
9. Explain the "integral" approach followed in preparing interim reports and distinguish it from
the "discrete" approach.
10. Describe and apply procedures used in interim reports for LIFO liquidations, costs
associated with more than one interim period, income taxes, and accounting changes.
11. List the minimum disclosure requirements for interim financial reports.
In his well-publicized The Numbers Game speech delivered in September 1998, former SEC
chairman Arthur Levitt cited materiality as one of five gimmicks used by companies to
manage earnings. Although his remarks were not specifically directed toward the issue of
geographic segment reporting, the intent was to warn the corporate America that materiality
should not be used as an excuse for inappropriate accounting. To make the point even more
salient, the SEC issued Staff Accounting Bulletin (SAB) 99, Materiality, in August 1999, which
warns financial statement preparers that reliance on a simple numerical rule of thumb, such as
5% of net income, is not sufficient. SAB 99 reminds financial statement preparers that:
The omission or misstatement of an item in a financial report is material if, in the light of
surrounding circumstances, the magnitude of the item is such that it is probable that the
judgment of a reasonable person relying upon the report would have been changed or
influenced by the inclusion or correction of the item.
Further, SAB 99 reminds companies that both quantitative and qualitative factors should be
considered in determining materiality. With respect to segment reporting, SAB 99 states:
The materiality of a misstatement may turn on where it appears in the financial statements.
For example, a misstatement may involve a segment of the registrant's operations. In that
instance, in assessing materiality of a misstatement to the financial statements taken as a
whole, registrants and their auditors should consider not only the size of the misstatement but
also the significance of the segment information to the financial statements taken as a whole.
"A misstatement of the revenue and operating profit of a relatively small segment that is
represented by management to be important to the future profitability of the entity" is more
likely to be material to investors than a misstatement in a segment that management has not
identified as especially important. In assessing the materiality of misstatements in segment
information - as with materiality generally situations may arise in practice where the auditor will
conclude that a matter relating to segment information is qualitatively material even though, in
his or her judgment, it is quantitatively immaterial to the financial statements taken as a whole.
Thus, in addition to quantitative factors, such as the relative percentage of total revenues
generated in an individual foreign country, companies should consider qualitative factors as
well. Qualitative factors that might be relevant in assessing the materiality of a specific foreign
country include: the growth prospects in that country and the level of risk associated with doing
business in that country.
There are competing arguments for the FASB establishing a significance test for determining
material foreign countries. On one hand, such a quantitative materiality test flies in the face of
the warning provided in SAB 99. For example, a 10% of total revenue or long-lived asset test
might give companies an excuse to avoid reporting individual countries that would be material
for qualitative reasons. Assume that from one year to the next a company increases its
revenues in China from 2% of total revenues to 6% of total revenues. Although 6% of total
revenues would not meet a 10% test, the relatively large increase in total revenues generated
in China could be material in that it could affect an investors assessment of the companys
future prospects. This company might be reluctant to disclose information about its revenues
in China because of potential competitive harm.
On the other hand, the FASB could establish a materiality threshold low enough, for example,
5% of total revenues, that would be likely to ensure that material countries are disclosed
regardless of whether they are material for quantitative or qualitative reasons. A bright-line
materiality threshold would ensure a minimum level of disclosure and would enhance the
comparability of financial disclosures provided across companies.
2. The word disaggregated refers to a whole that has been broken apart. Thus,
disaggregated financial information is the data of a reporting unit that has been broken
down into components so that the separate parts can be identified and studied.
4. Defining segments on the basis of a companys organizational structure will remove much
of the flexibility and subjectivity associated with defining industry segments under SFAS
14. In addition, the incremental cost of providing segment information externally should
be minimal because that information is already generated for internal use. Analysts
should benefit from this approach because it reflects the risks and opportunities
considered important by management and allows the analyst to see the company the way
it is viewed by management. This should enhance the analysts ability to predict
management actions that can significantly affect future cash flows.
The Profit or Loss Test. An operating segment is separately reportable if its profit or loss is
10 percent or more of the greater (in absolute terms) of the combined profits of all
profitable segments or the combined losses of all segments reporting a loss.
The Asset Test. An operating segment is separately reportable if its assets comprise 10
percent or more of combined assets of all operating segments.
9. If operating segments are not based upon products or services, or a company has only
one operating segment, then revenues from sales to unaffiliated customers must be
disclosed for each of the companys products and services.
10. Information must be provided for the domestic country, for all foreign countries in which
the company generates revenue or holds assets, and for each foreign country in which
the company generates a material amount of revenues or has a material amount of
assets.
11. Two items of information must be reported for the domestic country, for all foreign
countries in total, and for each foreign country in which the company has material
operations: (1) revenues from external customers, and (2) long-lived assets.
12. The minimum number of countries to be reported separately is one: the domestic country.
If no single foreign country is material, then all foreign countries would be combined and
two lines of information would be reported; one for the United States and one for all
foreign countries. SFAS 131 does not provide any guidelines related to the maximum
number of countries to be reported.
13. The existence of a major customer and the related amount of revenues must be disclosed
when sales to a single customer are 10 percent or more of consolidated sales.
14. U.S. publicly traded companies are required to prepare quarterly financial reports to
provide investors and creditors with relevant information on a more timely basis than is
provided by an annual report.
15. Companies are required to follow an "integral" approach in which each interim period is
considered to be an integral part of an annual accounting period, rather than a "discrete"
accounting period in its own right. For several items, the integral approach requires
deviation from the general rule that the same accounting principles used in preparing
annual statements should also be used in preparing interim statements.
16. Cost-of-goods-sold should be adjusted in the interim period to reflect the cost at which the
17. Income tax expense related to interim period income is determined by estimating the
effective tax rate for the entire year. That rate is then applied to the cumulative pre-tax
income earned to date to determine the cumulative income tax to be recognized to date.
The amount of income tax recognized in the current interim period is the difference
between the cumulative income tax to be recognized to date and the income tax
recognized in prior interim periods.
18. When an accounting change occurs in other than the first interim period, information for
the pre-change interim periods should be reported based on retrospective application of
the new accounting principle. If retrospective application of the new accounting principle
to pre-change interim periods is not practicable, the accounting change may be made only
at the beginning of the next fiscal year.
20. Four items of segment information are required to be included in interim reports: revenues
from external customers, intersegment revenues, segment profit or loss, and total assets if
there has been a material change in assets from the last annual report.
1. D
2. C
3. A
4. C
5. B
6. D
7. C
8. A
9. B
10. B
11. C
12. C
13. C With regard to major customers, SFAS 131 only requires disclosure of the
total amount of revenues from each such customer and the identity of the
segment or segments reporting the revenues.
14. D
15. A
16. C
17. D
18. C If there has been a material change from the last annual report, total
assets, but not individual assets, for each operating segment must be
disclosed.
21. D Total operating losses of $1,020,000 (K and M) are larger than total
operating profits of $770,000. Thus, based on the 10 percent criterion, any
segment with a profit or loss of $102,000 or more must be separately
disclosed. K, O, and P do not meet that standard while L, M, and N do.
Asset Test
Combined segment assets $67,500,000
10% criterion x 10%
Minimum $ 6,750,000
23. D
24. B The test to verify that a sufficient number of industry segments is being
Any segment with an absolute amount of profit or loss greater than or equal
to $78,000 (10% x $780,000) is separately reportable. Based on this test, each
of the four segments must be reported separately.
This test is based on the greater (in absolute amount) of total profit from
profitable segments or total loss from segments with a loss. In this case,
any segment with profit or loss greater than or equal to $26,200 (10% x
$262,000) is separately reportable.
None of the individual foreign countries meets either the revenue or long-
lived asset materiality test, so no foreign country must be reported
separately. However, information must be presented for the United States
separately and for all foreign countries combined.
38. (15 minutes) (Treatment of Accounting Change Made in Other than First
Interim Period)
Retrospective application of the FIFO method results in the following
restatements of income for 2008 and the first quarter of 2009:
2008 2009
Net income in the second quarter of 2009 is $4,560 [$20,000 9,000 3,400 =
$7,600 3,040 (40%) = $4,560].
The accounting change is reflected in the second quarter of 2009, with year-
to-date information, and comparative information for similar periods in 2008
as follows:
This assignment requires the student to select a company and find the note
on operating segments in that companys annual report. The responses to
this assignment will depend upon the company selected by the student for
analysis.
This assignment requires students to select a company, find the most recent
quarterly report for that company, and then determine whether the company
provides the minimum disclosure required by APB Opinion 28 as listed in the
text. The responses to this assignment will depend upon the company
selected by the student for analysis.
The only geographic area that can be directly compared across these four
pharmaceutical companies is the United States. Bristol-Myers Squibb
provides more detailed (and perhaps more useful) information than the other
companies. Only Merck and Pfizer reports an individual country (Japan)
other than the U.S. Issues that could be discussed include different
quantitative thresholds used by companies in determining what is a material
country, and the fact that disclosure of geographic areas aggregated above
the individual country level (e.g., E/ME/A, Pacific) is not required by SFAS
131. One can assume that Bristol-Myers Squibb does not have a material
amount of revenues or assets in any single country and voluntarily provides
1. Using the advanced query function in FARS to search for the phrase
material seasonal variations returns two hits: APBO 28, paragraph 18,
and the dissent to APBO 28 by one member of the Board.
2. APBO 28, paragraph 18 requires firms with material seasonal variations
to disclose this fact to avoid the possibility that interim results with
material seasonal variations are taken as indicative of the estimated
results for a full year.
1. Using the advanced query function in FARS to search for the phrases
competitive harm and segments returns five hits: FAS 131,
paragraphs 74, 75, 97, 109, and 111.
2. FAS 131, paragraph 109 indicates that concerns were raised about
publicly traded companies being at a disadvantage compared to
nonpublic companies or foreign competitors who do not have to disclose
segment information, and that segment information might put a company
at a disadvantage in price negotiations with customers or in competitive
bidding situations.
3. FAS 131, paragraph 111 indicates that the FASB decided not to provide a
competitive harm exemption because it would provide a means for
noncompliance with FAS 131.
4. FAS 131, paragraph 97 describes three reasons why the FASB decided
not to require the disclosure of research and development expense by
segment. First, it might result in competitive harm by providing
competitors with early insight into a companys strategic plans. Second,
research and development is only one item that indicates where a
company is focusing its efforts and is more significant for some
companies than for others. Third, research and development activities
often are centralized and not allocated to segments.
Analysis Case 1Airline Industry Interim Reporting
The purpose of this assignment is to show how interim reports can provide
more timely information about significant economic events than annual
reports. The responses to this assignment will depend upon the company
selected by the student for analysis. Delta Air Lines, Inc., provided the
following types of information in its interim report for the quarter ended
September 30, 2001.
The income statement reflects the financial impact from the disruption of air
travel subsequent to September 11. Delta experienced a 22% decline in
operating revenues in 3Q 2001 compared to the same quarter in the previous
year, and reported a loss of $259 million in 3Q 2001 as opposed to net
income of $133 for the same quarter in 2000.
Analysis Case 2Wal-Mart Interim and Segment Reporting
Operating income for the quarter ended January 31 can be determined for
each segment by subtracting the amounts reported in the three quarterly
reports from the amounts reported in Note 11.
Wal-Mart SAM'S
Operating Income Stores CLUB International
These results show the seasonal nature of the companys two largest
segments (Wal-Mart and International), with the quarter ended January 31
generating a larger amount of operating income.
These results indicate that profit margins are highest in the fourth quarter
of the year, the quarter with the largest percentage of total sales.
These results indicate that Wal-Mart Stores by far is the most profitable
segment for the Wal-Mart Company. Although the International segment
has a reasonable Operating Profit Margin, that segments Return on
Assets is very low. Return on Assets must be interpreted with caution,
however, because the ending balance in Total Assets is used in the
denominator of the ratio rather than the average amount of Total Assets
for the year. The International segments Return on Assets (6.46%) is
understated to the extent that a significant portion of Total Assets were
acquired late in the year.
Excel Case 1Altria Group Operating Segment Information
1. The ratios required to be calculated for Altria Group, Inc. are as follows:
East, South Asia, and Pacific Rim is the only area in which the company
has experienced a decline in revenues in 2004 and 2005. This is the
region in which the company has the smallest percentage of total
revenues and it also is the area with the smallest profit margin (in 2005).
Perhaps this is the area in which the company should concentrate its
efforts, especially because the company does not appear to be very
successful there.