Segment Reporting: Its History and Trend

Joyce Wong San Francisco State University

Introduction As a result of a substantial increase in merger activities and foreign operations, the importance attached to segmental disclosure becomes more significant nowadays in the evaluation of a firm's profitability, opportunities for growth, and types of risk. Thus, most financial statement users agree that, although consolidated financial information is important, it is more useful if supplemented with disaggregated information that provide information about the various segments of an enterprise or affiliated group of companies. Recognizing the importance of segment data, the Financial Accounting Standard Board (FASB) has continuously paid effort in issuing and modifying the standards for Segment Reporting. And meanwhile, the International Accounting Standard Board (IASB), as part of the attempt to converge International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (US GAAP), it has announced starting from January 1st 2009 that it would adopt the same management approach to reporting on the financial performance of its

operating segments as is required by the US GAAP. In my paper, I will investigate the history of Segment Reporting, the argument against segmental disclosure, the controversy related to the adoption of the US GAAP approach to Segment Reporting by IASB, and end with recommendations on how to improve the existing standards in the future.

[GUR00][GUR00][GUR00]History of Segment Reporting (1) Statement of Financial Accounting Standards (SFAS) No. 14 (http://www.nysscpa.org/cpajournal/1998/0598/features/f460598.htm) In 1976, FASB issued SFAS No. 14, Financial Reporting for Segments of a Business Enterprise in response to several calls by groups such as the Financial Analyst Federation, Financial Executive Institute, National Association of Accountants, the Accountants International Study Group, and New York Exchange who felt such information is essential to financial statement users. In SFAS No. 14, segments were defined by industry grouping, with specific identification of the relevant industry left to the company. Geographic area financial information was also required. However, the SFAS No. 14 definition of industry segment was not precisely written that many companies did not provide expected segment information by considering themselves a single-segment company. Many complained that the resulting

disclosure were highly aggregated and of limited use for decision-making purpose, SFAS No. 14 was therefore subsequently amended by SFAS No. 21 and later superseded by SFAS No. 131, Disclosures about Segments of an Enterprise and related Information.

(2) SFAS No. 131

FASB issued SFAS No. 131 in 1997, requiring all public companies to report financial and descriptive information about its reportable operating segments. As defined by SFAS No. 131, an operating segment is a component that exhibits all of the following characteristics: It engages in activities that may earn revenues and incur expense. Its operating results is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing its performance. Discrete financial information is available.

After the operating segments are identified, it must subject to the aggregation criteria and quantitative thresholds. The aggregation criteria states that an entity is permitted to aggregate operating segments if the segments are similar in all of the following areas: The nature of the production processes. The nature of the production processes.

The types or class of customers. The methods used to distribute products or provide services. The nature of the regulatory environment. Following the similar segments are aggregated, the segment is determined

reportable if it meets one or more of the following quantitative thresholds: Combined (external and internal) revenue is 10% or more of combined revenue of all reportable segments. Profit or loss is 10% or more of the greater absolute amount of: Combined profit of all segments not reporting a loss. Combined loss of all segments that reported a loss. Assets are 10% or more of the combined assets of all segments.

After passing the quantitative criteria and quantitative thresholds, we have to make sure the combined revenue from sales to unaffiliated customers of all reportable segments must constitute at least 75% of the combined revenue from sales to unaffiliated customers of all operating segments. If the 75% test is not satisfied, additional segments must be identified until the test is met. Required by SFAS No. 131, the information that need to be presented for each of a

firm's reportable segments, and in the aggregate for the segments that are not separately reported are as follows: The factors used to identify reportable segments The types of products and services sold by each segment The basis of organization (such as being organized around a geographic region, product line, and so forth) Revenues Interest expense Depreciation and amortization Material expense items Equity method interests in other entities Income tax expense or income Extraordinary items Other material non-cash items Profit or loss

(3) Does the new standard serves better to the users than the old standard The main difference between SFAS No. 14 and SFAS No. 131 is how segments are defined. SFAS No. 14 was defined by industry grouping of products and services sold to external customers, while SFAS No. 131 adopts a management approach segments are defined in the way how management organize them internally to make operating decisions and to assess performance. As management approach offers less discretion about segment definition and that, as a result, the information provided under SFAS no. 131 would be less subjective than what was provided under the industry approach. Therefore, the new standard has induced more segmentation. In

(http://faculty.chicagobooth.edu/philip.berger/research/published %20papers/Berger_Hann_03_JAR.pdf), it was reported that of the 2,999 firms in the sample, the percentage (number) of multisegment firms increases from 22% (664) under SFAS No.14 to 40% (1,207) under SFAS No.131. Furthermore, about a quarter of the SFAS No.14 single-segment firms become multisegment firms under the new standard. These descriptive results support the findings of previous work using small samples (see Herrmann and Thomas [2000] and Street, Nichols, and Gray [2000]). As the analysts consistently claimed that segment information is the most important details that they are looking for today, the adoption of the new standard is surely a good news to them. A study that investigate whether there was any improvement in analyst forecast accuracy following the release of the first 10-K containing the new segment data. It was found that for the sample of firms that changed their number of reported segments upon restatement, analysts' earnings forecast errors are significantly reduced in the post- SFAS No.131 period. However, as the chief operating decision maker (CODM) at each company can utilize a variety of measure of financial information to make operating decision, segment disclosure can differ. The major criticism of SFAS No. 131 is that these differences is likely to hinder comparability between companies who own similar lines of business within the same industry. Moreover, SFAS No. 131 does not require the measure of segment profit used to be consistent with the assets attributed to the segment (as SFAS No. 14 did), it means for

instance, depreciation expense may be allocated to a segment, but the assets to which the depreciation relates need no be allocated to any segment. Finally, the new standard does not specify the measure of segment profit or loss to be disclosed and allows any measure used internally for decision making to be reported as the segment profit, this will encourage the company to provide misleading information and cherry-pick the data that is to their advantage.

(4) IAS No. 14 to IAS No. 14R The IASB (and previously the IASC) issued IAS No. 14 to require segment information in 1982. It was similar in approach to SFAS No. 14. and require identification of two sets of segments one based on the product/services supplied by the entity and the other based on geographical area. And it was, however, too general in its requirement to be effective as it let the judgement of individual companies to determine whether the segment is significant enough to be reported. Furthermore, according to http://www.nysscpa.org/cpajournal/1998/0598/features/f460598.htm IAS No. 14 was also criticized for: Permitting too many alternative interpretations in a n attempt to accommodate its diverse constituencies. Not Providing sufficiently detailed definition of and guidance for key items

Not requiring the disclosure of additional financial and descriptive data about segments.