International Financial Reporting Standards require that publicly

International Financial Reporting Standards require that publicly traded companies provide segment information based on the management approach. An operating segment must engage in activities that generate revenue and incur expenses, and discrete information is available that is regularly reviewed by the chief operating decision maker. If an operating segment meets specific criteria then it is reportable and disclosed in the notes to the financial statements.

Instructions

(a) What does financial reporting for segments of a business enterprise involve?

(b) What are the reasons for requiring financial data to be reported by segments?

(c) What are the possible disadvantages of requiring financial data to be reported by segments?

(d) What accounting difficulties are inherent in segment reporting?

(a) Financial reporting for segments of a business enterprise involves reporting financial information on a less-than-total enterprise basis. These segments may be defined along organizational lines, such as divisions, branches, or subsidiaries. Segmentation could be based on areas of economic activity, such as industries in which the enterprise operates, product lines, types of services rendered, markets, types of customers, or geographical areas. In addition to these possible individual definitions of an enterprise’s segments, a company may use more than one of the above-cited bases of segmentation.

(b) The reasons for requiring financial data to be reported by segments include the following:

    1.  They would provide more detailed disclosure of information needed by investors, creditors, and other users of financial statements.

    2.  Appraisers can evaluate major segments of a business enterprise before considering the business in its entirety.

    3.  In addition to being useful and desirable, such information is practical to compute.

    4.  The growth potential of an enterprise can be evaluated by reviewing the growth potential of its major segments.

    5.  Users can better assess management’s decisions to drop or add a segment.

    6.  Projection of future earnings power is made more effective when approached on a segment basis because different segments may have differing rates of growth, profitability, and degrees of risk.

    7.  Managerial ability is better assessed with segment data because managerial responsibility within the enterprise is frequently decentralized.

(c) The possible disadvantages of requiring financial data to be reported by segments include the following:

    1.  They could be misinterpreted due to the public’s general lack of appreciation of the limitations of the somewhat arbitrary bases for most allocations of common costs.

    2.  They may disguise the interdependence of all the segments.

    3.  They might result in misleading comparisons of segments of different enterprises.

    4.  Confidential information would be revealed to competitors about profitable or unprofitable products, plans for new products or entries into new markets, apparent weaknesses that might induce competitors to increase their own efforts to take advantage of the weakness, and the existence of advantages not otherwise indicated.

    5.  Information thus made available might cause customers to challenge prices, to the disadvantage of the company.

    6.  Operating data reported by segments might be misleading to those who read them. Segment data prepared for internal management purposes often include arbitrary judgments that are known to those using the data and taken into account in making evaluations. The difficulty of making such background information available and understandable to outside users is con­sidered by many to be insurmountable.

    7.  Uniform reporting categories would be established that might call for additional expense in recording and reporting, and that, because arbitrarily defined, might not fairly represent the operations of the enterprise as a going concern. Some fear that establishment of arbitrary reporting requirements might in turn lead to arbitrary rules for business activities in order to make the required reporting possible.

(d) The accounting difficulties inherent in segment reporting include the following:

    1.  The basis of segmentation must be established. [The various possible bases were cited in answer (a), above.]

    2.  The transfer prices must be determined. Transfer prices are those charged when one segment deals with another segment of the same enterprise. Various possible transfer prices exist, and the company must select one.

    3.  The method of reporting segment sales must be defined. A company may or may not include inter-company transactions with other segments within the enterprise in its sales.

    4.  The computation of segment net income must be defined. The net income may be merely a contribution margin; that is, sales less variable costs or a more conventional measure of net income. If a contribution-margin approach is used, the variable costs must be identified. If a more conventional measure of net income is used, the treatment of various items for each segment’s net income must be established. Such items include the following:

        a.  Determining whether common costs should be allocated to segments.

        b.  Selecting allocation bases if common costs are to be allocated.

        c.  Determining which costs of capital (interest, preferred dividends, etc.) should be attributed to segments.

        d.  Determining whether extraordinary items should be attributed to segments.

        e.  Determining how income tax should be allocated to segments.

        f.  Determining how a minority interest’s share of income, and income from investee companies, should be attributed to segments.

    5.  The segment information to be reported, relating to a balance sheet and statement of cash flows, must be established. This includes allocation of assets to various segments.

    6.  The treatment of segment information in interim financial reports must be established.

    7.  The method of presenting segment information in financial statements must be established. Such presentation may be by notes or by separate financial statements.

    8.  The additional disclosures required, such as accounting policies used, must be established.

    9.  The effect of annual comparisons must be considered. This would entail retroactive restatement of previously reported segment information presented currently for comparative purposes.