7
The birth and dissemination of segment reporting
1.1. Why does segment reporting exist?
The need for a segment of a larger group of companies. Thus, it became evident in the
consolidated financial reporting alone
5
. The international accounting standard setters,
FASB and IASB, to tackle this problem economic environments in which it operates”
6
.
From the company's point of view, the motive to disclose segment information derives
from the agency theory perspective, and its primary aim is to facilitate investors' earnings
predictions. When a company has diversified into segments Whose profits do not
correlated with each other, consolidated information does not Provide useful information
for investors for earnings forecasts purpose
7
. Companies, however, wish to overcome this
problem and include segment information in their financial statements because it reduces
information between company owners and managers, and therefore lowers the cost of
equity capital
8
.
Indeed, segment reporting Has Been developed as one of the specific disclosures required
in the financial statements Particularly intended for investors' use. When segmental
reporting is high quality, financial statement users can identify risk and return profiles of
different segments, and therefore better understand the organization as a whole
9
. Segment
reporting should reveal companies' diversification strategies and its transfers of resources
across its segments
10
. In a nutshell, useful segment reporting reveals dissimilarities in the
company to its investors
11
.
It is self-evident that they consider information segment as one of the most valuable
pieces of information for their decision-making
12
. For instance, in their survey of 140
sell-side analysts, Epstein and Palepu (1999) found that segment data is the most useful
for investment decisions. Segment information was found to provide the analysts with
additional insight into the past and future operating performance of both the company and
5
Epstein & Jermakowicz 2008, Troberg 2007
6
FASB 1997
7
Aitken et al. 1997
8
Yoo & Semenenko 2012
9
Troberg et al. 2010
10
Berger & Hann 2007
11
Troberg et al. 2010
12
Yoo & Semenenko 2012
8
a whole and by segment. Indeed, 93% of survey respondents claimed that they would
prefer even more complete disclosure of product line and segment profitability.
1.2. The segment reporting in the US Accounting Principles
In the United States, both academically and professionally, is from the second half of the
1960s that the inadequacy of the budgets of diversified companies was felt in order to
make an accurate assessment of their past performance and future prospects.
And ' so that the' Accounting Principles Board (APB) of ' American Institute of Certified
Accountants (AICPA) public in 1967, the Statement 2 "Disclosure of Supplemental
Financial Information by Diversified Companies"
13
.
Precisely because it is not an APB Opinion , but only a statement is only stimulated the
disaggregation of the budget data , by identifying the information that should be
published; on the contrary a precise definition of elementary component of the diversified
enterprise is not elaborated , nor is the concept of quantitative relevance defined .
It is between 1969 and 1970 that the Securities and Exchange Commission (SEC) turns
around. The SEC, more precisely, requires the separate presentation, for each line of
business and class of similar goods / services, of the revenues, the pre-tax result, the
extraordinary income components , but also the criteria followed both for the allocation
of common costs , which for the determination of the intra-segment transfer prices . The
absolute novelty is the provision of a 10% materiality threshold.
The same Commission suggests examining some elements of great importance, such as
the return, the risk and the growth opportunities characterizing the various components
of the diversified business activity, but without providing specific guidelines in this
regard.
However, the SEC's forecasts are characterized by the generality and discretion that
distinguishes them
14
.
13
ANGIOLA N., Imprese diversificate e informativa settoriale, Torino, Giappichelli, 2004
14
ANGIOLA N., Imprese diversificate e informativa settoriale, Torino, Giappichelli, 2004.
9
1.2.1 Statement of Financial Accounting Standard N. 14
It is in this context that the Financial Accounting Standard Board starts work that will
lead to the issue in 1976 of the first US accounting standard on the subject, the Statement
of Financial Accounting Standards (SFAS) 14, Financial Reporting for Segments of a
Business Enterprise
15
.
Following the issuance of SFAS 14, companies must disclose separately information
regarding the various industry segments in which they have operated, foreign
transactions, exports and the most important customers. These industry segments are
defined by SFAS 14 as " a component of the company that produces goods / services or
a group of connected goods / services, to be allocated mainly to customers who are
outside the company, to obtain of a profit
16
".
For the identification of the sectors subject to external presentation, or reportable, it is
required to contemplate a series of phases:
▪ The identification of the individual goods / services that generate the company's
revenues;
▪ Grouping, for subsequent levels of approximation, in industry segment;
▪ Selection, on the basis of very specific criteria, segments that appear relevant from a
quantitative point of view
17
.
The process of grouping goods and services is based on three fundamental criteria:
▪ "Nature of the product": the goods and services aimed at the same uses have close
links and similarities in terms of risks, profitability and growth opportunities;
▪ "Nature of production processes": the goods and services for which the same
workforce, the same equipment, the same raw material, etc. are used, can be
considered connected;
15
FINANCIAL ACCOUNTING STANDARDS BOARD, SFAS 14, Financial Reporting for Segments of a Business Enterprise, FASB, Stamford,
Connecticut, 1976.
16
SFAS 14, par. 10a of the Definitions section
17
SFAS 14, par. 9, 11
10
▪ "Markets or marketing methods": the goods and services offered in the same
geographical areas, to the same type of customer, for which the same sales staff is
employed, etc.., may present affinity links.
The accounting standard specifies that some typical classifications of economic activities,
processed by specific governmental bodies (for example, the Standard Industrial
Classification - SIC and the Enterprise Standard Industrial Classification - ESIC)
18
, can
help the drafter of the budget in the process aimed at identifying the different industry
segments within the company.
With reference to quantitative significance, SFAS 14 indicates a 10% threshold in relation
to revenues (internal and external), identifiable assets and results. Specifically, a segment
is considered relevant if the revenues or activities that distinguish it are at least 10% of
the corresponding values of all segments, or when the result in absolute value is at least
10% of the overall result of all sectors in profit or the overall result of all sectors at a loss,
whichever is greater in absolute term
19
. The segments subject to external presentation via
the financial statements must represent at least 75% of total revenues, without considering
internal sale
20
.
The information to be explicit include revenues from sales of goods and services to
customers outside the enterprise and inter-segment, the operating profit or loss,
identifiable assets, capital investment and depreciation
21
.
Regarding information by geographical segments, in the process of grouping countries
into distinct areas, various factors must be considered, such as proximity, the economic
system and the competitive environment, the nature and size of the relationships existing
between operations. carried out in different countries
22
.
These are rather generic elements that give rise to different interpretations.
18
SFAS 14, par. 91-98
19
SFAS 14, par. 15, 103
20
SFAS 14, par. 17-18
21
SFAS 14, par. 22-27
22
SFAS 14, par. 34
11
Also, for the geographical segments, the quantitative relevance threshold of 10% is
applied, comparing exclusively the external revenues and the segment's activities with the
consolidated values.
Exports must always be analysed from the point of view of the producing country, ie as
internal operations. The disclosure framework required is completed with information on
the most important customers and governments, including foreign ones
23
.
The procedure aimed at identifying the segments subject to presentation provided in
SFAS 14 highlights a series of limits:
▪ Failure to provide for the obligation to report the disaggregated information in the
interim financial statements;
▪ Lack of coherence between segment information and those reported in other parts of
the Annual Report;
▪ Significant discretion granted to management, which, for the purpose of avoiding the
external disclosure of "sensitive" information, can, for example, reduce the number
of segments (up to even exhibit only one segment), using more aggregation criteria
generic. This reduces not only the amount of information provided, but also their
significance.
These significant limitations lead the US standard setter to revise SFAS 14, arriving in
June 1997 with SFAS 131, Disclosures About Segments of an Enterprise and Related
Information.
1.2.2 Statement of Financial Accounting Standard N. 131
The SFAS 131 strives to fill the gaps existing in the previous SFAS 14. In the new
standard, the identification of the sectors follows the so called. “Management approach”
and is based on a very precise logical process, focused on the methods according to which
the management structures the company from an organizational point of view, on the one
hand, and on the information that it uses to manage it, from the other
24
.
23
ANGIOLA N., Imprese diversificate e informative settoriale, Torino, Giappichelli, 2004
24
SFAS 131, par. 4- 5
12
In the accounting standard in question, the operating segment is defined as a component
of the company:
▪ Responsible to carrying out certain activities which may result in costs and revenues
(including those related to the operations Interdivisional);
▪ Keeping under constant observation by the subjects who take charge of deciding the
resources that must be destined to the same and to evaluate its performance (Chief
Operating Decision Maker, CODM);
▪ For which separate accounting information is available
25
.
The term Chief Operating Decision Maker does not indicate the "title" that has been
assigned to one or more individuals, but instead refers to a specific "function". The
CODM, in fact, must have special skills, such as the adoption of decisions on the
allocation of resources to the various elementary components of the company and the
evaluation of their performance. This function can be performed by the Managing
Director (CEO) or by a group of subjects that can include the President, the Vice
Presidents and the Finance Director, etc..
26
In order to identify the operating segments, the standard considers the following aspects
to be relevant
27
:
➢ The "nature of the activities" included in each component, in the sense that it must be
sufficiently homogeneous in relation to the subsequent levels of aggregation;
➢ The presence of a "responsible manager" for each member of the company, who, as
the case, may be a President, a Vice President, a Finance Director, etc. The standard
notes that, as a rule, an operating segment is characterized by the existence of a
segment manager, which responds directly to the CODM and interfaces with it to
analyse the performance of the segment, forecasts and objectives;
➢ The "type of information" presented to the Board of Directors, being an expression of
the objectives pursued at the highest decision-making levels.
25
SFAS 131, par. 10
26
SFAS 131, par. 12
27
SFAS 131, par. 13-14
13
The identification of the operating segments is, therefore, consequential
28
.
In companies that have a matrix organization
29
, it may happen that the CODM uses
different classes of disaggregated information, by product lines or geographical areas.
In this case, paragraph 15 of the standard states that the operating segment coincides with
the company component that reflects the goods and services. This assumes that
information regarding products and services is more useful from the perspective of users
of the financial statements.
Furthermore, SFAS 131 asks to highlight separately the components of the company that
are vertically integrated with each other (upstream or downstream), if the CODM analyses
these components analytically, in order to evaluate the performance and the breakdown
of resource
30
. This is an important change from the previous accounting standard,
particularly useful for improving the quality of the information provided, especially for
companies operating in particular sectors, for example the oil sector.
Once the operating segments have been identified, it is necessary to verify if these can be
aggregated. The two aspects that give the possibility to enucleate a segment object of
presentation are the similarity and the dimensional thresholds.
The discharge of any similarities requires the study of operating segments
31
:
▪ From an economic point of view. The segments may have substantial similarity in the
performance of the medium-long term, in cases where present of similar connotations
on the economic side. When expressing an opinion, it is necessary to consider the
trend over time not only of the gross margin, but also of other indicators, such as
turnover, operating cash flows, etc. In fact, two segments may show similarities on an
economic level, despite having average rates of remuneration of different sales.
28
ANGIOLA N., Imprese diversificate e informative settoriale, Torino, Giappichelli, 2004.
29
In matrix-organized enterprises is possible to identify some managers who are responsible for the different product lines at a
global level and others, instead, who deal with well-defined territorial areas. Furthermore, these managers periodically report to
the CODM without any intermediation, which provides to report the two types of information to the Board of Directors. ANGIOLA
N., Imprese diversificate e informativa settoriale, Torino, Giappichelli, 2004.
30
SFAS 131, par. 79-80
31
SFAS 131, par. 17
14
Conversely, management may believe that two segments that have average rates of
return on equal sales are not similar;
▪ From the point of view of the nature of the goods and services provided, the nature of
the production processes, the type of customer served, the methods of distribution of
goods and services, the system of rules that characterizes the reference environment
(rules that regulate banking, insurance, etc.). If an analysis of these aspects gives rise
to a positive judgment regarding the similarity of two or more components, then we
proceed to amalgamation, unless this way of working is not compatible with the basic
rules governing SFAS 131, indicated in paragraphs 3-8 of the accounting principle.
Considering the dimensional aspect, we speak of the reportable segment when at least
one of the following quantitative limits is exceeded
32
:
➢ The revenues of the segment (internal and external) must be equal to at least 10% of
the total revenues of all operating segments, both internal and external;
➢ The result (profit or loss) in absolute value of the segment must correspond to at least
10% of the highest amount, in absolute value , between the total profits made by those
segments that show a positive result and the total losses achieved by those segments
that instead show a negative result;
➢ The assets of the segment must be greater than or equal to 10% of the total assets of
all operating segments.
Furthermore, SFAS 131 requires verification that the total external revenue of the
segments, which exceed the above criteria, are at least 75% of total revenues. If this
threshold is not exceeded, then other operating segments must be identified until the
percentage is integrated
33
.
In this regard it is specified that the operating segments to be identified to reach the 75%
threshold are not the largest of those that had previously been discarded. Therefore, any
segment that does not integrate at least one of the thresholds of which before can become
a reportable segment.
32
SFAS 131, par. 18
33
SFAS 131, par. 20
15
Smaller segments can be treated in three ways:
▪ Posted separately despite the small size;
▪ Merged with other smaller segments in compliance with paragraph 19 of the
accounting principle;
▪ Exposed into a residual voice "All others", or similar name.
To guarantee the comparability over time of segmented information, SFAS 131 requires
to the management, when it seems it to be significant, to present data relating a segment
that is not “accountable”, if it was previously subject to separate disclosure. Conversely,
in the period in which a segment becomes reportable for the first time, for having
exceeded the quantitative relevance thresholds, it is also necessary to reclassify the
corresponding information relating to the previous periods, if this appears feasible
34
.
It is also necessary to consider that when the number of segments becomes very high and,
therefore, the relative information very detailed, practical difficulties may arise. In
particular, it is considered that this circumstance may arise when the company identifies
several reportable segments greater than 10
35
. This threshold, set by SFAS 131, is only
indicative and can be exceeded
36
.
The following diagram illustrates how to apply the main provisions for identifying
reportable operating segments as defined in this Statement. The diagram is a visual
supplement to the written standards section. It should not be interpreted to alter any
requirements of this Statement nor should it be considered a substitute for the
requirements
37
.
34
SFAS 131, par. 22, 23
35
ANGIOLA N., Imprese diversificate e informative settoriale, Torino, Giappichelli, 2004
36
SFAS 131, par. 24
37
Source: FINANCIAL A CCOUNTING S TANDARDS BOARD, SFAS 131, Disclosures about Segments of an Enterprise and Related
Information, FASB, Stamford, Connecticut, 1997, p. 44.
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