Segment Reporting, Transfer Pricing and Balanced Score Card - Term Paper Example

Running Head: Financial and Management Accounting Segment Reporting, Transfer Pricing and Balanced Score Card Student Name Student ID Number Professor’s Name Institution Submission Date Table of Contents Table of Contents 2 1.0 Executive Summary 3 2.0 Introduction 4 3.0 Segment Reporting 4 3.1 Why Segment Information is important 4 3.2 Profitability level and Segment disclosure choices 6 3.2.1 Abnormal profitability and the rate of adjustment 6 3.2.2 Differences in profitability across segments 7 3.3 Benefits of segment reporting 7 4.0 Transfer pricing 8 5.0 Balanced score card 9 5.1 The financial perspective 10 5.2 The learning and growth perspective 10 5.3 Business process perspective 11 5.4 The customer perspective 11 6.0 Conclusion 12 7.0 Recommendations 12 References 13 1.0 Executive Summary The objective of financial and management accounting in an organization is to avail appropriate and timely information to help managers make decisions that affect the entire organization. In most cases, information about pricing, customers is not exposed outside the business due to its sensitivity. However, financial accounting is an area that provides information to the external users due to the interest they have in the business. The purpose of this report is to discuss how segment reporting, target pricing and balanced score card are useful in the financial and management accounting practices. The report is divided into four main sections: the introduction, the main body, conclusions and recommendations. The main body of the report contains headings and subheadings. The first main heading in the body of the report is about segment reporting, which is broken down into sub-sections that highlight the reasons for segment reporting, how profitability affects segment reporting and the benefits of segment reporting to the user of financial information, researchers and the stock market predictions. The second main heading is target pricing while the third main heading in the body is about balanced score card. Several sub-headings are discussed under this and include the financial perspective, the learning and growth perspective, the business process perspective and the customer perspective. The report ends with conclusive remarks and recommendations for further research in the area of segment reporting. Target pricing and balanced score card. 2.0 Introduction In the current business operations, many companies rely on their financial and management accounting information to make strategic decision that would enable their business succeed and possibly outcompete their rivals. Thus, the financial aspect is inevitable in any business entity and in some cases companies fail to utilize this great resource to their own benefit. This report seeks to discuss three financial and management accounting concepts, that is segment reporting, target pricing and balanced score card and their relevance to the functioning of companies. 3.0 Segment Reporting Research indicates that people who use financial statements are interested in the information that is consolidated. Unfortunately, consolidated statements does not contain all the information required by the financial analysts, while the annual reports of large companies often contain information beyond this. The information could include both the non-financial and narrative disclosures about the undertakings in each division or main sections of the company. Also the financial statements usually comprise of segmented or disaggregated financial information, which is normally termed as segment reporting. Therefore, segment reporting is where a company breaks down its business operations into constituent parts and reports financial information of individual parts. Business operations can be segmented into different ways, but the most famous is the segmentation based on the type of business, industry, geographical area or combining all these (Roberts, 2005). 3.1 Why Segment Information is important The table above contains financial reports about segments of the top ten biggest non-financial companies in Europe. It can be seen that all the companies have given information on more one LoB segment; with the highest being six segments. According to the results, the largest LoB segment registered 95% of the total sales while the lowest segment comprise of 26%. Additionally, all the companies have provided information on their geographical segments, with the total sales ranging from 66% to 32% for the largest and smallest segments respectively. Surprisingly, neither is Europe or the home country the largest segment for all the companies. In fact, the domestic sales for all the companies does not account for over 25% of the total sales (Roberts, 2005). The information reported in the table is a clear indication of segment reporting and its usefulness can be understood in respect to the following arguments. Many financial users are often interested to knowing how a particular segment of a business enterprise performs and its prospects as opposed to the entire enterprise. For instance, in case of a multinational business operation, the host governments will always have more interest in the performance of the business group located in their countries (Behn et al, 2002). Similarly, other business stakeholders like creditors, customers and suppliers will definitely be interested with the information from the subsidiary they have business dealings with. Thus, these users will expect that consolidated and disaggregated information for their consumption so that they understand what is happening within their area of operation (Herrmann and Thomas, 2000). Contrary, shareholders would be interested in the information about performance of the entire company rather than from the individual segments since they invest their resources in the company as a whole (Roberts, 2005). In this respect, it is right to argue that reports from business segments are of less interest or relevance to the shareholders of the company. However, this is not meant to misunderstand the purpose of segment reports to the overall financial reporting. The reason behind is that a company comprise of various parts or segments which have to be fully understood in terms of performance and prospects to be able as well understand the performance of the entire company (Street et al, 2000). Therefore, for the user of information to be in a position to understand the current performance of the company and its future prospects, they should first have information about the various segments of the business entity they are associated with. 3.2 Profitability level and Segment disclosure choices According to Berger and Hann (2005) theoretical models have often addressed the issue of segment disclosure and not the how the disaggregated the disclosure looks like. Companies disclose segment information depending on the level of profitability in those segments. Thus, the influence of profitability on the decision of the managers to report on business segments is indicated as follows. 3.2.1 Abnormal profitability and the rate of adjustment Firms are more susceptible to an increase in the rate of abnormal profitability erosion when the abnormal profitability is higher and the rate at which the abnormal profits can be adjusted to the normal rate of return is slower (Berger and Hann, 2005). What this implies is that firms are more likely to aggregate their business operations into fewer segments when they experience increase in the gradual rates reduction in their abnormal profits. Most managers consider segment reporting as the most sensitive of all the reporting in the business and the degree of this sensitivity depends mainly on the rate of aggregation in the information of the segment. Also, the cost prediction of firms could be counteracted by benefit the capital markets get as a result of increased disclosure (Piotroski, 2003). This means that in case disaggregated information is of great value to the capital markets for the firms with high abnormal profits with an increased rate of decrease in abnormal profitability, then the possibility of such firms aggregating is very minimal. Thus, there is a complex relationship between intentional disclosure and profitability, although it depends on the profitability level and the type of competition (Berger and Hann, 2005). 3.2.2 Differences in profitability across segments Firms prefer reporting on various segments when the operating units have immense differences in profitability (Berger and Hann, 2003). The argument is that when profitability results vary considerably across the operating units, it becomes costly competitively to inform rivals about the market to join and its results are often aggregated. Thus, when firms report different profitability in various segments enables investors to attach a lot of worth to high-profit segments since they can use them for expansion purposes, while they attach low value to low-profit segments and they consider them as abandoned (Piotroski, 2003). Therefore, it is expected that as the profitability measures goes up, the propriety cost of disaggregated disclosure also increases. 3.3 Benefits of segment reporting It is evident that segment reporting helps users to know how the company performs and to make predictions for future cash flows. However, the benefits may not be practical and the segment report may not be of great importance to the users. In order to clearly understand the benefits of segment reporting different approaches are used: user decision making analysis, predictive ability of various forecasts and tests of stock market reaction (Roberts, 2005). Research has been conducted to ascertain whether and how segment information help users in decision making. The main focus is on the type of decisions they make and the kind of information they use in making such decisions. In the process, also the forecasts made are assessed to determine whether or not they are accurate at the time or for the firm, for which segment information is reported (Herrmann and Thomas, 2000). It was determined that segment reporting helped users to make more accurate forecasts which help companies prepare for the future. Roberts (2005) argues that several predictive ability studies have also been used by researchers to conduct their individual forecasts of the performance of companies. This approach is based on the assumption that some market participants use segment information in this manner. Both the aggregated data model, segment sales information model and segment profits model are used by researchers to make forecasts for companies. Lastly, disclosure of LoB data significantly reduces prevalence of risk in the stock market. Investors are therefore made aware of the profitable segments to invest their resources without incurring unexpected losses. 4.0 Transfer pricing Transfer pricing refers to the pricing by one division of the company for goods and services that it delivers to another division of the same company. In case of multinationals, it can be defined as the process of establishing the prices at which one company maybe a holding company charges its subsidiaries for the goods and services it delivers to them. The transfer price is therefore the price set for transactions that take place between these related entities (Bhat 2009). The importance of transfer pricing arises from among others the tax implications it has on the tax regimes under whose jurisdiction these related entities operate in. An example is where a company exports goods to a subsidiary company in another country that has a higher corporation tax rate than the one charged in the parent company’s country. In this case the parent company may fix the transfer price at a higher amount so that the subsidiary makes a reduced profit and hence reduces the corporation tax it will be charged by the tax authorities. The bigger responsibility to pay the corporation tax will be on the parent company which operates in a country with lower corporation tax rates hence obtaining tax savings. Multinational companies over the years have used transfer pricing to suite their interest in areas where they want to reduce the taxes they pay by way of shifting their profits to their related entities that are based in countries that are referred to as safe tax havens. According to UNCTAD (2007), multinational companies (MNCs) contribute 10 percent of the global gross domestic product and a third of all the exports in the world and with each MNC just like any business aiming to reduce its tax payable, this has given rising to many challenges in countries deemed to have high corporation taxes. The multinationals have also exploited the transfer pricing option to take immediate advantage of tax losses in their related entities in countries where it would have taken them a number of years to knock off this tax losses or where the domestic laws regulate the time period for which they can knock of this tax losses against their tax payable. To address this challenges that have disadvantaged some countries, there has to be a global effort to jointly address the issue of transfer pricing that has continued to confer undue advantages to some countries at the expenses of others. One possible solution but though a complicated one is to harmonize the tax laws related to companies operating in different tax regimes so as to eliminated the so called safe tax havens. Another solution would be to form a global organization charged with reviewing the transfer prices by multinationals as well as developing tax related laws that will address global taxation of multinationals. 5.0 Balanced score card This is an approach to measurement of the company’s performance that seeks to incorporate both the financial and the non- financial aspects of the company’s performance. Traditional methods of measuring the company’s performance relied on the financial performance and ignored other factors that are important in achieving the organization’s goals and objectives. The term balanced score card has evolved over the years to not only be a measure of performance but rather a strategic planning and management system that helps managers translate their strategic documents in to achievable action plans. The balanced score card according to Kaplan (2010) introduces four perspectives into which an organization should be viewed from namely the financial, internal business process, learning and growth and the last one is the customer perspectives. This perspectives have been shown be the diagram 1 below. Kaplan (2010) advocates that data about the four perspectives should be collected and keenly analyzed so as to arrive at a good decision whether the company’s goals and objectives have been met or not. 5.1 The financial perspective Most companies have never had a problem in keeping and analyzing the financial data as traditionally this is the perspective that has always been used to measure the business success. It’s important for companies to carry out basic book keeping and accounting functions which will at the end of the period provide important bases to decision makers to determine how much on tract they are with the company’s goals and objectives and device corrective measures if they are off the mark. The financial perspective should as well be expanded to incorporate cost benefit data as well as risk assessment so as to make the perspective more meaningful. 5.2 The learning and growth perspective The management of the company is charged with the responsibility of ensuring that the company remains on the growth path at all times. One of the ways of achieving this is by ensuring that the company retains a qualified team that is properly trained and equal to the tasks it’s charged to perform. The employees should therefore be provided with on job trainings to enlighten them on the ever changing business environment as well as to equip them with thorough knowledge of the company’s vision so that each one of them pulls to the same direction. According to Ahmed & Rafiq (1995), the key to meeting organization goals lies as well with the incentives given to the people driving these organizational goals. The company’s work force should be properly remunerated to motivate them to devote their energy into the success of the company. The management should as well be concerned about such issues as employee retention and welfare as key component of the organizations success. 5.3 Business process perspective The success of the company rests on how well the management is able to formulate strategies that keep the business of the company on track and ensuring that the company’s products and services conform to the basic standards set as well as ensuring that the customers’ expectations are met at all times. Proper metrics must be instituted by people who have a clear understanding of the company’s business as well as its mission and strategic plans. One way of eliminating inefficiencies in business processes is by eliminating duplication of activities, minimizing the number of activities per process, aligning processes to the relevant departments and personnel and removing many bureaucracies and bottlenecks that tend to slow the business process. Automating the business processes and procedures is also one way of ensuring that the business processes of the company are aligned to the overall goals and objectives of the company. 5.4 The customer perspective This perspective revolves around issues treating to customer satisfaction, quality of products and service delivery, customer retention, market share in the industry the company is operating in among others. So as to ensure that the company is sustainable in its core business, the management must be concerned about the general feeling of its key customers towards its products and services as this will affect on its future performance and ability to compete with other businesses. The modern business environment dictates that any major decisions that a company makes must be geared towards satisfying the customers’ needs a consolidating the customer base. 6.0 Conclusion In conclusion, the report has exclusively discussed the three Financial and Management Accounting concepts of segment reporting, transfer pricing and balanced score card, which are basically important tools for any business undertakings. Segment reporting as indicated in the report is part of the company’s entire financial reporting and represents various constituent parts of the business unit in the company. Transfer pricing is a situation where the holding company determines the prices for goods or services for the subsidiaries and it is purposely enforced to reduce the effects of corporate tax in the host countries. On the other hand, balanced score card is used as a strategic planning and management tool by a company in the achievement of action plans. Generally, the three concepts guide companies in decision making process and they can never be underestimated. 7.0 Recommendations Based on this report, I recommended that further research should be conducted on the concept of segment reporting, transfer pricing and balanced score card to provide more literature on how practically companies are conducting them. Business entities should carry out specific disclosures that are in line with the segment accounting principles and other issues related to the information availed in the relevant segments. The issue of transfer pricing is still a challenge to multinationals which has to be addressed globally so that other countries do not feel unfairly treated. It is important that countries engage in global corporation to be able to handle this problem. References Ahmed, P & Rafiq, M 1995, using the 7Ps as generic marketing mix: an explanatory survey of UK and European marketing academics, journal of marketing intelligence & planning, Vol.13, Is.9, Pp 4-15. Behn, B.K., Nicholas, N.B. and Street, D.L. (2002), The predictive ability of geographical segment disclosures by US companies: SFAS No 131 vs SFAS No. 14’, Journal of International Accounting Research, Vol. 1. Berger, P. G., & Hann, R. (2005), Segment profitability and the proprietary costs of disclosure. SSRN Electronic Paper Collection. Berger, P., & Hann, R. (2003). Segment disclosures, proprietary costs, and the market for corporate control. Proprietary Costs, and the Market for Corporate Control (December 2002). Bhat, G. (2009). Transfer pricing, tax havens and global governance, discussion paper, Deutsches Institut für Entwicklungspolitik gGmbH Herrmann, D. and Thomas, W.T. (2000), An analysis of segment disclosures under SFAS 131 and SFAS 14’, Accounting Horizons, September. Kaplan, Robert S. (2010). Conceptual foundations of the balanced scorecard, working paper, 10-074, Harvard business school, Harvard University. Piotroski, J. (2003), Segment Reporting Fineness and the Precision of Investor Beliefs. Working paper, University of Chicago. Roberts, C.B. (2005), Segment Reporting, Major Issues in the Financial Reporting of MNEs. Street, D. L., Nichols, N. B., & Gray, S. J. (2000). Segment disclosures under SFAS No. 131: Has business segment reporting improved?. Accounting Horizons, 14(3), 259-285. United Nations conference on trade and development, (2007). World investment report, New York, Geneva. Read More