Segment Reporting for Investor - Essay Example

___________ ____________ ____April 2006 Segment reporting for investor Introduction A segment by definition is a part. This paper would concentrate on a segment of a company as accepted in regulatory literature. A segment of a company is widely defined to be a part of the company that is carrying on business activities and which may or may not be earning revenues and/or incurring costs. Another condition which qualifies a part of a company as segment is that the chief executive of the company must periodically review the performance of this part in order to provide it a status of a segment. "Operating segments are components of a company for which separate financial information is available and is evaluated regularly by the chief operating decision maker (CODM) in deciding how to allocate resources and in assessing performance"(Link,2003). Company segments arise due to the complex nature of activities carried on by today's corporates.These activities not only embrace multiple products produced over different business lines adopting varying technologies and processes but also because of the fact that these activities cross national boundaries and spread geographically over many countries. Consolidated financial results of such a corporate, widely spread and complex, become a simplistic statements of broad figures- which hides more information than revealing it.Any decision maker,be it an investor or some other person or organization,finds it difficult to analyze the true financial position of the company with this broad set of results.Segment reporting was specified exactly to get around this difficult position.Under segment reporting a corporate's financial results are broken down segment wise and presented in a manner to exhibit clearly as to how they are contributing to the consolidated position.This evidently would enable any decision maker to analyze the corporate body from several segmental views and identify strengths and weaknesses which may vary in degrees.The decision based on such an analysis would be more factual and objective. Two widely accepted segmenting techinques distinguish between operating business lines and geographical segments. We examine below how such segment reporting influences investors and corporate entities who prepare such segmental data. We also examine the various regulatory and accounting prescriptions that govern segment reporting by corporate entities before taking up concluding remarks. Perception of Investors Investors are primarily concerned with the safety and return on amounts invested or to be invested in any entity. Safety and return concerns have a direct bearing on risk perceptions of the investors. Investors are essentially risk profiling a corporate entity and invest money only if calculated risk is permissible with their risk taking capabilities. The information that goes in such risk profiling has been theoretically built into share price movements and asset pricing constructs. From the mid-1950s to the early 1980s, a random walk theory (RWT) of share prices was developed based on the past empirical evidence of randomness in share price movements. RWT basically stated that speculative price changes were independent and identically distributed, so that the past price data had no predictive power for future share price movements. RWT also stated that the distribution of price changes from transaction to transaction had finite variance. The fundamental concept behind random walk theory is that competition in perfect markets would remove excess economic profits, except from those parties who exercised some degree of market monopoly. This meant that a trader with specialized information about future events could profit from the monopolistic access to information, but that fundamental and technical analysts who rely on past information should not expect to have speculative gains. Segment report essentially present investors an opportunity to project some such specialized information and gain from it. Efficient Markets Hypothesis (EMH) states that current prices always 'fully reflect' available information, so that the only reason prices change between two periods is the arrival of new information. The EMH requires that only two necessary conditions be met. First, the market must be aware of all available information .The type of information available is determined by the strength of the EMH being tested. In a Weak Form EMH, current prices entirely reflect all that can be known from the study of historical prices and trading volumes. If the Weak Form is valid, technical analysis becomes ineffective. Any information contained in past prices has been analyzed and acted on by the market, so that shares are neither under-valued nor over-valued. In a Semi- Strong EMH, current prices efficiently adjust to information that is publicly available. If this form of the hypothesis holds true, then fundamental as well as technical analysis is also ineffective because all publicly available information has been thoroughly analyzed, assessed and acted upon. Finally, in a Strong Form EMH, current prices fully reflect all information, and not just that information which is to be found in the historical trading pattern or available publicly. Thus, if the Strong Form holds true, any attempt to make profitable use of monopolistic access to information is useless because this information has already been incorporated into the market price of the share. The second necessary condition is that of the rational expectations element of the EMH, or informational efficiency. It means that actual returns can be randomly greater or lesser than expected returns, but on average, unexpected returns must be zero. The main implication of the rational expectations is that no system of trading rules can have greater expected returns than the equilibrium expected returns derived by the market. In other words in a perfect market scenario of RWT and varying degrees of market perfection in 3 forms of hypotheses under EMH the prices determined are efficient and there is no incentive on the market to either change prices or move away from equilibrium prices until unless some new unabsorbed information/event comes about making it necessary to move towards a new equilibrium. Segment reporting can either assist investors in getting clues of this specialized information or even to prevent other investors (insiders) from gaining from such specialized information. The capital asset pricing model (CAPM) is used in corporate finance to arrive at a theoretically appropriate price of an asset given that asset's systematic risk(or market risk)(Sharpe,1964). The CAPM formula reckons the asset's sensitivity to systematic risk in a number often referred to as beta () , as well as the expected return on a market portfolio(M) and the expected return of a theoretical risk-free asset. A liner relationship based on return on a share and its variance and covariance with market return is posited in CAPM.Segmental reporting SR gives the analysis of the segments and the key figures such as sales, net assets and profits of each segment. This assists investors to assess the contribution that each part is making to the whole group which enables them to make more informed decisions, better understanding of the current situation of the company and to make predictions regarding the company's future profitability with greater accuracy and greater confidence. This implies that variance and covariance with market return can be affected considerably by segment data. Segment disclosure provide strong evidence that prediction models based on industry segment data and prediction models based on geographical segment data have significantly smaller average prediction error than prediction models based on consolidated data. All of the above theoretical constructs essentially concern earnings and security prices predictability and vital role of segment reporting therein is evident. Lastly segment reporting provides relevance, reliability and comparability of results of corporate entities to investors. A cross sectional analysis throws out direct comparisons with other competitors in the industry and helps strengths to strengths and weaknesses to weaknesses comparisons. Even opportunities and lurking threats can be revealed by such delineated data. Perception of Preparers "Now the SEC wants to find out if the internal information being provided by companies is the same as that presented to and acted on by their ''chief operating decision maker...But what information is shared with which top decision maker can vary from company to company, and create compliance hassles.....All of these are very subjective types of rules that are open to interpretation'' (Reason, 2001).Complicated compliance is a major issue SEC had been trying its best to bring about consistency between CEO used internal segmental data and that presented to outside decision makers by the corporate entity. Corporate entities have been found to circumvent regulatory prescriptions of standards so as to present diluted segmental reporting. "The SEC... also intends to investigate whether companies are aggregating businesses that are not similar or are limiting the amount of information... And one test of compliance... will be whether companies refer to segments consistently in their investor communications"(Reason, 2001). Different and fine tuned standards have come about due to that e.g. FAS 131 for FAS 14 etc. The major reason for corporate entities to present a diluted picture has been sourced in their wide ranging fears of disclosing sensitive information through segmental reporting which competitors would take advantage off. Edwards and Smith (1996) assessing to the empirical research showed that competitive disadvantage is the major concern before and after introduction of standard. It is apparent that such corporate entities expect their competitors to sit tight and not reveal equivalent segment information about their operations. Regulators like SEC have been cracking down on all such cases of non compliance to bring transparency in entire system of segment reporting. Many entities doubt, "the usefulness to shareholders of the individual elements of segmental disclosure" (Edwards, 1996).Yet other entities believe that, "that segmental information is not useful for assessing investment risk and company performance" (Edwards, 1996). Corporate entities also have cost considerations in preparing segment statements. Right from collection of such data and covering its analysis to its final publishing costs mount for corporates.It is a very conscious decision for corporates to decide on segmental reporting keeping its marginal costs and benefits in account. That marginal costs exceed benefits often forms a moving reason to dilute compliance. It is the view that "when disclosure is costly, firms with good news have incentives to disclose this information for improved firm valuation and decreased cost of capital" (Newman and Sansing, 1993 &, Darough and Stoughton et al, 1990). Complexity of resulting financial statements is another deterring factor. The entire internal accounting system is to be reoriented for segmental reporting. However more important consideration is the auditing complexity that occurs after segmental accounting. Auditors become more aware, like other decision makers, of several factors which were hitherto limited to desktops of CEOs leading to undesirable regulatory and tax consequences. Reporting corporate entities have to finely balance all these considerations while ensuring regulatory compliance. Different Standards and Practices International Financial Reporting Standards(IFRS) and the US GAAP have made it mandatory for listed entities to comply with segment reporting requirements. IFRS includes clearly entities in the process of getting listed .It however leave the option of full compliance to non listed entities. US GAAP encourages but does not compulsorily require non-listed entities to comply with segmental reporting stipulations (Price, 2006). IFRS requires business and geographical reporting - one as primary format, the other as secondary. The choice will depend on the impact on business risks and returns. The secondary format requires less disclosure. US GAAP require reporting based on operating segments and the way the chief operating decision-maker evaluates financial information for the purposes of allocating resources and assessing performance. In terms of identification of segments IFRS requires that segment identification should be based on profile of risks and returns and internal reporting structure. Specific factors are given to determine whether products and services are similar. As for business/operating segments identification six factors are given, focusing on economic and political conditions, special risks, exchange control regulations and currency risks. Qualifying criteria is that revenue, results or assets are 10% or more of all segments. If revenue of reported segments is below 75% of the total, additional segments are reported until the 75% threshold is reached. Segments not identified as above are included as unallocated items. No limit is placed on number of reported segment"(Price, 2006). US GAAP base segment identification on the internally reported operating segments. Similar criteria apply for the aggregation of similar operating segments. Aggregation requirement of similar geographical segments is not specified though certain disclosures (such as revenues and assets) are required, on a consolidated basis, pertaining to domestic operations, foreign countries in total and each material country. Threshold definitions for reportable segments is same as that for IFRS. Segments not reported are included in 'all other' category, with sources of revenue disclosed. Like IFRS there is no upper limit on number of reported segment (Price, 2006). IFRS requires accounting policies to be same as those adopted in case of consolidated reporting. Entities may disclose additional segment data based on internal accounting policies. Symmetry in allocation of assets/ liabilities, revenues/ expenses is required. US GAAP requires accounting policies to be same as those adopted for internal reporting to the chief operating decision-maker for the purposes of allocating resources and assessing performance. Herein symmetry in allocation of assets/ liabilities, revenues/ expenses is not required. But information pertaining to asymmetrical allocations must be disclosed (Price, 2006). In main disclosures IFRS does not require disclosure of factors used to identify reportable segments. However it requires disclosures pertaining to composition of segments in that types of products and services included in each reported business segment and composition of each geographical segment are to be disclosed. Profits disclosures are required with the results of continuing operations disclosed separately from the results of discontinued operations. Full assets disclosures are required fro each segment. However liabilities need be disclosed only for primary segment format only. All external revenue disclosures are required whereas inter-segment revenue is disclosed only in primary segment format only. Depreciation and amortization expense and other significant non-cash expense disclosures are required only for primary segment format. Exceptional (significant) items disclosures are encouraged but not required for primary segment format only. Interest revenue, interest expense, major customers and Income tax disclosures are not required segment wise. However capital expenditures need be disclosed on an accrual basis. Profit/loss from investments in equity method investees, and amount of investment in equity method investees is disclosed if operations of associate are substantially all within a single segment. However reconciliation of total segment revenue, total segment measures of profit or loss (for continuing and discontinued operations), total segment assets, total segment liabilities and any other significant segment totals to the corresponding totals of the entity are required to be disclosed to give out a totality view of segments(Price, 2006). US GAAP does require disclosure of factors used to identify reportable segments including basis of organization (for example, based on products and services, geographic areas, regulatory environments) and types of product and service from which each segment derives its revenues. Regarding disclosures on composition of segments it is at par with IFRS.Full segment wise profit disclosures are required to be made. It requires full segment wise assets to be reported whereas liabilities are not required to be reported. It requires both external and inter-segment revenues to be disclosed on a consolidated basis, and on a segment basis if included in the measurement of segment profit/loss for internal reporting. Depreciation, amortization expense, other significant non-cash expense, exceptional (significant) items, interest revenue, interest expense, income tax, capital expenditure on an accrual basis, profit/loss from investments in equity method investees and amount of investment in equity method investees are all required to be disclosed for reportable segments if these are included in the measurement of segment profit/loss in internal reporting or otherwise regularly reported to chief operating decision-maker. For each external customer greater than or equal to 10% of consolidated revenue total revenue is disclosed, as well as the relevant segment that reported the revenues. However reconciliation of total segment revenue, total segment measures of profit or loss (for continuing and discontinued operations), total segment assets, total segment liabilities and any other significant segment totals to the corresponding totals of the entity are required, leaving outside segmental liabilities, to be disclosed to give out a totality view of segments(Price, 2006). The evolution in both IFRS and US GAAP has been from '14 series standards' to '131 series standard for US GAPP and 14 R standard for IFRS'.US authorities have given substantial leeway to corporates to choose from FAS 131 or 14R.Their critical differences have already been enumerated above. FAS No. 14, Financial Reporting for Segments of a Business Enterprise, was issued in 1976 in response to several calls by interested groups. In FAS 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 companies began exploiting the vagueness of standards and even $1 billion companies declared themselves as single segment companies. Because many companies did not provided expected segment information, the Association for Investment Management and Research suggested that businesses report disaggregated data "in a format that coincides with and reflects how it is organized and managed.FAS 131 was the result" (Albrecht & Chipalkatti, 1998). The same problems plagued the original IAS No. 14, issued in 1981, with similarity in approach to FAS No. 14. It was found too general in its requirements to be effective. Public enterprises were required to report about significant industry segments and geographic segments in which they operated, but IAS No. 14 left it to the judgment of individual companies to determine what was significant. Most companies reported themselves as single segment companies. Thus a need was felt for better aligned standard IAS no.14 R was the result. (Albrecht & Chipalkatti, 1998). Conclusion and Recommendation Despite complexity in reporting and competitive fears segment reporting is required given the complex and widespread interests of today's corporate entities. Segment reporting standards have been in vogue since 1970s and 1980s.The standards evolution has come quite a long way in ensuring standardization of segment reporting process. However more needs to be done to bring about international accounting standards on a standard keel with clear cut matrix presentation of segment reporting prescriptions dissolving several national differences. Their regulatory practices also have to come to common and concerted agenda the world over for the cause of financial transparency. The regulatory process should ensure a liberal draw from as many sources of external information about the corporate entity in interpreting its reported segment data as possible. The regulator(s) should also install a system and culture for provision of this information to investors. Lastly regulator must encourage better compliance by benchmarking it for its quality and timeliness and reward it through some category of regulatory forbearance. Better segment reporting in an improved system would help the investor take more knowledge based decisions. . Works Cited Link, Kevin W."Segment Reporting: Analysis of the Impact on the Banking Industry". The Journal of Bank Cost & Management Accounting.2003. Sharpe, William F. "Capital asset prices: A theory of market equilibrium under conditions of risk". Journal of Finance, 19 (3), 425-442. 1964. Reason, Tim."SEC Wants Better Segment Reporting. But is the agency's new focus on business unit disclosure more bark than bite".CFO.com.September 03, 2001. Edwards and Smith.1996. Edwards, Pamela.1996. Newman and Sansing.1993. Darough and Stoughton et al.1990. PricewaterhouseCoopers." Similarities and Differences. A comparison of IFRS and US GAAP." February 2006. IFRS: IAS 14. US GAAP: FAS 131. Albrecht ,W. David and Chipalkatti ,Niranjan."New Segment Reporting". CPA Journal. May 1998. Read More