A diversified company, generally speaking, can be dissected according to one or more of the following bases:
Base # 1. Organisational Division:
The term ‘division’ has different meanings in different companies. Most commonly, the term ‘division’ refers to the use of company operating structure or organisation charts as a basis for segmenting operations into reporting units.
A division is a separate profit responsibility centre possessing authority over both revenue (sales) and cost, although some functions (e.g., finance, research, development) remain centralised. The accounting systems in such companies are usually structured to collect costs and revenues by managerial responsibilities represented by divisions and their sub-units.
Divisions in some manufacturing companies also delineate the various industries, product lines or geographical areas in which the enterprise operates. However, the products manufactured in divisions are not always homogeneous.
Different products, i.e., products with unlike characteristics, are assigned to a given division for a variety of reasons such as physical contiguity of the operations, managerial competence, benefits from integrating or combining production or marketing operations, etc.
In some companies, division may be market-oriented and each division handles a variety of products in a given market. Under all circumstances, divisions are, at best, only approximations to those segments which are to be selected for reporting to the external users.
Thus, the division as a basis of segmentation denotes managerial responsibilities (operating, planning and control) in a company where management has been decentralised by delegating authority for a comparatively broad range of functions to each division head.
The division as basis of segmentation is considered an appropriate base for segmentation for external financial reporting purposes because it is sometimes used for internal reporting and managerial control also. Organisational lines define areas of managerial responsibility, planning and control. Therefore, segmentation on such basis meets the information needs of investors and creditors.
Secondly, the data are often readily available and therefore they could be promptly adapted for external reporting.
Thirdly, auditors might not have any difficulty in verifying the data which are already in use by management.
However, organisational division is criticised on some grounds as a basis of segmentation.
Firstly, information, which is appropriate for managerial planning, control and decision-making, may not necessarily be useful to investors and creditors. The investors generally are not aware about the operations of a company’s various divisions or units. Investors tend to understand the relevance of information if it is provided by industry, product lines or markets.
Secondly, divisionaised reporting does not promote uniformity either within a particular company or between competing firms. The reasons for this is that various companies may emphasise drastically different concepts when setting up divisions such as geographical areas, legal entities, products, executive responsibility, anticipated growth, organisational units or combinations of these which destroy comparability among companies.
Thirdly, company could change its organisational structure which would require a change in definition of a segment. If these changes do not reflect changes in the underlying nature of the operations of the enterprise (changes in industry, product lines or the market served), segmented data presented along organisational lines may not be comparable from period to period.
A study conducted by the Accountants International Study Group comments:
“Companies commonly create subsidiaries or divisions to administer different activities. Organisational divisions are ordinarily created, however, according to administrative requirements and are not necessarily reliable bases for identifying segments that are homogeneous as to profitability, growth and risk. Since accounting records commonly are maintained for organisational divisions, some companies use those divisions as bases for reporting information on segments. The practical problems of adjusting accounting records to a theoretically appropriate basis of segmentation may be considerable.”
Base # 2. Basis of Business Activities:
Business activities imply that segmentation can be done broadly in terms of:
(i) Broad Industries Groupings,
(ii) Lines-of-business or product lines and
(iii) Individual Products and Services.
(i) Broad Industry Groupings:
According to International Accounting Standard No. 14, industry segments (industry groupings) “are the distinguishable components of an enterprise engaged in providing a different product or service, or a different group of related products or services, primarily to customers outside the enterprise”.
Financial Accounting Standards Board (USA), Statement No. 14, contains a similar definition. An industry is usually regarded as a broad group of related products or services. This segmentation base uses broad groupings of similar products and services as reporting units.
Examples include textile mill products, paper and allied products, oil-refining, ship-building, tobacco products, furniture and fixtures, agricultural product. The industries in which an enterprise operates might be described as particular areas of economic activity, distinguished from other areas of economic activity on the basis of end-products or services rendered.
ASB’s (India) AS17 Segment Reporting defines business segment as follows:
A business segment is a distinguishable component of an enterprise that is engaged in providing an individual product or service or a group of related products or services and that is subject to risks and returns that are different from those of other business segments.
Factors that should be considered in determining whether products or services are related include:
(a) The nature of the products or services;
(b) The nature of the production processes;
(c) The type or class of customers for the products or services;
(d) The methods used to distribute the products or provide the services; and
(e) If applicable, the nature of the regulatory environment, for example, banking, insurance, or public utilities.
There are circumstances where it may appear that an enterprise has a number of industry segments but where industry segmentation could be meaningless or more misleading than helpful.
The following examples of such situations are given in a study conducted by the UK’s Institute of Chartered Accountants in England and Wales:
(a) In vertically integrated companies where the volume of transactions between lines of business and the degree of integration is significant, so that the results of one line of business are directly dependent on the results of the other lines of business and are not of themselves meaningful.
(b) Where products are interdependent in the market, for example, a company which manufactures and sells equipment and spares for that equipment may, as a matter of policy, decide the relative levels of profit to be earned on the equipment and spares, respectively. The disclosure of the equipment and spares lines of business separately might not be meaningful in these circumstances.
(c) Where lines of business rely on common manufacturing facilities and could not be economically carried on without each other.
(d) Where one line of business is a by-product of the main line of business and would not exist but for that main line of business.
(e) Where lines of business rely on common sales or distribution outlets and either could not be economically carried on without each other or alternative outlets could not be found.
(f) Where a company operates one line of business primarily to support or promote its other line of business.
The Financial Accounting Standards of the USA (Statement No. 14) and Canadian Institute of Chartered Accountants both exempt vertically integrated operations segmentation. The Canadian Institute of Chartered Accountants considers only horizontal integration (defined as extension of activity in the same general lines of business or expansion into supplementary, complementary or compatible products) and states that: “Integration of this type does not normally result in an enterprise operating in more than one industry.”
Emmanuel and Gray argue:
“Attention should be focused on the development of an approach which accommodates both the management’s perception of how the company is operated, on both an industrial and geographical basis, and yet also meets the needs of users for objective data which is comparable and corresponds in some degree, with external classifications of industrial and geographical data”.
(ii) Lines-of-Business or a Product Line:
A line of business or a product line is defined on the basis of the end-products produced. A product line refers to major business lines or operating activity in which a company is engaged. It is generally considered to be a relatively narrow group of related products, whereas an industry constitutes a broader grouping.
For example the manufacture of furniture and fixtures might be regarded as a single industry within which there might be a number of product lines, e.g., office furniture, household furniture, public buildings (schools, colleges, etc.) and related furniture and fixtures.
An industry is deemed to be an aggregation of product lines. The distinction between segmentation by industry and segmentation by product line is often difficult to draw and, at times, the two may be congruent. For example, an enterprise which manufactures desks and men’s suits might be considered as being in both the furniture and apparel industries.
At the same time, it could be viewed as having two product lines, each of which happens to fall into a particular industry classification. Segment reporting by industry is similar in approach to product line reporting, except that the categories are broader. Industry segmentation and product line segmentation both have problems which are similar in nature.
There is no common agreement as to what constitutes an industry; industries tend not to be discrete and they are constantly changing as new products and markets are created and old ones disappear.
A drawback to the use of industry or product line as a basis of segmentation is that innovations, obsolescence, fluctuations in demand influence greatly the basis of segmentation, i.e., industry and product line. This, in turn, may create difficulty in distinguishing one industry or product line from another.
(iii) Individual Products and Services:
Segmentation base may imply individual products and services using narrowly defined groups or categories of products manufactured or sold and services rendered as reporting units.
An example would be to disaggregate office furniture into the reporting units: chairs, sofas, desks, stools, filing cabinets and benches; or oil refining as one industry group to be disaggregated as the following reporting units: refined fuels, oils, greases, etc.
Segmentation on the basis of individual products would prove useful in making predictions and analysis of a company’s profit prospects and risk element. Product-wise data produce a comparable data which could be compared with data of other firms, competitors, customers, suppliers.
However, this segmentation basis has a drawback, in that no suitable classification of products and services is available. Also, providing product-wise data requires unrealistic cost allocations which make the segments profit figures unreliable.
A comprehensive working of figures is needed to produce the data. Since detailed disclosure is provided, certain companies could suffer a high level of competitive damage. Defining specific product lines also involves complexities and difficulties.
“There is little agreement on what constitutes a product line. Also, there are many practical problems to establishing an all-inclusive, well-defined list of product categories which could be uniformly used by all corporations. Some companies, particularly diversified companies, view their product lines very broadly. Others see their product lines in narrow terms. One company selling canned foods may simply view itself as being in the food business. Another company in the same business may regard its product lines as being canned fish, canned meals and canned soups. It may go even further and break these categories down by different trade-marks or container sizes. The product lines of some companies tend to trend together. For example, it may be difficult for a company that makes soaps, detergents, window cleaners, waxes and polish to draw a clear distinction between the cleaning compounds and polishing products, particularly as some products both clean and wax.”
Base # 3. Market Structure:
Market structure is considered by some as a possible solution to the problem of defining segments of diversified companies on the premise that different markets have different degrees of risk attributed to them, e.g., both risk and profitability can be affected by whether the firm supplies manufacturers, middlemen or consumers and whether there is a high proportion of sales to government bodies, to particular industries, or to particular company groups. Information for different markets is valuable to users in determining the future growth and stability of the company.
Such information indicates the degree of dependence:
(i) On a single major customer,
(ii) On a group of customers,
(iii) On a particular industry as the major purchaser of its products and
(iv) On business with government.
It has also been suggested that data relating to sales, in each major customer category be disclosed even if another method is chosen for the disclosure of segmental information. Market basis of segmentation, however, does not possess readily available data in the form needed to make the necessary segmental disclosure.
Some more points are mentioned here against market segmentation:
(i) Segmentation by market has problems in determining profits by customers. Cost allocation among the different markets may be highly complex, confusing and unreliable.
(ii) The marketwise data may prove harmful to the reporting company.
(iii) Wrong impressions are likely to be created about potentialities of different markets. Alternative markets may be available and therefore no useful purpose will be served by providing market information.
The Financial Accounting Standards Board (USA) has proposed that if 10 per cent or more of the revenue of an enterprise is derived from sales to any single customer, that fact and the amount of revenue from each such customer should be disclosed.
Similarly, if 10 per cent or more of the revenue of an enterprise is derived from sales to domestic government agencies in the aggregate or to foreign governments in the aggregate, that fact and the amount of revenue should be disclosed.
Base # 4. Geographical Segments:
AS17 Segment Reporting defines geographical segment as follows:
A geographical segment is a distinguishable component of an enterprise that is engaged in providing products or services within a particular economic environment and that is subject to risks and returns that are different from those of components operating in other economic environments.
Factors that should be considered in identifying geographical segments include:
(a) Similarity of economic and political conditions;
(b) Relationships between operations in different geographical areas;
(c) Proximity of operations;
(d) Special risks associated with operations in a particular area;
(e) Exchange control regulations; and
(f) The underlying currency risks.
The Canadian Institute of Chartered Accountants defines a geographical segment as:
“…a single operation or group of operations located in a particular geographical area. Such operations are those that generate revenue, incur costs and have assets employed in or associated with generating such revenue. An enterprise’s domestic operations are considered to be a separate geographical segment”
Geographical segment is generally proposed in terms of:
(i) Foreign and
(ii) Domestic segmentation.
It is assumed that segmentation on the basis of geographical area reflects differing prospects for growth, rates of profitability and degrees of risk in various parts of the world and perhaps even in various parts of the home country.
Foreign geographical areas are individual countries or groups of countries as may be found suitable in an enterprise’s particular circumstances. Foreign geographical segments generate revenue either from sales to unaffiliated customers or from inter-segment sales or transfers between geographical areas.
No single method of grouping the countries can be suggested; each enterprise should group its foreign operations on the basis of differences that are most important in its particular circumstances.
Some factors to’ be considered in determining foreign geographical areas include:
(a) Proximity of operations in different countries,
(b) Similarities in business and political conditions prevailing in various countries, and
(c) Nature, scale, and degree of interrelationship of operations in various countries.
An enterprise’s domestic operations are regarded a separate geographical segment. Domestic area includes those revenue producing operations of the enterprise located in the home country that generate revenue either from sales to unaffiliated customers or from inter-segment sales or transfers between geographical areas.
Operations, either domestic or foreign, should have identified with them the revenues generated by those operations, the assets employed in or associated with generating those revenues, and the costs and expenses incurred in generating those revenues or employing those assets.
As compared to domestic operations, operations in foreign geographical areas and sales to foreign markets may involve greater risk due to foreign government instability, exchange rate fluctuations, changes in industrial policy of the government, competition in international business, political decisions, protectionism, etc. Due to uncertainty involved in foreign operations, profits arising on foreign operations are likely to be extreme or marginal.
It should be understood that “foreign operations” are different from “export sales”. The Financial Accounting Standards Board of the USA and the Canadian Institute of Chartered Accountants provide for geographical segmentation of operations as well as the disclosure or export sales where such operations and sales are significant.
Ernst and Whimmey observe:
“The distinction between foreign operations and export sales may be unclear. Foreign operations may, for example, include sales of domestic products through marketing efforts, additional manufacturing processes, or other activities conducted outside the home country. Frequently, the transfer of marketing and manufacturing activities from domestic to new foreign markets is a gradual process.”
Emmanuel and Gray are of opinion that a dual analysis of foreign operations by location of operations and location of markets can be significant and hence desirable at least in respect of turnover; with perhaps some reference to exports from all locations to all markets.