The following items of information have been proposed for disclosure in published annual reports of diversified companies:
Item # 1. Segment Revenue: According to AS-17 Segment Reporting:
Segment revenues are the aggregate of:
(i) The portion of enterprise revenue that is directly attributable to a segment,
(ii) The relevant portion of enterprise revenue that can be allocated on a reasonable basis to a segment, and
(iii) Revenue from transactions with other segments of the enterprise.
Segment revenue does not include:
(a) Extraordinary items as defined in AS-5, Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies;
(b) Interest or dividend income, including interest earned on advances or loans to other segments unless the operations of the segment are primarily of a financial nature; and
(c) Gains on sales of investments or on extinguishment of debt unless the operations of the segment are primarily of a financial nature.
The International Accounting Standards Committee in its Standard No. 14 defines segment revenue as follows:
“Segment revenue is revenue that is directly attributable to a segment, or the relevant portion of revenue that can be allocated on a reasonable basis to a segment, and that is derived from transactions with parties outside the enterprise and from other segments of the same enterprise.”
The Canadian Institute of Chartered Accountants defines ‘segment revenue’ as “revenue, directly attributable to a segment, from sales to customers outside the enterprise and from intersegment sales or transfers of products and services”.
The following are excluded from segment revenue as these do not relate to segments:
(a) Revenue earned at head office level or corporate level,
(b) Income from investments accounted for by the equity method,
(c) Interest and dividend income other than that earned on an asset included in the segment’s identifiable assets,
(d) Extraordinary gains, and
(e) Intersegment charges for the cost of shared facilities or other jointly incurred expenses. The most controversial issue regarding segment revenue is about the treatment of intersegment sales or transfers.
Those who argue that intersegment sales or transfers should be included in segment revenue give the following arguments:
(а) Inclusion of intersegment transfers makes segment operating profit figure accurate and reliable.
(b) Pricing of intersegment transfers does not involve much difficulty and they can be priced appropriately.
(c) In case intersegment transfers are not included, its exclusion would require exclusion of costs incurred in intersegment transfers.
It has been argued by critics that intersegment transfers should be excluded from segment revenue.
The Financial Accounting Standards Board comments:
(i) Financial accounting should recognise only those revenues which have been realised through bargained market transactions;
(ii) The transfer price is not objectively verifiable because there have been no arms-length transactions;
(iii) The level of segment activity, including intersegment transfers, may be affected by internal production decisions, and
(iv) The total reported segment sales, including inter-segment transfers, will differ from consolidated figures unless appropriate eliminations are presented.
However, the Financial Accounting Standards Board in its Standard No. 14 suggested that intersegment transfers (including inter area or intra enterprise transfers) be reported on the same basis as the enterprises uses to account for them internally.
The amount of the intersegment transfers have to be separately disclosed in “respect of both industries and geographical areas. The basis of accounting as well as the nature and effect of any change in basis must be disclosed.
Item # 2. Segment Expense:
According to AS-17 Segment Reporting:
Segment expense is the aggregate of:
(i) The expense resulting from the operating activities of a segment that is directly attributable to the segment, and
(ii) The relevant portion of enterprise expense that can be allocated on a reasonable basis to the segment,
Including expense relating to transactions with other segments of the enterprise.
Segment expense does not include:
(a) Extraordinary items as defined in AS-5, Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies;
(b) Interest expense, including interest incurred on advances or loans from other segments, unless the operations of the segment are primarily of a financial nature;
(c) Losses on sales of investments or losses on extinguishment of debt unless the operations of segment are primarily of a financial nature;
(c) Income tax expense; and
(e) General administrative expenses, head office expenses, and other expenses that arise at the enterprise level and relate to the enterprise as a whole.
However, costs are sometimes incurred at the enterprise level on behalf of a segment. Such costs are part of segment expense if they relate to the operating activities of the segment and if they can be directly attributed or allocated to the segment on a reasonable basis.
Item # 3. Segment Profitability:
The question of segment reporting involves the reporting of segment operating profit or loss which is the difference between segment revenue and segment expense.
Generally, there are two concepts of segment profitability:
(a) Segment contribution
(b) Segment net profit.
Segment contribution is calculated by deducting the expenses traceable to the segment from segment revenues. Segment contribution is also known as ‘defined profit’ since traceable expenses would include directly fixed costs as well as direct variable costs. The segment contribution approach calls for separating all costs and revenues into two groups, those directly attributable to the reporting segments and those not directly related.
The resulting marginal income under this method can be interpreted, in general, as the addition to total enterprise profit attributable to the presence of a particular segment. In other words, contribution margin measures the amount that each segment has contributed toward joint segment costs and profits taken as a whole.
Segment contribution approach can easily be followed with ease because there is no need to make joint cost allocations to segments which are often considered time-consuming and costly. The contribution approach is commonly used by management for internal management uses such as planning, control, decision-making, and cost-volume-profit analysis.
Therefore, this approach can be applied without much difficulty for external reporting purposes to the benefit of existing and potential investors in planning their investments. Another advantage of the contribution margin approach is its objectivity since it avoids the arbitrariness involved in allocation of indirect costs.
The segment net profit approach considers all costs in the determination of operating profit and loss. The profit so determined is known as net income or operating profit. Arguments have also been advanced to include in segment operating profit certain items which could sometimes be usefully traced to a segment.
The Research Committee of the Canadian Institute of Chartered Accountants has accepted this position when it says:
“A number of respondents thought that additional items should be taken into account in determining a segment’s operating profit or loss; for example: income from investments accounted for on an equity basis, extraordinary items, minority interest and income taxes. These respondents argued that the allocation of such items would make the segmented data more meaningful, provide a better insight into a segment’s relationship to the enterprise as a whole and facilitate inter-enterprise comparison of segments.”
The segment net profit approach considers all costs and revenue whether they are direct or joint. Determining net income in this manner involves allocating joint revenues and joint costs. However, the amounts of joint revenues are much smaller than those of joint costs and therefore allocation of joint revenues involves less difficulty. It is also said that net income under this approach is likely to be accurate and reliable although joint costs allocations are involved in it.
Financial accounting still uses estimates, judgements, and assumptions in the preparation of financial reports with regard to many items such as depreciation, allowance for bad debts, etc. Since most financial statement users understand the nature of complexities involved in the preparation of financial statements, they will not be misled by the inclusion of joint costs in segment net income.
Furthermore, exclusion of joint costs is not in conformity with the standard of adequate disclosure in company annual reports because the contribution margin does not disclose a segment’s ability to earn income and does not place the financial statements of a segment in a diversified company on an equal basis with a non-diversified (unitary) company engaged in the same line of business.
Item # 4. Assets:
The disclosure of segment assets gives an indication of the resources employed in generating segment operating results. Segment assets include (a) assets used by or directly associable with a segment, and (b) assets used jointly by two or more segments to be allocated on a reasonable basis.
The following assets are not included in segment assets:
(a) Assets maintained for general corporate purposes (i.e., those not used in the operations of any industry segment)
(b) Inter-segment loans and advances (except for financial segment); and
(c) Investments accounted for by the equity method.
It has been suggested that information should be given about the total net book amount of assets identifiable with both industry and geographical segments. ‘Net’ means after deducting provision for bad and doubtful debts and for accumulated depreciation.
According to the Financial Accounting Standards Board, the purpose of the requirement is “to allow financial statement users to assess the relative investment commitment in an enterprise’s various segments and to assess the results obtained by the various segments in relation to the investment commitment”.
Liquid assets in the form of cash, short-term deposits and marketable securities are the most common type of general corporate assets although there is some disagreement about how liquid assets should be treated.
On this controversy, Arthur Anderson and Co., has expressed the following view:
“Some have questioned whether cash maintained on the books of subsidiaries and divisions should be included in a segment’s identifiable assets. While some companies may conclude that this should be done, particularly if the cash is under the control of segment management, we, believe that all cash and cash items, no matter what their location, can be considered to be corporate assets since they are not directly used in operations and can normally be shifted among segments on a basis similar to debt (which, for this reason, among others, is not segmented). If cash and marketable securities maintained on the books of subsidiaries and divisions are significant and it is not otherwise apparent, companies should consider disclosing how those items were treated in determining segment ‘identifiable assets’.”
It is also suggested that segment assets should be classified into different categories such as plant, inventories, debtors, etc.
Item # 5. Liabilities:
A suggestion has emerged in corporate financial reporting that liabilities should be reported on a segment basis. It does not involve much difficulty about liabilities which are directly traceable to segments. However, most business enterprises have common liabilities for the business as a whole.
For example, debt is issued by the enterprise as a whole. Besides, the corporate office of a company may control the financing decisions, with the result that a segment’s debt may be attributable to management policy rather than to the particular requirements of the segment.
The International Accounting Standards Committee observes:
“Liabilities are generally not allocated, either because they are considered to relate to the enterprise as a whole or because they are viewed as giving rise to a financing result rather than an operating result.”
According to AS-17 Segment Reporting:
“Examples of segment liabilities include trade and other payables, accrued liabilities, customer advances, product warranty provisions, and other claims relating to the provision of goods and services. Segment liabilities do not include borrowings and other liabilities that are incurred for financing rather than operating purposes. The liabilities of segments whose operations are not primarily of a financial nature do not include borrowings and similar liabilities because segment result represents an operating, rather than a net-of-financing, profit or loss. Further, because debt is often issued at the head-office level on an enterprise-wide basis, it is often not possible to directly attribute, or reasonably allocate, the interest-bearing liabilities to segments.”
Item # 6. Funds Flow:
Rappaport and Lerner have advocated the production of a segmented funds statement for a number of reasons including the following:
(a) Users are concerned with liquidity and would be interested in knowing which segments are net sources of funds and which segments are net users.
(b) The disclosure of application of funds indicates to the shareholders management’s commitment to future prospects of various segments. An investor may or may not agree with management’s resource allocation plan, but the information allows the investor yet another basis for valuing the company’s shares.
Despite the utility of a segmented funds statement, its production is not feasible because of allocation problems especially in relation to liquid assets and liabilities. However, it is practicable to disclose the capital expenditure (i.e., additions to property, plant and equipment) of each reportable industry segment.
Also, the required reporting of depreciation, depletion and amortisation expenses for each segment coupled with segment operating profit or loss allows the user roughly to approximate the contribution of each segment to the funds generated from operations during the period.
Item # 7. Accounting Policies:
Investors improve their predictions when business enterprise disclose sufficient information regarding the impact of accounting changes on their earnings.
Accounting policy disclosures are mainly required relating to:
(a) The basis of segmentation (type of products and services included in industry segments and a description of the geographical areas into which the enterprise’s foreign operations have been segmented); and
(b) The basis of accounting for inter-segment sales or transfers.
There is a more general requirement for accounting policies relevant to industry segment to be described to the extent that they are not adequately explained by disclosures of the enterprises accounting policies. The Financial Accounting Standards Board of the.
USA and the Canadian Institute of Chartered Accountants both do not require specifically accounting policy disclosures in respect of:
(а) The methods of allocating common expenses.
(b) The company’s policy in defining general corporate expenses and general corporate assets.
Item # 8. Inter-Segment Transfers:
Total revenues, including inter-segment transfers, should be disclosed in the segment income statements. The amount of such transfers should be shown either on a separate line or by footnote.
Management should be free to determine the most appropriate method of pricing inter-segment transfers; the method used for pricing inter-segment transfers for internal reporting purposes will also usually be satisfactory in presenting the segment income statements.
The methods of pricing inter-segment transfers should be disclosed in the segment reports. Where a major portion of a segment’s sales (say, 50% or more) represent transfers to other segments of the firm, there is a substantial doubt that such an activity should be viewed as a separate segment.
Item # 9. Extraordinary Items:
Unusual, infrequent, or extraordinary items should be attributed to segments, whenever a directly identifiable relationship exists. More importantly, some such items may be peculiar to a segment’s particular industry and thus relate to its degree of risk, growth and profitability in a meaningful fashion.
Item # 10. Minority Interests:
If all of the minority interest relates to a segment, minority interest should be deducted. If the minority interest relates to more than one segment, it should be treated as a common cost.
Item # 11. Segment Depreciation and Capital Expenditures:
These should be reported since they are likely to be useful and are easy to verify.
Item # 12. Reconciliation to the Consolidated Amounts:
It has been emphasised that segment data should be reconciled to the consolidated financial statements. There seems little doubt that reconciliation is desirable, it helps, among other things, to stress that the segment data are a disaggregation of the consolidated financial data and that the same accounting principles are used for both, except that most inter-segment transactions eliminated from consolidated financial statements are reinstated and included in segment data.
Item # 13. Additional Information:
Disclosure of additional information about segments should be governed by the same precepts as disclosure of additional information about company-wide activities. If disclosure is necessary to understanding, then it should be required.
Among the items to be disclosed may be (a) the basis or bases of segmentation and the nature of operations of the various segments. This should include a listing of the classes of products included in each segment with the most significant of those products listed first, (b) if common costs are allocated, the method of allocating them; (c) an explanation of the treatment of investments accounted for by the equity, method.
Item # 14. Disclosure of Budget Data:
Budgetary data are useful in making investment decisions. Backer in his study has found that inclusion of forecast earnings in reports to shareholders would provide an additional basis for investor decisions and evaluating management’s performance.
Backer is of opinion that it may be advisable for management to give favourable budget information in external reports and thereby avoid taking direct responsibility for the realisation of plans but to have benefits for increased investment attractiveness.
Segmental disclosure of budgetary data would help investors and creditors make better decisions by improving their ability to evaluate the future potential of both the company and its management. It would also help Government to make better estimates of investment levels, tax revenues, and guide them in policymaking decisions in the areas of taxes and investments.