Many U.S. companies operate in several different industries or in different geographic area. When this occurs, the difficulties related to financial statement analysis are compounded. Investors who must evaluate the relative strengths and weaknesses of stock of a diversified company have a difficult task when analyzing such companies which report only the aggregate of their operations. Industry segments and geographic areas of operations can have different levels of risk and opportunities. Strengths and weaknesses of a company are difficult to isolate when only consolidated financial statement are presented and segments exist. For this reason, financial statement analysts prefer to rely upon supplementary information provided in financial statements referred to as segment reporting which provides disaggregated information to assist them in evaluating the company.
The need for segment information is the result of many environmental factors, including the growth of conglomerates, acquisitions, diversifications, and foreign activities of enterprises. Segment information is included (1) within the body of the financial statements, with supporting footnote disclosures, (2) entirely in the footnotes, or (3) in a separate schedule that is considered an integral part of the financial statements.
REPORTABLE SEGMENT SFAS 131, Disclosures about Segments of an Enterprise and Related Information, defines an operating segment as a component of an enterprise that engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same enterprise), whose operating results are regularly reviewed by the enterprise’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance, and for which discrete financial information is available.
Examples of a segment of a business include a subsidiary, a division, a department, a product, a market, or other separations where the activities, assets, liabilities, and operating income can be distinguished for operational and reporting purposes. Information about segments of a business, especially for diversified companies, is useful to investors of large, complex, heterogeneous, publicly traded enterprises in evaluating risks, earnings, growth cycles, profit characteristics, capital requirements, and return on investments that can differ among segments of a business. A reportable segment is determined by:
1. Identifying the enterprise’s products and services, 2. Grouping the products and services into industry segments, and 3. Selecting the significant industry segments by applying various test established for this purpose. Under SFAS 131, information must be reported separately about an operating segment that reaches one of three quantitative thresholds: (1) Its revenue (including sales to external customers and intersegment sales or transfers) is equal to at least 10% of the combined revenue, internal and external, of all the enterprise’s operating segments; (2) its assets are equal to at least 124 10% of the combined assets of all operating segments; and (3) the absolute amount of its reported profit or loss is equal to at least 10% of the greater, in absolute amount, of the combined reported profit of all operating segments that did not report a loss or the combined reported loss of all operating segments that did report a loss (profit or loss test).
Note: SFAS 131 state that a group of customers under common control must be regarded as a single customer in determining whether 10% or more of the revenue of an enterprise is derived from sales to any single customer. A parent and a subsidiary are under common control, and they should be regarded as a single customer. SFAS 131 does not specifically define the reported revenue of an operating segment except to say that it includes both sales to external customers and intersegment sales or transfers. SFAS 131 requires disclosures about measurements of segment profit or loss (including revenue) and segment assets, but it does not stipulate how those measurements are to be made.
SEGMENT DISCLOSURES Segment information that must be disclosed in financial statements includes an enterprise’s operations in different industries, foreign operations and export sales, and major customers. Detailed information must be disclosed relating to revenues; segment’s operating profit or loss, and identifiable asset along with additional information. Segment information is primarily a desegregation of the entity’s basic financial statements. Publicly held corporations must report for each reportable segment of the entity the following information:
1. Revenues. 2. Operating profit or loss. 3. Identifiable assets. 4. Depreciation, depletion, and amortization expense. 5. Capital expenditures. 6. Effects of accounting changes. 7. Equity in net income and net assets of equity method investees whose operations are vertically integrated with the operations of the segment, as well as the geographic areas in which those vertically integrated equity method investees operate. GAAP requires companies to report the following items for each foreign operation, if (1) revenue from such operations is 10 percent or more of the consolidated revenue or (2) identifiable assets of the entity’s foreign operations are 10 percent or more of consolidated total assets:
1. Revenues. 2. Operating profit or loss 3. Identifiable assets. If 10 percent or more of the revenue of an enterprise is obtained from sales to any single customer, that fact and the amount of revenue from each such customer must be disclosed. According to a committee of the Financial Analysts Federation, the elements of good reporting include: 125
1. Clear presentation of information that goes beyond the minimum reporting requirements and put company operations in perspective. 2. Written commentary that explains why important developments occurred. 3. A timely, consistent, and responsible investor relations program that informs the financial analyst in an unbiased manner.
4. An ability to articulate and communicate the business philosophy and principal strategies of management and the way in which management is organized to carry them out. Segment analysis is especially useful in understanding the relative contribution of segments to the overall performance and asset base of a company. Segment information discloses a great deal about a company’s diversification policy and enables the analysts to make meaningful industry comparisons. The analyst’s task is made difficult because of the rather limited segment disclosures required and the accounting practices involved in compiling the data.
The company must also disclose if foreign operations, sales to a major customer, or domestic contract revenue provide 10 percent or more of total sales. The percentage derived and the source of the sales must be stated.
The following information about geographic areas is reported if practicable: external revenues attributed to the home country, external revenues attributed to all foreign countries, material external revenues attributed to an individual foreign country, the basis for attributing revenues from external customers, and certain information about assets. Useful segment information that may be disclosed includes sales, operating profit, total assets, fixed assets, intangible assets, inventory, cost of sales, depreciation, and amortization. Segment cash flow need not be reported.