It's Time to Implement Segment Disclosures

Act now; the clock is ticking.
BY KENNETH R. BUNCE

EXECUTIVE SUMMARY

  • SOME COMPANIES MAY HAVE OVERLOOKED the potential financial reporting impact of FASB Statement no. 131, which must be applied to 1998 financial statements. The statement requires companies to report financial and other information about their operating segments.

  • STATEMENT NO. 131 IS LIKELY TO RESULT in companies reporting more operating segments and more information about those segments than previously. Some of these disclosures may be considered sensitive or viewed as putting an enterprise at a competitive disadvantage.

  • ONE OF THE MOST IMPORTANT STEPS in determining segment disclosures is identifying the company's operating segments. In determining whether it has identified its operating sections properly, a company should consider how it described its business components in other parts of its annual report and how it described itself to analysts and on the company's Web site.

  • COMPANIES THAT HAVE NOT DONE SO SHOULD devote time to analyzing the impact of complying with Statement no. 131. The company's independent auditor may be helpful in providing interpretive and implementation guidance and in determining how other aspects of the company's annual report and SEC filings may be affected.
KENNETH R. BUNCE, CPA, is a partner in the professional practices department of KPMG Peat Marwick LLP in New York.



With so many companies paying attention to the new accounting standard on derivatives or racing against time to solve Year 2000-related problems, some may have overlooked another potentially significant financial reporting matter with a rapidly approaching deadline. FASB Statement no. 131, Disclosures about Segments of an Enterprise and Related Information , is effective for years beginning on or after December 15, 1997. This means companies must comply with its requirements to report financial and other information about operating segments in their 1998 financial statements.

Few of the companies affected by Statement no. 131 elected to adopt it early. (See the article on page 37.) This suggests companies may have

  • Not thoroughly evaluated the statement's disclosure requirements but believe they will not cause any significant problems when adopted. Companies that have historically reported only one industry segment are the most at risk.

  • Evaluated and understood the statement but are not particularly pleased with the nature and extent of the additional information they will be required to disclose. As a result, they are delaying the pain as long as possible or are waiting to see how other companies adopt the statement with the hope of finding creative ways around certain requirements.

In either case, companies should not be misled by the seemingly harmless title of Statement no. 131. While its disclosure-only requirements do not require accounting changes and thus will not have an impact on how the company determines its consolidated net income, Statement no. 131 is likely to require enterprises to report more operating segments and more information about those segments. Because Statement no. 131 adopts a management approach to replace the industry segment approach used in FASB Statement no. 14, Financial Reporting for Segments of a Business Enterprise , some of the new disclosures may be sensitive in nature.

WHY NEW RULES?
When companies finally adopt Statement no. 131, the primary benefits to financial statement users are expected to include

  • The ability to see an enterprise through management's eyes, thereby making it easier for the user to predict management actions or reactions that can have a significant effect on the enterprise's prospects for future cash flows.

  • The elimination of confusion caused by varying broad interpretations of what constitutes an industry segment.

  • Reporting that is more consistent with discussions about the enterprise's components elsewhere in the annual report (president's letter, management's discussion and analysis) and in company press releases.

THE MANAGEMENT APPROACH
Under the new management approach, determining which industry a component of an enterprise operates in is not relevant. Instead, an operating segment is determined in substantially the same way information is reported internally and used by the enterprise's chief operating decision maker to evaluate performance and make operating decisions. This means operating segments could include components of an enterprise that sell products to others in the consolidated group (vertically integrated operations) as well as start-up operations. The measures and amounts of assets and operating results of these segments reported to the chief decision maker generally are those the company must disclose in its financial statements. The accounting methods used to determine segment operating results do not have to be consistent with those an enterprise uses to prepare its consolidated financial statements. In fact, the methods used to determine segment operating results do not even have to follow GAAP. A company is, however, required to make reconciliations to consolidated totals and to disclose the nature and extent of any significant reconciling differences.

From a company's viewpoint, the cost of complying with the Statement no. 131 disclosures should be relatively low. If information already is being generated for use by the chief operating decision maker, the company should have to produce very little incremental information to satisfy the statement.

THE RISK OF COMPETITIVE HARM
Some companies are concerned that certain information they are required to disclose under Statement no. 131 may be sensitive or could put an enterprise at a competitive disadvantage. For example, information disclosed about a segment could affect contract negotiations with a customer, vendor or employee union. Nonpublic and foreign enterprises, which are not required to follow Statement no. 131, may as a result gain a competitive advantage over U.S. public companies.

FASB was sympathetic to those and other issues. It addressed specific concerns by

  • Eliminating some of the disclosure requirements proposed initially.

  • Adding quantitative materiality thresholds (10% tests) for identifying reportable segments.

  • Allowing management to select the other operating segments it may need to report to meet the 75%-of-consolidated-revenues test, which ensures entities disclose an adequate number of segments.

  • Changing the disclosure requirements about products, services and geography from a segment basis to an enterprise-wide basis.

FASB, however, did not provide a competitive-harm exemption. Companies should not look for the SEC to be more sympathetic than FASB. The commission said it expects companies to apply all of Statement no. 131's provisions rigorously.

STATEMENT NO. 131 ADOPTION TIPS
The first step a company will take in adopting Statement no. 131 is to identify the chief operating decision maker. This is a function (not a title) usually the highest level of management (the CEO or COO) responsible for an enterprise's overall resource allocation, although it could be performed by more than one person, such as an executive or management committee. There can, however, be only one person or group in a company identified as performing this function.

Once a company identifies the decision maker, the entity must determine the operating segments reported to that person or group. Operating segments usually are evident from the structure of the enterprise's internal organization. However, companies also should consider how they have historically described the components of their businesses in other parts of the annual report and in SEC filings. A company's independent auditor and the SEC may expect the company to determine its operating segments in the same way. In addition, the auditor and the SEC also may look at how the company describes its business on its Web site or how the business is described and measured in analysts' reports. This presumes that company executives describe the enterprise in a way that enhances analysts' understanding and thus indicates how it is internally managed.

Companies also can expect the auditor and the SEC to scrutinize how the company applies Statement no. 131's aggregation criteria, whose purpose is simply to reduce the extent of reportable information when it otherwise would not add significantly to a user's understanding of the enterprise. Companies can aggregate operating segments if they have similar economic characteristics and meet all of the other five aggregation criteria specified in Statement no. 131.

Auditors, the SEC and financial statement users are concerned that if a company misapplies the aggregation criteria, it will reduce the extent and visibility of useful information in its financial statements. They presume that if information is reported to and used by the company's decision maker, then it probably also is significant to users. If in applying the criteria a company decides not to report a segment separately because it believes it is similar to another operating segment, it should weigh carefully why it reports the segment separately to the decision maker.

For each segment, companies must disclose certain specific elements of segment assets and operating results if they report them to the chief decision maker. In fact, even if a company does not include certain specified elements in the measure of segment assets or segment profit and loss but still reports them to the decision maker, it must disclose these elements in the financial statements.

After completing the initial assessment, companies may wish to reevaluate the nature and extent of the information they report to the decision maker. A word of caution: Independent auditors and the SEC may view changes to the type of information or level of detail provided to the decision maker with considerable skepticism. However, legitimate opportunities exist to change the form and content of information that meets the decision maker's needs and also complies with Statement no. 131 objectives and requirements.

Once a company has come to terms with the information it will have to disclose under the FASB statement, it may want to see how other companies have complied or will comply with the statement. Given the relatively small number of early adopters, it may not be possible to find examples of all of the specific implementation issues a company faces. Delaying the release of full financial statements to see how competitors or others in the same industry comply may not be a particularly useful strategy. Enterprises in the same industry may have different internal organizations and thus their operating segments will differ. In addition, the extent of the information and the measures of segment assets and operating results the decision maker of these enterprises uses also may be different. As a result, comparability of companies within the same industry could be reduced. FASB acknowledged that Statement no. 131 could affect comparability but did not consider this a key requirement in adopting the statement. In fact, FASB expressed concern that enterprises reporting under Statement no. 14's industry segment approach may have appeared more comparable than they really are.

ACTION TO TAKE NOW
It would be prudent for companies to devote more attention to the potential impact of adopting Statement no. 131. A company should consult its independent auditor on interpretive matters and on the documentation needed to satisfy the auditor about the significant assertions and judgments the company has made to comply with Statement no. 131. The independent auditor also can inform the company on how the MD&A and other aspects of the annual report and SEC filings may be affected. Companies may still have legitimate planning opportunities that will mitigate potential concerns and still allow them to meet the objectives of FASB Statement no. 131.

SPONSORED REPORT

Year-end tax planning and what’s new for 2016

Practitioners need to consider several tax planning opportunities to review with their clients before the end of the year. This report offers strategies for individuals and businesses, as well as recent federal tax law changes affecting this year’s tax returns.

QUIZ

News quiz: IRS warning on cyberattacks and a change in pension rules

Once again, the IRS sounds the alarm about a threat from cyberthieves. See how much you know about this and other recent news with this short quiz.

CHECKLIST

Bolster your data defenses

As you weather the dog days of summer, it’s a good time to make sure your cybersecurity structure can stand up to the heat of external and internal threats. Here are six steps to help shore up your systems.