|NANCY B. NICHOLS, CPA, PhD, is assistant professor of
accounting at James Madison University in Harrisonburg,
Virginia. Her e-mail address is firstname.lastname@example.org. |
DONNA L. STREET, PhD, is Arthur Andersen Alumni Professor of Accounting at James Madison University. Her e-mail address is email@example.com.
Most public companies are now determining what impact FASB Statement no. 131, Disclosures about Segments of an Enterprise and Related Information , will have on their 1998 financial statements. The pronouncement requires companies to report financial and descriptive information about reportable operating segments, the components of the enterprise that provide separate financial data to the company's decision maker. As companies take the steps necessary to comply with Statement no. 131, they should look first at some of the major changes from previous guidance. The financial statements of early adopters of Statement no. 131, many of which had to alter their segment disclosures to comply, illustrate many of these changes and can help companies determine how they should segment their businesses for financial reporting purposes and handle other implementation issues as well.
Statement no. 131 replaces Statement no. 14, Financial Reporting for Segments of a Business Enterprise , for years beginning on or after December 15, 1997. Statement no. 14 defined industry segments based on related products and services. Statement no. 131 requires companies to base operating segments on the organization's internal structure, which is not necessarily by industry. It also requires limited enterprisewide disclosures. Following are some other differences between the two statements:
- Statement no. 131 establishes disclosure requirements for reportable segments based on how a company is managed rather than on the industry, geographic and major customer approach of Statement no. 14.
- Statement no. 131 requires more detailed disclosures for operating segments, including significant noncash items other than depreciation, depletion and amortization.
- Under Statement no. 131, companies must disclose limited segment information in interim financial statements; Statement no. 14 had no such requirement.
All companies, even those with only one reportable operating segment, must provide enterprisewide disclosures. Exhibit 1, page 39, compares some of the major disclosures required under Statement nos. 131 and 14.
|Seeing Is Believing
Companies preparing to implement FASB Statement no. 131 will find it helpful to examine the financial statements of the 14 early adopters discussed in this article. It's easy to use the Web to access their annual reports:
Statement no. 131 requires companies to disclose segment information based on how management organizes the segments of the enterprise to make operating decisions and assess performance. Operating segments are a company's revenue-producing components for which it produces separate financial information for internal use that is reviewed regularly by the company's chief operating decision maker. This is the individual, the CFO or COO, or group, a management or executive committee, that allocates the company's resources and assesses how its segments perform.
Statement no. 131 allows companies some flexibility in how they determine their segments, including by products and services, geography, legal entity or type of customer. Statement no. 14 took a different approach, requiring companies to disclose industry segments based on related products and services using measures such as standard industry classification codes. Statement no. 131's segments, based on a company's internal organization structure, may differ significantly from the industry-based segments under Statement no. 14. For example, a company that previously combined a variety of consumer products into one industry segment may now be required to disclose several segments based on its internal reporting structure.
Our review of U.S. companies included in Business Week' s Global 1,000 found 14 early adopters of Statement no. 131: Baker Hughes, Best Foods, Boeing, Coca-Cola Enterprises, E.W. Scripps, General Motors, Harley-Davidson, Host Marriott, McDonald's, JC Penney, Reynolds Metals, Texas Instruments, Time Warner and Wal-Mart. Of the 14 companies, 7 disclosed more segments under Statement no. 131 than they did under Statement no. 14, 6 disclosed the same number and 1 (Best Foods) reported fewer segments. Only Best Foods and Coca-Cola Enterprises have one reportable segment.
OPERATING SEGMENT IDENTIFICATION
A company's operating segment identification process should begin with its organizational chart and identifying the chief operating decision maker. The company controller should identify the business units that provide separate financial information to that decision maker; these units are the company's operating segments. In its 1997 annual report, for example, GM discussed at length how it had determined its reportable segments and identified its chief decision maker as a group called the president's council.
After identifying its operating segments, a company can determine its reportable segments by applying the Statement no. 131 aggregation criteria. The company may combine two or more operating segments if the segments have similar long-term financial performance and the same basic characteristics in products and services, production processes, technology underlying the production process, type or class of customers, methods used to distribute products or provide services and, if applicable, regulatory environment. For example, in its 1997 annual report, Baker Hughes said, The company's nine business units have separate management teams and infrastructures that offer different products and services. The business units have been aggregated into three reportable segments since the long-term financial performance of these reportable segments is affected by similar economic conditions.
After aggregating its segments, a company should consider the quantitative thresholds under Statement no. 131. A company must report separate information about aggregated segments that meet a greater than or equal to 10% test based on (1) reported revenue, (2) the absolute amount of reported profit or loss or (3) assets for all operating segments. However, if total external revenue reported by the segments is less than 75% of consolidated revenues, the company must identify additional segments until the 75% requirement is met. Statement no. 131 suggests a practical limit of 10 reportable segments. One early adopter (Time Warner) reported 10 segments. Statement no. 131 provides additional guidance about determining reportable segments in a flowchart in appendix B.
|Exhibit 1: Major Disclosure Categories of FASB Statement no. 131 and FASB Statement no. 14|
Under Statement no. 131, there should be a better match between the divisions discussed in a company's management's discussion and analysis (MD&A) and those reported under segment reporting. This uniformity provides a direct link between internal and external reporting and should help users identify the risks and opportunities management believes are important. Under Statement no. 14, Host Marriott, typical of many other companies, discussed a variety of business units in its 1996 MD&A while reporting no industry segments. However, under Statement no. 131, Host Marriott's reportable segments now match the number discussed in its MD&A. In fact, the majority of the early adopters' MD&As parallel their reportable segments.
Under the management approach, a company's reportable segments do not have to follow its product and service lines. However, for many companies, the segments will continue to do so. Other companies, especially those in the early stages of international expansion, may report a combination of product and service and international segments. For example, Wal-Mart went from claiming one industry to reporting three operating segments (Wal-Mart stores, Sam's Club and international). In some cases, companies may be managed geographically and determine reportable segments based on geographic location. McDonald's disclosed four reportable segments: United States, Europe, Asia/Pacific and Latin America. Exhibit 2 illustrates the segment identification process for a company with a mix of product lines and operating segments similar to Wal-Mart.
DETAILED OPERATING SEGMENT DISCLOSURES
For companies with more than one reportable segment, required disclosures include certain general information, segment profit or loss, segment assets, measurement information and reconciliation information. The general information disclosures include the criteria used to identify reportable segments, whether the company aggregated segments and the types of products and services from which a segment derives its revenues. Several early adopters provide extensive information about reportable segments (see 1997 annual reports of GM and Reynolds Metals).
Under Statement no. 131, entities must report profit or loss and total assets for each operating segment. The dollar amounts should be the same as those provided the decision maker for resource allocation and performance decisions. The dollars disclosed do not have to be determined in accordance with GAAP, a change from Statement no. 14. Many analysts find this provision troublesome because it allows management to determine how segment profit is calculated; analysts are concerned managers will manipulate information to enhance profitability. Moreover, not having a specific definition will result in a lack of uniformity, which in turn will reduce the comparability of segments between companies.
In addition to profit or loss and total assets, companies must disclose the following information for each segment if the amounts are included in determining the segment's profit or loss provided to the decision maker:
- Revenues from external customers.
- Revenues from other operating segments.
- Interest revenue or expense.
- Depreciation, depletion and amortization expense.
- Unusual items under APB Opinion no. 30, Reporting the Results of Operations, Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions.
- Equity in net income of investees accounted for under the equity method.
- Income tax expense or benefit.
- Extraordinary items.
- Other significant noncash items.
Companies must disclose the following additional information if it is included in determining segment assets reviewed by the decision maker:
- Investments in equity-method investees.
- Additions to long-lived assets other than financial instruments.
Each of the 12 early adopters with more than one reportable segment consistently disclosed the following required information for each segment:
- Revenues from external customers.
- Operating or segment profit.
- Depreciation and amortization expense.
- Total assets.
- Capital expenditures.
Six companies provided a reconciliation from total segment profit to consolidated earnings before taxes (Baker Hughes, Boeing, JC Penney, Reynolds Metals, Texas Instruments and Wal-Mart). Four reported revenues from other operating segments (GM, Reynolds Metals, Time Warner and Wal-Mart). Two (GM and Host Marriott) disclosed interest income and expense. Two (GM and Reynolds Metals) disclosed earnings from and investment in nonconsolidated affiliates. Boeing voluntarily disclosed research and development and liabilities by segment. Companies usually make voluntary disclosures to highlight good news.
To improve analysts' ability to estimate segment operating cash flow, Statement no. 131 requires companies to disclose significant noncash items, in addition to depreciation and amortization, if the information is reported internally. This was a compromise from requiring companies to disclose segment cash flow. Only E. W. Scripps disclosed other noncash items.
Under Statement no. 131, companies must include reportable segment information in interim statements beginning in the second year of application. Statement no. 14 required no quarterly disclosure. The interim disclosure requirements are limited to
- External customer revenues.
- Intersegment revenues.
- Segment profit or loss.
- Total assets if there has been a material change since the last annual report.
- Any differences in the basis of segmentation or measurement of segment profit or loss from the company's last annual report.
- A reconciliation from total segment profit or loss to consolidated income before taxes.
All 12 early adopters disclosed external customer revenues, segment profit or loss and a reconciliation from total segment profit to consolidated income before taxes in their 1998 first-quarter interim statements. Four companies disclosed total segment assets. E. W. Scripps included the most extensive interim information by adding disclosures for depreciation, other noncash items and additions to long-term assets.
Restatement of previously reported information. When they adopt Statement no. 131, companies must restate prior-period information. After adoption, companies that restructure internally in a way that changes their reportable segments must restate prior periods unless doing so is impracticable. Reynolds Metals, for example, which restructured during 1997, said it was not practicable to present the new segment information for the year 1995 because it is not available and the cost to develop is excessive.
Statement no. 131 requires all entities, even those with one reportable segment, to make disclosures about products and services, geographic areas and major customers. A company must make the disclosures only if it has not included them in the reportable segment disclosures.
The statement requires companies to report revenues from external customers for each product and service or each group of similar products and services for the company as a whole. All early adopters either provided this information in their reportable segment disclosures or indicated they operate in only one line of business.
The geographic disclosures include revenues from external customers and long-lived assets. These disclosures are required for the entity's country of domicile and foreign countries in the aggregate, with separate disclosures that are material for individual foreign countries. In contrast to Statement no. 14, the new standard does not require disclosure of operating profit or loss by geographic location. Of the 10 companies disclosing geographic information, 8 reported only the required items. Best Foods and GM also reported operating income. If a company does not report geographic information because it is impractical to do so, that fact should be disclosed.
Requiring companies to disclose separate geographic information for the country of domicile will result in their making separate disclosures of U.S.-only information. In past years, many companies reported geographic information for North America, combining the United States with Canada and Mexico. Other than Coca-Cola Enterprises, all early adopters disclosed U.S.-only amounts. Coca-Cola reported amounts for North America, including short-period amounts for Canadian bottlers that it said are not indicative of full-year results.
Statement no. 131 should result in companies reporting more geographic segments. For example, in 1996, Harley-Davidson disclosed aggregate foreign operations; the next year it reported separate geographic information for the United States, Canada, Germany and Japan. Texas Instruments illustrates the difference between specific country disclosure under Statement no. 131 and Statement no. 14's broader geographic disclosures. In 1996, the company disclosed information for three areas, the United States, Europe and East Asia. In 1997, it disclosed information for four areas, the United States, Japan, Singapore and the rest of the world.
Statement no. 131 continues to require disclosures about major customers. If a company derives 10% or more of its revenue from a single external customer, it must disclose that fact and the total amount of revenue from each major customer and must identify the segment(s) reporting such revenues. For example, Boeing disclosed the percentage of sales to the U.S. government included in the information, space and defense systems segment.
Statement no. 131 changes the framework for reporting segment information to a system based on a company's management approach. Our review of early adopters suggests companies should carefully review the level of consistency between their MD&As and reportable operating segments. While considerable variation existed in 1996, the majority of early adopters have consistent MD&A and segment reporting under Statement no. 131. A company that discusses products or geographic areas separately in its 1998 MD&A that it does not report separately in the operating segment information should consider disclosing those items in its enterprisewide information.
Restructurings, spin-offs and international expansions are common in today's business environment. Reportable segments under Statement no. 131 likely will be affected by these activities. Because companies generally are required to restate prior periods when reportable segments change, they need to address this reporting issue as they undertake these activities.
Evidence from early adopters indicates companies also need to evaluate their geographic groupings carefully. Under Statement no. 131, many companies now have to provide additional or more specific geographic information in their financial statements. All companies are required to report U.S.-only information and many will be required to report other individual country information. Significant operations in a single country, such as Germany or Japan, no longer can be concealed by including them in vague groupings such as Europe/Asia or Asia/Pacific.