Often, the rules and regulations created by governing bodies are reactions to societal events and pressures. This pattern certainly holds true in regards to financial reporting. The first financial reporting regulations were set in place during the Great Depression in reaction to the stock market collapse of 1929. These regulations were The Securities Act of 1933 and The Securities Exchange Act of 1934, which established the Securities and Exchange Commission (SEC) and became the foundation for future financial reporting regulations.
While addressing Congress, President Roosevelt said that the 1933 Act “…puts the burden of telling the whole truth on the seller. It should give impetus to honest dealing in securities and thereby bring back public confidence. “[1] Some companies had already been publishing financial statements prior to these requirements, apparently believing that the benefits of disclosure outweighed the costs. However, there were no standards that governed these disclosures and some of the statements were basically useless.
For example, a corporation released an annual report in 1902 that stated “[t]he settled plan of the directors has been to withhold all information from stockholders and others that is not called for by the stockholders in a body. So far no request for information has been made in the manner prescribed by the directors…”[2] I think that most investors would agree that the financial reports released by corporations today are far more useful than this sort of disclosure which happened prior to the enactment of the Acts of 1933 and 1934.
Again, in the 1960’s societal pressures resulted in financial reporting changes. Amid the civil rights movement, the feminine movement, and the environmental movement, congressional hearings of the Subcommittee on Antitrust and Monopoly of the Senate Committee on the Judiciary began to investigate U. S. industries. During these hearings, in 1965, economics Professor Joel Dirlam recommended in his testimony that the Securities and Exchange Act of 1934 be amended to require corporations to report “the relative profitability of different divisions and product lines”. 3] The Subcommittee was so intrigued by this idea that it asked Manuel Cohen, Chairman of the SEC to comment on Professor Dirlam’s recommendation. Cohen responded “with a letter and memorandum to Senator Hart [Chairman of the Subcommittee on Antitrust and Monopoly] …pointing out some of the difficulties of Dirlam’s proposal and reasons for not requiring such information at that time. “[4] In May 1966, Manuel Cohen addressed the Financial Analysts Federation at their annual meeting stating that disclosure of sales and profit on a divisional basis should be the next goal of financial reporting by conglomerate companies.
According to Skousen “[t]his date is often accepted as the beginning of the campaign for segmented disclosure by diversified companies. “[5] Later in 1966 “Cohen testified before the Subcommittee on Anti-trust and Monopoly, indicating that the SEC already has authority under the 1933 and 1934 Acts to require disclosure of segment operating results if that is in the interest and for the protection of the investing public. “[6]
This caught the attention of many different professional financial organizations who according to Sprouse had “an apprehensive attitude toward the activities of the SEC…[i]t was considered important, therefore, that some group seize the initiative in determining how far the reporting requirements for diversified companies should go and in marshalling the support for acceptable recommendations. “[7] In 1967 the Accounting Principles Board (APB) released its Statement No. , “Disclosure of Supplemental Financial Information by Diversified Companies”, which urge[d] diversified companies to disclose voluntarily supplemental financial information as to industry segments of the business. The Board believes that the experience derived from voluntary disclosure efforts, together with the conclusions to be derived from research activities and further study, should provide it with a sound basis for making a definitive pronouncement in the future. [8]
Some critics of segment reporting were concerned about the possibility of companies losing their competitive advantage due to the disclosure of profit information by line of business as well as the additional costs of generating these reports. However, several organizations including the Financial Analysts Federation (FAF), the Financial Executives Institute (FEI), and the National Association of Accountants (NAA) issued pronouncements that generally supported the reporting of segment information. [9] In 1968, the SEC proposed a requirement to report line of business information when registering with the exchange.
The proposal required that each company: [s]tate for each of the five years the approximate amount or percentage of sales or operating revenues and contribution to net income, excluding extraordinary items, attributable to each class of related or similar products or services which contributed 10% or more to the total of sales and revenues, or to net income, before extraordinary items and income taxes, during either of the last two fiscal years… In addition, [the company should] state, if practicable, the amount of assets employed in each segment of the business for which operating results are reported. 10] The APB and FEI both had issues with the proposal, most notably the 10% requirement, believing that 15% was a better threshold for disclosure. Furthermore, the APB felt that the considerable difficulties in allocating assets to segments might ultimately provide misleading data to investors. [11] When the SEC released the change to registration requirements on July 14th, 1969, disclosure of each segment’s assets was no longer required and only lines of business which contributed 15% or more to income before taxes or total sales were required to be reported separately.
In 1970 these requirements were added to the 10-K annual reports filed with the SEC and in 1974 companies filing with the SEC had to disclose segment information in their annual reports to stockholders. As mentioned earlier, although many organizations generally supported segment reporting there were many disagreements and obstacles pertaining to the actual implementation of these new reporting requirements. Some of the main questions were: – How is a segment defined? Who decides?
Which ones should be reported? – Which information should be reported? – Should intra-corporation transactions be included? – How do you allocate common costs to individual segments? In 1973, the Financial Accounting Standards Board (FASB) set out to answer these questions and placed a segment reporting project on its technical agenda. In December 1976 FASB released its Statement of Financial Accounting Standard No. 14 (SFAS 14), “Financial Reporting For Segments of a Business Enterprise”.
According to FASB, “[t]his Statement requires that the financial statements of a business enterprise…include information about the enterprise’s operations in different industries, its foreign operations and export sales, and its major customers. This Statement also requires that an enterprise operating predominantly or exclusively in a single industry identify that industry. “[12] In the Statement an industry segment was defined as, “component of an enterprise engaged in providing a product or service or a group of related products and services primarily to unaffiliated customers (i. e. , customers outside the enterprise) for a profit. [13] The Board goes on to say that there are currently no systems that suitably classify an industry segment for the purpose of financial reporting, therefore “determination of an enterprise’s industry segments must depend to a considerable extent on the judgment of the management of the enterprise”. [14] SFAS 14 determined which segments should be reported by using the following quantitative tests: COMMENT: ACS #? For purposes of this Statement, an industry segment shall be regarded as significant—and therefore identified as a reportable segment…if it satisfies one or more of the following tests.
The tests shall be applied separately for each fiscal year for which financial statements are presented… a) Its revenue (including both sales to unaffiliated customers and intersegment sales or transfers) is 10 percent or more of the combined revenue (sales to unaffiliated customers and intersegment sales or transfers) of all of the enterprise’s industry segments. b) The absolute amount of its operating profit or operating loss is 10 percent or more of the greater, in absolute amount, of: (i) The combined operating profit of all industry segments that did ot incur an operating loss, or (ii) The combined operating loss of all industry segments that did incur an operating loss… c) Its identifiable assets are 10 percent or more of the combined identifiable assets of all industry segments. [15] In addition to industry segments, these same tests can be applied in order to determine if geographical segment information is required. For instance, if 10% of an enterprise’s revenue were produced in a country or region, that country or region would qualify as a reportable segment.
Finally, if one customer makes up 10% or more of a business’s revenue “that fact and the amount of revenue from each such customer shall be disclosed. “[16] These quantitative tests are also subject a qualitative measure. For example, in order to promote comparability, a segment that has contributed more than 10% of an enterprise’s revenue in the past (and that is expected to in the future) should be presented as a segment even if that particular line of business did not meet the 10% requirement in the current year.
Furthermore, in order to ensure that these segments represent a “substantial portion” of a company’s total operations, FASB used the following test: The combined revenue from sales to unaffiliated customers of all reportable segments (that is, revenue not including intersegment sales or transfers) shall constitute at least 75 percent of the combined revenue from sales to unaffiliated customers of all industry segments. If this test is not met, more segments are required to be disclosed.
SFAS 14 requires that revenues, operating profits and losses, and identifiable assets be presented in an enterprise’s financial statements. These numbers will include intra- company transactions. If an asset is used by more than one segment, it should be allocated among those segments on a “reasonable basis”. Additional disclosures are also required such as aggregate depreciation information and capital expenditures for a segment as well as disclosures pertaining to unconsolidated subsidiaries.
If an enterprise issues complete financial statements for interim periods, they are required to disclose segment information in their interim reports as well. The Board was convinced that the new standard, although not perfect, was the best option in order to maximize verifiability, completeness, usefulness, and comparability in a conglomerate’s financial reporting. Nevertheless, over the next few years there were quite a few changes made to SFAS 14.
I will provide a quick summary of these changes: – SFAS No. 18 (1977) eliminates the requirement to report segment information on an interim basis. – SFAS No. 21 (1978) suspends the requirement for non-public companies to disclose segment information. – SFAS No. 24 (1978) states that if a parent or investee company submits complete separate financial statements in addition to consolidated statements, the parent or investee company may not be required to disclose segment information. SFAS No. 30 (1979) changes the requirements for disclosure of governmental customer information to be the same requirements as for non-governmental customers. SFAS 14, although slightly modified, continued being the standard for segment reporting into the 1990’s. However, many critics were concerned about the shortcomings of the Statement, most notably, “…that the flexibility in applying the segment definition criteria in SFAS No. 4 resulted in less useful information indicating that the segment definition guidelines have been exploited by companies to suit their own financial- reporting purposes. “[17] According to Albrecht & Chipalkatti, [m]any companies exploited the vagueness in the SFAS No. 14 definition of industry segment to consider themselves a single- segment company. A FASB study of 6,935 public companies found that about 75% said they operated in only one industry segment in the 1985-1991 period. Forty-three percent of the 1,051 companies with sales more than $1 billion were single-segment companies. 18] According to the Association for Investment Management Research (AIMR), one of the 10 largest businesses in America was reporting as a single segment enterprise under the requirements of SFAS 14. [19] Furthermore, the fact that firms were required to submit segment information based on both geographic area and industry with no consideration to the internal structure of a company caused two sets of segment information to be produced. One set was used by management for internal decision-making and the other set was reported externally to conform to SFAS 14. 20] As a result, “the business review section and the chairman’s letter in an annual report frequently discuss the enterprise’s operations on a basis different from that of the segment information in the notes to the financial statements…”[21] In response to these issues, the AIMR stated that it, “believe[d] that segment data are most useful when they depict the way in which the enterprise itself is organized and managed…”[22] The American Institute of Certified Public Accountants (AICPA) Special Committee on Financial Reporting released a report in 1994 that agreed with the statements of the AIMR.
The report, “Improving Business Reporting—A Customer Focus,” identified some of the most important improvements needed to segment reporting: 1) Disclosure of segment information in interim financial reports 2) Greater number of segments for some enterprises 3) More information about segments 4) Segmentation that corresponds to internal management reports 5) Consistency of segment information with other parts of an annual report. In response to these issues, in June 1997 FASB released Statement of Financial Accounting Standards No. 31 (SFAS 131), “Disclosures About Segments of an Enterprise and Related Information” which superseded SFAS 14. The major change in the new Statement is how business segments are defined: An operating segment is a component of an enterprise: a. 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), b.
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 c. For which discrete financial information is available. An operating segment may engage in business activities for which it has yet to earn revenues, for example, start-up operations may be operating segments before earning revenues. [23] This new approach is referred to as the “management approach”[24] and its intention is to help financial analysts see the business operations from a manager’s perspective. 25] In theory, this management approach provides more predictive/feedback value, as it will allow analysts to see the same information that managers use to make operational decisions. It should also improve the consistency of segment reporting information with other parts of the annual reports. Although the definition of a segment has been changed, the quantitative requirements used to determine a reportable segment (i. e. , the 10% rule) is the same as it was under SFAS 14. There are a few more major changes made by SFAS 131. The first is the amount of financial information that is required to be disclosed.
In addition to the previously required information, the disclosure of interest expense, interest revenues, income tax expense, and significant non-cash items, if management uses the information while making operational decisions, is required. [26] Next, any foreign income can be aggregated, unless income from an individual country is deemed material in which case it must be disclosed separately. No regional foreign information is to be presented. The last major change implemented by SFAS 131 is that interim segment reporting, once eliminated by SFAS No. 18, is once again mandatory.
Because the new management approach relies on information that is already used by the enterprise, interim reports can now be produced with more timeliness and cost effectiveness than under the previous Standard. A study done by Hermann & Thomas shows that the SFAS 131 definitely changed enterprises’ financial reports: We find that the change in segment reporting requirements under SFAS No. 131 has made a relatively significant impact on the disclosure of segment information. Over two-thirds of the sample firms have redefined their primary operating segments upon adopting SFAS No. 131.
There has also been an increase in the number of firms providing segment disclosures and companies are disclosing more items for each operating segment. For enterprise-wide disclosures, the proportion of country-level geographic segment disclosures has increased, while the proportion of broader geographic area segment disclosures has decreased. However, the number of firms reporting earnings by geographic area has declined greatly as this item is no longer required to be disclosed for firms reporting on a basis other than geographic area. [27] Of course, there are some criticisms of SFAS 131.
One of the biggest is the fact that it does not necessarily adhere to GAAP. If the financial information used by managers in making operational decisions is not prepared according to GAAP (which it is not required to be), then the segment information that is disclosed will not be GAAP either. As you can imagine, some professionals cannot believe that FASB is willing to let this happen. One accountant asks, “How will the user know that revenue is cash basis or that many expenses are not accrued in the internal reporting process but rather are part of the year- end closing process to prepare third-party reports? [28] I think she raises a very good point. Another criticism that has been brought up is that if an enterprise would like to reduce the number of segments that it must disclose, all it has to do is change their management structure. “For instance, a company might require the head of a smaller segment to report not to the chief decision maker but to another executive, avoiding any need to disclose that unit’s results to the public. “[29] However, overall, SFAS 131 has improved segment reporting. [30] Internationally, segment reporting standards have undergone a similar evolution.
In 1981 the International Accounting Standards Committee (IASC) issued International Accounting Standard No. 14 (IAS 14). This standard was very similar to FASB’s SFAS 14, and like its American counterpart IAS 14 was “too general in its requirements to be effective. “[31] The International Standard left it up to the companies to determine which of their segments were significant and it required that both product and geographical segment information be reported. However, a 1994 survey showed that out of 1,062 large enterprises in 32 countries, 38% still reported only one industry segment. 32] Patricia McConnell of Bear Stearns in New York City said of IAS 14, “[a]lthough this provided users of financial statements with a lot of information, it wasn’t what users considered most useful. “[33] In an effort to correct the shortcomings of IAS 14 the Committee issued a revision in 1998, but it still used the industry and geographical location as the primary bases for determining business segments. The new Statement, IAS 14R, required disclosure of both industry and geographic segments.
This “two-tier approach” was a considerable divergence from SFAS 131, which was released in the U. S. at around the same time. IAS No. 14R defines a business segment as a distinguishable component of an enterprise engaged in providing an individual product or service or a group of related products or services and subject to risks and rewards that are different from those of other segments… A geographic segment is a distinguishable component of an enterprise engaged in providing products or services within a particular geographic or common bloc. [34]
The “risk-reward” qualitative threshold that is included in the definition of a business segment is meant to ensure separate reporting of segments that have different risk and reward characteristics even if they are in the same industry or geographic region. This risk-reward approach determines if the primary tier will be based on business segments or geographic segments. Whichever basis is not used in the primary tier will be used in the secondary tier. The divergence of the FASB and IASC standards in the late 1990’s caused some confusion and inefficiencies.
SFAS 131 used a management approach that did not require disclosure of an enterprise’s vertical integration or geographic segments. SFAS 131 also allowed some information to be reported that did not necessarily adhere to GAAP. On the other hand, IAS 14R utilized a two-tier, risk-reward approach that required disclosure of both business and geographic segments. This information would adhere to GAAP. In 2006, the International Accounting Standards Board (IASB), which replaced the IASC five years earlier, issued International Financial Reporting Standard 8 (IFRS 8) as part of the ongoing efforts of global convergence in accounting standards.
IFRS 8 uses the management approach and is essentially the same requirement as SFAS 131 (which is now known as ASC 280 because of FASB’s codification project). A few minor differences remain, such as the requirements to disclose liability as well as intangible asset information by segment under IFRS, but for the most part the differences between International and U. S. reporting standards have been eliminated. In introducing IFRS 8, the chairman of IASB, David Tweedie said, “IFRS 8 continues our work to eliminate major differences between IFRSs and US GAAP and to improve financial reporting. [35] It seems that the work of FASB and IASB have certainly accomplished these goals, at least in regards to the subject of segment reporting. ———————– [1] 77 Cong. Rec. 937, as cited by George Benston, “An Appraisal of the Costs and Benefits of Government Required Disclosure: SEC and FTC Requirements,” Law and Contemporary Problems, Vol. 41, No. 3, Reweaving the Corporate Veil, (1977): 30. [2] Jones, “Management Freedom in Annual Reports,” as cited by A. A. Sommer Jr. , “The Annual Report: A Prime Disclosure Document,” Duke Law Journal, Vol. 972, No. 6 (1973): 1097-8. [3] Hearings before the Subcommittee on Anti-Trust and Monopoly, Committee on the Judiciary, United States Senate, Eighty-Ninth Congress, First Session, as cited by Alfred Rappaport and Eugene Lerner, “Public Reporting By Diversified Companies,” Financial Analysts Journal, Vol. 26, No. 1 (1970): 55. [4] K. Fred Skousen, “Chronicle of Events Surrounding the Segment Reporting Issue,” Journal of Accounting Research, Vol. 8, No. 2 (1970): 294. [5] Ibid. , 294. [6] Ibid. , 294. 7] Robert Sprouse, “Diversified Views About Diversified Companies,” Journal of Accounting Research, Vol. 7, No. 1 (1969): 138. [8] Leonard Savoie, “Financial Reports in 1968,” Financial Analysts Journal Vol. 24, No. 2 (1968): 69. [9] FASB, “Statement of Financial Accounting Standards No. 14,” (1976), ¶43. [10] SEC, “Notice of Proposed Amendments to Forms S-1, S-7 and 10,” as cited by A. Rappaport & E. Lerner, (1970), 56. [11] A. Rappaport & E. Lerner, (1970), 56. [12] FASB, (1976), ¶1. [13] Ibid. , ¶10. [14] Ibid. , ¶12. [15] Ibid. , ¶15. [16] Ibid. , ¶39. 17] Association for Investment Management and Research, “Financial Reporting in the 1990’s and Beyond,” as cited by Don Herrmann & Wayne Thomas, “An Analysis of Segment Disclosures Under SFAS No. 131 and SFAS No. 14,” Accounting Horizons, Vol. 14, Iss. 3 (2000). [18] W David Albrecht & Niranjan Chipalkatti, “New Segment Reporting,” The CPA Journal, Vol. 68, No. 5 (1998). [19] Ibid. [20] D. Hermann & W. Thomas (2000). [21] FASB, “Statement of Financial Accounting Statement No. 131,” (1997), ¶61. [22] AIMR, “Financial Reporting in the 1990’s and Beyond: An Executive Summary,” Financial Analysts Journal, Vol. 8, No. 6 (1992), 22. [23] FASB (1997), ¶10. [24] FASB (1997), ¶4. [25] D. Hermann & W. Thomas (2000). [26] FASB, “Statement of Financial Accounting Statement No. 131,” as cited by D. Hermann & W. Thomas (2000). [27] D. Hermann & W. Thomas (2000). [28] Wanda Wallace, “FASB Must Be Kidding About Segment Reporting,” Accounting Today, Vol. 9, No. 15 (1995). [29] Ian Springsteel, “Sliced, diced, and still obscure: New rules on reporting business segment information set by the Financial Accounting Standards Board,” CFO: The Magazine for Senior Financial Executives, (February, 1998), 85. 30] Donna Street, Nancy Nichols, & Sidney Gray, “Segment disclosures under SFAS No. 131: Has business segment reporting improved? ” Accounting Horizons, Vol. 14, Iss. 3 (2000). [31] Albrecht & Chipalkatti (1998). [32] Ibid. [33] “IASC Revises Two Standards,” Journal of Accountancy, Vol. 184, Iss. 6 (1997), 14. [34] Albrecht & Chipalkatti (1998). [35] IASB, “Press Release: IASB Issues Convergence Standard on Segment Reporting,” (Nov. 30, 2006), retrieved from http://www. ifrs. org/News/Press+Releases/IASB+issues +convergence+standard+on+segment+reporting. htm on April, 9, 2011.