Elsevier

Business Horizons

Volume 48, Issue 4, July–August 2005, Pages 303-310
Business Horizons

Does the “management approach” contribute to segment reporting transparency?

https://doi.org/10.1016/j.bushor.2004.10.017Get rights and content

Abstract

Segment reporting creates an opportunity for companies to add value to the information they disseminate about their industry and geographic operations. This article examines the “management approach” to segment reporting from a user perspective that should be of great interest to corporate financial executives. The management approach to segment reporting requires companies to report segment financial information consistent with the way they manage their businesses. We conclude that, despite more segment data being reported, the potential of the new management approach to significantly benefit users is compromised by uneven compliance among reporting companies. The complicity of external auditors in compliance shortcomings should concern all stakeholders in the financial reporting process. Noting two high-profile examples of accounting fraud, we comment on how the management approach sheds light on Enron's operations, while WorldCom concealed important segment information due to probable auditor malfeasance.

Section snippets

The value of credible segment reporting

Companies active in many businesses must report information to shareholders about those business segments. Although current segment reporting requirements prescribe disclosure of supplementary financial information in the footnotes of financial statements and not recording transactions in the statements themselves, one should not doubt the importance of segment data to financial statement users. The Association for Investment Management and Research (AIMR) captures that critical essence,

Background on segment reporting

Initially viewed as a major enhancement of financial information provided by diversified firms, the disclosures required by SFAS 14 (1976), “Financial Reporting for Segments of a Business Enterprise,” eventually lost their luster. The omission of segment information from interim reports and SFAS 14's somewhat contrived “standardized approach,” using SIC codes to identify companies' lines of business and geographical activities, created pressure for reform. Many users favored new quarterly and

International development

Concurrent with the development of SFAS 131, the International Accounting Standards Committee (1997) (now the IAS Board) was revising IAS 14, “Segment Reporting.” IAS 14 calls for a company to identify its reportable business segments based on the risk and return profiles of the company's different business activities; groups of business activities with similar risk and return characteristics are to comprise the reportable segments. Similar to SFAS 131's management approach, paragraph 27 of IAS

Related research findings

In a pre-SFAS 131 experiment involving 56 financial analysts, Maines, McDaniel, and Harris (1997) report that, “consistent with the FASB's expectations, our findings suggest that analysts will view segment data as more reliable when externally reported segment definitions are congruent with internal segment definitions,” as should happen under the management approach. However, companies' concerns over proprietary information that competitors can use against them are deep-rooted and not likely

What segment information should be in the public domain?

In framing an answer to this question, we refer to a basic AIMR concern about the nature and utility of reported segment data. Should the objective of segment reporting be to help users understand a particular company, or to make comparisons among the segments of different companies? By opting for the former after repeatedly revisiting this question, a majority of the AIMR's Financial Accounting Policy Committee embraced the management approach embedded in SFAS 131. The Canadian Institute of

What segment information do users want?

Although specific user needs may be elusive, with analysts often concealing what they really want because they consider their specific analytic techniques to be proprietary, standard financial statement analysis approaches to assessing an entity's profitability and risk include:

  • ratio analyses of profitability, short-term liquidity risk, and long-term solvency risk;

  • separating reported data into operating and nonoperating or financial categories;

  • converting differing accounting principles to the

What segment information should management provide?

Although management should provide information that addresses users' needs, they often go to great lengths to avoid reporting transparent segment information. As discussed, there are certainly legitimate reasons for concealing truly proprietary information that, if revealed, could injure the enterprise. However, the financial executive who earlier proclaimed his frustration regarding lack of comparability in SFAS 14 segment data suggests that a company making a major strategic investment in a

The disclosure principle

The disclosure principle suggests that management should disclose information that outsiders know it has, lest they assume the worst. Moreover, inadequate segment disclosures seem unnecessary under a management approach based on internal data already available. Companies need not undertake the costly extraction and construction of information to convey selected messages or to satisfy more standardized requirements. Even SFAS 131's added mandate for disclosure of segment information in quarterly

Survey results and implications

One way to assess the effect of a new accounting standard is to study the disclosures occurring just before and just after the new pronouncement, observing changes in the aggregate while flagging individual noteworthy company examples. A major advantage of this approach is the likelihood of little change in the reporting entity in one year; the approach enables the researcher to see how the same entity reported under two different standards, not distorted by the acquisitions and divestitures

The Accounting Horizons surveys

Two surveys published in the September, 2000 issue of Accounting Horizons compare the last segment data reported under SFAS 14 with the first segment data reported after implementation of SFAS 131, which most companies adopted in 1998. Herrmann and Thomas (2000) surveyed 100 of the 250 largest US-domiciled companies in the Fortune 500 list, and Street, Nichols, and Gray (2000) examined 160 US-domiciled companies in the 1997 Business Week Global 1000, looking specifically at geographic

Our “best practices” survey of the Dow Jones Industrials

We examined the before and after (1997 vs. 1998) segment disclosures reported in Form 10-K to the Securities and Exchange Commission by the 30 DJIA companies on some 15 dimensions, subjectively judging the quality of the disclosures. Our objective was to identify “best practices” evidenced by some of the top companies in the country. While previous surveys included DJIA companies, this is the first to look at them alone and in detail. Although financial reporting practices evolve over time, we

Enron and WorldCom

We also looked at the segment reports of two companies now subject to accounting fraud inquiries, Enron and WorldCom, to see what effect adopting SFAS 131 had on their segment reporting. As now defunct audit firm Arthur Andersen audited both companies, we did not expect to find any best practices here. Rather, we wondered whether Enron and WorldCom's segment reporting quality raised questions that, at least in retrospect, could be construed as warnings.

Overall assessment and recommendations

We concur with other observers that the overall quantity of segment data increased with the advent of SFAS 131's management approach and that, on balance, users are better off because of it. Users seeking a clearer understanding of individual companies are ahead, as long as the reported data reflects management's actual decision-making framework. Users seeking to compare companies are behind, hampered mostly by the noncomparable profitability measures now being reported. But as we noted

Acknowledgments

The authors gratefully acknowledge the useful comments and suggestions made by Michael Davis, Peter Knutson, David Myers and Samuel Weaver.

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This manuscript was accepted under the editorship of Dennis W. Organ.

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