How-to- Determine
Operating Segments tell the full story of an Entity
Just a compliance activity is what Segment reporting is understood
by the financial reporting teams across geographies. This undermines its
importance and hence is at most times overlooked by the senior management and
audit committees.
In this article, I plan to take you through a short journey to
the key requirements of ‘Operating Segments’ – IFRS 8. The entire article will keep its focus on
How-to
discern the importance of segment reporting in narrating the full story of an entity.
WHY IFRS 8 is IMPORTANT?
When an
entity becomes large, it becomes important to understand how they operate. Almost
all information contained in consolidated financial statements is focused on
providing users with the financial position and performance of the entity as a
whole. This information is useful but it seldom tells the full story. How do we
know? When we read an earnings guidance by a large entity we get an
understanding of how they function in different markets, with different
products and services and its major clients, or capital expenditure for a budding
division. Any one of these shows that the business is typically managed at a
level lower than the consolidated entity. It is at this level that investors
want detailed financial information. Different segments will generate
dissimilar streams of cash flows, to which are attached disparate risks and
which bring about unique values. Thus, without disaggregation, there is no
sensible way to predict the overall amounts, timing, or risks of a complete
undertaking’s future cash flows. Investors want to see the business through the
eyes of management.
OPERATING
SEGMENTS
Operating segments are components of an entity whose
separate financial information is available and is evaluated regularly by the Chief
Operating Decision Maker (CODM) in deciding how to allocate resources and in
assessing performance.
Let’s look at the four key elements in determining the
operating segments:
* Chief Operating Decision Maker (CODM): may be an individual or a committee, depending
on the entity. It is a function that allocates resources to, and assesses the
performance of, the operating segments. The position of a person is not
relevant as long as the person is responsible for strategic decision of the
segments. Some examples include the CEO, the COO, the executive committee or
the board of directors.
*
Business Activities: must
be capable of earning revenue and/or incurring expenses for consideration of
separate operating segments. The lack of any revenue and/or expense being
allocated to a division does not exclude it from being a separate operating
segment. Example a cost centres in an entity may not record the revenue
separately as sales are not allocated on that basis. If discrete financial
information is prepared and reviewed by the CODM, such cost centres would be
considered as separate operating segments
*
Discrete Financial
Information: is a judgemental area and will depend on the entity. If
the CODM has sufficient information to assess the performance and allocate the
resources for the business activities – it will qualify as discrete financial
information. A set of financial statements is not required to identify
operating segments. The information can
be met with operating performance information only, such as gross profit by
product line or operating profit by region.
*
Reviewed by CODM
regularly: In simple hierarchy entities information which is in
standard monthly financial reporting pack provided to the CEO or board –if it
is not CODM. Entities with matrix-style or overlapping reporting might have to
consider the factors provided in IFRS 8:
1.
The nature of business activities of each
component;
2.
The existence of managers responsible for each
component; and
3.
The information provided to the board – when board
is not the CODM.
For example,
assume that the CODM reviews two sets of operating results – one by major
product line and the other by geographical region. If we consider the above 3
factors in this situation we can draw a conclusion that one set of operating
results will have more prominence in the internal reporting as compared to the
other set. It is observed from practice that there are any few cases where
operating segments lack clarity, even after the factors are considered.
REPORTABLE SEGMENTS
They are the basis
for disclosure of segment reporting in the financial statements, and they can
comprise single operating segments or
an aggregation of operating segments.
The steps in the
process of determining reportable segments is explained as under:
*
Aggregation: Two
or more operating segments may be aggregated into a single operating segment if
they have similar economic characteristics, and the segments are similar in
each of the following respects:
1.
the nature of the products and services;
2.
the nature of
production processes;
3.
the type of client
for their products or services;
4.
the methods used
to distribute their products or provide the services
5.
the nature of
regulatory environment – e.g. Pharma or Banking
* Quantitative Thresholds:
An entity shall report separately information about an
operating segment that meets any of the following quantitative thresholds:
1. Its
reported revenue, including both sales to external clients and intersegment
sales or transfers, is 10% or more of the combined revenue, internal and
external, of all operating segments;
2. the
absolute amount of its reported profit or loss is 10% or more of the greater,
in absolute amount, of :
a.
the combined reported profit of all operating
segments that did not report a loss and
b.
the combined reported loss of all operating
segments that reported a loss.
3. its
assets are 10% or more of the combined assets of all operating segmnts.
Operating segments that do not
meet any of the quantitative thresholds may be considered reportable, and
separately disclosed, if management believes that information about the segment
would be useful to users.
If any of the identified
operating segments or aggregated groups of operating segments have similar
economic characteristics and meet a majority of the aggregation criteria - then
aggregate them and treat as reportable segments. Individual operating segments
can also be treated as reportable segments, even if they are not aggregated
with another segment or do not meet the quantitative threshold.
