Operating Segments Through Management's Eyes
Author:
Derarca Dennis
IFRS 8 Operating Segments, (‘the standard’) aligns the identification and reporting of operating segments with internal management reporting. The standard replaces IAS 14, ‘Segment reporting’, the key differences between the old and new standard are outlined in Table 1(see below). Segment reporting under IFRS 8 should highlight the information and measures that management believes are important and are used to make key decisions. It should also provide a better link between the financial statements and the information reported in management commentaries such as the Operating and Financial Review. The standard converges IFRS with US Accounting Standard SFAS 131 ‘Disclosure about Segments of an Enterprise and Related Information’.
What is the scope of IFRS 8?
IFRS 8 applies to entities that prepare financial statements, and:
- whose equity or debt securities are traded in a public market, or
- that file, or are in the process of filing, financial statements with a securities commission or other regulatory organisation for the purposes of issuing any class of instruments in a public market.
The IASB did not intend to change the range of entities required to present segment information, however on reading the standard it would appear to have a wider scope than IAS 14. In accordance with IFRS 8 some entities whose equities and debt securities are not traded publically and were not within the scope of IAS 14 will have to provide segment disclosures, where as previously these entities were encouraged to but not required to disclose segmental information.
INSIGHT: IFRS 8 will apply to entities that issue instruments on the public market where those instruments can only be redeemed by ‘putting them back’ to the issuer. For example, XYZ Equity Investment Fund issues units to the public that can be redeemed only by selling them back to the fund. IFRS 8 would apply to XYZ Equity Investment Fund if it was required to file financial statements with a regulator for the purposes of issuing those units.
When does it apply?
IFRS 8 applies to annual reporting periods beginning on or after 1 January 2009. Early adoption was permitted but very few companies have chosen to adopt early.
What is the key principle?
IFRS 8 requires disclosures that enable users to evaluate the nature and financial effects of the business activities in which it engages and the economic environment in which it operates.
INSIGHT: IFRS 8 requires judgement in its application. Management should consider the key principle as it determines its segment disclosures rather then relying on a set of rules. The key concept is that the entity should provide information used by management that will allow users to understand the entity’s main activities, where those activities are located and how well those activities are performing.
What is an operating segment?
An operating segment is a component of an entity:
- that engages in business activities from which it may earn revenues and incur expenses;
- whose operating results are regularly reviewed by the entity’s Chief Operating Decision Maker ,(‘CODM’) defined below, to make decisions about resources to be allocated to the segment and assess its performance; and
- for which discrete financial information is available.
What or who is a chief operating decision maker?
The CODM is a function and not necessarily a person. That function is to allocate resources to, and assess the performance of, the operating segments. It is likely to vary from entity to entity – it may be the CEO, the chief operating officer, a group of executive directors, or the executive directors. The title or titles of the person(s) identified as CODM is not relevant, as long as it is the person(s) responsible for making strategic decisions about the entity’s segments.
How are operating segments identified?
There are four key steps. Entities will need to:
1 Identify the CODM.
2 Identify their business activities (which may not necessarily earn revenue or incur expenses).
3 Determine whether discrete financial information is available for the business activities.
4 Determine whether that information is regularly reviewed by the CODM.
INSIGHT: Identifying the CODM and the components that are regularly reviewed by the CODM to make decisions can be difficult. It is also important to reassess regularly the identification of the CODM, particularly following a business reorganisation, acquisition or disposal.
How do I determine an entity’s reportable segments?
Not all operating segments need to be separately reported. Operating segments are only required to be reportable if they exceed quantitative thresholds.
Quantitative thresholds (IFRS 8 para 13)
Information on an operating segment should be separately reported if:
- reported revenue (external and inter-segment) is 10% or more of the combined revenue ,internal and external, of all operating segments;
- the absolute amount of the segment’s reported profit or loss is 10% or more of the greater of: the combined reported profit of all operating segments that did not report a loss, and the combined loss of all operating segments that reported a loss;
- the segment’s assets are 10% or more of the combined assets of all operating segments.
Two or more operating segments may be combined (aggregated) and reported as one if certain conditions are satisfied.
Aggregation of operating segments (IFRS 8 para 12)
Two or more operating segments may be combined as a single reportable segment if:
- aggregation provides financial statement users with information that allows them to evaluate the business and the environment in which it operates;
- they have similar economic characteristics; and
- they are similar in each of the following respects:
(a) the nature of the products and services,
(b) the nature of the production processes,
(c) the type or class of customer for their products and services,
(d) the methods used to distribute their products or provide their services, and
(e) the nature of the regulatory environment (i.e., banking, insurance or public utilities), if applicable.
Minimum number of reportable segments
After determining the reportable segments, the entity should ensure that the total external revenue attributable to those reportable segments is at least 75% of the entity’s total revenue. When the 75% threshold is not met, additional reportable segments should be identified (even if they do not meet the 10% thresholds), until at least 75% of the entity’s total external revenue is included in its reportable segments.
INSIGHT: The Operating segments identified by one company may not be the same as those recognised by their competitors albeit that they operate in the same sector due to fact that the companies are managed differently.
Financial statement disclosures
Once the reportable segments have been identified the next step is to obtain all the information that you are required to disclose. The disclosures focus on the information that management believes is important when running the business. Non –IFRS compliant measures that are used to assess performance should also be used for the segment disclosures. The disclosure requirements are summarised below.
General information
- Factors used to identify the reportable segments.
- Types of product/service from which each reportable segment derives its revenue.
Information about the reportable segment; profit or loss, revenue, expenses, assets, liabilities and the basis of measurement
- A measure of profit or loss and total assets.
- A number of specific disclosures, such as revenues from external customers if they are included in segment profit or loss or and presented regularly to the CODM.
- Explanation of the measurement of the segment disclosures.
- The basis of accounting for transactions between reportable segments.
The nature of differences between the measurements of segment disclosures and comparable items in the entity’s financial report (for example, accounting policy differences and asymmetrical allocations).
Reconciliations
Totals of segment revenue, segment profit or loss, segment assets and segment liabilities and any other material segment items to corresponding totals within the financial statements.
Entity-wide disclosures
- Revenues from external customers for each product and service, or each group of similar products and services.
- Revenues from external customers attributed to the entity’s country of domicile and attributed to all foreign countries from which the entity derives revenues.
- Revenues from external customers attributed to an individual foreign country, if material.
- Non-current assets (other than financial instruments, deferred tax assets, post-employment benefit assets, and rights arising under insurance contracts) located in the entity’s country of domicile and in all foreign countries in which the entity holds assets.
- Non-current assets in an individual foreign country, if material. Extent of reliance on major customers, including details if any customer’s revenue is greater than 10% of the entity’s revenue.
Note. There is no longer a primary and secondary segment format. An entity that has determined that its operating segments are based on its products and services does not need to provide geographical segment information other than the specific entity-wide disclosures described above.
Key implementation issues
The key implementation issues are as follows:
- IFRS 8 would appear to have a wider scope than IAS 14
- The standard introduces a ‘management approach’ to identifying and measuring the financial performance of an entity’s operating segments. Reported segment information will be based on the information used internally by management. This means that:
(a) the way entities identify segments and measure and present segment information could change;
(b) there will be more diversity in reported segment information;
(c) segment information may not be measured in accordance with IFRS – entities are required to reconcile segment financial information to the consolidated financial statements; and
(d) entities will no longer need to prepare two sets of information for internal and external reporting.
- Reportable segments are no longer limited to those that earn a majority of revenue from sales to external parties, so entities may now be required to report the different stages of vertically integrated operations as separate segments.
Practical experience
IFRS 8 aligns segment reporting under IFRS with the requirements of the equivalent US standard SFAS 131. IFRS 8 adopts the requirements of the US standard almost in its entirety.
INSIGHT: Experience from the US shows that:
- Identifying the chief operating decision maker (CODM) can be difficult. Judgements about the components of an entity that are regularly reviewed by the CODM have been challenging and subject to regulatory scrutiny.
-The regulator has challenged companies about the identification of operating segments and the appropriateness of aggregating operating segments.
- Companies subject to Sarbanes-Oxley Section 404 requirements may incur additional costs in ensuring that internal processes and systems are sufficiently robust in capturing internal segment information.
What to do on first-time adoption of IFRS 8
- Identify the CODM. Identifying the correct person(s) is fundamental to correctly identifying the reportable segments.
- Be aware that more operating (and therefore reportable) segments may be identified – for example, where vertically integrated operations are identified or where more components of the business are regularly reviewed by the CODM. Management should consider the implications of presenting this information in the financial statements.
- Restate the comparatives. Management should consider the impact of IFRS 8, resolve any issues and begin capturing the relevant data well before the initial application of the standard in annual or interim financial statements.
- Consider the impact of the information that will be disclosed. IFRS 8 does not contain a ‘competitive harm’ exemption and requires entities to disclose the financial information that is provided by the CODM. The management accounts reviewed by the CODM may contain commercially sensitive information, and IFRS 8 might require that information to be disclosed externally. This was a key issue for many US companies on initial adoption of SFAS 131.
- Review internal control processes for management accounts. Management accounts may not be subject to the same processes and systems as the consolidated financial statements. Entities might need to spend time and money ensuring that their management accounts are sufficiently robust to support external disclosures and audit. IFRS 8 also requires a reconciliation between total reportable segment revenues, total profit or loss, total assets and any other amounts disclosed for reportable segments to corresponding amounts in the financial statements. There should be an audit trail between the management accounts and the consolidated financial information.
- Revisit goodwill impairment. Goodwill cannot be allocated to a group of cash-generating units larger than an operating segment. Management should consider the impact of changes in the identification of operating segments on goodwill impairment.
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