Operating Segments

INTRODUCTION

Large companies can often operate within several different business sectors and/or in different geographical locations. Each of these sectors/locations can involve risks and opportunities that can differ significantly from each other. For example, while an entity’s toy division might be facing stiff competition from Chinese imports, its food division might be performing very well and expanding market share rapidly.

If the results of all divisions of the company are amalgamated into a single set of financial statements without any analysis of divisional performance, it would be very difficult for users of these statements to engage in a meaningful measure of company performance for the period.

Thus, IFRS 8 requires entities within the scope of the standard to disclose information that will allow users to evaluate the nature and financial effects of the business activities in which it engages and the economic environments in which it operates.

IFRS 8 Operating Segments applies only to organisations whose equity or debt securities are publicly traded and to organisations that are in the process of issuing equity or debt securities in public securities markets. Should other organisations opt to disclose segment information in financial statements that comply with international financial reporting standards, it must comply fully with the requirements of IFRS 8.

According to the core principle of IFRS 8, an entity should disclose information to enable users of its financial statements to evaluate the nature and financial effects of the types of business activities in which it engages and the economic environments in which it operates.

The emphasis is now on disclosing segmental information for external reporting purposes based on internal reporting within the entity to its “chief operating decision maker”. The IASB believes that by requiring entities to report segmental information using the approach adopted by IFRS 8 (that is, a “management approach”) allows the users of the financial statements to review segmental information from the “eyes of management”, as opposed to a “risks and rewards” approach under the old IAS 14.

In addition, the cost and time needed to produce such segmental information is greatly reduced since most, if not all, of this information is already available within the entity, which is a distinct advantage in the case of public companies that are required to report on a quarterly basis.

DEFINITION

IFRS 8 defines an operating segment as 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 to make decisions about resources to be allocated to the segment and assess its performance
  • For which discrete financial information is available.

Segmental reports are designed to reveal significant information that might otherwise be hidden by the process of presenting a single statement of comprehensive income,  income statement and statement of financial position for the entity.

REPORTABLE SEGMENTS

An entity should report financial and descriptive information about its reportable segments. Not all operating segments would automatically qualify as reportable segments. IFRS 8 requires segmental information to reflect the way that the entity is actually managed. The operating segments are those that are used in its internal management reports. Consequently, management identifies the operating segments.

The standard prescribes the criteria for an operating segment to qualify as a reportable segment and must separately report information about an operating segment that meets any of the following thresholds (the “alternative quantitative thresholds”):

  • Its reported revenue, from both external customers and intersegment sales or transfers, is 10% or more of the combined revenue (internal and external) of all operating segments; OR
  • The absolute measure of its reported profit or loss is 10% or more of the greater, in absolute amount, of
    • The combined reported profit of all operating segments that did not report a loss and
    • The combined reported loss of all operating segments that reported a loss; OR (c) Its assets are 10% or more of the combined assets of all operating segments.

Furthermore, if the total revenue attributable to all operating segments (as identified by applying the alternative quantitative thresholds criteria, above) constitutes less than 75% of the entity’s total revenue as per its financial statements, the entity should look for additional operating segments until it is satisfied that at least 75% of the entity’s revenue is captured through such segmental reporting.

In identifying the additional operating segments as reportable segments (for the purposes of meeting the 75% threshold); the Standard has relaxed its requirements of meeting the “alternative quantitative thresholds” criteria. In other words, an entity has to keep identifying more segments even if they do not meet the “alternative quantitative thresholds” test until at least 75% of the entity’s revenue is included in reportable segments.

There is no precise limit to the number of segments that can be disclosed, but if there are more than ten, the resulting information may become too detailed. Information about other business activities and operating segments that are not reportable are combined into “all other segments” category.

It is important to note that even though IFRS 8 defines a reportable segment in terms of size, size is not the only criterion taken into account. There is some scope for subjectivity.

DISCLOSING SEGMENTAL INFORMATION

IFRS 8 prescribes extensive segmental reporting disclosures. These include:

  • General information about how the entity identified its operating segments and the types of products and services from which each operating segment derives its revenues.
  • Information about the reported segment profit or loss, including certain specified revenues and expenses included in segment profit or loss, segment assets and segment liabilities and the basis of measurement; and
  • Reconciliations of the totals of segment revenues, reported segment profit or loss, segment assets, segment liabilities and other material items to corresponding items in the entity’s financial statements.

The standard clarifies that certain entity-wide disclosures are required even when an entity has only one reportable segment. These disclosures include information about each product and service or groups of products and services.

Additional disclosures include:

  • Analyses of revenues and certain non-recurrent assets by geographical area, with an expanded requirement to disclose revenues / assets by individual foreign country (if material), irrespective of identification of the operating segments, and
  • Information about transactions with “major customers”, that is, those customers that individually account for revenues of 10% or more of the entity’s revenues.

IFRS 8 also expands considerably the disclosure of segment information at interim reporting dates.

DRAWBACKS TO SEGMENTAL REPORTING

Despite the usefulness of the information provided by segmental reports, there are limitations which must be borne in mind.

  • IFRS 8 states that segments should reflect the way in which an entity is managed. This means that segments are defined by directors. This may lead to too much flexibility. It also means that segmental information is useful only for comparing the performance of the same entity over time, not for comparing the performance of different entities.
  • Common costs may be allocated to different segments on whatever basis the director sees as reasonable. This can lead to the arbitrary allocation of these costs.
  • A segment’s operating results can be distorted by trading with other segments on noncommercial terms.

These limitations have applied to most systems of segmental reporting, regardless of the accounting standard being applied. IFRS 8 requires disclosure of some information about the way in which common costs are allocated and the basis for inter-segment transactions.

 

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