When you analyze the financial results of a company, operating segment information can
be very insightful. This is where financial accounting and management accounting meet,
where the external reporting largely aligns with the internal reporting. It’s an opportunity
for a company to provide transparent, useful information to investors. What a company might
call a business unit or division internally, is called operating segment or reportable
segment in external reporting.
Let’s go through some real world examples
of segment reporting, before we dive into the accounting principles and rules that regulate
it. What can we learn from the segment reporting by Amazon, Apple, ExxonMobil and Verizon?
In Amazon’s segment reporting, three operating segments are disclosed: North America, International,
and AWS. This is what I would call a “hybrid” structure. The first two operating segments
(North America and International) are geographically based segments earning money from retail sales
of consumer products and subscriptions. The AWS segment earns money from global sales
of compute, storage, database, and other service offerings.
In revenue, AWS is 12% of the total.
In Operating Income, AWS is 63% of the total! Based on the relative profitability of the
operating segments, you could argue that Amazon is primarily a high margin cloud computing
company, doing some low margin retail on the side. Besides the revenue and operating income
numbers, you can find information about segment assets, property and equipment, as well as
depreciation and amortization by segment in the Amazon annual report.
Apple operates on a geographical basis. The sum of the net sales for the five geographical
operating segments adds up to the total net sales for Apple as a whole. On the profitability
side, the operating income for the five geographical operating segments adds up to a total number
called segment operating income. From this, you deduct research and development expense,
and other corporate expense, to tie out to total operating income for the company. This
is a good example of a reconciliation between the total amounts for the reportable segments
to the financial statement amounts.
From the ExxonMobil discussion of operating
segments, we learn something about how to best define the operating segments of the
business that are reported separately. The factors used to identify these reportable
segments are based on the nature of the operations that are undertaken by each segment.
The Upstream segment is organized and operates to explore for and produce crude oil and natural gas.
The Downstream segment is organized and operates
to manufacture and sell petroleum products.
The Chemical segment is organized and operates
to manufacture and sell petrochemicals.
These segments are broadly understood across
the petroleum and petrochemical industries, in other words this structure of reporting
operating segments allows investors to compare divisional performance between competitors
in the same industry.
If a company reorganizes internally, then
the external segment reporting changes accordingly. Verizon 2.0 has two reportable segments that
the company operates and manages as strategic business units: Consumer and Business.
Verizon previously operated and managed the business under its historical Wireless and Wireline
segments. For comparison purposes, highlights for both the current and previous operating
structures are represented here side by side.
These real world examples of segment reporting
illustrate how useful operating segment information can be to investors. Do a search using the
terms “segment information” or “information about segments” in the notes to the financial
statements of the 10-K filing of any listed company, and see what you can uncover!
What are the accounting principles and rules that regulate segment reporting? Under US
Generally Accepted Accounting Principles, ASC280 is the place to go. Under International
Financial Reporting Standards, IFRS 8. These standards are largely converged, in other
ways they treat the topic roughly the same.
Both standards are based on 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.
What is the definition of an operating segment?
According to ASC 280, an operating segment is a component of a public entity (an entity
whose equity or debt securities are publicly traded) that has all of the following characteristics:
It engages in business activities from which it may recognize revenues and incur expenses
Its operating results are regularly reviewed by the public entity’s chief operating decision maker
to make decisions about resources to be allocated to the segment and assess its performance
Its discrete financial information is available
That’s a definition that accounting experts can hold a weeklong conference on, or write
implementation roadmaps for of about 100 pages in length. Let’s zoom into two of the main
elements of the definition.
Chief operating decision maker. That’s not
a job title you normally find on any org chart of a company. The CODM is a function and not
necessarily a person. You identify the CODM by determining which individual (or group
of individuals) is responsible for allocating resources to and assessing the performance
of the operating segments. This is likely to vary from entity to entity – it may be
the CEO, the chief operating officer, the senior management team or the board of directors.
Its discrete financial information is available. Discrete financial information may consist
of only limited results of operations information, such as revenues and gross profit margin,
without balance sheet information. And for the non-native speakers of English, discrete
(d i s c r e t e) is not the same as discreet (d i s c r e e t). The former means individually
separate and distinct, while the latter means careful and prudent in one's speech or actions,
especially in order to keep something confidential or to avoid embarrassment.
In segment reporting, there are three quantitative tests that companies perform: the 10% test,
the practical limit test of 10, and the 75% test.
The 10% test. A public entity shall report separately information about an operating
segment that meets any of the following quantitative thresholds:
Its reported revenue, including both sales to external customers and intersegment sales
or transfers, is 10 percent or more of the combined revenue, internal and external, of
all operating segments.
The absolute amount of its reported profit
or loss is 10 percent or more of the greater of either the combined reported profit of
all operating segments that did not report a loss, or the combined reported loss of all
operating segments that did report a loss.
Its assets are 10 percent or more of the combined
assets of all operating segments.
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 readers of the financial
statements. So there are suggested thresholds for disclosure, but even if an operating segment
does not meet any of the quantitative criteria, a company could choose to report it separately.
Alternatively, two or more operating segments may be aggregated into one reportable segment
if they have similar economic characteristics (as in: the range of the entity’s business
activities and the economic environments in which it operates).
If the number of segments rises above 10, the entity should consider whether a practical
limit has been reached. This limit is logically connected to the previous test, as 10 segments
that each meet the 10% test one way or another will get you to around 100% of the business
results. The words “should consider” indicate that this is a “soft” test where a company
has the choice to differ from the suggested approach.
A real “hard limit” test is the 75% test: a company needs to report additional segments
if external revenue of all segments is less than 75% of consolidated revenue. Adding additional
segments decreases the “all other segments” category, and needs to get the sum of the
reported segments’ revenue above the 75%.
What’s the core principle behind operating
segment reporting? An entity shall disclose information to enable users of its financial
statements to evaluate the nature and financial effects of the business activities in which
it engages and the economic environments in which it operates.