SFAS No. 14, Financial Reporting for Segments of a Business Enterprise, was issued in 1976 in response to several calls by groups such as the Financial Analysts Federation, Financial Executives Institute, National Association of Accountants, the Accountants International Study Group, and New York Stock Exchange who felt financial statement users had a legitimate need for such information. In SFAS No. 14, segments were defined by industry grouping, with specific identification of the relevant industry left to the company. Geographic area financial information was also required.

Since that time, events and changed conditions created a need to modify SFAS No. 14. Many companies exploited the vagueness in the SFAS No. 14 definition of industry segment to consider themselves a single-segment company. A FASB study of 6,935 public companies found that about 75% said they operated in only one industry segment in the 1985­1991 period. Forty-three percent of the 1,051 companies with sales more than $1 billion were single-segment companies. The Association for Investment Management and Research (AIMR) complained that one of the 10 largest U.S. companies was a single-segment company.

Because many companies have not provided expected segment information, the Association for Investment Management and Research suggested that businesses report disaggregated data "in a format that coincides with and reflects how it is organized and managed." While such a format reduces comparability of segment data between companies, the AIMR felt that, "If we could obtain reports showing the details of how an individual business firm is organized and managed, we would assume more responsibility for making meaningful comparisons of those data to the unlike data of other firms that conduct their business differently."

The AIMR also called for quarterly reporting of segment data and more detail of disaggregated data. Another factor in the evolving reporting environment was SFAS No. 94, Consolidation of All Majority-Owned Subsidiaries, issued in 1987. It resulted in the loss of much detailed information about subsidiary operations different in character from those of the parent company.

The Specifics of SFAS No. 131

Definition of Segments. There are four substantial differences between SFAS No. 14 and SFAS No. 131, but the major change in SFAS No. 131 from its predecessor is clearly how segments are defined. Under SFAS No. 14, segments were defined by industry grouping of products and services sold to external customers. Under SFAS No. 131, segments are defined from a management approach perspective--how management organizes segments within the enterprise for making decisions and assessing performance. Consequently, segments are evident from the structure of the enterprise's internal organization. The internal organization is based on divisions, departments, subsidiaries, and other internal units the chief operating decision maker uses to make operating decisions and to assess an enterprise's performance. Referring to a hierarchical organizational chart should provide guidance in identifying the operating segments.

An enterprise component qualifies as an operating segment if--

* it engages in business activities that may or may not earn revenues or incur expenses,

* its operating results are regularly reviewed by the enterprise's chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance, and

* discrete financial data are available.

The chief operating decision maker may be the chief executive officer, chief operating officer, president, or even a committee that collectively performs the function of allocating resources and assessing performance of the enterprise's components. An operating segment manager's area of responsibility and authority may be defined by industry grouping,
geographic area, functional expertise, or contingent
organizational needs.

SFAS No. 131 retains the same quantitative thresholds for segment identification as used in SFAS No. 14--10% of assets, revenues, or profit or loss. SFAS No. 131 permits aggregating two or more operating segments into a single reportable segment if it is consistent with the objective and basic principles of the statement. Similarity is required in characteristics such as nature of product or services, nature of production process, etc.

Vertical Integration. A second substantial difference between SFAS No. 14 and SFAS No. 131 deals with vertical integration. SFAS No. 14 focused on an enterprise's end product--products and services sold to external parties in its industry segment approach. Operating segments under SFAS No. 131 are major parts of an enterprise and include components that are vertically integrated into the enterprise and start-up operations that may not yet have revenues.

Disclosures. A third substantial difference between SFAS No. 14 and SFAS No. 131 is the amount of financial disclosures and their conformity with GAAP. SFAS No. 131 requires several specific disclosures that result in more detail than under SFAS No. 14. Key disclosure requirements of SFAS No. 131 are summarized in Table 1. SFAS No. 131 permits, but does not require, a complete set of financial statements for each reportable segment.

Profit and loss and total asset information reported should be what is used by the chief operating decision maker to allocate resources and evaluate performance. SFAS No. 131 disclosures will not conform to GAAP if the information used is not GAAP-based. If several alternative measures of profit and loss (and total assets including allocations) are reviewed by the chief operating decision maker, the profit and loss (and total asset) information closest to GAAP should be what is reported.

Interim Statements. A fourth substantial difference between SFAS No. 131 and previous requirements is reporting segment data on an interim basis. SFAS No. 14 required that segment information be reported on an interim basis, but SFAS No. 18, Financial Reporting for Segments of a Business Enterprise--Interim Financial Statements, in November 1977, rescinded the requirement. Under SFAS No. 131, reporting some segment data on an interim basis is again required.

Other Requirements. If the total of external revenue reported by operating segments constitutes less than 75% of total consolidated revenues, additional operating segments should be identified as reportable segments, even if they meet none of the 10% criteria. Information about revenues and assets shall be reported by geographic area if the operating segments do not reflect a geographic organization. IAS No. 131 is effective for all years beginning after December 15, 1997.

An Evaluation of SFAS No. 131

SFAS No. 14 has been described as an experiment because it required segment disclosures for the first time. Given the widespread calls for continuation of segment disclosures and for reform in how segments are identified, the FASB faced two major choices. First, it could continue the industry segment approach by tightening the loopholes that gave companies sufficient wiggle room to avoid adequate segment disclosure. Second, it could create a new method for identifying segments that would contribute to increased compliance while simultaneously disclosing new types of information. The FASB chose to continue the segment disclosure experimentation with the latter approach, which we believe is the better choice.

The FASB could have successfully tightened the loopholes that permit many companies to avoid identifying segments on an industry basis. Such an approach would have many benefits:

* The concept of division on the basis of end products and services is widely understood by investors, analysts, and the general public.

* It would contribute to enhanced cross-sectional comparability by analysts and investors. This comparability is made possible by the wealth of data, aggregated along industry lines, that Federal and state agencies assemble and publish.

* Standard accounting procedures (i.e., GAAP) could be consistently applied if segments would be formed on a consistent basis from company to company.

However, supplying disaggregated financial data on an industry basis has two shortcomings:

* The most significant shortcoming is if managerial responsibilities are not organized along industry lines, the external financial disclosures on an industry basis would be artificial and irrelevant for analyzing the risks and rewards of the actual business segments of the enterprise, making enterprise cash flow predictions problematic.

* Providing the information is relatively costly if managerial responsibilities are not organized along industry lines. That is, organizations already prepare financial reports for segments for resource allocation and performance evaluation. If these managerial areas do not fall along industry lines, a second set of accounting segment disclosures would need to be prepared for external financial reporting.

Nevertheless, the FASB chose the management approach to identifying segments over the industry approach. The management approach is expected to produce these benefits:

* Disclosing information about the structure of an enterprise's internal organization and its means of evaluating performance are important because it discloses management's insights into the overall production process. It highlights the opportunities and risks management believes are important. For example, a disclosure of the current structure might prompt a user to ask, "Why is the enterprise organized like this?" As answers are uncovered, user assessment of risks and rewards should produce a more efficient allocation of capital. In addition, if users can "see the enterprise through the eyes of management," they should be better able to predict managerial actions and reactions that can affect an enterprise's prospects for future cash flows.

* Because information about those segments is already being generated for management's use, the incremental cost of providing information could be relatively low. The FASB chose to require that
companies externally disclose the same information as used internally for decision making, instead of mandating a specific format for assessing segment performance. This information has the potential to provide users with additional insights into the managerial decision making process.

* It is thought that identifying segments based on the structure of an enterprise's internal organization will make identification of segments more objective and verifiable. Auditors should be able to identify segments by referring to organizational charts, strategic issues discussed in board of director minutes, and performance reports entered into the board of director minutes.

The managerial approach has two shortcomings:

* Cross-sectional comparisons will be more difficult because it is expected that segment disclosures will reflect the diversity among business enterprises. Individual investors will need to increase their reliance upon professional analysts, who are assuming more responsibility for interpretation of segment data.

* Segment performance disclosures are required to be in the same format as presented to and used by management. There is no reason to expect they will adhere always to GAAP. Non-GAAP segment disclosures could make it difficult to analyze performance and compare across different enterprises.

Implementation Issues

There are two implementation issues that bear watching. We believe the success of SFAS No. 131 rests primarily on the ability of auditors to deal with what management identifies as its segments. This should be no easy task. Auditors will not be able to rely solely upon management representations of the organization's internal structure, but will have to determine the actual structure for themselves. The second issue is the ability of the investment community to successfully interpret and use the non-GAAP financial data that will be reported. As noted before, SFAS No. 131 should make cross-sectional comparisons more difficult.

Events and Conditions that Led to IAS No. 14 Revised

The original IAS No. 14 was issued in 1981 and was similar in approach to SFAS No. 14. It was, however, too general in its requirements to be effective. Public enterprises were required to report about significant industry segments and geographic segments in which they operated, but IAS No. 14 left it to the judgment of individual companies to determine what was significant. A 1994 IASC background paper, Reporting Financial Information by Segments, reports that 38% of the 1,062 large companies from 32 countries it surveyed reported only one industry segment.

IAS No. 14 also was criticized for 1) permitting too many alternative interpretations in an attempt to accommodate its diverse constituencies, 2) not providing sufficiently detailed definitions of and guidance for key items, and 3) not requiring the disclosure of additional financial and descriptive data about segments. By 1990, the Organization for Economic Co-operation and Development, the International Organization of Securities Commissioners (IOSCO--an association of 90 securities regulators and securities market self-regulatory organizations from 65 countries), and a United Nations working group were recommending the IASC incorporate additional disclosure items and correct implementation issues in IAS No. 14.

At this time, the broad structure of international accounting standards also came under scrutiny by user groups. Faced with mounting criticism from the IOSCO for not developing a set of core standards with a restricted set of alternatives, the IASC initiated its Comparability and Improvement Project that resulted by late 1995 in a core set of 10 improved standards (not including segments) with reduced alternatives. Consequently, the IOSCO formally agreed to recognize the IAS for cross-border security listings on all exchanges pending completion of a comprehensive set of 40 core standards (including segment reporting) due by mid-1998. The FASB and Canadian projects on segment reporting also served to speed the IASC initiative on segment reporting.

The Specifics of IAS No. 14R

In IAS No. 14R, the IASC reaffirms that the primary bases for classification of business components are related products or services and geography. The new standard 1) provides explicit quantitative thresholds for the reporting of segments, 2) has clear definitions of all disclosures, and 3) provides clear guidelines that an enterprise may apply to its segment reporting.

The IASC applies the financial analysis notion of assessing enterprise risks and rewards to its classification of business and geographic segments. The risk-rewards approach enters the segment-reporting scheme in two ways: in the definition and identification of segments and in the determination of the nature of primary and secondary reporting requirements.

Definition of Segments. IAS No. 14R defines a business segment as a distinguishable component of an enterprise engaged in providing an individual product or service or a group of related products or services and subject to risks and rewards that are different from those of other segments. It would be similar to an industry segment except the IASC has imposed a risks-rewards qualification. In other words, the IASC intends to discourage the aggregation of segments that belong to the same industry but differ in risk or reward characteristics.

A geographic segment is a distinguishable component of an enterprise engaged in providing products or services within a particular geographic or common bloc, and subject to risks and returns that are different from those operating in other areas or blocs. Geographic segments are based either on the location of an enterprise's input factors or the location of its final customers. Risks and rewards associated with a product or a service or with a group of products or services may vary by country or economic bloc.

Two-Tier Structure. IAS No. 14R requires a two-tier structure for its segment reporting requirements. The two-tier approach requires information both by business and geographic segments. The risk-rewards approach is used to determine whether business segments or geographic segments should be the primary tier (or layer) of segment reporting. If the primary tier is based on business (geographic) segments, the secondary tier is based on geographic (business) segments. The choice of segment type for the primary layer is based on the internal organization of the enterprise, the reporting structure to the CEO and the board of directors, and the nature of the risks and rewards faced by the organization. If an enterprise's mode of organization resembles neither business segments nor geographic segments (i.e., based on management organization), the IASC requires the enterprise to choose between business segments and geographic segments for its first and second tiers.

Other Requirements. IAS No. 14R applies to all financial statements based on IAS GAAP for all periods beginning on or after July 1, 1998. It does not apply to interim statements. Additional disclosure requirements are summarized in Table 2.

Implementation Issues

Under IAS No. 14R a company should report separately two segments that have similar products or services but differ in risk-reward profile. It seems possible that companies may ignore these differences and continue to report based on industry segments as they have been doing for the past 15 years. Auditors will be faced with a challenging task as they determine if the organization is properly divided into segments and tiers. Auditors must necessarily rely upon management representations of differences in risk-reward profiles. IAS No. 14R should result in significant compliance costs for companies that are domiciled in countries that adopt IAS No. 14R (i.e., the emerging market economies) and companies that intend to raise capital through ADRs and GDRs domiciled in countries that have a weak or nonexistent segment reporting standard.

Evaluation of IAS No. 14R

In IAS No. 14R the IASC has vastly improved its segment disclosure requirements. IAS No. 14 was too loosely defined to meet the requirements of an international financial analyst community. The IASC had two alternatives: tighten its definition of an industry segment by using a risk-reward approach or adopt the FASB management approach to identify segments. The IASC chose to tighten the definition of an industry segment by using a risk-reward approach, which we believe is its better choice.

To appreciate why this approach is a better choice for the IASC and the management approach is a better choice for the FASB, it is necessary to examine user needs and the financial reporting environments. There is no international system of financial markets, only financial markets that exist in various countries. These markets differ because of social, economic, and political reasons. Enterprises domiciled in different countries encounter different regulatory and accounting requirements. As a result, management styles differ from country to country based on the interaction of all of these factors. Likewise, investors and analysts with an international interest have different backgrounds, experiences, and perspectives. Segment reporting based on managerial organization would increase the level of difficulty in financial analysis because of these qualitative factors. This is in contrast to the financial market environment in the U.S. where there is more homogeneity in managerial style, organization, regulatory environment, and investor perspectives. As explained before, segment reporting under the management approach is a better choice in the U.S.

The IAS chose the risk-reward approach because it could be understood and applied across different cultures and financial markets without compromising the need to present information that could be useful in predicting future cash flows. Analyzing an organization's structure on the basis of products and services with similar risk-reward profiles can withstand the rigors of translation across international boundaries.

A summary of the key differences between SFAS No. 131 and IAS No. 14R is shown in Table 3.

Impact on Sponsored ADRs

The SEC is still debating the full impact of SFAS No. 131 on all foreign companies required to file financial statements for new securities issues and for listing on American exchanges. Currently, such foreign companies are required to file Form 20F (similar to 10K) with a GAAP reconciliation of its net income and stockholders' equity. Most companies must meet the requirements of Item 17 of Form 20F, which requires a summary segment disclosure of total sales and revenue by category of activity and geographical market. For companies issuing ADRs in the U.S., the SEC encourages Item 18 disclosures that match the disclosure requirements of a domestic company.

Under SFAS No. 14, companies issuing ADRs in the U.S. faced the onerous task of providing additional segment disclosures that conformed to the definition of industry segments. In almost all cases, this represented an increase in disclosure. For companies that prepared statements based on home country GAAPs that did not require segment disclosures, this was a particularly daunting task. This task will be no less daunting for the latter group with the issuance of SFAS No. 131. The SEC might eventually accept IAS No. 14R as a suitable alternative for the U.S. standard as it has done with IAS No. 7 (cash flows), IAS No. 21 (foreign exchange transactions and translation), and IAS No. 22 (business combinations) if the IOSCO recognizes IAS as valid for cross-border listings. In this situation, a foreign company listing or issuing ADRs in the U.S. may be in a unique situation of having a choice of standards--IAS No. 14R or SFAS No. 131--for segment reporting. *