1. McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13 Segment and Interim Reporting

2. 13-2 Segment Reporting Large, diversified companies can be viewed as a portfolio of assets operated as divisions or subsidiaries, often multinational in scope. The various components of a large company may have different profit rates, different degrees and types of risk, and different opportunities for growth.

3. 13-3 Segment Reporting A major issue for accountants is how to develop and disclose the information necessary to reflect these essential differences. The following discussion presents the accounting standards for reporting an entity’s operating components, foreign operations, and major customers.

4. 13-4 Segment Reporting Generally speaking, segment reporting refers to the supplemental disclosure of revenue, profits, assets, and other information for selected industry segments of an entity as well as disclosures about its foreign operations.

5. 13-5 FASB 131 FASB131 states that the segment disclosure should include the reportable segments’ measures of profit or loss. Thus, the report shall be the same as used for internal decision-making purposes. Stated otherwise, whatever is used for internal decision-making purposes to measure the operating segment’s profit or loss shall also be used in the externally reported disclosures.

6. 13-6 FASB 131 FASB 131 defines an operating segment as a component of an enterprise: –That engages in business activities from which it may earn revenues and incur expenses( including revenues and expenses relating to transactions with other components of the same enterprise). [Continued on next slide.]

7. 13-7 FASB 131 –Whose 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. –For which discrete financial information is available.

8. 13-8 Defining Reportable Segments The process of determining separately reportable operating segments, that is, segments for which separate supplements disclosures must be made, is based on management’s specification of its operating segments that are used internally for evaluating the enterprise’s financial position and operating performance.

9. 13-9 The Percent Quantitative Thresholds Separate disclosures are required for segments meeting at least one of the following “10 percent significance” tests: The Revenue Test The Profit (or Loss) Test The Asset Test

10. 13-10 Revenue Test The operating segment 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.

11. 13-11 Profit (Loss) Test The absolute amount of the reported profit or loss is 10 percent or more of the greater, in absolute amount, of: –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.

12. 13-12 Asset Test The assets of the operating segment are 10 percent or more of the combined assets of all operating segments.

13. 13-13 Comprehensive Disclosure Test After determining which of the segments are reportable under any of the three 10 percent tests, the company must apply a comprehensive test. The comprehensive test is the 75 percent consolidated revenue test.

14. 13-14 Seventy-Five Percent Revenue Test The total revenue from external sources by all separately reportable operating segments must equal at least 75 percent of the total consolidated revenue. The reporting company must identify additional operating segments as reportable until this test is met.

15. 13-15 Other Considerations A practical limit of about 10 segments is used as an upper limit on the number of reportable segments because above that number, the supplemental information may become overly detailed. A company having more than about 10 reportable segments should consider aggregating the most closely related segments.

16. 13-16 Other Considerations In addition, companies must exercise judgment to determine the individual segments to be reported. For example, a segment may meet or fail a specific test because of some unusual situation, such as an abnormally high profit or loss on a one-time contract.

17. 13-17 Other Considerations The concept of interperiod comparability should be followed in deciding whether or not the segment should be disclosed in the current period. Companies should separately report segments that have been reported in prior years but fail the current period’s significance tests because of abnormal occurrences.

18. 13-18 Other Considerations Similarly, companies need not separately report a segment that has met a 10 percent test on a one-time basis only because of abnormal circumstances. A company is required, however, to indicate why a reportable segment is not disclosed.

19. 13-19 Other Considerations Finally, if a segment becomes reportable in the current period but has not been reported separately in earlier periods, the prior years’ comparative segment disclosures, which are included in the current year’s annual report, should be restated to obtain comparability of financial data.

20. 13-20 Reporting Segment Information In segment reporting, the following must be disclosed for each segment determined to be separately reportable: –General information about the factors used to identify the entity’s reportable segments. –Information on items included in the determination of segment assets. [Continued on next slide.]

21. 13-21 Reporting Segment Information –Information about specified revenues and expenses included in reported segment profit or loss, segment assets, and the basis of measurement used to determine profits. –Reconciliations of the total reportable segments’ revenues, measures of segment profit or loss, and segments’ assets to the related consolidated totals for those items.

22. 13-22 Reporting Segment Information Companies are allowed to present “the four required disclosures” in separate schedules or in the footnotes. Most companies present footnote disclosures with accompanying schedules.

23. 13-23 Reporting Segment Information Interim reports must disclose the following about each reportable segment: –Revenues from external customers. –Intersegment revenues. –A measure of segment profit or loss. [Continued on next slide.]

24. 13-24 Reporting Segment Information –Total assets for which there has been a material change from the most recent annual report. –Any differences from the most recent annual report in the definition of operating segments or in how segment profit or loss is computed. –A reconciliation of the total of segment profit or loss to the entity’s consolidated totals.

25. 13-25 Enterprisewide Disclosures FASB 131 established what it termed “enterprisewide disclosure” standards to provide users with more information about the risks of the company. These enterprise disclosures focus on three areas: products and services; geographic areas; and, major customers. These enterprisewide disclosures are typically made in a footnote to the financial statements.

26. 13-26 Goodbye Segment Reporting! This concludes the discussion of segment reporting. The remainder of the chapter presents another major area of financial disclosure: interim financial reporting.

27. 13-27 Hello Interim Reporting! Interim reports, which cover a time period of less than one year, are as important to investors and other statement users as annual reports. The interim report is, in many ways, a smaller version of the annual report. It includes an abbreviated income statement, balance sheet, statement of cash flows, and selected footnotes and other disclosures for the interim period being reported, as well as comparative data for prior interim periods.

28. 13-28 Interim Reporting The purpose of interim reporting is to provide investors and other interested parties with contemporary reports on the operating progress of the entity. Interim reports are used to assess the entity’s performance and to estimate any turning points in the income trend of the business. Rapid stock market reactions to the release of interim information indicate that investors and other financial statement users look closely at these reports.

29. 13-29 Interim Report Format The SEC requires quarterly financial within 45 days after the end of each quarter, except that the annual report may be used in place of the last interim report of the fiscal year. Interim reports generally contain the following items: –Comparative income statement, and the most recent quarter of the current fiscal period. –Income statements for the cumulative year-to- date time period and for the corresponding period of the prior fiscal year. [Continued on next slide.]

30. 13-30 Interim Report Format –A condensed balance sheet at the end of the current quarter and a condensed balance sheet at the end of the prior fiscal year. –A statement of cash flows as of the end of the current cumulative year-to-date period, and for the same time span for the prior year. –Footnotes that update those in the last annual report. –A report by management analyzing and discussing the results for the latest interim period.

31. 13-31 Accounting Issues Interim reporting presents accountants with several technical and conceptual measurements issues. Most of these center on the accounting concept of periodicity and division of the annual period. APB 28 provides the professional guidance regarding interim financial reporting.

32. 13-32 Discrete Versus Integral View Two divergent views of interim reporting were held before the release of APB 28. The discrete theory of interim reporting views each interim period as a basic accounting period to be evaluated as if it were an annual accounting period. Any end-of-period adjustments and deferrals would be determined using the same accounting principles used for the annual report.

33. 13-33 Discrete Versus Integral View The integral theory of interim reporting views an interim period as an installment of an annual period. Under this view, recognition and adjustment of certain income or expense items may be affected by judgments about the expected results of the entire year’s operations. [Continued on next slide.]

34. 13-34 Discrete Versus Integral View For example, expenses that normally would be charged to operations in one period for annual accounting purposes could be deferred and expensed in several interim periods based on an allocation using sales volume, production levels, or some other basis.

35. 13-35 Discrete Versus Integral View Both views were applied in practice, and it was up to the Accounting Principles Board to settle the conflict. The integral view was selected as the primary theory for interim reporting, although some modifications of this theory were made so that reports would conform closely to the results of operations for the year.

36. 13-36 Reporting Revenue One of the most significant elements of the interim income statement is revenue from sales. Investors wish to assess the revenue-generating capability of the entity, so they compare revenue of the current interim period with revenue of the corresponding interim period of prior years.

37. 13-37 Reporting Revenue Thus, revenue must be recognized and reported in the period in which earned and cannot be deferred to other periods in order to present a more stable revenue stream. Revenue from seasonal business, such as in agriculture, food products, wholesale or retail outlets, and amusements, cannot be manipulated to eliminate seasonal trends.

38. 13-38 Reporting Revenue Businesses that experience material seasonal variations in their revenue are encourage to supplement their interim reports with information for 12-month periods ending at the interim date for the current and preceding years. Such disclosures reduce the possibility that users of the reports might make unwarranted inferences about the annual results from an interim report with material seasonal variation.

39. 13-39 Cost of Goods Sold (CGS) Cost of goods sold is generally the largest single expense on the interim income statement. In general, the interim cost of goods sold should be computed using the following guidance (APB 28): –“Those costs and expenses that are associated directly with or allocated to the products sold or the services rendered for annual reporting purposes…should be similarly treated for interim reporting purposes.”

40. 13-40 CGS Exceptions Estimated gross profit rates may be used to determine interim cost of goods sold. Temporary liquidations of LIFO-base inventories are charged to cost of goods sold using expected replacement cost of the items. [Continued on next slide.]

41. 13-41 CGS Exceptions Lower-of-cost-or-market valuation method allows for loss recoveries for increases in market prices in later interim periods of the same fiscal year. Standard cost systems should use same procedures as for annual reporting except that price variances or volume or capacity variances expected to be absorbed by end of the year should be deferred.

42. 13-42 All Other Costs and Expenses The integral view adopted by the APB is most evident when dealing with period costs. A number of allocations and estimations are required for dealing with these costs. APB 28: “Costs and expenses other than product costs should be charged to income in interim periods as incurred, or be allocated among interim periods based on an estimate of time expired, benefit received or activity associated with the periods.”

43. 13-43 Allocation Situations The following examples illustrate when an expenditure may be deferred and allocated to several periods: –Some costs such as major machinery repairs should be deferred and allocated to the interim periods that benefit from the expenditure. –Property taxes should be deferred or accrued to ensure and appropriate allocation to each interim period. [Continued on next slide.]

44. 13-44 Allocation Situations –Quantity discounts offered to customers based on annual sales should be estimated and charged to sales during each, of the interim periods rather than being recognized only in the fourth interim period. –Major advertising costs should be allocated on the basis of the expected sales volume in each interim period that benefits from the advertising.

45. 13-45 Accounting for Income Taxes in Interim Periods The interim income tax computation poses a particularly troublesome problem for accountants because the actual tax burden is computed on income for the entire fiscal year. In addition, temporary differences between tax accounting and GAAP accounting require the recognition of deferred taxes. Nevertheless, the interim tax provision is a significant item and requires estimates and a number of subjective evaluations based on the anticipated annual tax.

46. 13-46 Nonoperating Items Nonoperating items would include the following: disposal of a segment or extraordinary; unusual or infrequently occurring items; and, contingent items. APB 28 requires the measurement and reporting of major nonoperating items on the same basis as used to prepare the annual report. Major nonoperating items should be recognized in the interim period in which they occur.

47. 13-47 Accounting Changes Accounting for changes in accounting principles or estimates should be presented in interim reports in the same manner as in annual reports. APB 20 provides the guidelines for treatments of changes in annual reports. Changes in estimates are handled currently and prospectively, that is, from the change date forward in time, because estimates are a normal part of the accounting process.

48. 13-48 Accounting Changes Cumulative effect-type: Make effective--and determine cumulative effect on retained earnings--as of beginning of first interim period of fiscal year, restating prior interims of current fiscal year. Retroactive type: Restate prior interims of current fiscal period and interims of prior years. Adoption of LIFO: Make effective as of first interim period of fiscal year.

49. 13-49 Goodbye Chapter 13!!! Segment and Interim Reporting—now that’s what you call CREATIVE ACCOUNTING !!!

50. McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13 End of Chapter