Operating segments

Operating Segments

Operating segments are distinct components of a larger entity that engage in business activities, generating their own revenues and incurring expenses. In the realm of financial reporting, these segments are crucial for providing transparency into a company's diverse operations, enabling stakeholders to understand how different parts of the business contribute to its overall performance. Identifying operating segments is a cornerstone of segment reporting, a disclosure requirement for publicly traded securities.

History and Origin

The concept of segment reporting evolved to address the increasing complexity of diversified businesses. Early accounting standards provided limited guidance on how companies should break down their financial information. In the United States, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 131, "Disclosures about Segments of an Enterprise and Related Information," in 1997. This standard, now codified as Accounting Standards Codification (ASC) 280, introduced the "management approach" to segment reporting, aligning external disclosures with internal management's view of the business⁵⁹, ⁶⁰.

Concurrently, the International Accounting Standards Board (IASB) developed its own standard. International Accounting Standard (IAS) 14, "Segment Reporting," was adopted by the IASB in April 2001, replacing an earlier version from 1981⁵⁷, ⁵⁸. Later, in November 2006, the IASB issued IFRS 8, "Operating Segments," which largely converged with the U.S. GAAP approach and became effective for annual periods beginning on or after January 1, 2009⁵⁴, ⁵⁵, ⁵⁶. The U.S. Securities and Exchange Commission (SEC) adopted technical amendments in January 1999 to conform its reporting requirements with SFAS 131, ensuring that financial statements provided detailed segment information⁵³.

Key Takeaways

• An operating segment is a component of an entity that earns revenues and incurs expenses, has its operating results regularly reviewed by the chief operating decision maker (CODM), and for which discrete financial information is available.⁵⁰, ⁵¹, ⁵²
• The primary objective of identifying and disclosing operating segments is to offer users of financial statements a clearer view of a company's diverse business activities and the economic environments in which it operates.⁴⁷, ⁴⁸, ⁴⁹
• Segment reporting standards, such as ASC 280 and IFRS 8, adopt a "management approach," meaning segment information is based on internal reports used by the CODM.⁴⁴, ⁴⁵, ⁴⁶
• Companies are required to provide quantitative and qualitative information about their operating segments, including revenues, expenses, assets, and liabilities.⁴², ⁴³
• The disclosure of operating segments helps investors make more informed investment decisions by breaking down the overall financial results.⁴¹

Interpreting Operating Segments

Interpreting operating segments involves analyzing the financial and descriptive information provided by a company. The "management approach" means that the way a company structures its internal reporting for decision-making purposes dictates how it identifies and presents its operating segments externally. This allows users of financial statements to "see the entity through the eyes of management"³⁹, ⁴⁰.

Analysts often examine the relative profitability, growth rates, and risk profiles of different operating segments. For instance, a diversified company might have one operating segment with high growth potential but lower current profit and loss, while another might be mature and highly profitable with stable cash flows. Understanding these individual contributions helps in assessing the company's overall strategy, future prospects, and how resource allocation decisions are made.³⁷, ³⁸

Hypothetical Example

Consider "Global Tech Solutions Inc.," a publicly traded company. Its CODM reviews internal reports that categorize the business into three main areas:

1. Software Development: This segment creates and sells proprietary software solutions. It generates its own revenues from software licenses and incurs expenses related to research, development, and marketing.
2. IT Consulting Services: This segment provides IT advisory and implementation services to external clients. It earns revenue from service contracts and has distinct operational costs.
3. Hardware Manufacturing: This segment designs and produces specialized hardware components. It has its own production facilities, sales channels, and associated costs.

For each of these three components, Global Tech's CODM regularly reviews discrete financial information to assess performance and make decisions about where to allocate capital. For instance, if the Software Development segment consistently shows strong growth in revenue and increasing profit margins, the CODM might decide to allocate more assets or invest more in research and development for that segment, diverting resources from a slower-growing segment. This internal reporting structure forms the basis for how Global Tech would present its operating segments in its external financial statements.

Practical Applications

Operating segments are central to understanding a company's multifaceted operations. They are applied in various contexts:

• Investment Analysis: Investors and analysts use segment information to assess a company's performance, identify trends, and make informed investment decisions, as different segments may have varying levels of profitability, growth, and risk³⁵, ³⁶.
• Regulatory Compliance: Public entities are required by regulatory bodies like the SEC to disclose information about their operating segments in their financial statements. This is mandated by standards like ASC 280 in the U.S. and IFRS 8 internationally. These standards require disclosures about products and services, geographical areas, and major customers³², ³³, ³⁴.
• Strategic Planning: Management uses the identification of operating segments to inform strategic planning, including decisions on resource allocation, divestitures, or expansion into new markets. The internal view of these segments helps managers optimize business performance³⁰, ³¹.
• Credit Analysis: Lenders and creditors analyze segment information to evaluate a company's ability to generate cash flows from different business lines and assess specific risks associated with each segment before extending credit.

Limitations and Criticisms

Despite the benefits of operating segment disclosures, certain limitations and criticisms exist. A primary concern is the discretionary nature involved in defining and reporting segments, particularly under the "management approach." While this approach provides an internal view, it can lead to variations in information published by different companies, potentially hindering comparability across firms²⁷, ²⁸, ²⁹. For example, the allocation of shared costs or corporate overhead across different segments can be subjective, impacting reported segment profitability²⁴, ²⁵, ²⁶.

Critics also point out that while the standards require disclosure of segment revenues and certain expenses, the absence of specific line items for segment-level balance sheets (such as segment liabilities) can limit the depth of analysis, unless those amounts are regularly provided to the CODM²², ²³. Furthermore, frequent changes in reported segment definitions can disrupt the time series of segment information, making historical comparisons challenging for external users¹⁹, ²⁰, ²¹. The usefulness of segment reporting is also limited by the fact that internal reports, while informative for management, may not always capture the full economic picture for external stakeholders¹⁸.

Operating Segments vs. Reportable Segments

The terms operating segments and reportable segments are closely related but not interchangeable. An operating segment is the foundational unit—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 CODM to make decisions about resource allocation and performance assessment, and for which discrete financial information is available.
¹⁵, ¹⁶, ¹⁷
Reportable segments, on the other hand, are operating segments (or aggregations of operating segments) that meet specific quantitative thresholds or qualitative criteria set forth by accounting standards like ASC 280 and IFRS 8. These thresholds typically relate to a segment's revenue, profit or loss, or assets, usually 10% or more of the combined total for all operating segments. ¹³, ¹⁴Companies are required to disclose detailed information only for those operating segments that qualify as reportable segments. Therefore, while all reportable segments are operating segments, not all operating segments are necessarily reportable. Operating segments that do not meet the quantitative thresholds may be aggregated into an "all other" category or combined if they share similar economic characteristics.
¹¹, ¹²

FAQs

Q1: What is the primary purpose of identifying operating segments?
A1: The primary purpose is to provide external users of financial statements with a more detailed understanding of a company's diverse business activities, financial performance, and the economic environments in which it operates. This helps in assessing future cash flows and making informed investment and credit decisions.

⁹, ¹⁰Q2: Who determines what an operating segment is within a company?
A2: An operating segment is identified based on how a company's chief operating decision maker (CODM) organizes the business internally to make decisions about allocating resources and assessing performance. This is known as the "management approach."

⁷, ⁸Q3: Are all operating segments disclosed separately in a company's financial statements?
A3: No, not all operating segments are disclosed separately. Only those operating segments that meet certain quantitative thresholds or qualitative criteria, becoming reportable segments, are required to be disclosed individually. Smaller operating segments are often aggregated into an "all other" category.

⁵, ⁶Q4: How does segment reporting benefit investors?
A4: Segment reporting helps investors by breaking down complex, diversified companies into understandable parts. This allows them to analyze the profitability, risks, and growth opportunities of individual business lines, leading to more granular and informed investment decisions.

³, ⁴Q5: What are "discrete financial information" in the context of operating segments?
A5: "Discrete financial information" refers to separate financial data—such as revenues, expenses, and profit and loss—that is available for each operating segment. This information is used by the CODM to review the segment's performance.¹, ²