IFRS 8 – Operating Segments
Why is segment information necessary in financial reporting?
In the modern economy, many companies produce and provide several groups of goods and services (diversified companies) and/or operate in multiple geographic areas (multinational companies). Each group of goods or services and each activity in a geographic area may differ from others in various parameters, including profitability rates, growth opportunities, competitive structure and risks.
Why do aggregated financial statements fail to provide sufficient information about different activities?
The financial statements of the reporting entity, including consolidated financial statements, present the financial position and results of operations in aggregate. That is, all groups of products or services and all geographic areas are presented together as a whole. For example, it is not possible to understand from the financial statements what the profit (or loss) is for a particular product or service group or a particular geographic region, nor is it possible to know their total assets.
How does aggregation obscure economic reality – an illustration?
For illustration, consider a company that produces and markets two completely different product groups: computers and shoes. The computer business is profitable and generated an annual profit of $10,000 thousand, while the shoe business lost $10,000 thousand in the same year. The financial statements in this case would present zero profit. Does this figure provide sufficient relevant information to users? Certainly not. An investor who knows the real situation may, for example, decide to buy the company’s shares with the intention of discontinuing the shoe business. Moreover, since the financial statements do not present the asset base of each activity, users cannot calculate the return on assets for each segment to assess business performance.
What information gap led to the development of segment disclosures?
Thus arose the need to add disclosures to the financial statements that provide information on the different types of goods and services the company produces and the various geographic areas where it operates. Such information helps users better understand past performance, better assess risks and potential returns, and make informed decisions about the entity.
What is the scope of IFRS 8 compared to other IFRS Accounting Standards?
Unlike most IFRS Accounting Standards, IFRS 8 does not deal with recognition, measurement or presentation principles of items in the primary financial statements. Its provisions address only the disclosure requirements for operating segments in the notes.
Why is segment reporting required mainly for public companies?
Segment reporting is a relatively new requirement in financial accounting (from the late 1970s), reflecting the growth of conglomerates and globalisation that turned many companies into international corporations. For cost-benefit reasons, segment reporting is required only for public companies, while private companies are not required to disclose segment information but may choose to do so.
Why is segment information considered sensitive for reporting entities?
The importance of segment information also lies in its sensitivity for reporting entities. Disclosing profitability by segment may sometimes appear harmful from a business standpoint, since competitors, suppliers, customers and employees get access to this sensitive information. Nonetheless, IFRS Accounting Standards do not include any exemption on the grounds of business harm or confidentiality. Segment information is therefore an integral part of financial statements.
What is the central objective of IFRS 8?
IFRS 8 Operating Segments is part of the convergence with the US GAAP project. The central principle of IFRS 8 is to provide disclosures that enable users to evaluate the nature and financial effects of the entity’s business activities and the economic environment in which it operates.
What is the “management approach” adopted by IFRS 8?
IFRS 8 is based on an innovative “management approach”, rather than on an objective approach to segment identification. Under the management approach, segment identification, as well as some items required to be disclosed, are based on the information used by the reporting entity’s chief operating decision maker (CODM) for decision-making. This information may not necessarily be prepared under IFRS and may even be on a completely different basis (e.g., cash basis or non-GAAP).
Why does IFRS 8 prefer the management approach?
The rationale is to improve relevance by presenting the business “through the eyes of management”. This information is likely to be more consistent with other parts of the periodic report, such as the board of directors’ report, which contains management’s explanations of the financial statement data. Another advantage of the management approach is relatively low implementation cost, since it uses existing internal information.
How does the management approach affect comparability between entities?
However, the management approach introduces inherent variation between entities’ segment reporting and reduces comparability. Two dimensions create this diversity:
- Basis and type of segmentation – under IFRS 8, only one segmentation basis is used. Hence, two companies with identical activities may present segment information differently, one by business line while the other by subsidiaries or geography.
- Segment measures – the reported measures are not necessarily IFRS-based. For example, similar companies might report segment results using different metrics, such as operating profit, adjusted operating profit, EBITDA, profit before tax, or net profit. Even revenue may be reported on a cash basis, contrary to IFRS recognition principles.
What challenges arise from prioritising relevance over comparability?
This preference for relevance over comparability makes enforcement challenging and leaves room for potential manipulation.
How does IFRS 8 ensure that segment reporting remains meaningful?
To ensure effective segment reporting, the Standard also sets quantitative thresholds for determining which segments are reportable and allows, in some cases, the aggregation of segments.
What types of disclosures are required for reportable segments under IFRS 8?
The Standard prescribes both qualitative and quantitative disclosure requirements for reportable segments, including supplementary information on goods and services, geographic areas, and major customers. Notably, under the management approach, disclosures depend heavily on what information is provided to the CODM. For instance, information must always be given on segment profit/loss and its composition (including revenue), but disclosure of additional items such as segment assets or liabilities is required only if provided to the CODM.
How does segment identification interact with impairment testing?
Finally, identifying operating segments can also affect accounting for impairment of assets, since cash-generating units used in impairment testing often align with operating segments.