Investors aren’t looking for high-level overviews from your financial reporting. They want you to dig deep and get some accounting dirt underneath your nails. Because the view from 30,000 feet might look nice in headlines, but it doesn’t drive fully informed decision-making for the investing public.
That’s where our friends at the Financial Accounting Standards Board (FASB) enter the equation. They’re here to ensure investors can view the business from the same perspective as management, creating transparency they both expect and demand. And as I’m about to explain, segment reporting is an integral part of that transparency, a notion that nearly every company – from pre-IPOs to public entity veterans – should always keep in mind.
What Is Segment Reporting?
Segment reporting is a look under an organization’s hood, providing insights on the operations typically not obvious from the financial statements alone. And since these insights come straight from management, segment reporting is an open window for investors to see things through the eyes of management, one that goes beyond mere financial results by discussing the individual pieces of the operational puzzle.
On the US GAAP (Generally Accepted Accounting Principles) front, guidance on segment reporting comes from ASC 280 in the ol' FASB accounting standards codification. Here, it provides the framework and requirements companies must follow, all with an eye toward a few distinct objectives:
- A disaggregated perspective on a company’s operating results and financial position from management so users can better understand a company’s prospects for future cash flows
- Information not easily attained from the standard financial statements to let users and investors make more informed decisions
- Entity-wide information on topics like product lines, services, revenues, customer bases, and target markets, amongst others
Obviously, segment reporting is joined at the hip with financial reporting. However, at its heart, it’s really just a disclosure matter and doesn’t change anything in your existing accounting or on the face of the financial statements themselves. Therefore, as intimidating as it might sound at first, the segment reporting guidance is, for the most part, all about footnotes in your financials, although critical ones.
Understanding Segment Reporting
If you’ve been a public company for a while now, you already understand the importance segment reporting plays in your financials. Or at least you should. Thus, we’re really speaking to companies that either need a refresher course or are preparing to go public with these insights.
It’s that second category – pre-IPO companies – that segment reporting tends to take by surprise since there’s no required equivalent on the private side of the fence. The good news, however, is that there isn’t anything especially complicated or overwhelming about segment reporting as long as you understand what an operating segment is and stick to the framework the guidance provides.
According to ASC 280-10-50-1, an operating segment is a component of a public entity that:
- Engages in business activities from which it may recognize revenues and incur expenses
- Has operating results regularly reviewed by the public entity’s chief operating decision-maker (CODM) to make decisions about allocating resources to the segment and assessing its performance
- Has discrete financial information available
Translating that into something a little more palatable, think of your operating segments as how your entity manages its business like, for example, by products and services or geographically. This is usually obvious from the way an entity structures its internal organization and where information is aggregated and presented to the CODM.
Also, management keeps an eye on such operating segments to figure out how much capital to devote to them for a particular operating period. As they go, they’re also able to identify the high performers and the laggers, something that isn’t always easy in the typical morass of financial statements.
Of course, investors want that same information from a company – top-performing business segments and profit centers, a pulse on future cash flows, and a more granular view of operations.
Therefore, while some public companies see ASC 280 and its disclosure requirements as a perpetual thorn in the side, thanks to the management approach to segment identification, it forces companies to perform certain tasks that benefit the investor and organization alike.
Identifying Your Reportable Operating Segments
Now that we’ve discussed what segment reporting is and why it’s so important to both investors and organizations, let’s zoom in a bit further and see what segment reporting looks like on a more practical level. And we’re going to start at the ground floor – by identifying what constitutes a reportable segment in the first place, and that occurs over several steps:
1. Identify All of Your Operating Segments
Falling in the walk before you run category, identifying all of your operating segments is obviously an essential first step. As stated above, operating segments within your company are those that engage in business activities, are regularly reviewed by your CODM, and have discrete financial information available.
Zeroing in on your chief operating decision-maker, take note that a CODM is a function and not necessarily a job title like CEO, COO, and CFO. In this case, the function is evaluating segment performance across your company and, at times, allocating resources to those segments.
Whoever you choose as your CODM – often an executive officer, manager, or even a committee of the board of directors – they’ll receive financial information summarized in various categories. These categories – products and services, customer bases, geography, and more – typically constitute your operating segments. Thankfully, since most companies already provide such financial information to the CODM, identifying your operating segments shouldn’t be a time and resource-consuming task.
2. Aggregation of Multiple Operating Segments
In certain circumstances, you’ll find that two or more operating segments share similar economic characteristics and comply with other aggregation requirements. In these instances, you can aggregate them into a single operating segment to keep everything as simple and concise as possible. That is, as long as they share certain similar elements:
- The nature of the products or services
- The nature of the production process
- The class or type of the target customer base
- How they distribute their products or provide their services
- Regulatory environment and bodies
Demonstrating similar economic characteristics is generally a challenging exercise. This is due to the granularity of the analysis necessary to evaluate economic similarity and the limited guidance in ASC 280.
3. Ten-Percent Quantitative Threshold Tests
ASC 280 requires an entity to disclose information about any operating segments that meet any of these three quantitative thresholds:
- Combined revenue from sales to external customers and intersegment sales of the operating segment is 10% or more than the combined revenue of all your operating segments.
- The absolute amount of an operating segment’s profit or loss is 10% or more of the greater, in absolute amounts, of either (1) the combined reported profit of all operating segments not reporting a loss, or (2) the combined reporting loss of all operating segments not reporting a profit.
- An operating segment’s assets are 10% or more of the combined assets of all operating segments.
Remember, if the segment satisfies any of these ten-percent tests, you must classify it as a separately reportable operating segment. Therefore, in your segment disclosures, you’ll have to provide disaggregated financial information for that specific segment’s operations.
4. The 75-Percent Combined Revenue Test
Yes, there is another test involved. This time, you’re checking to see if you identified enough reportable segments based on the quantitative tests. And you do this by seeing if the combined revenues from external sales in your reportable segments are at least 75% of the consolidated revenues.
If not, you must disclose information on additional operating segments until you meet or exceed that 75% threshold. And to answer a thought that pops up into everyone’s mind at this step, the operating segments you add do not have to satisfy all of the criteria we discussed above. Also, you can choose which segments to add according to what you think is most valuable for investors to know. It does not have to be the next largest segment.
5. Aggregate Your Remaining Operating Segments
At this point, you’ve identified all of your required reportable segments, possibly leaving you with a stack of remaining operating segments. For simplicity’s sake, the guidance lets you aggregate information for these remaining segments into an “all other” category as long as you describe the different sources of revenue in your disclosure. Keep in mind, you should not identify the “all other” category as a reportable segment by itself.
What Are Your Segment Reporting Disclosure Requirements?
To segue over to your actual disclosures, GAAP Is specific on what information you must include.
Remember that lengthy list of identifying factors we mentioned? The ones you might use to identify your reportable segments? Well, the guidance requires you to not only disclose the specific factors you used to categorize your segments – i.e. by product, service, customer base, or geography – but also describe the types of products and services generating the revenue in each segment.
Information on Profits, Losses, and Assets
GAAP requires a measure of profit or loss and total assets for each of your reportable segments. Revenues, expenses, gains, and losses that may relate to a reportable segment but that are not included in the measure reviewed by the CODM are excluded from the profit or loss measure used in segment disclosures. Also, if your CODM uses any of the following key financial metrics to make decisions, then you must include the information, whether or not it’s in your profitability measurements:
- Revenue from external sales
- Revenue from intersegment transactions
- Interest revenue
- Interest expense
- Depreciation, depletion, or amortization expense
- Unusual items
- Equity in the net income of investees accounted for using the equity method
- Income tax expense or benefit
- Other significant non-cash items
There’s a better than average chance the financial information for your reportable segments doesn’t align with your consolidated financial statements. Whether the differences stem from intercompany sales or something else, the guidance requires you to reconcile the total revenues, profits or losses, and assets across all of your reportable segments to their coinciding consolidated totals.
Specifically, total revenues, profit or loss, and assets reported for all the segments are reconciled to revenues, consolidated income before income taxes and discontinued operations, and assets reported in the consolidated financial statements.
Form 10-Q Requirements
Fortunately, the segment reporting guidance doesn’t require you to provide all segment information in your quarterly reports. Instead, where you present condensed interim financial statements, it only requires:
- Revenue from external customers
- Intersegment revenues
- Segment profit or loss measurements
- Total assets when there’s been a material change from the amount in your most recent annual report
- Descriptions of differences in segment profit or loss measurements or segmentation from your most recent annual report
- Reconciliation between your consolidated income and the total profit or loss from all of your reportable segments
Changes to Your Operating Segments
Org charts evolve. Growth creates complexities in your operations. The bottom line – your reportable segments are likely to change over time. And when a change in the composition of an entity’s segments or in the segment measures occurs, it can trigger a requirement to either restate comparative-period segment information or to disclose information about the change.
For a change in the composition of segments, restatement of prior periods should be made where practicable. For a change in the segment measure, a disclosure on the nature and effect of the change at a minimum is required.
When it comes to ASC 280, the focus isn’t exclusively on your operating segments. Naturally, some entity-wide insights can also give investors a better understanding of your organization’s overall performance.
That’s why the guidance also requires three entity-wide disclosures in your annual financial statements:
Revenue Information on Products and Services
What is your revenue bread-and-butter? That’s the point of this disclosure – to give a statement user clarity on the products and services – or groups of similar products and services – that drive revenue from external sales.
Revenue & Asset Information by Geographic Areas
This data focuses on the geographic areas you operate within. You're required to report revenues from external sales in your home country as well as foreign countries. Also, if revenue from an individual foreign country is material, you should disclose that information separately from the general foreign countries bucket.
Note the same reporting requirements hold for all long-lived assets, where you’re required to report those in your home country as well as foreign countries, again separating those considered material. Of course, none of this speaks to IFRS accounting policies as that's a whole different ball of accounting wax.
Revenue Information About Major Customers
The third of the required entity-wide disclosures concerns information on your major customers. Specifically, investors want to know if you rely on a small number of customers for a significant portion of your revenue and, thus, increase customer concentration risk.
So, if any single customer accounts for 10% or more of your external revenues, you must disclose this information as well as the revenues you derive from that customer and the segment generating the income.
Advice for Pre-IPO Companies
We understand that, especially for companies preparing for an IPO, there’s already a lot on your plate and not a ton of time to accomplish all of it. However, segment reporting is one of those requirements that sticks around in perpetuity, or at least as long as you’re a public entity.
On the pre-IPO front, you’ll need to have your disaggregated segment information ready before your audit and Form S-1. Also, the SEC pays especially close attention to companies concluding they only have a single reportable segment, so make sure you’ve done your true diligence in applying the framework. Simply put, pre-IPO companies should be ready to defend their conclusions.
As overwhelming as this may sound, though, it’s not like you have to go at it alone. Whether you’re a noob prepping for your IPO or a public entity that needs a segment reporting refresher, Embark’s team of reporting dynamos have the experience and expertise you need to forge a compliant path. And trust us when we say the right team and advisors are irreplaceable assets as you get ready to ring the bell.