advanced financial accounting 7e (baker lembre king).chap013

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc. All rights reserved.

13

Segment and Interim Reporting

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.

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.

13-4

Segment Reporting

• Generally speaking, segment reporting refers to the supplemental disclosure of revenue, profits, assets, and other information for selected operating segments of an entity as well as disclosures about its foreign operations.

• No supplemental disclosures are required for non-operating segments.

13-5

FASB 131

• FASB 131 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.

13-6

FASB 131

• 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.

13-7

FASB 131

• FASB 131 defines an “operating segment” as having three characteristics:– 1. The component unit’s business activities

generates revenues and incurs expenses, including any revenues or expenses in transactions with other business units of the company.

[Continued on next slide.]

13-8

FASB 131

– 2. The component unit’s operating results are regularly reviewed by the entity’s chief operating decision maker who determines the resources to be assigned to the segment and evaluates its performance.

– 3. Separate financial information is available for the component unit.

13-9

Defining Reportable Segments

• The process of determining separately reportable operating segments.

• Segments for which separate supplementary 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.

13-10

The Percent Quantitative Thresholds

• Separate disclosures are required for operating segments meeting at least one of the following “10 percent significance” tests:

– The Revenue Test

– The Profit (or Loss) Test

– The Asset Test

13-11

Revenue Test

• The segment's revenue, including both external sales and intersegment sales or transfers, is 10 percent or more of the total revenues from external sales plus intersegment transactions of all operating segments.

13-12

Profit (Loss) Test

• The absolute value of the segments profit or loss is 10 percent or more of the greater, in absolute value, of (a) the total profit of all operating segments that did not report a loss, or (b) the total loss of all operating segments that did report a loss.

13-13

Asset Test

• The segment’s assets are 10 percent or more of the total assets of all operating segments.

13-14

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.

13-15

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.

13-16

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.

13-17

Other Considerations

• In addition, companies must exercise judgment to determine the individual operating 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.

13-18

Other Considerations

• The concept of interperiod comparability should be followed in deciding whether or not the operating 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.

13-19

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.

13-20

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.

13-21

Reporting Segment Information

• FASB 131 requires the qualitative and descriptive information to be provided in its segment disclosures, including the following major items:– 1. General information about how the company

identifies each separately reportable segment and the types of products or services from which each reportable segment earns its revenues

[Continued on next slide.]

13-22

Reporting Segment Information

– 2. Methods used to determine segment revenues.

– 3. Measures used to determine segment profit or loss.

– 4. Methods of determining segment assets.– 5. Reconciliations to consolidated totals.

13-23

Reporting Segment Information

• FASB 131 specified that segment disclosures must also be made in interim statements such as quarterly financial statements.

• Most companies present footnote disclosures with accompanying schedules.

13-24

Enterprisewide Disclosures

• FASB 131 established what it termed “enterprisewide disclosure” standards to provide users with more information about the risks of the company.

13-25

Enterprisewide Disclosures

• 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.

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.

13-27

Hello Interim Reports!

• Interim reports, which cover a time period of less than one year, provide timely information on the operating progress of the entity throughout the year.

• Many companies prepare monthly financial statements for internal management purposes.

• Publicly held companies are required to publish quarterly reports.

13-28

Interim Reports

• Rapid stock market reactions to the public releases of quarterly information indicate that investors and other financial statement users look closely at these reports.

13-29

Interim Report Format

• Form 10-Q is the SEC’s quarterly report and for most companies this quarterly report must be filed within 35 days after the end of each of their first three quarters.

• The annual report may be used to replace the fourth quarter’s report.

13-30

Interim Report Format

• The SEC does not require interim financial statements to be audited, but selected quarterly financial data must be reported in a footnote in the annual financial report.

13-31

Interim Report Format

– Quarterly financial reports generally contain the following items:

– 1. An income statement for the most recent quarter of the current fiscal period and a comparative income statement for the same quarter for the prior fiscal year.

– 2. Income statements for the cumulative year-to-date time period and for the corresponding period of the prior fiscal year.

13-32

Interim Report Format

– 3. A condensed balance sheet at the end of the current quarter and a condensed balance sheet at the end of the prior fiscal year.

– 4. 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.

13-33

Interim Report Format

– 5. Footnotes that update those in the last annual report.

– 6. A report by management analyzing and discussing the results for the latest interim period.

13-34

Accounting Issues

• Interim reporting presents accountants with several technical and conceptual measurement issues.

• Most of these center on the accounting concept of periodicity and the division of the annual period into interim periods.

• APB 28 provides the professional guidance regarding interim financial reporting.

13-35

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.

13-36

Discrete Versus Integral View

• Any end-of-period adjustments and deferrals would be determined using the same accounting principles used for the annual report.

13-37

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.

13-38

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 that benefit from the expanse, based on an allocation using sales volume, production levels, or some other basis.

13-39

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.

13-40

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.

13-41

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.

13-42

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.

13-43

Reporting Revenue

• 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.

13-44

Cost of Goods Sold (CGS)

• Cost of goods sold is generally the largest single expense on the interim income statement.

• A general rule is that interim cost of goods sold should be computed with the direct and allocated costs elements on the same basis as used to compute the annual costs of good sold.

13-45

CGS Exceptions

• APB 28 does permits the following practical modifications to this general rule:– 1. Use of estimated gross profit rates.

– 2. LIFO temporary liquidations. These are due to seasonality and other factors.

– 3. Lower-of-cost-or-market valuations.

– 4. Standard cost systems.

[Continued on next slide.]

13-46

All Other Costs and Expenses

• The integral view adopted by the APB is evident when dealing with interim period costs.

• The general principle is that costs and expenses should be charged to interim income in the interim period incurred.

13-47

Allocation Situations

• The following descriptions illustrate when an expenditure may be deferred and allocated to several interim periods:– 1. Some companies concentrate their major

equipment repairs in a plant shut-down time in one interim period.

– 2. Property taxes should be deferred or accrued in each interim period rather than recognized fully as an expense of the interim period in which they are paid.

[Continued on next slide.]

13-48

Allocation Situations

– 3. Major advertising campaign costs should be allocated to the interim periods that benefit rather than be recognized solely in the interim period they are incurred.

13-49

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.

13-50

Accounting for Income Taxes in Interim Periods

• Nevertheless, the interim tax provision is a significant item and requires estimates and a number of subjective evaluations based on the anticipated annual tax.

13-51

Nonoperating Items

• Nonoperating items would include the following: disposal of a component of the entities; 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.

13-52

Nonoperating Items

• The materiality test for extraordinary items should be based on the estimate of income for the entire fiscal year.

• The materiality test for discontinued operations and unusual and infrequent transactions should be based on the operating income of the interim period in which these items are first reported.

13-53

Accounting Changes

• FASB 154, Accounting Changes and Error Corrections, specified three categories of accounting changes, as follows:– a) change in accounting principle

– b) change in an accounting estimate

– c) change in a reporting entity

13-54

Accounting Changes

• A change in accounting principle may be made by an entity only if the change is required by a new accounting standard, or if the company can justify that the new accounting principle is preferable to the old accounting principle.

13-55

Accounting Changes

• The Retrospective Application method is used to account for changes in accounting principles.

• Prior periods’ financial statements are restated for the direct effects of the change in principle.

13-56

Accounting Changes

• Changes in accounting estimates are the result of new information that becomes available to the entity and are accounted for currently and prospectively. Prior period financials are not changed.

13-57

Accounting Changes

• Changes in depreciation, amortization or depletions, according to FASB 154, requires accounting for changes in the method of depreciation, amortization or depletion of long-lived, nonfinancial assets, to be accounted for as a change in accounting estimate effected by a change in accounting principle.

13-58

Accounting Changes

• A change in reporting entity requires a retrospective application to all prior periods presented to reflect the new reporting entity.

• An entity making an accounting change is also required to make a number of disclosures in the period of the change.

13-59

Goodbye Chapter 13!!!

Segment and Interim Reporting—now that’s

what you call CREATIVE ACCOUNTING !!!

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc. All rights reserved.

13

Segment and Interim Reporting

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