When to Rethink Segment Reporting
Segment reporting disclosures provide vital insights into how management views and operates the business. While providing this information to investors and other stakeholders is important, getting segment reporting right can be challenging given the broad range of inputs to be considered, from organizational and strategic to technical and quantitative.
Beyond the challenges of creating appropriate disclosures, companies will often encounter changes to the business or organizational structure that need to be considered by management when evaluating their current and future state segment reporting.
Here are the three common situations that lead to changes in segment reporting and what management should consider when addressing them.
1. Pursuing an IPO
Identifying reporting segments is a significant requirement for companies that are considering an IPO. Where this information has likely historically been presented and utilized internally, the details below the consolidated level—such as profitability measures and the types of products and services from which segments generate revenue—must be audited and included in the financial statement footnotes. Because segment reporting helps investors understand management’s priorities as well as relevant financial information that aligns with how management views the business, this disclosure usually becomes an integral part of a company’s equity story. Potential investors in a company’s public offering will look to these disclosures for further information on the company’s growth to date and to understand the potential for future value creation.
Segment disclosures may represent a challenge for private companies going through the IPO process, as they require a thoughtful, auditable analysis to determine both the operating segments and whether any of these should be aggregated for reporting purposes. The SEC has historically challenged certain aggregation positions, requiring companies to justify that their operating segments have similar quantitative and qualitative characteristics.
Segment reporting continues to be an SEC focus area, particularly in an IPO environment. The accounting rules specify that the determination of segments should align with the information used by a company’s chief operating decision maker (CODM) to assess a segment’s performance and make decisions on how to allocate resources to the segment. The SEC has specified that the CODM can be an individual or group of individuals who evaluate the company’s day-to-day operational results rather than a sole decisionmaker. As such, concluding on the CODM and evaluating the information that person or group of people utilize to make decisions is an area of judgment that can be challenged by the SEC.
2. Acquiring a Business
Acquisitions often result in changes in management structure, the products and services provided by the company, or the geographies in which the company operates. Depending on the size and nature of the acquired business, the acquisition may or may not result in a segment change. Companies can face multiple challenges when evaluating its segment reporting as the result of the acquisition.
When an acquisition results in the CODM reviewing multiple sets of operating results based on product line and geography, the internal reporting based on product lines would be used to determine operating segments. In other cases, however, when the CODM receives financial information based on something other than product line and geography, other considerations—such as nature of the business activities, the existence of segment managers, and the information presented to the board of directors—may be helpful in order to identify changes in reporting structure.
3. Organizational Change
Divestitures are a primary example of an organizational change. Divestures are a common way for companies to obtain funding, eliminate an underperforming or non-core line of business, improve the bottom line, and help management maintain strategic focus on the most valuable aspects of the company. Consideration must be given to the individual facts and circumstances of the divestiture to determine how the transaction affects management’s view of the business going forward.
Another example of organizational change is heavy investment by a company in organic growth, including diversifying product or service offerings, aggressive sales and marketing initiatives or operational improvements. Such organic growth initiatives can impact multiple factors that need to be considered when determining segments, including the makeup of a company’s customer base, a shift in business strategy as a result of new product or service offerings, changes in resource allocation, or growth in new geographic operations.
At times, change is driven not by shedding operations or focused growth strategies, but by operating segments experiencing a shift in sales or profitability driven by market conditions. Such shifts may swing certain metrics that drive required segment reporting conclusions, such as whether an operating segment accounts for a certain percentage of the combined reported revenue, profit, or assets of all segments. For instance, if an operating segment experiences substantial growth or a significant decline, this volatility can trigger either the quantitative requirement to report a segment or allow the company to discontinue reporting an immaterial segment.
Each of the above scenarios may require revisions to a company’s segment reporting and should lead management to consider the following actions:
- Ensure consistency between segment reporting in a company’s financial statements and other publicly available information: Management needs to ensure that segment information reported in the company’s financial statements is consistent with other information that is subject to SEC and stakeholder review. This review can include press releases, company websites, and industry presentations. Inconsistencies in this information can produce confusion among investors and result in questions from the SEC.
- Establish effective internal controls over segment reporting: Management should take steps to ensure the company has strong internal controls over segment reporting. Examples include establishing appropriate executive review procedures, implementing procedures for proper validation, and identification of reportable segments for both quantitative and qualitative measures and developing appropriate financial statement disclosures and review procedures to ensure consistency throughout the filing.
- Consider availability and integrity of data for the purposes of recasting financial statements: When companies change their segment structure, management is required to retrospectively restate all prior period comparative information. Companies may not have the optimal information to be able to restate prior periods or might be forced into disclosing information at a level which may not be desirable for the company. Although companies are allowed to opt out of this requirement, the SEC expects that such instances will be very rare, and companies must be prepared to support this conclusion.
Changes in segment reporting require thoughtful consideration due to the overarching operational and financial report impacts. Companies should carefully consider the factors and situations discussed above to determine the most appropriate segment structure to ensure investor transparency, compliance under the standard, and to enable management to more effectively manage the business.