Operating Segments

Companies usually sell more than one product, each of which is subject to its own market forces. Some products are profitable and others are not. Some require more assets while others require less. Similarly, businesses operate in more than one geographic region with each having its own demographics, business cycle, etc. It is important to not let the company's management shroud underperforming products/markets in over-performing products/markets so as to portray a misleadingly everything-is-profitable picture. In financial reporting literature, such components of a company that generate their own revenues and incur expenses, that are reviewed separately by management from a decision-making perspective and for which separate financial information is available, are called operating segments.

Reportable Segments

For companies that are listed on stock exchanges or are in the process of such listing, financial reporting standards require disclosures that allow users of financial statements to see through the consolidated presentation of all the products/markets and identify stand-alone performance of segments. Reportable segments are those operating segments whose:

However, the reportable operating segments should cover at least 75% of the company's total revenue.

Examples

Example 1: defining an operating segment

Different companies have different management reporting frameworks and identification of operating segments depends on the perspective with which the company's top management reviews its performance and makes resource-allocation decisions.

Apple, Inc. (NYSE: AAPL) for example reports its segments based on geographic areas. In its 2013 filling with the SEC, it identifies its operating segments as "generally based on the nature and location of its customers, i.e. Americas, Europe, Japan, Greater China, Rest of Asia Pacific and Retail."

Microsoft (NYSE: MSFT) on the other hand identifies its operating segments based on its products. In its 2012 annual report, MSFT says that they "operate their business in five segments: Windows & Windows Live Division, Server and Tools, Online Services Division, Microsoft Business Division, and Entertainment and Devices Division."

Example 2: identifying reportable operating segments

Oil Horse, Inc. is a company engaged in upstream and downstream oil and gas operations. It has been defining its operating segments as upstream, downstream, chemicals and financing. Due to the sheer size of each segment, they all met the quantitative threshold for definition of reportable operating segment. Subsequent to a recent management shakeup, the company modified its management reporting framework and it now looks at its operations from a geographical point of view. Using the following information, identify which of the operating segments are required to be reported separately. All amounts are in billion CUs

AlphasiaBalaiaEssosMiddle-earthNovindusValinorTotal
Revenue22102432104102
Profit/(loss)3.2-0.547-1.3-0.312.1
Assets341228402012146

Solution

Identification of reportable segments requires calculation of each segment's percentage revenue, profit and assets with reference to the sum of revenue, profit and assets respectively. Calculation of percentage revenue and percentage assets is quite straightforward: divide each segment's revenue/assets by total revenue/assets. Percentage profit/(loss) however, is tricky. It is calculated by dividing each profit/(loss) figure by 14.2 billion, which is the greater of (a) all profits i.e. (3.2+4+7=14.2 billion) and (b) all losses (i.e. 0.5+1.3+0.3=2.1 billion).

The results are summarized below:

AlphasiaBalaiaEssosMiddle-earthNovindusValinor
Revenue %21.57%9.80%23.53%31.37%9.80%3.92%
Profit %22.54%3.52%28.17%49.30%9.15%2.11%
Assets %23.3%8.2%19.2%27.4%13.7%8.2%
Reportable segmentYesNoYesYesYesNo

Balaia and Valinor are not reportable operating segments because none of there percentages are 10% or greater. Novindus is an operating segment because the standards require any one of the three criteria to be 10% or greater (and not all). Since reportable operating segments cover 86% (=(22+24+32+10)/102) of the company's total revenue, the company meets the 75% revenue-coverage threshold and no additional operating segments are to be disclosed.

Disclosures

At minimum, companies are required to disclose the policies they use in identification of operating segments, aggregation of operating segments, calculation of segment revenues, profits and assets. For reportable segments, segment revenue, profit, assets, liabilities and relevant measurement methodology are required to be disclosed. On entity-wide basis, companies are required to disclose information about products and services, information about geographical areas and information about major customers.

Written by Obaidullah Jan, ACA, CFA <--- Hire me on Upwork