Importance of Segment Reporting

Importance of Segment Reporting

Introduction

Financial reporting is an essential undertaking due to the role it plays in enabling a firm to demonstrate its financial position and performance to the diverse stakeholders. Prospective investors use financial reports to determine if they have the potential to enhance their wealth generation by investing in a given company. Equally, the creditors will study the financial reports of the company in determining if they will offer credit support. Thus, financial reporting is instrumental in influencing the relationship a company has with the different stakeholders. However, some corporations operate geographical and business segments that have different financial performance and position. The international financial reporting standards (IFRS) number 8 provides for specific classes of corporations to disclose essential information regarding their operating segments, especially the ones publicly trading securities. The information these entities are required to disclose includes major customers, products offered, operating segments, and geographical areas they serve. Segment reporting implies reporting of the operating units or segments in the financial statement by disclosing their respective crucial importance to the external users of the financial information. The segment reporting is favorable to diversified companies that have different products from varied business lines or operate in different geographical markets. Accordingly, the research report that has been prepared evaluates the importance of complying with international financial reporting standards (IFRS) for segment reporting..

Discussion 

One of the key benefits of segment reporting as provided under IFRS 8 is the impact it has on enhancing the transparency of the financial reports prepared by a corporation. The extent to which the financial reports of a given company are viewed to be transparent is instrumental in determining the opinions of the analysts, investors, creditors, and suppliers on its ability to meet their varied interests. The segment reporting as provided under IFRS has the effect of enhancing the transparency of the financial reports since the stakeholders can determine the geographical or business segments since it demonstrates the area or units influencing its financial performance (Cereola, 2017).

Thus, the stakeholders have a better ground of making their investment or partnership decision with the company compared to the one that does not make segment reporting. Equally, the transparency on the performance of the diverse segments operated by the company gives a better understanding of the management of the need for changing strategic direction for the different segments. The segment reporting will demonstrate the profitability of the different segments based on their varied revenue generation and operational costs (Bens, 2018).

Consequently, the top management will determine areas for strategic decision changes for the different segments based on their individual performance to enhance their profitability in the future. Similarly, the transparency brought by the adoption of the segment reporting as provided by the IFRS helps in preventing hiding of unprofitable ventures by managers.

The preparation of consolidated financial statements that do not reflect the performance and position of the different segments has the effect of hindering the external readers of the financial information from discovering ventures that have been unprofitable and risk been closed in the near future (Jiang, 2017). This scenario has the possibility of misleading the suppliers in making uninformed decisions in supplying goods on credit to an unprofitable unit that has the potential of been closed since the information on its respective performance is not available to assess its riskiness. Accordingly, the extent of the corporation to give segment financial performance and position reports will prevent the managers from misleading stakeholders by hiding unprofitable operating ventures.

Additionally, complying with the IFRS requirements on segment reporting has the advantage of improving the context of the financial results reflected in the issued financial statements. The financial results are of use to the users of the financial information once they are able to understand the reasons behind the changing results between different financial years. The rationale behind this argument is based on the need for determining if the financial results been reported by a company are sustainable in the future (Lucchese, 2016). The favorable financial results of a company that different business or geographical segments could be influenced by emerging events or trends that are favorable to one of the units or geographical location (Bens, 2018).

For instance, the improving consolidated profitability of the Apple Incorporation could be due to the improving economic development in Asia and Africa that it has opened operations. Accordingly, the availability of the geographical segment reports will help in evaluating if the influence of the Asian and African segments on the financial performance of the company is sustainable in the future based on their political, economic, and social stability. The management of the company will determine the viability of increasing investment in the two geographical locations based on the enhanced returns in the future. Equally, the external users of the financial information will have a better understanding of the sustainability of Apple Incorporation in sustaining the expanding financial growth due to the influential segments responsible for the improving financial performance once segment reporting requirements are observed.

Furthermore, complying with the IFRS requirement on segment reporting has the advantage of enhancing the quality of the financial information shared with the external stakeholders. The quality of the financial information is essential in ensuring that investors can allocate their resources efficiently. The decision to observe segment reporting has the effect of enhancing the quality of the financial information since the sources of the figures are traceable from the units or geographical segments of the conglomerate company (Roychowdhury, 2019).

The potential of the company to manipulate the consolidated financial statement is curtailed since they have to match with the financial results of the different segments. Accordingly, the quality of the financial statements is enhanced with the observation of segment reporting. Enhanced quality of the financial information enables the investors to make informed decisions in investing in the company since they are assured of generating returns in the future based on the prospects of the main segments in generating high earnings in the future.

Similarly, the enhanced quality of financial information has the advantage of enabling investors to assess the riskiness of investing in a given company. The nature of the segment reporting in revealing the trend of the different units or geographies in generating the earnings has the effect of signaling to the investors on the possible performance in the future (Lucchese, 2016).

The investors can project potential performance by evaluating the trend of the main business lines or geographical segments. Declining performance of the main business units or geographical locations will signal the possibility of loss-making in the future. In contrast, a trend in which the main geographical or business unit segments are improving their results will signal the possibility of the company to realize high earnings for the shareholders in the future. Consequently, investors benefit through efficient allocation of their capital investment in companies promising high returns in the future due to the enhanced quality of the financial information with the adoption and compliance of the IFRS requirements on segment reporting.

Moreover, segment reporting, as provided under IFRS 8, is important in projecting the cash flow of diversified companies in the future. The cash flow generation is an essential element that is employed in determining the value of a company since it demonstrates the free cash flow available for the investors in the future. A firm with increasing cash flows implies that its value is expanding. In contrast, a firm with decreasing cash flows means that its intrinsic value is diminishing. Thus, the projected cash flow generation is crucial in determining if the value of the firm will expand or reduce in deciding to hold a stake. The segment reporting helps in assessing the ability of a company to generate cash flows in the future based on the trend of the different segments in generating free cash flows (Bedia, 2016).

An assessment of the historical pattern of the various segments of a company on the generation of cash flow can signal to the investors, creditors, analysts, suppliers, and employees on the ability of the firm to enhance free cash flow realization in the future. A trend in which the historical cash flows of the major segments of the company have been declining will signal to the diverse stakeholders that the value of the company has the risk of reducing in the future due to the failure of realizing adequate free cash flows (Albrecht, 2012). In contrast, a trend of increasing cash flow will signal to the stakeholders that the value of the company has a high potential of expanding in the future. Accordingly, the stakeholders can make informed decisions relating to the company based on the future financial prospects of its diverse operational segments.

Similarly, segment reporting has the advantage of enabling the management of the company to identify the competitive edges it enjoys from the business lines or geographical areas it operates. The competitive advantage or edge implies the areas in which the company has a comparative advantage or strength in enhancing its financial performance. The segment reporting allows for a comparative analysis of the different segments in determining the ones that are the pillar of its current consolidated financial performance (Albrecht, 2012). The comparative analysis of the different segments of the corporations enables the management to identify the ones it can exploit to enhance its competitiveness in the market. Consequently, the segments in which the firm should deploy a higher proportion of the investment capital to promote its financial performance are possible due to the presence of the segmented financial reports.

Equally, the management is capable of identifying the units that should be closed or geographical markets to leave based on accurate financial results (Nakano, 2019). The units or geographical with unviable returns can easily be identified from their respective segment financial reports in making an informed decision to close their operations. Consequently, segment reporting is essential in ensuring that the decision to increase capital investment in a given segment or close is informed by the prospects or losses it depicts, respectively. The compliance with the IFRS in segmenting reporting also has the advantage of enabling comparability of segments against competitors in different industries, sectors, and markets (Roychowdhury, 2019). A diversified company has the potential of producing products that spread across different industries or sectors. For example, Berkshire Hathaway Company that is one of the most diversified companies, owns Long & Foster, Dairy Queen, GEICO, Flight-Safety International, Duracell, and Pampered Chef business lines (Berkshire-Hathaway, 2020). This range of ventures wholly owned by Berkshire Hathaway Incorporation spread across different sectors and industries.

Accordingly, the decision by the Berkshire Hathaway Holding Company to prepare segment reports will be advantageous in allowing users of the financial information to assess the performance of the different ventures in comparison with the companies operating in the diverse industries and sectors it has touched. The comparative analysis of the respective business lines against competitors in the market will help in determining if the company is utilizing its resources effectively to enhance the wealth of the shareholders (Albrecht, 2012). Equally, geographical segments operating outside the home country can be compared with the competitors in the respective markets they operate if the company prepares segment financial reports. The management and the external stakeholders can compare and contrast the financial performance of a company that has diversified to foreign markets against the competitors in the respective destinations to assess its competitiveness (Bens, 2018). Accordingly, compliance with IFRS in segment reporting should be considered by diversified and multinational companies due to the advantage of optimal comparative analysis of their segments.

The segment reporting, as provided under IFRS, is important in enabling a diversified company to assess the impact of political and economic events on its different business lines and regional segments. Political and economic events affect different sectors and industries differently due to their relationship with the products or services offered. Thus, stakeholders are interested in assessing the effect a given political or economic event has on the performance of a given company based on the sector, industry, or region it operates. The preparation of consolidated financial statements for a diversified company without segment reports has the effect of hindering the users of the financial information on the effect of a given event on the different business lines or region segments it operates (Cereola, 2017). Accordingly, the preparation of the segment financial reports has the advantage of enabling the stakeholders to assess the potential impact of the economic or political event to the conglomerate performance in the future. The assessment of the future possible financial trend of the company with diversified segments will be based on the effects identified in its major segments.

Similarly, the stakeholders can assess the impact of a political or economic event that has occurred in a foreign market, and the firm has expanded its operations (Lucchese, 2016). The trend analysis of the historical financial performance of the segment in the foreign market will enable the analysts, creditors, and shareholders to determine the effect it has on the financial performance of the diversified company. The investors can predict the potential performance of the corporation in the future based on the performance of the essential segments in making the investment decision. Consequently, segment reporting is important in revealing specific impacts of a political and economic event to the respective units and regional units operated by a given company.

Furthermore, the preparation of the segment financial reports is essential in evaluating the efficacy of the segment managers. The segment financial reports help in determining the managers that are realizing positive and improving financial results. Similarly, ineffective managers will be revealed with the use of the segment financial reports by evaluating the historical movement of their respective segment’s financial performance (Lucchese, 2016). The ability of the top management to reveal the performance effectiveness of the different regional or unit managers is crucial in rewarding decisions, promotion, and extending work contracts objectively. The decision arrived in treating the various unit or regional managers will be based on the efficacy they have shown from their past performance. Consequently, the segment reports help in ensuring that objective decisions against the unit and regional managers are made by focusing on their respective performance reflected by their segment’s financial results.

Equally, the segment financial reports are useful in enabling the top management to determine the segments and regions that require financial support to rejuvenate the performance of the company. The segment reports work as a pointer of the varied performance of the diverse segments operated by a company (Bens, 2018). Thus, the top management of a company can identify the segment that calls for higher support during the times of epidemics and economic shocks based on the performance they have realized. Indeed, different segments are affected differently by macroeconomic events that should determine the capital that should be injected to recover from the losses suffered.  Similarly, the respective segment’s performance can be used in determining the ones that should face downsizing actions during undue economic times based on financial performance during adverse economic periods. The top management can quickly identify the business line and regions that are facing stringent adverse financial results in recommending for downsizing actions to avoid incurring huge losses (Lucchese, 2016). Accordingly, segment reporting is essential in enabling strategic decision-making during times of financial and economic crisis.

Even though segment reporting has numerous advantages to the external and internal stakeholders of publicly listed companies, various shortcomings have been identified in complying with IFRS 8. One of the shortcomings of segment reporting is that it is time-consuming. The preparation of the financial statements by publicly listed companies consumes substantial time due to the extensive processes required to consolidate the various ledgers and journals in realizing a given financial statement (Gutsche & Rif, 2019). Accordingly, the decision to prepare segment reports has the potential of consuming a significant proportion of the operations time that affects the firm adversely.

Similarly, complying with IFRS to prepare segment reports is a costly exercise that can affect the financial performance of a company. The process of preparing the financial statements is expensive due to the time and resources consumed (Gutsche & Rif, 2019). The firm is forced to hire more financial accountants to prepare and audit the financial reports prepared. Equally, a company can be forced to outsource the preparation of the segment financial reports. The hiring of more accountants or outsourcing of the service has the effect of increasing the operational costs that has a negative effect on the overall financial performance of the company (Gutsche & Rif, 2019). Thus, complying with the IFRS to prepare the segment financial has a detrimental financial effect on the company.

Segment financial reporting has also been cited as a risk of promoting data manipulation by the managers. The top management highly uses the segment financial reports in evaluating the efficacy of the various regional managers or business line managers in promoting the wellbeing of the company (Nakano, 2019). The financial performance trend of the various segments is used to determine if their contracts should be extended, awarding bonus stocks, and increasing the remuneration packages. Consequently, segment managers are interested in generating positive outcomes to protect their interests. This scenario has the effect of inducing the appetite of manipulating the financial results to protect their stay or wealth in the company. Segment managers faced with challenges in realizing profits or enhancing their financial performance are at a higher risk of engaging in data manipulation due to the adverse consequences they might face if they fail to meet the set results (Nakano, 2019). Accordingly, the use of the segment financial reports is a recipe for attracting financial fraud in a company due to potential manipulation of the financial results by the segment managers.

Moreover, Gutsche and Rif (2019) argue that segment reporting has the risk of increasing the proprietary costs. The proprietary costs imply the costs associated with manipulated disclosures such as managers concealing abnormal segment’s profits or agency costs in which managers can hide segments reporting low profits. The top management of the company will engage in such behavior to avoid competition or protect undue reactions from the investors in holding stocks of the company. The high abnormal profits of some segments will be concealed due to the fear it might attract new competitors eager to reap from the improving sector the segments serves. In contrast, low profits by some segments will be concealed by the top management to dispel the fear by the investors that the company is headed for decreasing profitability in the future (Nakano, 2019). This scenario might cause speculative selling of the stocks to hurt the market capitalization of the company due to decreased stock prices. Consequently, segment reporting has the risk of influencing the top management to engage in misleading disclosures of their segments to contain adverse movement in the market.

Conclusion

Financial reports are essential tools in enabling the different users of the financial information to make informed decisions. The information revealed in the financial reports signals to the interested stakeholders if the company has the potential to meet their interests in the future. Thus, it is essential for companies to provide timely, relevant, reliable, and understandable financial reports to the stakeholders to enhance their ability to make informed decisions. The segment reporting is one of the approaches that have been mulled as one that has the effect of enhancing the quality of the financial information for stakeholders. The segment reporting involves preparing a separate financial statement for the different segments operated by a diversified company. The decision by the IAS to cal for the segment reporting was informed by the enhanced quality of the information shared to the stakeholders in assessing the financial performance of the diversified companies alongside their different segments. Consequently, it is recommendable for the companies to consider adopting and embracing the IFRS 8 to enhance the quality of the financial information.
References

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