Segment reporting ensures greater transparency

ACCOUNTANCY

Transparency is the cornerstone of corporate financial reporting. Analysts and other stakeholders need complete information to evaluate the sustainability and growth of a company and to monitor the performance of its management. Complete disclosure of information results in appropriate valuation of companies and thus improves the efficiency of the capital market.

Theoretically, the risk for investment in equity of a company that discloses complete information is lower than that of investment in equity of a company that withholds information. Greater disclosure should therefore bring down the cost of capital for a firm. No one, including managers, dispute this. Yet, in practice, managers often seek to limit transparency as much as they can without violating the letter of the law.

A case in point is the reporting of segment information. For long, accounting standards have sought to ensure that corporations that serve customers or have assets located in more than one country or carry out more than one business should report the financial performance of each separately.

Since the performance of each business is likely to be affected by quite distinct factors, such disaggregated information would allow users of financial statements to more reliably predict the future prospects of the firm. The US GAAP mandated disclosure of segment information for the first time in 1976. Subsequently the rules have been modified in 1997.

The new rules require greater disclosure of disaggregated information. In India, the requirement for the disclosure of segment information came in force from accounting periods commencing on or after April 1, 2001, in respect of publicly traded companies and also in respect of all other commercial, industrial and business reporting entities whose turnover for the accounting period exceeds Rs 50 crore.

Accounting standards require companies to disclose segment revenue, segment expenses, segment results, segment assets and segment liabilities. In absence of a reasonable basis, common expenses and common assets and liabilities are not allocated to different segments. Accounting standards require companies to disclose information based on the internal management information system (MIS) that the CEO and the board of directors use to manage and oversee the strategy and operations of different segments. They do not require companies to redefine segments for external reporting. The objective is to allow investors to see the company through the eyes of the management. This also helps to predict management actions that can significantly affect future cash flows.

Disclosure of segment information provides an insight into how business segments are creating or destroying value. It also helps to understand the strategy and risk exposure of the company. Companies are not required to provide information on all segments. A segment is a reportable segment if: its revenue from sales, including revenue from internal transfers, is 10 per cent or more of total revenue, external and internal, of all segments; its segment result, whether profit or loss, is 10 per cent or more of: the combined result of all segments in profit, or the combined result of all segments in loss, whichever is greater in absolute amount; or its segment assets are 10 per cent or more of the total assets of all segments. If total external revenue attributable to reportable segments constitutes less than 75 per cent of the total enterprise revenue, additional segments are identified as reportable segments, even if they do not meet the 10 per cent threshold tests, until at least 75 per cent of the total enterprise revenue is included in reportable segments.

More often that not the efforts by regulatory bodies to ensure greater transparency through segment reporting have been thwarted by the actions of managers who have sought to evade accountability from stakeholders by limiting the amount of information provided in financial statements.

In their defence, managers argue that disclosure of proprietary information adversely affects the entity's competitive advantage and thus adversely affects the interest of shareholders. If this is true then companies that operate in a single business segment cannot create sustainable competitive advantage. We can pick up large number of successful companies that are operating in a single segment. Maruti, Tata Steel, ACC, DLF, Tata Tea, Bharti Televenture and Hero Honda are some of the companies which have maintained leadership position in their respective industries for a long period.

We may examine the issue from another angle. Does a company that discloses segment information actually lose in the competition? Many will agree that in India, Infosys Technologies Limited discloses disaggregated information about different business and geographical segments in which it operates in accordance with the spirit of the accounting rules for segment reporting. But it has been able to maintain a leadership position for quite a long period. Therefore, the argument put forward by managers is not tenable. Research in the US reveals that adoption of new rules stipulated in SFAS-131 has not hurt the competitive position of companies. However, it has improved external monitoring. Thus, disclosure of disaggregated information on different segments in which the company operates threatens the manager's job if the resource allocation between different segments is suboptimal or if the company pursues poor diversification strategy.

In fact, managers have strong incentives to aggregate segment information to avoid external scrutiny by the market for corporate control. They want to avoid accountability. However, in some situations it is just the mindset of managers. Take the example of Tata Motors. Tata Motors, which manufactures both commercial vehicles and passenger cars, does not treat the passenger car business separately from the commercial vehicles business for the purpose of segment reporting. Rather, it lumps them together into a single automobile business. The Centre for Monitoring Indian Industries' (CMIE) company database PROWSS considers passenger car manufacturing and commercial vehicles manufacturing as two separate sub-groups of the automobile industry. These two industries do not exhibit similar long-term financial performance. It is also difficult to assume that the board of directors and CEO carry on their function of overseeing the strategy and the operation of the company effectively by looking only at aggregated information for passenger cars and commercial vehicles.

Even if, for argument sake, we agree that it is debatable whether the two industries are different in terms of risk and return, perhaps Tata Motors would have done better to disclose the disaggregated information for the sake of investors and stakeholders who are interested to have the disaggregated information. The question of information overload does not arise because the company operates only in two business segments: manufacturing of passenger car and manufacturing of commercial vehicles. US GAAP indicates that the question of information overload begins when the number of segments goes beyond ten. It is hard to believe that managers of Tata Motors, which belongs to the highly respected Tata Group, are reluctant to submit their decisions to the scrutiny by the capital market.

In view of the managers' inherent reluctance to disclose information that strengthens external monitoring, the board of directors, particularly the audit committee of the board, should assume the responsibility of deciding what is to be disclosed and how much is to be disclosed. The board should strengthen the external monitoring by inducing managers to disclose all relevant information voluntarily and to implement accounting rules in spirit.

This, in turn, will strengthen monitoring by the board of directors. The auditor has to play an important role in ensuring this. For example, the auditor is privy to the board records and the internal MIS and therefore she is in the best position to assess the adequacy or otherwise of the disclosure of segment information in external financial report. It would be really unfortunate if she instead uses her expertise to justify the inadequate disclosure by the company.

The writer is a professor of finance and control at IIM-C