Investors Report

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Chapter

Chapter 6

Segmental Reporting

6.1 Introduction 73 6.2 Discontinued Operations 74 6.3 Segmental Reporting 76 6.4 Summary 80

Learning Objectives

After completing the study of this unit you should be able to:

• understand why the International Accounting Standards Board wanted separate disclosure of discontinued operations

• use segmental reporting information to help you interpret the performance of companies.

6.1 Introduction

In Chapter 5, we considered in depth the technique of ratio analysis and how it could start to help the users of financial statements with their interpretation of the company results. How- ever, as companies continue to expand and diversify, the IASB has developed new accounting standards to help users to better assess company performance.

In this unit, the aim is to explore the rationale behind the decision of the IASB to have separate disclosure of discontinued operations. It also looks at the use of segmental reporting information to help you interpret the performance of companies, and understand how non- financial measurements can also be used to help assess performance.

Twenty-five years ago, Sportsequip Ltd was a small private company based in the south of Edinburgh that manufactured and sold tennis racquets. They sourced their raw materials from local suppliers and sold their racquets throughout the East of Scotland.

Today, Sportsequip plc is a multinational organisation listed on the UK Stock Exchange. The parent company is still based in Edinburgh but the company now owns a number of subsidiary and associate companies around the globe. Some of these companies manufacture sporting goods; some are selling agents for Sportsequip products; some solely supply Sportsequip with raw materials, while others manufacture and sell products under their own brand name.

Do Sportsequip still make and sell just tennis racquets? No, the company has diversified and now offers a full range of sporting equipment and clothing, from cricket bats to hockey sticks and from tracksuits to football shirts. You name it. Sportsequip will supply it. As the structure of the companies has become more complex over the past couple of decades, the complexity of preparing their financial statements has grown. As the objectives of financial reporting are to provide a wide range of users with as much information as possible in order that they can make economic decisions, it is encouraging to see that the accounting legislators are continually reviewing ways of improving the financial information provided in a company’s annual report. See worked example 6.1.

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Worked example 6.1

If the legislation from 30 years ago was still in existence today, Sportsequip plc might have the following income statement as part of its annual financial results.

Sportsequip plc

Income statement Year to 31 December 21x3

£m

Sales 4,000

Expenses 3,000

Profit 1,000

What does this tell the user of the financial statements?

Required

You are a potential investor in Sportsequip plc and are attempting to forecast what next year’s results might be. The Chief Executive states in the Annual Report that an anticipated growth of 20% is expected across all markets next year. Inflation is negligible, so selling prices and costs will all be at this year’s level. What profit will Sportsequip plc generate next year?

Solution

Profit will be £1,200 because sales of £4,800 (£4,000 + 20%) will be offset by expenses of £3,600 (£3,000 + 20%).

Based on the income statement information provided, that is the extent of your analysis.

6.2 Discontinued Operations

Traditionally, users focused on a single figure, profit after tax, to determine how successful the company had been in the past and how it might perform in the future. However, the relevance of this single indicator would appear to be diminished today because:

• companies, and particularly groups of companies, operate worldwide and it would be nice to know how successful each country’s operations had been

• companies usually deal with a diversified product range and users would like to know how each product has contributed to the overall results

• companies and groups often change direction rapidly, moving out of some markets and investing heavily in others − the impact of such decisions on performance can be a useful indicator of future profitability

• more gains and losses may be excluded from the income statement nowadays because legislation requires them to be taken directly to reserves in the balance sheet.

In Chapter 3, we saw how the statement of changes in equity highlighted gains and losses that had been taken directly to the balance sheet. Section 6.3 on Segmental Reporting (IFRS 8) will deal with countries and products but for the moment, let’s consider how IFRS5 (Non-current

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Segmental Reporting

assets held for sale and discontinued operations) has helped when companies are perhaps changing strategic direction.

6.2.1 Format of the Income Statement

There are some key changes which you should note carefully.

An entity should present and disclose information that enables the users of financial statements to see clearly the impact that continuing operations and discontinued operations have had on the financial results.

• Continuing operations are the areas of the business that the company intends to remain involved in for the foreseeable future.

• Discontinued operations are those operations that have been sold or permanently ter- minated during the past trading period.

The income statement for Sportsequip plc might now look like the one in worked example 6.2.

Worked example 6.2

Sportsequip plc

Income statement Year to 31 December 21x3

£m

Continuing operations

Revenue 3,700

Expenses 2,200

Profit from continuing operations 1,500

Discontinued operations

Revenue 300

Expenses 800

Loss from discontinued operations 500

Total profit for the period 1,000

Required

In the light of this information, what profit will Sportsequip plc now generate next year if the conditions in worked example 6.1 were to apply?

Solution

Profit will be £1,800 because that is what the continuing operations will contribute to profit (£1,500 + 20%).

Note: The discontinued operation, which incurred a loss of £500m last year will have no impact on the results for the year to 31 December 21x4.

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By furnishing the potential investor with a little extra information, the income statement allows us to anticipate profit being 50% (£1800 / £1200) higher than we estimated against the old style income statement.

6.3 Segmental Reporting

As Sportsequip plc is a multinational company operating worldwide, it would be naïve to assume that its subsidiaries and associate companies in all countries experience the same trading and economic conditions. Clearly, the prediction given above that growth next year would be 20% throughout the world is unrealistic. Why should the market for tennis racquets and hockey sticks necessarily show the same growth pattern? Why should the market in South Africa show the same growth rate as the market in Australia?

Where companies are operating in a variety of ‘classes of business’ (tennis racquets, hockey sticks, etc.) and operating across a number of ‘geographical segments’ (South Africa, Australia, etc.), then the user of financial statements would benefit greatly from feedback of how each ‘class of business’ and each ‘geographical segment’ has performed.

The IASB issued an international accounting standard, IFRS 8, on Segmental Reporting. This standard required larger companies to include, as part of their financial statements, a disclosure note providing an analysis of their activities. Where companies operate across several business segments or in several geographical countries, segmental analysis enables users of the financial statements to appreciate more thoroughly the results of the company and makes them more aware of the impact that changes in significant components of a business can have on the company as a whole.

6.3.1 Segmental Analysis

IFRS 8 calls for the analysis of fiveitems, each to be split by class of activity and geographical area. These fall under the following headings.

• Revenue − consists of revenue directly attributable to a segment, whether relating to sales to external customers or revenue relating to ‘internal sales’ to other segments within the group. If inter-segment sales are material, they should be disclosed separately in the segmental analysis.

• Profit or loss− the segment profit or loss should be analysed based on the results before interest and tax. The profit before interest is taken because normally interest incurred is a matter of overall financial policy, rather than something specifically connected to an identifiable segment. In determining segment profit or loss, you should remember that it is likely that costs have been incurred by the company for the benefit of more than one segment. The normal treatment of these common costs is simply to deduct them from the total segment results without apportionment.

• Net assets − defined as the operating assets minus the operating liabilities. As with common costs above, there may well be assets held by the company (for example, the head office building) which are difficult to allocate across the different segments and are, therefore, shown as unallocated.

IFRS 8 largely leaves it to the directors to decide whether or not the company has two or more segments but the standard expects that segmental information should be provided for each reportable segment, defining a reportable segment as one which contributes at least 10% of sales or contributes at least 10% of profit or one which has 10% or more of the total assets of the company.

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Segmental Reporting

A typical segmental reporting disclosure note might appear as shown in the example which follows.

Caves plc

Segmental Report for Year ended 31 December 20x5

Business segment (£m)

Stationery Books Videos Group

20x5 20x4 20x5 20x4 20x5 20x4 20x5 20x4

Revenue 12 10 35 40 53 20 100 70

Profit before tax

Segment profit 3 2 8 10 20 10 31 22

Common costs 2 2

Group profit 29 20

Net assets

Segment net assets 20 20 45 40 60 40 125 100

Unallocated assets 20 20

Total assets 145 120

Geographical segment (£m)

Europe USA Far East Group

20x5 20x4 20x5 20x4 20x5 20x4 20x5 20x4

Revenue 60 25 25 30 15 15 100 70

Profit before tax

Segment profit 20 10 7 7 4 5 31 22

Common costs 2 2

Group profit 29 20

Net assets

Segment net assets 50 40 40 40 35 20 125 100

Unallocated assets 20 20

Total assets 145 120

The point about segmental reporting is that each segment may differ in terms of:

• profitability

• risk

• rate of growth

• potential for future development.

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Without calculating the numbers from the example above the following paragraph highlights some of the analyses that users could carry out when given segmental data for two years are given below.

6.3.2 Business Segment Analysis

The following features could be investigated:

• sales growth percentage for each business segment

• total sales growth percentage for the group

• percentage split of total sales between the business segments

• profit margin (profit/sales) for each business segment

• profit margin for the group

• profit growth percentage for each business segment

• the percentage that each business segment contributes to group profit

• ROCE (profit/net assets) for each business segment

• ROCE for the group

• percentage increase in investment for each business segment

• the percentage of the overall investment allocated to each business segment.

Clearly, a very similar list could be drawn up for the geographical segment.

Given the analysis above, users of the financial statements, firstly, can see the impact that changes in individual segments have had on the results as a whole and, secondly, having this enhanced understanding of what has happened in the past, they are in a much better position to assess the future prospects of the organisation.

Section 6.2 illustrates how IFRS 5 on discontinued operations had started to provide users with additional information. However, IFRS 5 should not be seen as a substitute for segmental reporting because it does not analyse different activities in detail. IFRS 5 offers some analysis on the face of the profit and loss account, which can give users of the financial statements an overview of the total results, but the disclosure note on segmental analysis might just provide them with that extra bit of detail.

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Worked example 6.3

We might now have the following information for Sportsequip plc.

Sportsequip plc

Income statement Year to 31 December 21x3

21x3 21x2

£m £m

Revenue

Tennis racquets 1,500 1,500

Hockey sticks 1,500 1,400

Sportswear 1,000 700

4,000 3,600

Expenses 3,000 2,800

Profit

Tennis racquets 500 500

Hockey sticks 100 100

Sportswear 400 200

1,000 800

Required

What could we now deduce about Sportsequip plc results?

Solution

We can determine, for both years, how much each class of business contributes to sales and profit.

Revenue breakdown 21x3 21x2

Tennis racquets 37.5% (£1,500/£4,000) 41.6%

Hockey sticks 37.5% (£1,500/£4,000) 38.9%

Sportswear 25.0% (£1,000/£4,000) 19.5%

100% 100%

Profit breakdown 21x3 21x2

Tennis racquets 50% (£500/£1,000) 62.5%

Hockey sticks 10% (£100/£1,000) 12.5%

Sportswear 40% (£400/£1,000) 25.0%

100% 100%

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We can calculate the revenue increase for each class of business which might help us to determine the growth area for the future:

Tennis racquets no increase

Hockey sticks 7.1% increase (£1,500/£1,400)

Sportswear 42.8% increase (£1,000/£700)

By linking the profit to the sales, we can also calculate the profit margin for each class of business for both years.

Revenue breakdown 21x3 21x2

Tennis racquets 33.3% (£500/£1,500) 33.3%

Hockey sticks 6.7% (£100/£1,500) 7.1%

Sportswear 40.0% (£400/£1,000) 28.5%

Conclusion

The sportswear market has the highest sales growth and the highest profit margin, suggesting a rosy future for this class of business. The tennis racquet market has gone flat in terms of growth, although it is still the major contributor to the company’s sales and profit. Hockey stick sales increased slightly, but at a low and declining profit margin, perhaps due to competition in the marketplace.

The segmental analysis shown above provides so much more meaningful information than the single profit and single sales figure that we used to see on the income statement. And remember, there’s more! Companies must disclose their net assets (investment) for each class of business and geographical segment. Linking profit to net assets enables us to calculate the return on capital employed (ROCE) for each business segment so that we can see which areas of the business are generating the best returns.

6.4 Summary

In this unit, we have seen how IFRS 5 requires companies to disclose information on areas of the business that have been discontinued during the trading period.

In addition, , IFRS 8 requires companies to provide segmental information to user groups. This could be either business or geographical segments. Sales, expenses, profit,assets and liabilities must be disclosed for each segment, providing the users of financial statements with information on the growth and decline in areas of the business, as well as enabling them to calculate profit margins and returns on investment by segment.

Both of these standards are further evidence that the ‘accounting world’ continually strives to improve the quality of financial reporting.