ch07 beechy ism

CHAPTER 7

Segment and Interim Reporting

The previous five chapters (Chapters 2 to 6) have focused on combining the financial results of the various parts of an economic entity. This chapter, in contrast, deals with the division of the whole into smaller units. In the first part (Segment Reporting), we divide the results of operations into smaller units by industry and by geographical area while still retaining the annual time frame. In the second part (Interim Reporting), we divide the annual results into shorter time periods while retaining the overall consolidated reporting approach.

SUMMARY OF ASSIGNMENT MATERIAL

Case 7-1: Ermine Oil LimitedThis is a one-topic case that asks students to explain why one company has no segmented disclosure while a very similar company does report industry segments and export sales.

Case 7-2: Interim ReportingThis past UFE question highlights some of the main conceptual problems or issues associated with interim reporting.

Case 7-3: Shaw Navigational Company This case requires students to think about the implications of equity reported non-consolidated subsidiaries for segmented reporting. The issue of the reportability of a small but very different segment is raised, as is the implication of lease reporting for the measurement of assets in the 10% asset test.

P7-1 (10 minutes, easy)Review of information to determine operating and geographical segments.

P7-2 (20 minutes, medium) Analysis of numerical data in order to determine reportable industry segments; presentation of required segmented information.

P7-3 (15 minutes, easy) Using the IFRS standards to determine reportable segments.

P7-4 (15 minutes, easy) Using the IFRS standards to determine geographic segments.

Copyright © 2014 Pearson Canada Inc. 375

Chapter 7 – Segment and Interim Reporting

P7-5 (15 minutes, medium) Using the IFRS standards to determine reportable segments.P7-6 (25 minutes, medium) Finding the errors and shortcomings in a draft note on operating segments. This is a good analytical exercise.

P7-7 (20 minutes, easy) The problem focuses on the difference in the two approaches to interim reporting as they pertain to taxes.

P7-8 (20 minutes, medium) The problem focuses on the difference in the two approaches to interim reporting. It is an effective problem for highlighting the difference.

P7-9 (20 minutes, medium) Determining income tax expense by quarters when quarterly losses are incurred. This problem requires knowledge of IAS 34.

P7-10 (30 minutes, hard) Determining income tax expense by quarters when there is an operating loss carry-forward from the previous period. This problem requires knowledge of IAS 34.

ANSWERS TO REVIEW QUESTIONS

Segmented reporting questions:

Q7-1: The objective of segmented reporting is to help the enterprise’s stakeholders evaluate the financial position and risk exposure of the components of the business so as to better evaluate the financial position of the enterprise as a whole.

Q7-2: Segments may correspond to specific subsidiaries, but not necessarily. Individual subsidiaries may operate in more than one segment, and one segment may be comprised of many subsidiaries.

Q7-3: IFRS 8 applies only to public companies, although any company can provide segmented reporting.

Q7-4: The IASB considers cost-benefit relationships by recommending disclosure only of information that is readily available within the reporting enterprise.

Q7-5: The core principle is that a company should disclose information that helps users evaluate the nature and financial results of its principal activities, as well as understand the economic environments in which it operates.



Q7-6: An operating segment is considered to be reportable as such if its revenues are at least 10% of total revenues including sales between segments, if its identifiable assets are at least 10% of consolidated assets, or if its operating profit is 10% or more of the consolidated operating profits.

Q7-7: Company D would probably report two operating segments: food retailing and food processing. Company L, on the other hand, would probably report only a single segment for food processing and retailing because its business constitutes a vertically integrated operation wherein the output of the processing plants is sold internally to the retail operations.

Q7-8: The definition of profit is ambiguous. It is measured on the same basis the company measures it in its internal reporting system.

Q7-9: IFRS 8 recommends that at least 75% of consolidated revenues should be disclosed by operating segment.

Q7-10: The approach taken by IFRS 8 for dealing with offsetting is that the 10% profit should be the larger of: a) 10% of the combined profits of all segments that reported profits or b) 10% of the combined losses of all segments that operated at a loss.

Q7-11: Only four pieces of information must be reported for geographic segments: total revenues from external customers in foreign countries; total revenues from sales to external customers in the home country; non-current assets in foreign countries; and non-current assets in the home country.

Q7-12: If a company relies on a single customer for 10% or more if its revenue, the company should disclose the total amount of revenues from each such customer and the segment that generates those total revenues.

Interim reporting questions:

Q7-13: The shorter the time period of reporting, the greater the estimation and allocation problems that arise. Many costs are annual costs and assignment to shorter periods poses new estimation problems. Some costs not only are annual but also are determinable only at the end of the year, such as income tax expense and bonuses. A way must be found to take these costs into account prior to their determination. Because of the shorter time frame and the proportionately smaller revenue and earnings, estimation problems that may be immaterial in annual reporting can become quite material in interim reporting.

Q7-14: Companies that are required by law, regulation or contract to prepare interim reports in accordance with generally accepted accounting principles must comply with IAS 34.

Q7-15: The exception reporting principle means that only new or changed accounting policies are disclosed.



Q7-16: The interim income statement, retained earnings statement and cash flow statement use the same period of the preceding year as the basis of comparison. The balance sheet uses the previous year-end balance sheet.

Q7-17: The two basic approaches to preparing interim statements are the discrete approach, or separate-period approach, wherein each interim period is reported as a distinct period using the same accounting principles as would be applied in annual reporting, and the integral approach, or part-of-a-year approach, wherein each interim period is viewed as a piece of the year and annual revenues and costs are prorated to the interim periods.

Q7-18: An annual cost such as retooling would be estimated and prorated to the interim periods under the integral or part-of-a-year approach. Under the discrete or separate-period approach, the cost would be recognized fully in the period in which it was incurred.

Q7-19: Under the integral or part-of-a-year approach, income taxes are viewed as an annual cost to be estimated and prorated to the individual interim periods based on pre-tax interim net income. Under the discrete or separate-period approach, the income tax for each quarter would be calculated on the year-to-date taxable income.

CASE NOTES

Case 7-1: Ermine Oil Limited

Objectives of the Case

This is a single-topic case that illustrates that even though two companies may appear to be very similar in their operations and markets, they could have radically different segment reporting.

Discussion

If both Ermine and Beluga are public enterprises, i.e., their securities are traded in a public market or they are required to file financial statements annually with a securities commission, then, to be in accordance with generally accepted accounting principles, they must follow IFRS 8. That is, they must disclose segmented information if they have reportable segments.

It may be that Ermine is not a public enterprise, but assuming that it is, there are several other reasons why it may not be required to disclose segmented information. Because Ermine is vertically integrated, with its divisions interdependent and primarily devoted to the production and delivery of the end oil products, it may be considered to be one operating segment. Since the divisions are set up as cost centres, the divisions may not meet the definition of a segment since they are not expected to earn revenue and incur expenses.

In general, an operating segment is considered significant if its revenue is 10 percent or more of the total enterprise revenue. However, as in the case of the transportation division, if an



operating segment has not previously been significant and is currently significant only because its sales are abnormally high, then it does not require segment disclosure. It does not appear that this has been a permanent shift.

A small percentage of Ermine’s sales are exports, so therefore foreign sales may be seen as insignificant and not reported separately.

Beluga, on the other hand, is not in just one operating segment since it has a chemical division which may involve some different business risks from the other divisions. Because of Beluga’s organization as profit centres, the divisions are expected to both earn revenue and incur expenses, and it appears that management considers the divisions to be separately significant. The extensive external sales imply significance in fact as well as appearance.

Definitely, separate disclosure of foreign sales would be appropriate since they are significant, unless this breakdown is provided as part of the operating segments.

Beluga may also feel that the segmented information is necessary for fair presentation to the financial statement users, even though the divisions may not all be reportable segments according to IFRS 8.

[SMA, adapted]

Case 7-2: Interim Reporting

Objectives of the Case This case illustrates some of the problems associated with measurement and allocation when providing interim reports.

Discussion

The following three major issues were raised in the discussion between the controller and the financial analyst: objectives of interim compared to annual reporting; measurement basis; and difficulties in making estimates for interim reports.

Financial reporting objectives

Annual and interim reports share several underlying issues. Both types of reports try to communicate information that will aid users in deciding how to allocate their resources and in assessing management performance. Overall, both help predict the company's future ability to earn income, generate cash flows, meet debt obligations and generate a return on its investments. In most cases both reports are used by the same people.

Interim reports have some users that are different than users of annual reports. Generally, interim reports are used to estimate annual results and determine trends in earnings or liquidity for the



business. As well, interim reports can be used to attract financing and/or satisfy debt covenants that may be is place. Most important, they provide users with information that is up-to-date.

For information in interim reports to be useful, it must be understood by users. This means that the information presented must be relevant, reliable and comparable to prior years. A tradeoff among timeliness, relevance, reliability and completeness must be made with interim reports. In addition, the benefits of more information must outweigh the costs.

All the financial statements are required in the interim report although they are condensed.

Measurement basis

For interim reports to be useful, the accounting policies must be consistent with the annual accounting policies. The determination of income for any accounting period shorter than the complete life of a business requires making estimates to match costs with revenues. In addition to the general problem of allocation to annual periods, estimating for interim periods is complicated by the fact that the period is shorter than a year and many expenses and revenues are determined on an annual basis only. There are two basic approaches to the preparation of interim reports: the integral and the discrete approach.

Under the integral approach, each interim reporting period is considered part of a larger accounting period. The rationale behind this approach is that the allocation of interim results helps users predict annual results. The integral approach smoothes out seasonalities and therefore involves many estimates that require the use of professional judgment.

The discrete approach considers the interim period to be a separate period. An entity using this approach records all costs and revenues in the interim period in question. Thus, the period is considered in isolation from the annual results. Allocations are restricted to ordinary costs: all revenues and extraordinary items are reported in the period they occur. Yearly results are not estimated and it is difficult to predict annual results using interim reports prepared using the discrete approach.

IAS 34 favours the discrete approach but provides some modifications. The problem is the shorter the accounting period, the more difficult it is to allocate costs and the more arbitrary the allocation.

Estimation difficulties

If the interim periods are used to predict year-end results, then the integral approach should be used as the basis of measurement. Making these estimates creates problems. Estimates are especially difficult if events have not taken place yet.



For example, if income is fluctuating between periods (profit in one period, loss in another), profitable periods could have an income tax provision and unprofitable periods could have income tax recoveries if they are more likely than not to be realized. An estimate of the total income could be made in order to smooth out the income tax expense for the year.

In addition, if there is a loss in the first reporting period, the question of whether to recognize a loss carry-back arises. Income over the next period may offset this loss. Again, the year's income will need to be estimated.

The existence of a loss carry-forward from prior years for which a tax recovery has not been recognized in the accounts raises another question. How should the loss carryforwards be applied to the current year's interim period; losses over the next period may offset any carryforward balance.

Many businesses are cyclical in nature. As a result, most of their sales may take place in one specific period. If this is the case, then an estimate would be required in order to match expenses occurring over the full year with the sales that occur in that particular interim period. Estimates of sales and expenses are therefore necessary.

Some costs based on income or sales are only determined once every year. Such expenses will therefore need to be estimated for interim periods. For example, a bonus that is declared in the final period of the year was partly earned in prior periods. Therefore, an estimate has to be made to allocate part of the expense to other periods. The estimate would be based on events that have not occurred yet and are difficult to predict.

Interim inventory should be valued on the same basis used for the annual reporting period. Procedures would therefore have to be applied to give the best possible estimate of the figure that would result if all normal inventory procedures were carried out. Thus, it would be necessary to adjust for shrinkage, obsolescence, excessive inventory quantities, and market declines in value.

Depreciation expense between periods also presents an estimation problem. Year-end depreciation expense is based on additions and disposals made throughout the year. If significant additions are planned for one period, depreciation expense in another period may not be representative of the total year's expense. Therefore, it is important to estimate both additions and disposals for the full year in order to give the user a better indication of the total expense for the year.

[CICA]

Case 7-3: Shaw Navigational Company

Objectives of the Case



This case raises two issues: (1) the impact of subsidiaries on segment reporting, and (2) the desirability of reporting a segment that is not related to the company’s primary business.

Discussion

The identifiable segments are determined by examining the information that the chief operating decision maker (CODM) receives. If the CODM receives discrete financial information about a business that generates revenues and incurs expenses and uses that information to assess the performance of the business and to allocate resources to it, then the business is an identifiable segment. It is likely that all three businesses discussed are identifiable businesses.

To determine if the identifiable segments have to be reported, several quantitative (10%) tests are conducted. The 10% guidelines pertain to total revenues, operating profits and assets. Management claims that 90% of their operating profits are generated by the shipping business. To make this argument they may be including the 20% of the profits from the insurance subsidiary that are related to the shipping business. ([[1,200,000 – 145,000 + .20[145,000]] ÷ 1,200,000 = 90.3%). However, it is unlikely that this would be the way the information would be presented to the CODM for review. It is more likely that the results of the insurance subsidiary are presented separate from the shipping business to the CODM. The fact that Shaw’s insurance subsidiary is generating a profit of 12.1% (145,000 ÷ 1,200,000 = 12.1%) of Shaw’s total net income indicates that the insurance subsidiary should be reported as a segment.

The bus company is in a completely different line of business with different risks than the shipping segment. One can argue that such a venture should be disclosed as a segment, especially if it is apt to grow faster than the shipping segment and thereby meet the guidelines as a reportable segment in the future. Nevertheless, it need not be reported now if it meets none of the 10% tests.

A side issue is the treatment of the leases for the buses. Shaw is a public company and thus is probably complying with the recommendations for capitalizing capital leases. If, however, the leases are not capitalized, then it would be worthwhile investigating as to whether the 10% of assets guideline would be satisfied if the leases were capitalized.

SOLUTIONS TO PROBLEMS

P7-1

JCN Company is a public company. Therefore, it would be required to comply with segmented reporting as outlined in IFRS 8. The laptop computers and software areas of business would both be over the 10% guideline for revenue and would therefore be reported as operating segments. For geographic segments, if revenues are material, there should be a separate segment. If we assume that 10% is material then United States, Canada, South America and Africa would be disclosed separately unless the operating segments above already provide that information. Before making a decision, materiality would need to be determined. It should also be considered whether any of the geographical areas should be grouped together.



P7-2

a) The most important indicator to identify business segments is whether the operation is managed as a separate segment. Given that this problem is silent on how the divisions are being managed, the relative independence of the operations may provide an indication of the appropriate treatment. It would appear that Auto Corporation should report Divisions A and C as one operating segment and Divisions B and D as a second operating segment. Divisions A and C share production facilities. Therefore they are not really separable as individual segments. Most costs and assets are allocated to A and C, rather than being directly assignable. Division B is a producer of input to Division D. The profits of B are highly sensitive to the transfer price. There is likely to be little autonomy for B.

b)

Segment 1 Segment 2 EliminateReconciled to Consolidated

External sales $275,000 $105,000 $380,000Inter-segment sales — 60,000 (60,000) -

275,000 165,000 380,000

Assignable operating expenses 155,000 85,000 (60,000) 180,000Depreciation expense 35,000 37,500 72,500

190,000 122,500 252,500

Segment operating profit (loss) $ 85,000 $ 42,500 $127,500Unallocated corporate expenses 59,500Entity profit before income taxes $ 68,000

Segment Assets $185,000 $200,000 $385,000Segment liabilities $ 45,000 $ 75,000 $120,000Capital expenditures $120,000 $ 40,000 $160,000

Note: This is only one way of presenting the required information. Other formats may be used.

P7-3

A segment is reportable if it comprises 10% of more of an enterprise’s total revenues, operating profits or combined assets. Only one of the 10% tests needs to be met.

1. Reportable segments under Revenue test:

Test: Segment revenues (including intersegment)Total revenues (including intersegment)

Red = (800+100) / (1,700 + 400) = 43%



Green = (600+200) / (1,700 + 400) = 38%

Red and green are reportable segments. Blue, grey and yellow revenues are all less than $210 (10% × $2,100) and are not reportable under this test.

2. Reportable segments under profit test:

Total profits (75+60+5) = $140Total losses (11+15) = $26

Apply 10% criteria to larger of total profits or total losses. Larger is total profits: $140 × 10% = $14. Therefore any segment reporting a profit or loss of $14 or more is reportable. Red, green and yellow are reportable under this test.

3. Total assets are $2,100. Any segment reporting assets of $210 ($2,100 × 10%) or more is reportable. Segments red and green both have assets greater than $210 and are reportable.

Other test: External revenues disclosed in separate operating segments must be at least 75% of consolidated external revenues. The three tests above identified red, green and grey as the reportable segments. External revenues for the three segments is (800+600+90) $1,490 which is 88% of total external revenues of $1,700.

Conclusion: Reportable segments are red, green, and yellow.

P7-4

The information under entity-wide disclosure requirements for geographical segments are external sales and identifiable assets. Prior to determining what geographical segments would be reported, a materiality level needs to be established. If 10% was chosen as the basis for materiality, geographic segments would appear to be as follows, based on the 10% guideline for external sales and/or assets. Other levels of materiality could have been established which would change the geographical segments.

External Sales AssetsSouth America 41% 35%United States 35% 28%

Assuming Canada is the home country, revenue and total assets would also have to be disclosed. The risks of operating in Canada, Asia and Europe are quite different, so Export Corporation should consider showing them all separately even though the materiality criteria are not met.

P7-5

A segment is reportable if it comprises 10% or more of an enterprise’s total revenues, operating profits, or combined assets. Only one of the 10% tests needs to be met.

1.1. Reportable segments under revenue test:



Segment revenues (including intersegment)Test :

Total revenues (including intersegment)

Segment 1 = 105/400 = 26.3%

Segment 2 = 31/400 = 7.8%

Segment 3 = 31/400 = 7.8%

Segment 4 = 35/400 = 8.8%

Segment 5 = 94/400 = 23.5%

Segment 6 = 67/400 = 16.8%

Segment 7 = 37/400 = 9.3%

Segments 1, 5, and 6 are reportable segments. The remaining segments are less than 10% and are not reportable under this test.

2.2. Reportable segments under profit test:

Total profits (40 + 6 + 5 + 48 + 7) = $106

Total losses (19 + 7) = $26

Apply 10% criteria to larger of total profits or total losses. Larger is total profits: $106 × 10% = $10.6. Therefore any segment reporting a profit or loss of $10.6 or more is reportable. Segments 1, 4, and 6 are reportable under this test.

3.3. Total assets are $600. Any segment reporting assets of $60 (= 600 × 10%) or more is reportable. Segments 1, 2, 5, and 6 have assets greater than $60 and are reportable under this test.

Other test: External revenues disclosed in separate operating segments must be at least 75% of consolidated external revenues. The three tests above identified Segments 1, 2, 4, 5, and 6 as the reportable segments. External revenues for the five segments are (95 + 25 + 35 + 90 + 10 =) $255, which is 85% of total external revenues of $300.

Conclusion: Reportable segments are 1, 2, 4, 5, and 6. Segments 3 and 7 can be reported in the “other” category.

P7-6

1. Sales to outsiders and between divisions would be labeled revenues from external customers and intersegment revenue.

2. Operating profit, capital expenditures and assets are not reconciled to the consolidated amounts. Liabilities should be reported if reviewed by the chief operating decision maker.

3. Export sales should be reported, not export gross profit.

4. A number of items must be reported if reviewed by the chief operating decision maker. These items typically include:- Depreciation, depletion and amortization by segment. - Income tax expense or benefit by segments.- Other items such as write-downs, disposals, restructuring costs, etc.

5. The segmented data accounts for only 65% of the company’s consolidated revenues, rather than the 75% minimum recommended.



6. It is not clear if there are any geographical segments that need to be reported or major customers.

7. General information about the products and services of each of the segments.

P7-7

Q1 Q2 Q3 Q4a) Discrete Approach

$20,000(100,000 × 20%)

$50,000(250,000 × 20%)

$260,000(50,000 × 20% + 500,000 × 50%)

$50,000(100,000 × 50%)

b) Integral Approach

$38,000(100,000 × 38%)

$95,000(250,000 × 38%)

$209,000(550,000 × 38%)

$38,000(100,000 × 38%)

Estimated average annual effective tax rate: Estimated income taxes ÷ Estimated income = 380,000 ÷ 1,000,000 = 38%

c) IFRS recommends that interim income tax expense be estimated by using the estimated average annual effective income tax rate (an integral approach).

P7-8

a) Integral or part-of-year approach:

1. The cost of the annual catalogue would be allocated over the four quarters, with only one-fourth of the cost appearing as an expense of the first quarter.

2. Programming and consulting fees would be allocated over the four quarters with one fourth appearing as an expense of the first quarter.

3. The payroll taxes will be accrued and expensed at the estimated average annual rate. The estimated average annual rate is 5% ([650 + 600 + 150 + 100] ÷ 30,000). Given that the $30,000,000 in salaries were paid evenly throughout the year ($7,500,000 per quarter), then the expense recognized each quarter will be $375,000 (7,500,000 × 5%).

4. The tax bill will be estimated and one-fourth will be charged to the first quarter.

5. The depreciation will be allocated evenly to the four quarters of the year, at $1,100,000 per quarter.



6. The net income for the year will be estimated, the bonuses payable on that net income will be calculated, and one-fourth of the estimated annual bonus will be charged to the first quarter.

b) Discrete or separate-period approach:

1. The full cost of the catalog would be charged to the first quarter.

2. The full cost of the programming and consulting fees would be charged to the first quarter. 3. The payroll taxes will be expensed when incurred. The pattern of expense will follow the

pattern of payments made for each quarter.

4. The tax could be recognized as an expense in full in the second quarter when billed and paid. It is more likely, however, that the first quarter’s share of the tax expense would be accrued in keeping with normal accrual accounting procedures.

5. The depreciation would be separately calculated for each quarter (on a declining balance basis). The depreciation expense would thus decline each quarter, just as it does for each successive year.

6. The bonuses would be calculated each quarter, based on the net income after income taxes for that quarter.

P7-9

The benefits of an income tax loss in an interim period are recognized in that period if:• the loss will be offset by taxable income in the other interim periods of that year;• the loss can be used as a tax loss carry back to a prior year; or• it is probable that the benefit of the loss will be realized as a tax loss carry forward.

Given that losses can be carried back one year, the benefit of the tax loss for the first quarter can be recognized. The cumulative loss for the second quarter is greater than what is available to carry back therefore a question may arise as to whether the benefit should be recognized. Given the established pattern of losses in Q 1 and Q2 followed by income in Q3 and Q4, it can be concluded that it is very likely that the loss in excess of the carry back amount will be offset by taxable income in Q3 and Q4 and therefore the benefit of the tax loss for the second quarter can be recognized. The income tax expense for the four quarters will as follows:

Q1 Q2 Q3 Q4Earnings (loss) before

income taxes $(2,250,000) $(1,650,000) $1,950,000 $ 1,800,000Income tax expense

(recovery) (1,012,500) (742,500) 877,500 810,000Net income $(1,237,500) $ (907,500) $1,072,500 $ 990,000



P7-10

a) The income for the year is expected to be $800,000 (4 × 200,000) and therefore taxable income is estimated to be $650,000 (after considering the tax loss carry forward of $150,000). The effective annual tax rate can be calculated as follows: Taxes payable are $260,000 (650,000 × 40%). Income for the year is $800,000. Effective rate is therefore 32.5% (260,000 ÷ 800,000). The income tax expense for each quarter will be $65,000 (200,000 × 32.5%).

b) Normally the tax expense for each quarter is expected to be $10,000 (25,000 × 40%) or $40,000 for the year. The loss carry forward of $150,000 reduces the taxes for the year to zero so that the effective tax rate is 0%. In addition, information available at the end of the first quarter allows management to change their assessment to one where they believe they can recover all of the tax benefit related to the $150,000 loss carry forward. Thus a tax asset of $20,000 ([150,000 - 100,000] × 40%) should also be recognized at that point. The following will be the pattern of taxes for all four quarters:

Q1 Q2 Q3 Q4Income before tax

25,000 25,000 25,000 25,000

I/T expense (0%) 0 0 0 0D/T asset recog. 20,000 0 0 0Income after tax 45,000 25,000 25,000 25,000

Alternate solution:It could be argued that the effective tax rate is –20% ($20,000 tax asset ÷ 100,000 income). If so

interpreted, the following will be the pattern of taxes for all four quarters:

Q1 Q2 Q3 Q4Income before tax 25,000 25,000 25,000 25,000I/T expense (-20%) 5,000 5,000 5,000 5,000Income after tax 30,000 30,000 30,000 30,000


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