As you prepare to operate as a public company, you will need to understand the increased financial reporting demands that accompany this transition. One major change which can often come as a surprise is segment reporting. The US Generally Accepted Accounting Principles (GAAP) requirements regarding segment reporting are explained in the FASB Accounting Standards Codification (ASC) Topic 280. The objective of segment reporting is to help financial statement users better understand your company’s performance, better assess your company’s prospects for future cash flows, and make more informed judgments about your company as a whole. The ASC 280 requirements attempt to give financial statement users information at a level of granularity similar to the level a decision-making executive within your company might receive.
This article is divided into three main sections: (I) the process of identifying reportable operating segments, (II) the disclosures that are required for each segment, and (III) the process of reporting entity-wide disclosures required for all public companies. The purpose of this article is to give you an overview; for more technical information, illustrative examples, and specific references to ASC 280, see our articles Segment Reporting Case Study and Entity-wide Disclosure Case Study.
I. Identifying Reportable Operating Segments
The process of identifying reportable operating segments can be broken down into six main steps:
- Identify all operating segments
- Evaluate operating segments for aggregation
- Apply the quantitative threshold tests (10 percent tests)
- Evaluate operating segments for aggregation again
- Apply the 75 percent test
- Aggregate remaining operating segments into “all other” category
1. Identify all operating segments
The identification of operating segments within your company is central to the discussion of segment reporting. An operating segment is a component of your company that (a) engages in business from which it may earn revenues and incur expenses (including revenues and expenses from transactions with other segments), (b) has its results regularly reviewed by your company’s chief operating decision maker (CODM), and (c) has discrete financial information available. Segment reporting should provide insights to the public from the perspective of the CODM and will likely draw data from reports that the CODM already uses internally.
Identifying the Chief Operating Decision Maker (CODM)
Before you can accurately identify operating segments, you must first determine who is acting as the CODM. “CODM” does not refer to a specific job title within your company (like the CEO), but rather represents a function—the person(s) who allocates resources and evaluates the performance of your company. It is possible that managers or executives other than the CEO—like the COO and some VPs—may be fulfilling this decision-making function.
The CODM likely receives company reports that are broken down into segments (e.g., geography or product type), and these likely constitute operating segments. Therefore, as you begin to prepare your segment disclosures, you will likely already have your company information in a format similar to what is required.
2. Evaluate operating segments for aggregation
Before you look at any quantitative thresholds (explained below), it may be appropriate to combine multiple operating segments together within the segment disclosure. If two or more operating segments have similar economic characteristics and projected trends in financial performance, they may be aggregated together as long as the following elements are also similar: (a) the nature of the products/services, (b) the nature of the production process, (c) the type or class of customer, (d) the method used to distribute products or provide services, and (e) the nature of the regulatory environment (e.g., banking, insurance, or public utilities). The emphasis is on the future prospects, so even if two segments are behaving similarly at present, aggregation would not be appropriate if the future is expected to be different. Conversely, if two segments have previously behaved differently, but are projected to be similar in the future, they may be aggregated.
After determining if any segments should be aggregated, it is time to assess the operating segments that you have identified against the quantitative thresholds (10 percent tests).
3. Quantitative threshold tests (10 percent tests)
When your company goes public, you will be required to provide disaggregated information about an operating segment if it meets one of the following quantitative thresholds:
- Its revenue—both from sales to external customers and intersegment sales—is 10 percent or more than the combined revenue of all segments together (before elimination of intersegment sales).
- The amount of its profit or loss is 10 percent or more of the greater (in absolute amount) of either:
- The combined profits of all operating segments
- The combined losses of all operating segments
- Its assets are worth at least 10 percent of the combined assets of all operating segments.
If a segment satisfies any of the three 10 percent tests, it should be classified as a separately reportable operating segment. This means that you will have to provide disaggregated financial information specific to that segment’s operations.
4. Evaluate operating segments for aggregation again
After you identify your separately reportable operating segments by the quantitative thresholds, you may look at the remaining operating segments (those that did not qualify under any of the 10 percent tests) to see if any are economically similar. This is like the process in step two, but the requirements are more lenient. Only a majority of the criteria mentioned in step two must be met (making it easier to qualify for aggregation). The purpose of segment reporting is to help financial statement users understand your company from the perspective of the CODM, so if aggregating multiple segments together still achieves this goal, aggregation would likely be appropriate. However, it is never appropriate to aggregate a segment that did not meet a quantitative threshold with one that did. Please see Segment Reporting Case Study for an example of this step four evaluation.
5. 75 percent test
According to GAAP requirements, the combined revenues earned by sales to external customers in the separately reportable operating segments must be at least 75 percent of the total consolidated revenues across all operating segments. If this 75 percent threshold is not met, you must disclose financial information on additional operating segments—even though they do not satisfy all of the criteria explained above—until the 75 percent bar is met or exceeded. When adding additional segments, you are not required to begin with the next largest segment (i.e., the largest operating segment that did not qualify for separate identification); rather, it is up to management’s discretion to determine what would be most valuable for investors to know.
6. Aggregate remaining operating segments into “all other” category
After you identify all separately reportable operating segments, the information for all other segments is aggregated into an “all other” category. The only requirement for this “all other” category is that the sources of the revenue should be described as part of the disclosure.
II. Disclosure Requirements
For each of the reportable segments you have identified, GAAP specifies what information is required in your disclosures.
Your company must disclose the factors that were used to identify the reportable segments, including the general basis for how the segments are divided (e.g., by product, geography, etc.). Additionally, you will need to describe the types of products and services behind the revenue in each segment. If your company reports as only one segment, you must provide a strong justification for doing so. The SEC has been known to ask for greater explanation for reporting as only one operating segment. (For example, see the following letter from the SEC to PowerSecure International, Inc. from 2016.)
Information about Profit or Loss and Assets
Your company is required to provide a measure of profit or loss and total assets for each of your reportable segments. In addition to the aggregated numbers, the following information is required if it is reviewed by the CODM, even if it is not included in the measure of segment profit or loss: (a) revenues from external sales, (b) revenue from transactions with other operating segments within your company, (c) interest revenue, (d) interest expense, (e) depreciation, depletion, or amortization expense, (f) unusual items, (g) equity in the net income of investees accounted for by the equity method, (h) income tax expense or benefit, and (i) other significant noncash items.
The amounts that your company discloses for each segment should be the same amounts that are reported to the CODM for decision making purposes. In fact, GAAP repeatedly reiterates that only the information used by the CODM should be disclosed. However, if the CODM uses multiple measures of a segment’s profits or losses or assets, the amounts disclosed in the segment disclosures should be those that correspond most closely with the consolidated financial statements.
The following explanations are required for the measurement of profits or losses and assets:
- The accounting basis for transactions
- Differences between the profit or loss measurement for each segment and that in your overall consolidated income statement
- Differences between the measurements of the segments’ assets and your company’s consolidated assets
- Any changes from prior periods in the measurement methods used to determine segment profits and losses and the effect of those changes
- The nature and effect of any asymmetrical allocation to segments (for example, a public entity might allocate depreciation expense to a segment without allocating the related depreciable assets to that segment)
It is likely that the amounts reported for a company’s reportable operating segments will not total the same amounts reflected in the consolidated financial statements due to certain reconciling items (i.e., intercompany transfers/sales). Consequently, GAAP requires your company to provide reconciliations between the reportable segments’ total revenues, total profits or losses, and total assets to the respective consolidated totals.
Quarterly Report Information
Your company is not required to provide all segment information on the Form 10-Q (quarterly or interim financial report). Rather, only the following are necessary:
- Revenue from external customers
- Intersegment revenues
- A measure of segment profit or loss
- Total assets for which there has been a material change from the amount disclosed in the last annual report
- A description of differences in segmentation or measurement of segment profit or loss compared to the last annual report
- A reconciliation of the total of the reportable segments’ measures of profit or loss to the public entity’s consolidated income
Changes in Operating Segments
If your company’s internal organization evolves such that your reportable segments change, the information from prior periods, including interim periods, must be restated to match the current information. However, restatements are only required if it is reasonable—not overly difficult—to do so. If prior periods are not restated after a change in segment structure, your company must disclose segment information under both the old basis and the new basis for the year in which the change takes place.
As you can imagine, changes can make segment reporting even more difficult to prepare.
III. Entity-Wide Disclosures
In addition to the operating segment disclosures discussed above, your company is required to provide three types of entity-wide disclosures to further enhance investors’ understanding of your company’s performance. Even if you have only one operating segment, these entity-wide disclosures are still required, but only on your annual report—Form 10-K. For an example of how an entity would make its entity-wide disclosures, see our article Entity-wide Disclosure Case Study.
Information about Products and Services
The first type of entity-wide disclosure relates to the revenue earned for each type of product or service at your company. You must report on the revenues earned from sales to external customers for each product and service or each group of similar products and services, unless it is unreasonable to do so.
Information about Geographic Areas
In addition to the information about products and services, your company is required to provide information about the geographic areas in which it operates. You must report your revenues from external customers in your home country as well as all foreign countries. If an individual foreign country’s revenues are material, they should be disclosed separately. Additionally, you need to report on all long-lived assets1 in your home country and all foreign countries. As with revenues, if assets in any individual foreign country are material, they should be reported separately.
Information about Major Customers
Finally, your company is required to provide information about major customers2, so that investors are aware if you rely significantly upon a single customer. If your company derives 10 percent or more of its external revenues from any single customer, you must disclose this fact along with the total revenues from that major customer and the segment(s) reporting the revenues. Neither the identity of the major customer(s) nor the amount of revenue from each individual segment sold to the customer(s) need to be disclosed.
If your company reports its operating segments on the basis of products and services or geography already, it is unnecessary to duplicate the disclosure.
As explained in this article, there are many details to consider when preparing your segment disclosure. You will need to have this disaggregated information ready in advance of your audit and Form S-1 generation. The SEC frequently requests more information about why a company did not report additional operating segments—in both annual 10-K reports and S-1 filings—so you should be prepared to defend your classifications. This article has provided an overview of what is expected of you for segment reporting, and you should use this information early in your company’s life to prepare for the first (and subsequent) public filing. See Exhibit 1 for a flowchart that summarizes the segment reporting steps. For a more detailed explanation of some of the issues discussed here, see our articles Segment Reporting Case Study and Entity-wide Disclosure Case Study.
- Advanced Financial Accounting, Christensen, Cottrell and Budd
- ASC 280
- Long-lived assets in ASC 280 exclude financial instruments, long-term customer relationships of a financial institution, mortgage and other servicing rights, deferred policy acquisition costs, and deferred tax assets.
- Per ASC 280, a “major customer” can be a group of entities known to a reporting public entity to be under common control and should be considered as a single customer. Additionally, the federal government, a state government, a local government, or a foreign government each shall be considered as a single customer.