Chapter 8 - Segment and Interim Reporting

CHAPTER 8 SEGMENT AND INTERIM REPORTING

Chapter Outline
I. In the past, consolidation of financial information made the analysis of diversified companies quite difficult. A. The consolidation process tends to obscure the individual characteristics of the various component operations. B. Many groups called for the presentation of disaggregated financial data as a means of enhancing the information content of corporate financial reporting. The move toward dissemination of disaggregated information culminated in December 1976 with the release by the FASB of Statement 14, Financial Reporting for Segments of a Business Enterprise.

II.

III. In response to the demand by financial analysts for improvements in segment reporting,

the FASB issued Statement 131, Disclosures about Segments of an Enterprise and Related Information, in June 1997. Note: SFAS 131 has been incorporated into the FASBs Accounting Standards Codification Section 280 Segment Reporting (FASB ASC 280). A. A so-called management approach is used in which segments are based on the way that management disaggregates the enterprise for making operating decisions; these are referred to as operating segments. B. Operating segments are components of an enterprise which meet three criteria. 1. Engage in business activities and earn revenues and incur expenses. 2. Operating results are regularly reviewed by the chief operating decision-maker to assess performance and make resource allocation decisions. 3. Discrete financial information is available from the internal reporting system. C. Once operating segments have been identified, three quantitative threshold tests are then applied to identify segments of sufficient size to warrant separate disclosure. Any segment meeting even one of these tests is separately reportable. 1. Revenue testsegment revenues, both external and intersegment, are 10 percent or more of the combined revenue, external and intersegment, of all reported operating segments. 2. Profit or loss testsegment profit or loss is 10 percent or more of the greater (in absolute terms) of the combined reported profit of all profitable segments or the combined reported loss of all segments incurring a loss. 3. Asset testsegment assets are 10 percent or more of the combined assets of all operating segments.

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D. There are several general restrictions on the presentation of operating segments. 1. Separately reported operating segments must generate at least 75 percent of total sales made by the company to outside parties. 2. Ten is suggested as the maximum number of operating segments that should be separately disclosed. If more than ten are reportable, the company should consider combining some operating segments. E. Information to be disclosed by operating segment. 1. General information about the operating segment including factors used to identify

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operating segments and the types of products and services from which each segment derives its revenues. 2. Segment profit or loss and the following components of profit or loss. a. Revenues from external customers. b. Revenues from transactions with other operating segments. c. Interest revenue and interest expense (reported separately). d. Depreciation, depletion, and amortization expense. e. Other significant noncash items included in segment profit or loss. f. Unusual items (discontinued operations and extraordinary items). g. Income tax expense or benefit. 3. Total segment assets and the following related items. a. Investment in equity method affiliates. b. Expenditures for additions to long-lived assets. IV. Entity-wide disclosures. A. Information about products and services. 1. Additional information must be provided if operating segments have not been determined based on differences in products and services, or if the enterprise has only one operating segment. 2. In those situations, revenues derived from transactions with external customers must be disclosed by product or service. B. Information about geographic areas. 1. Revenues from external customers and long-lived assets must be reported for (a) the domestic country, (b) all foreign countries in which the enterprise has assets or derives revenues, and (c ) each individual foreign country in which the enterprise has material revenues or material long-lived assets. 2. The FASB does not provide any specific guidance with regard to determining materiality of revenues or long-lived assets; this is left to managements judgment. C. Information about major customers. 1. The volume of sales to a single customer must be disclosed if it constitutes 10 percent or more of total sales to unaffiliated customers. 2. The identity of the major customer need not be disclosed. V. International Financial Reporting Standards (IFRS) also provide guidance with respect to segment reporting. A. IFRS 8, Operating Segments, is based on U.S. GAAP. Major differences between IFRS 8 and U.S. GAAP are: 1. IFRS 8 requires disclosure of total assets and total liabilities by operating segment if these are regularly reported to the chief operating decision maker. U.S. GAAP requires disclosure of segment assets but does not require disclosure of segment liabilities. 2. IFRS 8 specifically includes intangibles in the scope of non-current assets to be disclosed by geographic area. U.S. GAAP indicates that long-lived assets to be disclosed by geographic area excludes intangibles. 3. U.S. GAAP requires an entity with a matrix form of organization to determine

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operating segments based on products and services. IFRS 8 allows such an entity to determine operating segments based on either products and services or geographic areas.

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VI. To provide investors and creditors with more timely information than is provided by an annual report, the U.S. Securities and Exchange Commission (SEC) requires publicly traded companies to provide financial statements on an interim (quarterly) basis. A. Quarterly statements need not be audited. VII. APB Opinion No. 28 requires companies to treat interim periods as integral parts of an annual period rather than as discrete accounting periods in their own right. Note: APBO 28 has been incorporated into the FASBs Accounting Standards Codification Section 270 Interim Reporting (FASB ASC 270). A. Generally, interim statements should be prepared following the same accounting principles and practices used in the annual statements. B. However, several items require special treatment for the interim statements to better reflect the expected annual amounts. 1. Revenues are recognized for interim periods in the same way as they are on an annual basis. 2. Interim statements should not reflect the effect of a LIFO liquidation if the units of beginning inventory sold are expected to be replaced by year-end; inventory should not be written down to a lower market value if the market value is expected to recover above the inventory's cost by year-end; and planned variances under a standard cost system should not be reflected in interim statements if they are expected to be absorbed by year-end. 3. Costs incurred in one interim period but associated with activities or benefits of multiple interim periods (such as advertising and executive bonuses) should be allocated across interim periods on a reasonable basis through accruals and deferrals. 4. The materiality of an extraordinary item should be assessed by comparing its amount against the expected income for the full year. 5. Income tax related to ordinary income should be computed at an estimated annual effective tax rate; income tax related to an extraordinary item should be calculated at the margin. VIII. The authoritative literature provides guidance for reporting changes in accounting principles including those made in interim periods. A. Unless impracticable to do so, an accounting change is applied retrospectively, that is, prior period financial statements are restated as if the new accounting principle had always been used. B. When an accounting change is made in other than the first interim period, information for the interim periods prior to the change should be reported by retrospectively applying the new accounting principle to these pre-change interim periods. C. If retrospective application of the new accounting principle to interim periods prior to the change of change is impracticable, the accounting change is not allowed to be made in an interim period but may be made only at the beginning of the next fiscal year. IX. Many companies provide summary financial statements and notes in their interim reports. A. Minimum disclosure requirements for interim reports.
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B.

1. Sales, income tax, extraordinary items, cumulative effect of accounting change, and net income. 2. Earnings per share. 3. Seasonal revenues and expenses. 4. Significant changes in estimates or provisions for income taxes. 5. Disposal of a business segment and unusual items. 6. Contingent items. 7. Changes in accounting principles or estimates. 8. Significant changes in financial position. Disclosure of balance sheet and cash flow information is encouraged but not required. If not included in the interim report, significant changes in the following must be disclosed: 1. Cash and cash equivalents. 2. Net working capital. 3. Long-term liabilities. 4. Stockholders' equity.

X.

Four items of information must also be disclosed by operating segment in interim financial statements: revenues from external customers, intersegment revenues, segment profit or loss, and, if there has been a material change since the annual report, total assets.

XI. IAS 34, Interim Financial Reporting, provides guidance in IFRS with respect to interim financial statements. A. Unlike U.S. GAAP, IAS 34 requires each interim period to be treated as a discrete accounting period in terms of the amounts to be recognized. As a result, expenses that are incurred in one quarter are expensed in that quarter even though the expenditure benefits the entire year. And there is no accrual in earlier quarters for expenses expected to be incurred later in the year.

Learning Objectives
Having completed Chapter 8 of this textbook, Segment and Interim Reporting, students should be able to fulfill each of the following learning objectives: 1. 2. 3. 4. 5. 6. Understand how an enterprise determines its operating segments and the factors that influence this determination. Apply the three tests that are used to determine which operating segments are of significant size to warrant separate disclosure. List the basic disclosure requirements for operating segments. Determine when and what types of information must be disclosed for geographic areas. Apply the criterion for determining when disclosure of a major customer is required. Understand and apply procedures used in interim reports to treat an interim period as an
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integral part of the annual period.

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7. 8.

List the minimum disclosure requirements for interim financial reports. Recognize differences between U.S. GAAP and IFRS in segment and interim reporting.

Answer to Discussion Question

In his well-publicized The Numbers Game speech delivered in September 1998, former SEC chairman Arthur Levitt cited materiality as one of five gimmicks used by companies to manage earnings. Although his remarks were not specifically directed toward the issue of geographic segment reporting, the intent was to warn corporate America that materiality should not be used as an excuse for inappropriate accounting. To make the point even more salient, the SEC issued Staff Accounting Bulletin (SAB) 99, Materiality, in August 1999, which warns financial statement preparers that reliance on a simple numerical rule of thumb, such as 5% of net income, is not sufficient. SAB 99 reminds financial statement preparers that: The omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item. Further, SAB 99 reminds companies that both quantitative and qualitative factors should be considered in determining materiality. With respect to segment reporting, SAB 99 states: The materiality of a misstatement may turn on where it appears in the financial statements. For example, a misstatement may involve a segment of the registrant's operations. In that instance, in assessing materiality of a misstatement to the financial statements taken as a whole, registrants and their auditors should consider not only the size of the misstatement but also the significance of the segment information to the financial statements taken as a whole. A misstatement of the revenue and operating profit of a relatively small segment that is represented by management to be important to the future profitability of the entity" is more likely to be material to investors than a misstatement in a segment that management has not identified as especially important. In assessing the materiality of misstatements in segment information - as with materiality generally - situations may arise in practice where the auditor will conclude that a matter relating to segment information is qualitatively material even though, in his or her judgment, it is quantitatively immaterial to the financial statements taken as a whole. Thus, in addition to quantitative factors, such as the relative percentage of total revenues generated in an individual foreign country, companies should consider qualitative factors as well. Qualitative factors that might be relevant in assessing the materiality of a specific foreign country include: the growth prospects in that country and the level of risk associated with doing business in that country. There are competing arguments for the FASB establishing a significance test for determining material foreign countries. On one hand, such a quantitative materiality test flies in the face of the warning provided in SAB 99. For example, a 10% of total revenue or long-lived asset test might give companies an excuse to avoid reporting individual countries that would be material for qualitative reasons. Assume that from one year to the next a company increases its

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revenues in China from 2% of total revenues to 6% of total revenues. Although 6% of total revenues would not meet a 10% test, the relatively large increase in total revenues generated in China could be

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material in that it could affect an investors assessment of the companys future prospects. This company might be reluctant to disclose information about its revenues in China because of potential competitive harm. On the other hand, the FASB could establish a materiality threshold low enough, for example, 5% of total revenues, that would be likely to ensure that material countries are disclosed regardless of whether they are material for quantitative or qualitative reasons. A bright-line materiality threshold would ensure a minimum level of disclosure and would enhance the comparability of financial disclosures provided across companies.

Answers to Questions
1. Consolidation presents the account balances of a business combination without regard for the individual component companies that comprise the organization. Thus, no distinction can be drawn as to the financial position or operations of the separate enterprises that form the corporate structure. Without a method by which to identify the various individual operations, financial analysis cannot be well refined. The word disaggregated refers to a whole that has been broken apart. Thus, disaggregated financial information is the data of a reporting unit that has been broken down into components so that the separate parts can be identified and studied. The objective of segment reporting is to provide information to help users of financial statements: a. better understand the enterprises performance, b. better assess its prospects for future net cash flows, and c. make more informed judgments about the enterprise as a whole. Defining segments on the basis of a companys organizational structure removes much of the flexibility and subjectivity associated with defining industry segments under prior standards. In addition, the incremental cost of providing segment information externally should be minimal because that information is already generated for internal use. Analysts should benefit from this approach because it reflects the risks and opportunities considered important by management and allows the analyst to see the company the way it is viewed by management. This should enhance the analysts ability to predict management actions that can significantly affect future cash flows. An operating segment is defined as a component of an enterprise: a. that engages in business activities from which it earns revenues and incurs expenses, b. whose operating results are regularly reviewed by the chief operating decision maker to assess performance and make resource allocation decisions, and c. for which discrete financial information is available. Two criteria must be considered in this situation to determine an enterprises operating segment. If more than one set of organizational units exists, but there is only one set for which segment managers are held responsible, that set constitutes the operating segments. If segment managers exist for two or more overlapping sets of organizational units, the organizational units based on products and services are defined as the operating segments. The Revenue Test. An operating segment is separately reportable if its total revenues amount to 10 percent or more of the combined total revenues of all operating segments.

2.

3.

4.

5.

6.

7.

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The Profit or Loss Test. An operating segment is separately reportable if its profit or loss is 10 percent or more of the greater (in absolute terms) of the combined profits of all profitable segments or the combined losses of all segments reporting a loss.

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The Asset Test. An operating segment is separately reportable if its assets comprise 10 percent or more of combined assets of all operating segments. 8. For reportable operating segments, the following information must be disclosed: a. Revenues from sales to unaffiliated customers. b. Revenues from intercompany transfers. c. Profit or loss. d. Interest revenue. e. Interest expense. f. Depreciation, depletion, and amortization expense. g. Other significant noncash items included in profit or loss Unusual items included in profit or loss. i. Income tax expense or benefit. j. Total assets. k. Equity method investments. l. Expenditures for long-lived assets. m. Description of the types of products or services from which the segment derives its revenues. If operating segments are not based upon products or services, or a company has only one operating segment, then revenues from sales to unaffiliated customers must be disclosed for each of the companys products and services.

h.

9.

10. Information must be provided for the domestic country, for all foreign countries in which the company generates revenue or holds assets, and for each foreign country in which the company generates a material amount of revenues or has a material amount of assets. 11. Two items of information must be reported for the domestic country, for all foreign countries in total, and for each foreign country in which the company has material operations: (1) revenues from external customers, and (2) long-lived assets. 12. The minimum number of countries to be reported separately is one: the domestic country. If no single foreign country is material, then all foreign countries would be combined and two lines of information would be reported; one for the United States and one for all foreign countries. U.S. GAAP does not provide any guidelines related to the maximum number of countries to be reported. 13. The existence of a major customer and the related amount of revenues must be disclosed when sales to a single customer are 10 percent or more of consolidated sales. 14. U.S. GAAP requires disclosure of a measure of segment assets, but does not require disclosure of a measure of segment liabilities. IFRS 8 requires disclosure of total assets and total liabilities by segment if such a measure is regularly provided to the chief operating decision maker 15. U.S. publicly traded companies are required to prepare quarterly financial reports to provide investors and creditors with relevant information on a more timely basis than is provided by an annual report. 16. Companies are required to follow an "integral" approach in which each interim period is considered to be an integral part of an annual accounting period, rather than a "discrete" accounting period in its own right. For several items, the integral approach requires deviation from the general rule that the same accounting principles used in preparing
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annual statements should also be used in preparing interim statements. 17. Cost-of-goods-sold should be adjusted in the interim period to reflect the cost at which the liquidated inventory is expected to be replaced, thus avoiding the effect of the LIFO liquidation on interim period income.

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18. Income tax expense related to interim period income is determined by estimating the effective tax rate for the entire year. That rate is then applied to the cumulative pre-tax income earned to date to determine the cumulative income tax to be recognized to date. The amount of income tax recognized in the current interim period is the difference between the cumulative income tax to be recognized to date and the income tax recognized in prior interim periods. 19. When an accounting change occurs in other than the first interim period, information for the pre-change interim periods should be reported based on retrospective application of the new accounting principle. If retrospective application of the new accounting principle to pre-change interim periods is not practicable, the accounting change may be made only at the beginning of the next fiscal year. 20. The following minimum information must be disclosed in an interim report: a. Sales, income tax, extraordinary items, cumulative effect of accounting change, and net income. b. Earnings per share. c. Seasonal revenues and expenses. d. Significant changes in estimates or provisions for income taxes. e. Disposal of a business segment and unusual items. f. Contingent items. g. Changes in accounting principles or estimates. h. Significant changes in the following items of financial position: 1. Cash and cash equivalents. 2. Net working capital. 3. Long-term liabilities. 4. Stockholders' equity. 21. Four items of segment information are required to be included in interim reports: revenues from external customers, intersegment revenues, segment profit or loss, and total assets if there has been a material change in assets from the last annual report. 22. Under IAS 34, an annual bonus paid in the fourth quarter of the year would be recognized fully in that quarter. There would be no accrual of an estimated bonus expense in the first three quarters of the year. Under U.S. GAAP, the annual bonus would be estimated at the beginning of the year and a portion of the estimated bonus would be accrued as expense in each of the first three quarters.

Answers to Problems 1. D Objectives of Segment Reporting (LO1) 2. C Required Segment Disclosures (LO3) 3. A Required Segment Disclosures (LO3) 4. C Tests to Determine Reportable Operating Segments (LO2) 5. B Segment Reporting Requirements (LO1, LO3, LO4) 6. D Definition of Operating Segment (LO1)

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7. C Tests to Determine Reportable Operating Segments (LO2)

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8. A Segment Reporting Requirements (LO1, LO3, LO4, LO5) 9. B Required Segment Disclosures (LO3) 10. B Required Geographic Area Disclosures (LO4) 11. C Geographic Area Disclosure (LO4) 12. C Required Geographic Area Disclosures (LO4) 13. C Major Customer Disclosures (LO5) With regard to major customers, SFAS 131 only requires disclosure of the total amount of revenues from each such customer and the identity of the segment or segments reporting the revenues. 14. D Differences between IFRS and U.S. GAAP Segment Reporting (LO8) 15. D Approach Followed in Interim Reporting (LO6) 16. A Treatment of Seasonal Variations in Interim Reports (LO6) 17. C Treatment of Extraordinary Gain in Interim Reports (LO6) 18. D Required Disclosures in Interim Reports (LO7) 19. C Segment Disclosures in Interim Reports (LO7) If there has been a material change from the last annual report, total assets, but not individual assets, for each operating segment must be disclosed. 20. D Differences between IFRS and U.S. GAAP Interim Reporting (LO8) 21. D Determine Quantitative Threshold Under Revenue Test for Reportable Segments (LO2) Sales to outsiders $18,000 Intersegment transfers 3,000 Combined segment revenues $21,000 10% criterion x 10% Minimum $ 2,100 22. A Determine Quantitative Threshold for Disclosure of a Major Customer (LO5) Revenues from a single customer must be disclosed if the amount is 10 percent or more of consolidated sales. Consolidated sales only includes

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sales to outsiders; intersegment sales are eliminated. Consolidated sales (combined sales to outsiders) 10% criterion Minimum $376,000 x 10% $ 37,600

23. D Determine Reportable Segments under the Profit or Loss Test (LO2) Total operating losses of $1,020,000 (K and M) are larger than total operating profits of $770,000. Thus, based on the 10 percent criterion, any segment with a profit or loss of $102,000 or more must be separately disclosed. K, O, and P do not meet that standard while L, M, and N do. 24. C Determine Reportable Segments under Three Tests (LO2) Revenues Test Combined segment revenues 10% criterion Minimum Segments meeting testA, B, C, E Profit or Loss Test Since there are no segments with a loss, this test is applied based on total combined segment profit. Combined segment profit $5,800,000 10% criterion x 10% Minimum $ 580,000 Segments meeting testA, B, C, E Asset Test Combined segment assets 10% criterion Minimum Segments meeting testA, B, C, D, E Five segments are separately reportable. 25. D Determine Minimum Number of Reportable Segments under 75% Rule (LO2) 26. B Determine Minimum Number of Reportable Segments under 75% Rule (LO2) $67,500,000 x 10% $ 6,750,000 $32,750,000 x 10% $ 3,275,000

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The test to verify that a sufficient number of industry segments is being disclosed is based on revenues generated from unaffiliated customers. The four segments that are to be separately disclosed show outside sales of $520,000 out of a total for the company of $710,000. Since this portion is only 73.2 percent of the companys total, the 75 percent criterion established by the FASB has not been met. 27. C Determine Expense Amounts to be Recognized in Interim Period (LO6) Depreciation $60,000 x 1/4 = $15,000 Bonus $120,000 x 1/4 = 30,000 $45,000 28. C Determine Net Income to be Reported in Interim Period (LO6) Income as reported $100,000 Less: Extraordinary loss (recognized in full in the interim period in which it occurs) (20,000) Add: Cumulative effect loss (handled through adjustment of retained earnings balance at the beginning of the year) 16,000 $ 96,000 29. C Determine Bonus Expense to be Recognized in Interim Period (LO6) Bonus $1,000,000 x 1/4 = $250,000 30. C Determine Property Tax Expense to be Recognized in Interim Period (LO6) Property taxes $480,000 x 1/4 = $120,000 31. C Prepare Journal Entry for Property Tax Expense Recognized in Interim Period (LO6) Dr. Property Tax Expense $120,000 Dr. Prepaid Property Taxes 360,000 Cr. Cash $480,000 32. A Determine COGS in Interim Period under LIFO with LIFO Liquidation (LO6) 5,000 units x $80 = $400,000 300 units x $50 = 15,000 5,300 units $415,000 33. C Determine COGS in Interim Period under LIFO with LIFO Liquidation (LO6) 5,000 units x $80 = $400,000 300 units x $82 = 24,600 5,300 units $424,600 34. Apply the Profit or Loss Test to Determine Reportable Operating Segments

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(LO2) (10 minutes) Calculation of profit or loss. Revenues Intersegment Operating from Outsiders Transfers Expenses Profit Loss $250,000 $250,000

Cards $1,200,000 + $ 100,000 $900,000 = $400,000 Calendars 900,000 + 200,000 1,350,000 = Clothing 1,000,000 700,000 = 300,000 Books 800,000 + 50,000 770,000 = 80,000 Total $ 780,000

Any segment with an absolute amount of profit or loss greater than or equal to $78,000 (10% x $780,000) is separately reportable. Based on this test, each of the four segments must be reported separately. 35. Apply the Three Tests Necessary to Determine Reportable Operating Segments (LO2) (25 minutes) Revenue Test (numbers in thousands) Segment Plastics Metals Lumber Paper Finance Total Revenues Percentage $ 6,425 63.7% (reportable) 2,294 22.7% (reportable) 738 7.3% 455 4.5% 186 1.8% $10,098 100.0%

Profit or Loss Test (numbers in thousands) Segment Plastics Metals Lumber Paper Finance Total Revenues $ 6,425 2,294 738 455 186 Expenses $ 3,975 1,628 967 610 103 Profit $2,450 666 Loss $ (reportable) (reportable) 229 155

83 $3,199 $384

Since $3,199 is larger in absolute terms than $384, it will serve as the basis for testing. Each of the profit or loss figures will be compared to $319.90 (10% x $3,199). Asset Test (numbers in thousands)

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Segment Plastics Metals Lumber Paper Finance Total

Assets Percentage $1,363 21.3% (reportable) 3,347 52.3% (reportable) 314 4.9% 609 9.5% 768 12.0% (reportable) $6,401 100.0%

The plastics, metals, and finance segments meet at least one of the three tests and therefore are reportable. 36. A Variety of Computational Questions about Operating Segment and Major Customer Testing (LO2, LO5) (20 minutes) a. Total revenues for Fairfield (including intersegment revenues) amount to $4,200,000. Minimum revenues for required disclosure are 10% or $420,000. b. Disclosure of operating segments is considered adequate only if the separately reported segments have sales to unaffiliated customers that comprise 75% or more of total consolidated sales. In this situation that requirement is met. Red, Blue, and Green have total sales to outsiders of $3,137,000 (or 86%) of total consolidated sales of $3,666,000. Thus, disclosure of these three segments would be adequate. c. Major customer disclosure is based on a level of sales to unaffiliated customers of at least 10% or, for Fairfield, $366,600 ($3,666,000 x 10%). d. This test is based on the greater (in absolute terms) of profits or losses. In this problem, the total profit of Red, Blue, Green, and White ($1,971,000) is greater than the total loss of Pink and Black ($316,000). Therefore, any segment with a profit or loss of $197,100 or more (10% x $1,971,000) is reportable. Using this standard, Red, Blue, Black, and White are of significant size. 37. Apply the Three Tests Necessary to Determine Reportable Operating Segments and Determine Whether a Sufficient Number of Segments is Reported (LO2) (25 minutes) Revenue Test (numbers in thousands) Segment Books Computers Maps Travel Finance Total Revenues $ 205 936 455 432 184 $2,212 Percentage 9.3% 42.3% (reportable) 20.6% (reportable) 19.5% (reportable) 8.3% 100.0%

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Profit or Loss Test (numbers in thousands) Segment Revenues Books $ 205 Computers 936 Maps 455 Travel 432 Finance 184 Total $2,212 Expenses $ 218 899 400 314 132 $1,963 Profit Loss $ 13 $ 37 55 118 52 $262 $ 13

(reportable) (reportable) (reportable (reportable)

This test is based on the greater (in absolute amount) of total profit from profitable segments or total loss from segments with a loss. In this case, any segment with profit or loss greater than or equal to $26,200 (10% x $262,000) is separately reportable. Asset Test (numbers in thousands) Segment Books Computers Maps Travel Finance Total 37. (continued) Test for Sufficient Number of Segments Being Reported Four of Masons segments (computers, maps, travel, and finance) meet at least one of the tests carried out above. To determine whether a sufficient number of segments is being reported, revenues from unaffiliated parties for these four segments must comprise at least 75% of total consolidated revenues. Consolidated revenues (sales to outside parties and interest income-external) for the company amount to $1,644. These four segments do make up over 75% (actually $1,463 or 89%) of this total. Therefore, this company is presenting disaggregated information for enough of its segments. Segment Computers Maps Travel Finance Sales to Outsiders $ 696 416 314 37 Assets $ 206 1,378 248 326 1,240 $3,398 Percentage 6.1% 40.5% (reportable) 7.3% 9.6% 36.5% (reportable) 100.0%

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Total

$1,463

38. Apply Materiality Tests Adopted by a Company to Determine Countries to be Reported Separately (LO4) (15 minutes) Revenue Test (sales to unaffiliated parties) United States Spain Italy Greece Total $4,610,000 80.3% 395,000 6.9% 272,000 4.7% 463,000 8.1% $5,740,000 100.0%

Long-lived Asset Test United States Spain Italy Greece Total $1,894,000 83.7% 191,000 8.4% 106,000 4.7% 72,000 3.2% $2,263,000 100.0%

None of the individual foreign countries meets either the revenue or longlived asset materiality test, so no foreign country must be reported separately. However, information must be presented for the United States separately and for all foreign countries combined. 39. Allocate Costs Incurred in One Quarter that Benefit the Entire Year and Determine Income Tax Expense (LO6) (20 minutes) a. Determination of Income by QuarterEstimated Annual Tax Rate 40% 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Sales $1,000,000 $1,200,000 $1,400,000 $1,600,000 Cost of goods sold (400,000) (480,000) (550,000) (600,000) Administrative costs (175,000) (180,000) (185,000) (195,000) Advertising costs (25,000) (25,000) (25,000) (25,000) Executive bonuses (20,000) (20,000) (20,000) (20,000) Provision for bad debts (13,000) (13,000) (13,000) (13,000) Annual maintenance costs (15,000) (15,000) (15,000) (15,000) Pre-tax income $352,000 $467,000 $592,000 $732,000 Income tax* (140,800) (186,800) (236,800) (292,800) Net income $211,200 $280,200 $355,200 $439,200 * Calculation of income tax by quarter:

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Pre-tax income this quarter $352,000 Cumulative pre-tax income $352,000 Estimated income tax rate x 40% Cumulative income tax to be recognized to date $140,800 Cumulative income tax recognized in earlier periods -0Income tax this quarter $140,800

$467,000 $592,000 $732,000 $819,000 $1,411,000 $2,143,000 x 40% x 40% x 40% $327,600 140,800 $186,800 $564,400 327,600 $236,800 $857,200 564,400 $292,800

b. Determination of Income by QuarterChange in Estimated Annual Tax Rate Pre-tax income Income tax** Net income 39. (continued) ** Calculation of income tax by quarter: Pre-tax income this quarter $352,000 Cumulative pre-tax income $352,000 Estimated income tax rate x 40% Cumulative income tax to be recognized to date $140,800 Cumulative income tax recognized in earlier periods -0Income tax this quarter $140,800 $467,000 $592,000 $732,000 $819,000 $1,411,000 $2,143,000 x 40% x 38% x 38% $327,600 140,800 $186,800 $536,180 327,600 $208,580 $814,340 536,180 $278,160 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter $352,000 $467,000 $592,000 $732,000 (140,800) (186,800) (208,580) (278,160) $211,200 $280,200 $383,420 $453,840

40. Treatment of Accounting Change Made in Other than First Interim Period (LO6) (15 minutes) Retrospective application of the FIFO method results in the following restatements of income for 2010 and the first quarter of 2011: 2010 1st Q. Sales Cost of goods sold (FIFO) Operating expenses Income before income taxes Income taxes (40%) 2nd Q. 3rd Q. 4th Q. 2011 1st Q.

$10,000 $12,000 $14,000 $16,000 $18,000 3,800 2,000 4,200 1,680 4,600 2,200 5,200 2,080 5,200 2,600 6,200 2,480 6,000 3,000 7,000 2,800 7,400 3,200 7,400 2,960

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Net income

$2,520

$3,120

$3,720

$4,200

$4,440

Net income in the second quarter of 2011 is $4,560 [$20,000 9,000 3,400 = $7,600 3,040 (40%) = $4,560]. The accounting change is reflected in the second quarter of 2011, with yearto-date information, and comparative information for similar periods in 2010 as follows: Three Months Ended June 30 2010 2011 $3,120 $4,560 $3.12 $4.56 Six Months Ended June 30 2010 2011 $5,640 $9,000 $5.64 $9.00

Net income Net income per common share

41. LIFO Liquidation in Interim Report (LO6) (10 minutes) Determination of Cost-of-Goods-Sold and Gross Profit Sales (110,000 units @ $20) Cost-of-goods-sold 100,000 units @ $14 10,000 units @ $15 (replacement cost) Gross profit Journal Entries to Record Sales and Cost-of-Goods-Sold Dr. Cash or accounts receivable Cr. Sales revenue Dr. Cost-of-goods-sold Cr. Inventory Cr. Excess of replacement cost over historical cost of LIFO liquidation $2,200,000 $2,200,000 $1,550,000 $1,520,000 30,000 $2,200,000 $1,400,000 150,000 1,550,000 $650,000

To record cost-of-goods-sold with a historical cost of $1,520,000 and an excess of replacement cost over historical cost for beginning inventory liquidated of $30,000 (($15 $12) x 10,000 units). Answers to Develop Your Skills Cases Research Case 1Segment Reporting This assignment requires the student to select a company and find the note on operating segments in that companys annual report. The responses to this

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assignment will depend upon the company selected by the student for analysis. Research Case 2Interim Reporting This assignment requires students to select a company, find the most recent quarterly report for that company, and then determine whether the company provides the minimum disclosure required as listed in the text. The responses to this assignment will depend upon the company selected by the student for analysis. Research Case 3Operating Segments This assignment requires students to find the note on operating segments in each company's annual report, determine three items of information (answer three questions) from those notes, and prepare a written summary of their findings. The primary objective of this requirement is to help students develop their ability to present such findings in a written format. In answering these questions, students will become familiar with the different formats and terminology used by companies in providing operating segment information. The answers to these questions will change depending upon the most recent annual report available on the companys website. The following general observations indicate how these questions might be answered. 1. The answer to this question is determined by calculating the ratio segment revenues/total segment revenues for each segment of each company. Different terms can be used for revenues including net sales and net sales to external customers. Companies are required to disclose both revenues from sales to external customers and revenues from intersegment sales. This question should be answered using revenues from sales to external customers if reported separately. In 2008, each of the four companies defined operating segments on the basis of products/services. 2. This question is answered by calculating the ratio (current year segment revenues previous year segment revenues)/previous year segment revenues for each segment of each company. 3. This question is answered by calculating the ratio segment profit/segment revenues for each segment of each company (again using revenues from sales to external customers if separately reported). Segment profit goes under a variety of names including operating earnings, income from continuing operations, standard margin, and operating profit. Some companies might provide information for more than one measure of profit, e.g., income before income taxes and income from continuing operations, in

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which case the instructor might wish to indicate which measure of profit to consider in answering this question. There is no right or wrong measure of profit to use. General Electric does not include segment profit in its operating segment note, but instead (in 2008) refers the reader to a Summary of Operating Segments table (on page 26 of the annual report), which is part of Management's Discussion and Analysis. After reviewing the information provided by each of these companies in its segment footnote, instructors might wish to add additional questions to this assignment. For example, do these companies use generally accepted accounting principles in preparing segment information? Does each company provide a reconciliation to consolidated totals? Research Case 4Comparability of Geographic Area Information This assignment requires students to find the note on geographic areas in each company's annual report and then prepare a report describing the comparability of this information. In preparing this assignment, students will see the different formats used by companies in providing this information, and the different levels of detail on geographic areas provided. The comparability of this information will change depending upon the most recent annual report available on the companys website. The following comparison based upon the 2008 annual reports represents the type of analysis students might perform in solving this assignment. Geographic Areas Reported by Four Pharmaceutical Companies Bristol-Myers Squibb Eli Lilly Merck Pfizer U.S. U.S. U.S. U.S. Europe/MidEast/Africa E/ME/A Europe Europe Other Western Hemi. Pacific Japan Japan/Asia Other Other Canada/Latin America/AFME The only geographic area that can be directly compared across these four pharmaceutical companies is the United States. Bristol-Myers Squibb provides more detailed (and perhaps more useful) information than the other companies. Only Merck reports an individual country (Japan) other than the U.S. Issues that could be discussed include different quantitative thresholds used by companies in determining what is a material country, and the fact that disclosure of geographic areas aggregated above the individual country level (e.g., E/ME/A, Pacific) is not required. One can assume that BristolMyers

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Squibb does not have a material amount of revenues or assets in any single country and voluntarily provides information on a more aggregated, regional basis. The same appears to be true for Eli Lilly and Pfizer. Merck provides information for a combination of both individual countries (Japan) and aggregated regional area (E/ME/A). Research Case 5Within Industry Comparison of Segment Information The purpose of this assignment is to show students how segment information can be used to gain insights into the nature and location of a companys operations, and give them an opportunity to compare and contrast this information for two companies in the same industry. The responses to this assignment will depend upon the companies selected by the student for analysis. Students should discuss both the operating segments and geographic areas in which the companies operate. They might discuss the extent to which the two companies compete with each other in terms of product lines or geographic areas, as well as the extent to which this information can be compared. For example, if one company defines operating segments on the basis of products and another company in the same industry defines operating segments geographically, meaningful comparisons between the two companies will be difficult to make. Accounting Standards Case 1 Segment Reporting Source of guidance: FASB Accounting Standards Codification (paragraph 280-10-55-2): Segment Reporting; Overall; Implementation Guidance and Illustrations; Operating Segments - Equity Method Investees Original (pre-codification) source: FASB Staff Implementation Guide An equity method investee could be considered an operating segment, if, under the specific facts and circumstances being considered, it meets the definition of an operating segment, even though the investor has no control over the performance of the investee. Accounting Standards Case 2Interim Reporting Source of guidance: FASB Accounting Standards Codification (paragraph 270-10-50-6): Interim Reporting; Overall; Disclosure; Contingencies Original (pre-codification) source: APB Opinion 28, paragraph 22 Contingencies that could be expected to affect the fairness of presentation of financial data at an interim date must be disclosed in interim reports in the

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same manner required for annual reports. The materiality of a contingency should be judged in relation to annual financial statements. Analysis CaseWal-Mart Interim and Segment Reporting 1. Not surprisingly, Wal-Mart experienced a significant increase in net sales and income in the quarter ended January 31, which includes the holiday season, over the previous three quarters of the year (see Note 12). Operating income for the quarter ended January 31 can be determined for each segment by subtracting the amounts reported in the three quarterly reports from the amounts reported in Note 11.
Operating Income Fiscal Year Ended January 31, 2009 Quarter Ended April 30, 2008 Quarter Ended July 31, 2008 Quarter Ended October 31, 2008 Quarter Ended January 31, 2009 Wal-Mart Stores $ 18,763 4,362 4,715 4,286 $ 5,400 $ International $ 4,940 1,044 1,202 1,182 1,512 $ SAM'S CLUB $ 1,610 386 432 365 427

These results show the seasonal nature of the companys two largest segments (Wal-Mart and International), with the quarter ended January 31 generating a larger amount of operating income. 2. Note 12 can be used to assess profitability in terms of profit margin (Net income/Net sales) by quarter. Amounts in millions 2008/2009 Net income Net sales Net income/Net sales April 30 $ 3,022 94,070 3.21% Quarter Ended July 31 October 31 January 31 $ 3,449 $ 3,138 $ 3,792 101,544 97,634 107,996 3.40% 3.21% 3.51%

These results indicate that profit margins are highest in the fourth quarter of the year, the quarter with the largest percentage of total sales. Note 11 can be used to assess profitability in terms of operating profit margin (Operating income/Revenues) and return on assets (Operating income/Total assets) by segment. Wal-Mart InterSAMS

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Fiscal year ended January 31, 2009 Operating income (loss) Revenues from external customers Operating income/Revenues

Stores national CLUB $ 18,763 $ 4,940 $ 1,610 255,745 98,645 46,854 7.34% 5.01% 3.44% $ 1,610 12,339 13.05%

Operating income (loss) $ 18,763 $ 4,940 Total assets of continuing operations 84,361 59,903 Operating income/Total assets 22.24% 8.25%

These results indicate that Wal-Mart Stores by far is the most profitable segment for the Wal-Mart Company. Although the International segment has a reasonable Operating Profit Margin, that segments Return on Assets is very low. Return on Assets must be interpreted with caution, however, because the ending balance in Total Assets is used in the denominator of the ratio rather than the average amount of Total Assets for the year. The International segments Return on Assets (8.25%) is understated, for example, if a significant portion of Total Assets was acquired late in the year. Excel CaseCoca-Cola Geographic Segment Information 1. The ratios required to be calculated for the Coca-Cola Company are as follows:
Percentage of total net operating revenues Eurasia & Africa Europe Latin America North America Pacific Bottling Investments Total Percentage change in net operating revenues Eurasia & Africa Europe Latin America North America Pacific Bottling Investments Operating income as a percentage of net operating revenues (profit margin) Eurasia & Africa Europe Latin America 2008 6.87% 17.13% 11.32% 24.45% 13.86% 26.37% 100.00% 2008-2007 10.34% 9.62% 18.22% 5.67% 6.56% 16.06% 2007 6.90% 17.30% 10.61% 25.62% 14.41% 25.16% 100.00% 2007-2006 16.91% 15.62% 24.01% 11.48% 6.99% 52.59%

2008 35.84% 54.73% 54.73%

2007 31.63% 52.44% 53.91%

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North America Pacific Bottling Investments

19.13% 39.57% 2.96%

21.64% 38.56% 1.99%

2. There is no right or wrong answer to this question. Students could argue that Latin America and Europe would be the areas of the world in which to expand because profit margin is highest in these areas. There would seem to be more room to expand in Latin America given that this area has a relatively small percentage of total revenues. Revenue growth has been highest in Latin America in each of the last two years. Pacific is the area in which the company has experienced the smallest growth in revenues in 2007 and 2008. Yet this region has a relatively high profit margin. Perhaps this is the area in which the company should concentrate its efforts. Similarly, Eurasia & Africa has a relatively high profit margin, yet the company generates a very small amount of its revenues from this region. Perhaps there is an opportunity for growth in this area. 3. There is a great deal of non-accounting information that one would need to determine a specific region of the world in which to focus expansion. For example, one might need to gather information to answer the following questions: Is there a sufficiently large population with enough disposable income to be able to purchase the companys products? Are raw materials available locally? Is there a well-developed transportation infrastructure that would allow the products to be brought to consumers at a reasonable cost? Do local customs, culture, religion, etc. affect drinking habits, especially the consumption of soft drinks?

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