IFRS 8 Identifying operating segments

IFRS 8 Identifying operating segments – There are four key steps. Entities will need to:

  1. Identify the Chief Operating Decision Maker (CODM) (group/team/individual).
  2. Identify their business activities (which may not necessarily earn revenue or incur expenses).
  3. Determine whether discrete financial information is available for the business activities.
  4. Determine whether that information is regularly reviewed by the CODM.

Identifying the CODM and the components that are regularly reviewed by the CODM to make decisions can be difficult. It is also important to reassess regularly the identification of the CODM, particularly following a business reorganisation, acquisition or disposal. IFRS 8 Identifying operating segments

IFRS 8 defines an operating segment as a ‘component of an entity that engages in business activities from which it may earn revenues and incur expenses’. This recognises that not all business activities earn revenues. Following are some examples of operating segments: IFRS 8 Identifying operating segments

Cost centers as a separate segment

Manufacturing entities that are managed by reference to operating cost centres, may not record cost center revenues because the entity’s total customer revenues are not allocated to each cost center. IFRS 8 Identifying operating segments

Care should be exercised when determining whether an internally reported activity constitutes an operating segment (for example – A head office function that undertakes business activities (for example, a treasury operation that earns interest income and incurs expenses)) may be an operating segment as long as its revenues earned are more than incidental to the activities of the entity, and discrete financial information is reviewed by the Chief Operating Decision Maker (CODM)). IFRS 8 Identifying operating segments

As long as discrete financial information is prepared and reviewed by the CODM such components would be considered operating segments.

Cost centers are related to the company’s profit as they manage operational efficiency, customer service or increase the value of the product. Cost centers help managers to use resources in a more efficient way, based on an understanding of how they are used now. IFRS 8 Identifying operating segments

Although the cost centers contribute to receiving income, it is impossible to determine how much revenue was generated by the these centers. Any activities of these units, related to gaining profit or generation of the income, are not taken into account when it comes to internal management purposes. IFRS 8 Identifying operating segments

Expense recognition IFRS 8 Identifying operating segmentsIFRS 8 Identifying operating segments

The main function of the cost centers is to track expenses. IFRS 8 Identifying operating segments

Employees, who spend funds within the cost centers, are responsible only for expenses and do not bear any responsibility concerning income or investment decisions. The allocation of expenses between cost centers allows you to control total costs better.

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Thus, resource accounting takes place at a higher and more detailed level, for example, at the cost center level. And this allows to have more accurate forecasts and calculations based on future changes.

Vertically integrated operation

IFRS 8 defines an operating segment as a ‘component of an entity that engages in business activities from which it may earn revenues and incur expenses’. This recognises that not all business activities earn revenues.

Where transfer prices are charged between an entity’s stages of production (for example, with oil and gas companies), the fact that the transfer prices are not assessed by the Chief operating decision maker (CODM) would not exempt such activities from being considered operating segments. The operating segments of an oil and gas company may include exploration, development, production, refining and marketing – if the CODM manages the entity in this way. IFRS 8 Identifying operating segments

IFRS 8 Identifying operating segmentsA vertically integrated business model means that you consolidate multiple steps in the typical distribution process. Instead of operating solely as a manufacturer, distributor or retailer, a vertically integrated company performs tasks commonly carried out by suppliers or trade buyers. Vertical integration has several pros and cons relative to specializing in one business function.

In many cases, a company expands from a single trade focus to become vertically integrated. One way this can happen is for a manufacturer or wholesaler to carry out its own distribution processes to consumers.

A manufacturer might decide to set up distribution centers and manage its own distribution arrangements with retailers, or even sell directly to consumers. A manufacturer assuming management of its own distribution is engaging in forward integration.

Backward Integration

The opposite approach to vertical integration occurs when a product reseller decides to acquire its supplier or start its own manufacturing or distribution operation. When a distributor engages in manufacturing, or a retailer engages in manufacturing or distribution activities, it is referred to as backward integration. Retail stores that sell private label, or store brands, engage in this form of vertical integration.

Benefits

Vertical integration has a few core benefits. One is control. The more activities you carry out in the manufacturing and distribution process, the more control you have over the entire flow of goods until they reach the end customer. You may also benefit from lower costs. If you make goods, you only pay for the costs of manufacturing. When a wholesaler or retailer acquires goods from a manufacturer, a markup is added to the cost.

Concerns 

A major concern of vertical integration is that it requires your company and its leadership to have expertise in multiple distribution channel activities. The roles of manufacturer, wholesaler and retailer are distinct. A manufacturer wanting to distribute its goods directly to customers must not only have production strengths, but also the ability to market and efficiently distribute goods. Additionally, expanding into vertical integration can have significant upfront costs. You typically must either acquire existing suppliers or merchandising businesses, or build and develop them on your own.

R&D function

As long as discrete information is reviewed by the Chief Operating Decision Maker (CODM) a R&D function can be an operating segment. Typically, an entity’s research and development (R&D) function is a vertically integrated operation (see above), in which the R&D activities serve as an integral component of the entity’s business. The definition of operating segment envisages that part of an entity that earns revenue and incurs expenses relating to transactions with other components of the same entity may still qualify as an operating segment even if all of its revenue and expenses derive from intra-group transactions.

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Where entities allocate entity-wide R&D costs into the business activities for which the R&D is specifically being performed, the R&D function will be a separate operating segment as long as the CODM separately reviews discrete R&D activity and data. It will not be separate segment if the CODM does not review discrete financial data for the criteria.

What is Research and Development (R&D)?

R&D is a process by which a company obtains new knowledge and uses it to improve existing products and introduce new ones to its operations. R&D is a systematic investigation with the objective of introducing innovations to the company’s current product offerings. It achieves this by adding improvements to the current goods and services or introducing a new product offering. Can a R&D function be an operating segment?

Basic research is concerned with the acquisition of new knowledge. It is a systematic study that intends to gain a deeper understanding of the fundamental elements of a concept or phenomenon. Basic research is an initial stage of the R&D process. However, it does not provide the possible applications of concepts or phenomenon in production. Also, basic research is the most time-consuming part of R&D.

On the other hand, applied research is a systematic study of application knowledge in developing products or operations. Relative to basic research, applied research is more complex in nature. Thus, it requires higher spending than basic research.

Accounting for R&D

The general problem with R&D accounting is that future benefits from research and development are uncertain and R&D expenditures cannot be capitalized. Accounting standards require companies to expense all research and development expenditures as incurred. However, in case of an M&A transaction, the R&D expenses of the target company may be capitalized because the acquirer can recognize the fair value of the R&D assets. The R&D costs are included in the company’s operating expenses (part of profit or loss) and are usually reflected in its income statement.

Discontinued operation

A discontinued operation can meet the definition of an operating segment if: IFRS 8 Identifying operating segments

  • it continues to engage in business activities; IFRS 8 Identifying operating segments
  • the operating results are regularly reviewed by the CODM; and IFRS 8 Identifying operating segments
  • discrete financial information is available to facilitate the review. IFRS 8 Identifying operating segments

Example – Insurance company disposing of its workers’ compensation business

An insurance company discontinues its ‘workers’ compensation’ line of business. The discontinuation meets the criteria for ‘discontinued operations’ under IFRS 5, ‘Non-current assets held for sale and discontinued operations’. For internal purposes, separate financial results are maintained for this business, and they are reviewed by the CODM until the discontinuance is complete.

The operation is still being managed by the CODM and would continue to meet the definition of an operating segment. Conversely, if the CODM no longer reviews discrete financial information on the discontinuing operation, it would no longer fall within the definition of an operating segment.

For example, a furniture manufacturing plant shuts down its operations in Asia. The plant is no longer producing inventory and it has been reclassified under IFRS 5 as ‘assets held for sale’. Discrete financial information is no longer reported. As a result, it would not be considered an operating segment. Note. Disclosures would still be presented in accordance with IFRS 5.

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Overview of IFRS 8 Operating segments

  • Segment disclosures are required by entities whose debt or equity instruments are traded in a public market or that file, or are in the process of filing, their financial statements with a securities commission or other regulatory organisation for the purpose of issuing any class of instruments in a public market. IFRS 8 Identifying operating segments
  • Segment disclosures are provided about the components of the entity that management monitors in making decisions about operating matters (the ‘management approach’).
  • Such components (operating segments) are identified on the basis of internal reports that the entity’s chief operating decision maker (CODM) regularly reviews in allocating resources to segments and in assessing their performance. IFRS 8 Identifying operating segments IFRS 8 Identifying operating segments
  • The aggregation of operating segments is permitted only when the segments have ‘similar’ economic characteristics and meet a number of other criteria.
  • Reportable segments are identified based on quantitative thresholds of revenue, profit or loss or total assets. IFRS 8 Identifying operating segments
  • The amounts disclosed for each reportable segment are the measures reported to the CODM, which are not necessarily based on the same accounting policies as the amounts recognised in the financial statements. IFRS 8 Identifying operating segments IFRS 8 Identifying operating segments
  • As part of the disclosures, an entity reports a measure of profit or loss for each reportable segment and, if reported to the CODM, a measure of total assets and liabilities for each reportable segment. IFRS 8 Identifying operating segments
  • Disclosures are required for additions to non-current assets, with certain exceptions. IFRS 8 Identifying operating segments
  • Reconciliations between total amounts for all reportable segments and financial statement amounts are disclosed with a description of reconciling items.
  • General and entity-wide disclosures include information about products and services, geographic areas, major customers, the factors used to identify an entity’s reportable segments, and the judgements made by management in applying the aggregation criteria. Such disclosures are required even if an entity has only one segment. IFRS 8 Identifying operating segments
  • Comparative information is normally revised for changes in reportable segments. IFRS 8 Identifying operating segments

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IFRS 8 Identifying operating segments

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