There will be many entities out there now cursing the fact that they hadn’t looked at AASB 8 sooner.  With auditors having conducted audit visits for either half year reviews or full year audits, if management didn’t know that AASB 8 was a key reporting driver, odds are that they do now.  If this is a topic that has not previously been considered, this could very well result in a nasty surprise in the form of a qualified audit report.

AASB 8 Operating Segments, which applies to financial reporting periods beginning from 1 January 2009, will need to be considered by all entities preparing general purpose financial reports – and this is not limited to companies listed on the ASX.  The large end of town should perhaps be more cautious, given that ASIC has suggested that it will be looking at compliance issues with how entities have implemented the requirements of AASB 8.

AASB 8 had its genesis largely from the United States which implemented the ‘management based approach to reporting’ some time ago to allow analysts to ascertain how boards were managing and evaluating the performance of the various activities of a company and to avoid the common scenario of a company reporting that it operated in just one segment.   Compliance with the US equivalent standard has proven to be a concern for the SEC, and so ASIC is likely to be well aware of the some of the pitfalls by liaising with its US counterpart.

Question: But if AASB 8 applies generally only to listed entities, how does it affect others?

For entities preparing general purpose financial statements, the key impact will be the impairment of goodwill under AASB 136 and the interaction of that standard with AASB 8.  Paragraph 80 of AASB 136 requires that goodwill arising from a business combination be allocated to a cash generating unit (or groups thereof) at the lowest level within the business structure at which goodwill is monitored, but where such levels shall not exceed the size of an operating segment.  As a consequence of the latter part of this allocation requirement, if management has allocated goodwill to a part of the business that exceeds an operating segment, the standard will require management to reallocate that goodwill for the purposes of impairment testing.  This could lead to goodwill impairment that management might not have previously anticipated.

Question: So even though I am not applying AASB 8, I still need to identify the entity’s operating segments?

Yes.  And this could be a source of identifying some unexpected segments also, so management ought to review the criteria for identifying operating segments carefully.  Paragraph 5 of AASB 8 states that an operating segment is a component of an entity:

• that engages in business activities from which it may earn revenues and incur expenses (irrespective of whether those transactions are with external parties)
• whose operating results are regularly reviewed by the entity’s chief operating decision maker (‘CODM’) for the purpose of making decisions about resources to be allocated to the segment and assess its performance; and
• for which discrete financial information is available.
  

In identifying an operating segment, the segment will generally have a segment manager that is accountable to the CODM with respect to the performance of that segment.  The existence of such a position will generally be a good indicator in distinguishing between business activities for which there is a purposeful intention for it to make a contribution to the entity’s overall activities and performance and those components where revenue generation may be considered only incidental to the entity’s overall objectives or where the segment is not intended to generate revenue.  As an example, corporate head office operations may not constitute an operating segment since any revenue it generated (e.g. interest, or intercompany charges) might only be considered incidental to the overall activities of the business.

Who is the CODM?

Identification of the CODM is a crucial aspect in identification of operating segments.  The first point to note is that the CODM is intended to be a reference to a function and therefore need not be a particular person.  For example, it could be the board of directors.  The next point to consider is that the CODM function that must be identified is that which makes the decisions relating to the allocation of resources and assessment of performance of the operating segments.  This could be a source of judgement in itself.  To test whether you have identified the appropriate decision maker, consider whether there are instances where that decision maker could have its decisions overruled by a higher body.  Your CODM may end up being any of the following: the board, the CEO, the COO, other senior managers or executives.

What are the results that are reviewed?

The results that are ‘regularly reviewed’ by the CODM could take many forms and will depend upon the nature of the businesses activities. For instance, in a service business, the CODM may receive information of a components revenues and staff productivity to make decisions, whereas in a manufacturing business, the CODM may review sales, cost of sales, inventory levels, and overhead allocations.  The point is, the degree of detail contained in the results being reviewed is of little consequence as long as that information is used to by the CODM to make decisions.  Hence, the format of the management reports will impact on the identification of operating segments and hence goodwill allocations.
For those entities directly applying AASB 8, this information will also form the basis of operating segment disclosures in the financial statements.  It is this ‘management approach’ to reporting that AASB 8 is intended to capture since it provides readers with insight into the internal workings of management’s governance.  Unfortunately, the mechanics of this approach to reporting has also led to entities redesigning their management reporting practices in order to control the information that ends up in the financial statements of the entity.

What is discrete information?

There is no guidance as to the application of this requirement, however the literal interpretation is simply that separate identifiable information in relation to a component of the business is reported to the CODM.

I have determined my segments, but the CODM can only assess the recoverability of goodwill at a higher level.  Is this OK?

Management must compare the carrying amount of goodwill with it's recoverable amount.  Since goodwill does not produce cash flows on its own, it must be allocated to the cash generating units of the business where the value of the business can then be ascertained and compared against the carrying value of the net assets of the business.

Management may have valued the company as a whole (or valued components of the business) and intends on relying upon such valuation models for the purpose of assessing the carrying value of goodwill in the accounts.  This is a scenario which presents problems for management since management will be in breach of the requirements of AASB 136 for impairment testing purposes.

Example:  XYZ Manufacturing Pty Ltd is an international business with 3 Australian business units comprising (A) Manufacturing, (B) Distribution and (C) Retail.  The company is valued at $50m, and the carrying value of net assets in the accounts is $40m, including goodwill at $10m.  The goodwill can be attributable to each of the units but the board has not actually allocated the goodwill since it reviews goodwill at the Australian group level.  Last year, XYZ reported the Australian group operations as the reporting segment in the financial statements. The board receives operating results in its monthly board pack with respect to units A, B & C for the purposes of reviewing profitability of each unit, adjusting unit strategy and assessing future funding needs.  Given that the value of the company exceeds net assets, the board believe no impairment is evident and propose to sign off that goodwill is recoverable.     

At the group level, goodwill would appear to be recoverable.  However, it is evident that business units A, B & C represent 3 separate operating units.  In this example, goodwill must be allocated to at least the level of each operating segment since it has been determined that each of the segments would benefit from the goodwill originally acquired. (Goodwill acquired should be allocated to each of the acquirer’s cash generating units or groups of cash generating units that is expected to benefit from the synergies of the combination, irrespective of whether other assets or liabilities of the acquiree are assigned to those units or groups of units.  In this example it is presumed that if there were multiple CGUs within an operating segment of XYZ, goodwill is allocated to that group of CGU’s but the size of that group of CGUs must be capped at the level of the operating segment).

Goodwill should be initially allocated to each segment using a method that best reflects the value that is assumed by each segment in the form of goodwill from the acquisition.  Possible allocation methods might include specific valuations of goodwill components acquired, allocating goodwill based on the relative fair values of net assets or profit margins of each operating segment, or valuations of each segment using forecast cash flows post business combination.

XYZ must then ascertain the recoverable amount of each operating segment which will generally be based on a value-in-use model.  In this example, this will represent more work for management since they do not have valuation information below the whole-of-entity level.  If such information cannot be furnished to the entity’s auditors, this may result in a qualification to the accounts.