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Extracting value - Issue 4

Topical issues: segment reporting and impairment


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Deloitte Extracting Value imageIn our first issue of Extracting value for 2009 we focus on two topical financial reporting issues: segment reporting and impairment.

You can download a PDF version of this document at the bottom of this page.

Segment reporting

A new Standard, AASB 8 Operating Segments, applies to annual reporting periods ending on or after 1 January 2009. As segment disclosures are required in interim financial reports, entities with December year ends will be presenting their first information in accordance with AASB 8 at 30 June 2009. Entities with June year ends are currently in their comparative period for AASB 8.

The new standard is largely based on the United States equivalent requirements and adopts a 'through the eyes of management' approach to the disclosure of segment information. Whilst the Standard basically only applies to entities whose securities are traded in a public market, the linkage to goodwill impairment testing means that it is relevant for all entities.

Whilst some greet the Standard with an air of indifference, perhaps due to it being a 'disclosure standard', there are a number of important issues that entities need to consider. These include:

  • the new requirements might be expected to be subject to regulator and market scrutiny
  • commercially sensitive information may be disclosed to the market
  • comparative information must be provided in all but rare circumstances
  • goodwill impairment testing may require modification, often resulting in smaller cash-generating units to which goodwill is allocated - this applies to all entities, not just listed and similar entities.
Basic premise of the Standard 

The focus of AASB 8 is disclosure to the market of internally generated financial information. As mentioned earlier, the 'through the eyes of management' approach effectively means that what is reported internally is also reported externally.

Entities need to identify their operating segments based on the information provided to the 'chief operating decision maker', often abbreviated to 'CODM'. A business activity will generally be regarded an operating segment where operating results for that activity, such as revenue and profit measures, are regularly reviewed by the CODM. Operating segments can be aggregated in some cases so long as strict criteria are met.

The actual disclosures required are quite extensive and range from general information about how operating segments are determined to detailed financial information about the revenues, profit or loss and other key information reported to the CODM. Reconciliations and entity-wide disclosures are also required.

Applying the standard in practice 

The internal focus of AASB 8 means that entities need to carefully decide on what operating segments they have and whether any aggregation is possible. The disclosures made effectively reveal how the entity is structured and managed and consequently sensitive information may be disclosed to the market.

Our experience with the equivalent standard in the United States indicates that segment reporting is a regular target of Securities Exchange Commission (SEC) queries. General observations include:

  • it is difficult to avoid disclosing a business activity as an operating segment if revenue and profit measures are given to the CODM
  • there is strong resistance to aggregating segments if they are internally reported with high hurdles placed around the aggregation criteria
  • information disclosed elsewhere in the report, on an entity's website or from other sources (press releases, analyst information, etc) is cross-checked by regulators against the operating segments identified
  • the interaction with impairment testing is also a focus area for regulators.

A number of resources entities filing in the United States have been queried about why individual mines or fields have not been identified and disclosed as operating segments. The SEC has requested copies of the internal reports given to management in making these assessments and where individual fields or mines are reported to the CODM, it is usually difficult to meet the aggregation criteria due to dissimilarity in cost profiles, product mixes and so on.

Whilst the Australian Securities and Investments Commission (ASIC) has arguably not to date been as aggressive as the SEC in enforcement of accounting standard requirements, segment reporting can be expected to be a prime focus area for ASIC when AASB 8 is fully implemented. Accordingly, entities should be prepared to defend their identification and aggregation of operating segments.

One of the key messages in preparing for the requirements of AASB 8 is to critically appraise the way in which information is prepared for, and presented to, the CODM (often the board). This provides an opportunity to revisit the optimal management structure of the entity and make any changes prior to first reporting under AASB 8.
Summary 

The table below highlights some of the key differences between AASB 8 and AASB 114 Segment Reporting which is supersedes:

Area AASB 8 AASB 114 Significance
Identification of operating segments Business activities whose operating results are regularly reviewed by the Chief Operating Decision Maker (CODM) to make decisions about resource allocation and assess performance for which discrete information is available Two sets of segments (business and geographical) using a risk and rewards approach, with the internal financial reporting used only as a starting point

Potential increase in number of segments, especially for vertically integrated operations

Mines or fields may be separately reported and so become operating segments that must be disclosed unless the aggregation criteria are met

Measurement of information reported Disclose measure of segment profit or loss (and other items) reported to the CODM based on accounting basis used in internal reporting to the CODM Based on accounting policies adopted in financial statements together with specific definitions of segment revenues, expenses, assets and liabilities

Segment information may be subject to greater scrutiny

Internal pricing assumptions and other sensitive information may be presented to the market

Impairment of goodwill Cash-generating unit to which goodwill allocated should not be larger than operating segment (i.e. before aggregation) Cash-generating unit to which goodwill allocated should not be larger than primary or secondary segment (i.e. after aggregation) More impairment losses may be recognised, particularly if individual mines and fields (or even parts of mines or fields) are identified as operating segments

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Current issues in impairment testing

The use of judgment in performing impairment testing is not new or unique; however, the current market environment has significantly re-emphasised its importance. While a reasonable range of acceptable practice continues to exist, the severe market decline and volatility have created an environment in which traditionally accepted risk assessment methodologies must be contested to determine the fundamental value of a business.

A number of regulators, including ASIC and the SEC, are expecting that more write-downs will be recognised as a consequence of current market conditions.

The regulators have highlighted that the impairment review processes must be robust, transparent and well documented in order for investors to have confidence in reported asset values. For example, ASIC's review of 30 June 2008 financial reports noted a number of instances where entities did not disclose:

  • discount rates and growth rates used in value-in-use calculations
  • explanations for using forecast periods of greater than five years
  • sensitivity analysis in relation to changes in key assumptions.

The table below outlines those key impairment analysis areas that should be thoroughly evaluated in conducting impairment tests in the current economic environment:

Area Example considerations
Valuation approach
  • valuation concepts have not changed, but risks surrounding the appropriate application have. Care should be applied when placing more emphasis on one valuation approach over another
  • given the severe volatility in stock prices, a fair value based on financial information derived from comparable companies at a specific date may not be appropriate
  • a fair value based on comparable market transactions may not be appropriate due to the stalled M&A market
Discount rate
  • the market has changed the way it is pricing risk. Traditionally stable discount rate input variables may require re-assessment, e.g. equity risk premium, company specific risk, gearing level and cost of debt.
  • the discount rate should reflect a return that investors expect for a specific set of risk adjusted cash flows. Given the uncertainties in the current market, a risk of 'double-counting' may exist if both the cash flows and the discount rate are overly conservative
Risk adjusted cash flows
  • the effect of declining market conditions on the future revenue, earnings and expected cash flows of the reporting unit should be taken into account
  • significant divergence exists in forecast commodity prices and foreign currency exchange rates. The source and date of the forecast data is critical and impairment models should be sufficiently robust to evaluate various scenarios and sensitivities
Market capitalisation
  • the aggregate fair value of CGUs should be compared to the total market capitalisation of the company. Management should understand any differences, e.g. implied control premium, market volatility, temporary stock price declines
  • it may not always be reasonable to look at a single day's market capitalisation as the sole indicator of fair value in volatile markets. It may be appropriate to consider the market capitalisation based on a weighted average price

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Tracking the trends 2009: the top 10 global mining issues

We've also released a round-up of global perspectives covering the most pressing and significant issues facing mining companies in 2009. Among the issues covered in Tracking the trends 2009: the top 10 global mining issues are commodity prices, credit tightening, shortages of talent, equipment and electricity and sustainable development.

Click here to access Tracking the trends 2009 .

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