SCENARIO 2SEGMENT REPORTING ISSUES: STRATEGIC COST ALLOCATIONS

The upcoming four days of Wayne's vacation had never looked so good. The end truly was near. There were only a few loose ends for Wayne to tie up, but first he needed to have a quick conversation with his boss.

"Mr. Wilkinson, thanks for the call earlier. I am sorry it has taken me a while to get back to you. I have my group hard at work. The end of the year is almost here," Wayne said. Wayne heads the investor relations team, which is working on putting together the company's financial statements. The investor relations department serves as the intermediary between the executive team and the institutional investors, analysts, and large banks that anxiously await the finalized financial statements each year. Wayne's team must understand the numbers and eloquently explain them to outsiders.

"Wayne, this year has been very challenging for us, both strategically and operationally," said Mr. Wilkinson, one of the company's executives. "We have good people doing great work for the company. The numbers from the accountants look good and reflect our success, but we need them to look as nice as they possibly canwithin the letter of the law, of course!" Mr. Wilkinson stated.

Wayne responded, "I can assure you that my team has done everything it can to accommodate our analysts and other constituents. Our last task is to allocate indirect costs across the segments."

Mr. Wilkinson replied, "Those allocations are critical, Wayne. You know how much outside folks care about segment information and use it to build forecasts and assess the future of our company." He was correct. Segment reporting results receive a large amount of attention by the analysts, and Wayne's investor relations team is continually asked to drive down the revenues and expenses to the segments whenever possible. It is obvious to Wayne that these segment results matter as much as the consolidated ones.

"I can assure you that we are very aware, Mr. Wilkinson," Wayne said. "And my concern, as always, is how to best decide which costs should be assigned to which operating segments. Some of the headquarters' costs and the company's research and development expenses, among others, belong to many departments." If the investor relations team does not do its job well, not only will Mr. Wilkinson and the executives be disappointed, but interested parties who desire quality financial disclosures could be misled. This allocation exercise of indirect costs carries some significant pressures that Wayne's team members must be willing to handle.

"I recognize the challenge, but no one is better situated to allocate these costs than you and your team. The segment managers are aware that whatever decisions you make are final, and they must manage appropriately, especially if they want that year-end bonus!" Mr. Wilkinson explained. He continued, "All the executive team expects from you is to fairly report each segment's results. Let the segment managers handle the subsequent day-to-day decisions. That is not your concern." "No problem, sir. When we are finished I will have those numbers sent up to you." "I want that on paper, Wayne. You know how I feel about spreadsheets." "Of course, sir." Wayne smiled and hung up.

Every year it takes a monumental effort from Wayne and his investor relations team to finalize the financial statements. Wayne's final task of updating the segment reporting footnote to the financial statements is not as easy as it used to be. Revenues are easily traceable to each segment, but expenses are often shared by these segments, so how the team allocates them is often a challenging process to justify. In addition, the new segment reporting rules allow much greater flexibility in how segment performance is presented. In the cost allocation process, expenses can be shifted among operating segments and between operating segments and nonoperating segments. The goal of the new standard for segment reporting is to enable managers to disclose segment performance in the most transparent manner. Managers can choose which segments to disclose and the corresponding measure of performance as long as they match the internal reporting of the company. Greater discretion can lead to better information, but it also can open the door for manipulation (and misleading financial statements).

Such flexibility in reporting seems like a good thing, but the allocation process causes Wayne some grief. How his team allocates expenses that are not directly related to one particular segment can become a political process. Segments can be made to look better (or worse) based on how the costs are allocated. The edict from the executive team seems clear: Report "fairly" and "as nice as possible." Mr. Wilkinson's words make financial reporting partly an application of marketing strategy. Wayne's angst is understandable.

Wayne's company is broken down into three operating segments based on the three major product lines of the company (Mechanical, Innovation, and Enterprise) and a fourth corporate-level segment that typically is assigned all expenses not belonging to the three operating segments. All revenues and many product-related costs (including salaries) are directly identified with the appropriate operating segment. The challenge is how to handle indirect costs of resources that are shared by two or more segments, such as human resources or research and development. Each of these costs alone is significant enough to influence the operating margins of the segments. The investor relations team must justify that its allocation decisions are based on a rational methodology that is acceptable to both upper management and the segment managers, who are intensely interested in the final operating margins of their segments. The good news is that no matter how Wayne allocates these costs, total company income is unchanged. He wants to avoid any political debates and remove any appearance of bias in the final allocation of indirect costs.

This year, the investor relations team must consider how to allocate $1,474,000, which represents 16.5% of total revenues. These costs include charges for research and development, human resources, and information technology. One obvious option is to not allocate any of these costs, which would be advantageous for all operating segments from a profitability perspective. Consider the Enterprise segment, a recently added product line for which the executive team has high hopes. Currently the segment is operating at a small loss. Management's concern for the profitability of Enterprise will be exacerbated to the extent indirect costs are allocated to the segment.

The Mechanical segment is the typical cash cow that makes steady and predictable profits; it has provided significant support to the company for many years. The product line of the segment is highly competitive, but Mechanical has continued to be an industry leader through strong management policies and strategic direction. The size of Mechanical (78% of total sales) and steady cash flows make any allocations to or from this segment barely noticeable. Wayne's good friend Thomas runs Mechanical's operations, and Wayne knows Thomas has benefitted financially from the segment's profitability.

Finally, the Innovation segment also has been a huge success story. Lack of competition has made this particular product line highly profitable over the last two years. Being part of the company's leadership team and working directly with the executives on a regular basis, Wayne knows their desire is to keep the success of Innovation under the radar for as long as possible. The segment's profit margin of 48% is unheard of across the industry, and much of that is due to the lack of competitors. If new companies enter Innovation's space, its competitive advantage probably will not be sustainable.

Some of his graduate accounting and finance courses have taught Wayne that segment results are key inputs for analysts when developing forecasts of future performance. As the analysts speak, the market follows. Wayne's responsibility is to the company as a whole, but he recognizes the importance of each segment to the company.

As the team members entered the room to make their important allocation decisions and finalize the financial reports, their conversation turned to the task at hand, but their minds seemed someplace else. Charles, a veteran member (and pessimist) of the group, reminded everyone that, "Last year's allocation process was a nightmare. It seemed that all we accomplished was to make other people mad at us."

Wayne sensed the glum mood in the room but still felt the need to remind the team of the consequences of their allocation decisions. Segment income is a key input not only to analysts' forecasts of future performance but also for the evaluation of segment manager performance (and bonus awards). Wayne then responded to Charles' comment: "Yes, this is an unenviable task, but Mr. Wilkinson just reminded me how impressed he is with our work. Still, I am thankful that segment reporting is the last thing we do before year-end."

Questions:

1.What role does Wayne and his investor relations team play in reporting financial performance? What responsibilities and individual characteristics would you consider most important for investor relations team members in this role? What incentives and pressures does Wayne's team face in carrying out this role and these responsibilities? Refer to all 5 standards of the IMA Statement.

2.Consider the $1,474,000 in indirect research and development, human resources, and information technology costs shown in Table 2. Should Wayne's team allocate these costs to the three operating segments? Why or why not? If the team decides to do so, what factors should it consider in deciding how to allocate the costs? No math calculations

3.What specific bases (possibly not from the case) might the team consider to allocate the indirect costs shown in Table 2? How would you allocate the costs? Justify your decision. No math calculations

4.Are post-allocation profit margins relevant for assessing the performance of segments and their managers? Why or why not?

Table 2: Segment Reporting Disclosure Profit Before Segment Revenue Direct Expenses Allocation Profit Margin Mechanical $6,952,000 $4,792,000 $2,160,000 31% Innovation 1,265,000 658,000 607,000 48% Enterprise 623,000 677,000 (54,000) (9%) Corporate/Other 68,000 912,000 (844,000) 0 Pre-Allocation Total $8,908,000 $7,039,000 $1,869,000 21% Indirect Expenses: Research and Development $559,000 Human Resources 664,000 Information Technology 251,000 Allocable Costs $1,474,000 Company Profit $395,000 4%