The similarity of economic characteristics of two operating segments should be carefully evaluated from both a historical and expected future performance perspective. In practice, several years of historical and estimated future financial data are typically used for purposes of this evaluation. A reporting entity should consider not only the similarity of financial performance but also the economic conditions, exchange control regulations, and underlying currency risks, if applicable. If a reporting entity cannot demonstrate similar economic characteristics, then aggregation is not permitted. That is, it would not be appropriate to rely on the similarity of the qualitative aggregation criteria provided by ASC 280-10-50-11
to aggregate operating segments if they do not meet the quantitative criteria.
For example, assume a reporting entity sells centrally produced, identical products to similar classes of customers in two different countries in which the regulatory environments are the same. Operating results for each country are separately reported internally and meet the qualitative aggregation criteria. However, due to differences in selling price, and therefore profit margin, as well as differences in currency risk and exchange control, it may be difficult to support an assertion of similar economic characteristics. As a result, it may be challenging to support aggregating the individual country operating segments.
Through comments to registrants, the SEC staff has questioned whether the “similar economic characteristics” test was met when measuring the difference in financial performance between operating segments. We believe a reporting entity should consider the relative percentage difference of the operating measure and not just the absolute difference. For example, when the CODM uses gross margin to evaluate operating segment performance, the difference between a gross margin of 55% and 50% is a 5% absolute value difference but represents a 10% relative difference. Although there is no “bright line” when assessing similarity, operating segments with relative differences between performance measures of 5% or less likely would be considered economically similar, whereas relative differences in excess of 10% may not meet the economic similarity criterion for aggregation.
In some cases, a high percentage difference in the relative operating measure can result from a relatively narrow range in the actual, or absolute, operating measure (e.g., a reporting entity with operating segments having gross margins of 2% and 3% would differ by only 1% in terms of absolute value, but that 1% would represent a 50% difference in relative values). In these circumstances, a reporting entity may want to consider other factors in addition to the relative operating measure to evaluate the similarity of economic characteristics, including trends in sales growth, return on assets employed, and operating cash flows, as well as any other performance measures regularly reviewed by the CODM.
While the similarity of long-term average gross margins is a particularly important factor and is included as an example in ASC 280-10-50-11
, when a reporting entity is determining whether the economic characteristics of its operating segments are similar, other relevant factors should also be considered. For instance, the similarity of the performance measures that are regularly reviewed by the CODM, as well as other performance measures, such as trends in sales growth, returns on assets employed, and operating cash flows, should also be evaluated. Competitive and operating risks associated with each operating segment should be considered as these factors could impact prospective results of the segments. When assessing similarities and differences between operating segments, the evaluation should be made considering how wide or narrow the reporting entity’s breadth of business activities is and the economic environment in which they operate. Two or more operating segments considered to have similar long-term performance should be impacted similarly by events that have significant economic consequences.
Management should document its basis for concluding that operating segments are economically similar and should update the analysis on an annual basis, or more frequently if conditions that affect economic similarity change. In some circumstances, “temporary” dissimilarity in economic characteristics among operating segments may not necessarily preclude aggregation of operating segments if long-term economic similarity can still be demonstrated based on credible projections of future operations. Accordingly, a current change in operating performance may not necessarily result in a change to the composition of the reportable segments.
A reporting entity should monitor and consider whether its operating segment determinations are consistent with its publicly available information and disclosures. For example, press releases, investor presentations, analyst conference calls, and non-financial statement sections of SEC filings often include information regarding the nature of products and services, the type and class of customers, and how the reporting entity addresses its various market segments. If such information is not consistent with a reporting entity’s operating segment determinations, it may call into question those segment determinations.
Question FSP 25-4
Assuming all other qualitative aggregation criteria are met, would a reporting entity be precluded from aggregating a start-up business with mature businesses based solely on the fact that the current economic characteristics of the start-up business differ from those of its mature businesses?
No. One of the objectives of segment disclosures is to help users assess the future prospects of a reporting entity’s business. Further, ASC 280-10-50-11
indicates that operating segments with similar economic characteristics often exhibit similar long-term financial performance. Accordingly, to the extent that the future financial performance (including the competitive and operating risks) of the start-up business is expected to be similar to that of a reporting entity’s mature businesses in the near term, the economic characteristics requirement for aggregation would be satisfied.
For example, a retail chain may have mature store locations in five major cities. In the current year, the retail chain opens additional stores in those cities. Each store constitutes a separate operating segment because the CODM of the retail chain reviews financial results and makes decisions on a store-by-store basis. The retail stores meet all of the qualitative aggregation criteria. These “start-up” stores may meet the economic similarities requirement for aggregation with mature stores if management can establish that the financial performance of the mature and new stores is expected to converge in the near term.
Question FSP 25-5
Assuming all other qualitative aggregation criteria are met, would a reporting entity be precluded from aggregating a newly-acquired operating segment with its existing operating segment if the historical economic characteristics of the acquired operating segment are not similar?
It depends. The differing historical results of the newly-acquired operating segment compared to the reporting entity’s existing operating segment may indicate that the economic characteristics of the two operating segments are not similar. However, the seller’s historical results may not be relevant to future performance; therefore, the reporting entity should evaluate the newly-acquired operating segment’s future prospects. This evaluation would include the newly-acquired operating segment’s budget and the actions that management has taken or expects to take shortly after the acquisition. There should also be an evaluation of the achievability of management’s proposed changes to the acquired operating segment. If, after evaluating the future prospects, the two operating segments are expected to be economically similar within the near term, the two operating segments may be aggregated.