Discretionary Allocation of Corporate Income to Segments under FAS 131: Effects on the Persistence and Price-Relevance of Aggregated Segment Income

• In Event: Mostly Segment Reporting!

Abstract

Under a controversial provision of FAS 131 (and of IFRS 8), the sum of a company’s segment earnings need not equal corporate net income, nor is it required to equal any corporate earnings sub-total, such as operating income (however defined). We refer to the difference between summed segment earnings and corporate-level income, when it exists, as the ‘Gap’. This study examines the determinants of Gaps, and investigates whether summed segment earnings are more persistent and informative than corporate earnings when Gaps exist. The results suggest that Gaps shield segment-level managers from risk by excluding transitory income items from segment earnings, and from income items arising from decisions not made at the segment level. We also find evidence that companies facing high proprietary costs and agency costs are more likely to exhibit Gaps. We investigate the effects of signed Gaps by subtracting aggregated segment income from corporate income. When Gaps exist (corporate earnings differ from summed segment earnings), summed segment earnings is modestly more persistent than are corporate earnings. This difference appears to be attributable to negative Gaps. When negative Gaps exist, aggregated segment earnings are more informative (in terms of its association with concurrent stock returns) than are corporate earnings. When positive Gaps exist, summed segment income has a weaker association with concurrent stock returns than corporate earnings. Our results suggest that aggregated segment income is incrementally useful to investors when companies disclose negative Gaps.

Authors

• Qian Wang, Iowa State University

• Michael Ettredge, The University of Kansas