At the risk of sounding banal: “The market loves stories”. And strong segmental reporting is core to supporting a compelling investment narrative.
But there are instances where we find segmental reporting has outlived its expiry date. IFRS 8 Operating segments, drives the concept of presenting the business “through management’s eyes”, but perhaps management is in need of an eye test and some new spectacles.
Current challenges with segmental reporting
Looking outside in, it is hard to say whether management’s introspections around the core principles of IFRS 8 truly answer the key question: “Is our segmental reporting useful in supporting the originality of our investment story to the market?” So, as part of our Quick Wins, we reiterate the importance to users of segmental reporting in developing informed judgements around the level of differentiation in a company’s strategy; the level of experience and expertise among management teams in driving that strategy; and whether these combine well into a compelling opportunity for investors.
Investors and analysts want useful reporting, allowing them to have conviction in a company’s investment narrative. The credibility of the narrative is a function of the data that underpins it and the level of judgement management has applied in shaping that data. The use and application of management judgement remains an area of contentious debate in the investment community. Determining what an appropriate judgement by management is, given the level of information asymmetry between investors and management, is a subjective exercise. Doubt will continue to be cast by investors and analysts with respect to the risk of cherry-picking segmental disclosures, unless proven otherwise.
In my view, the CRUF guiding principles are the same elements that result in useful reporting: transparency, comprehensiveness, clarity, relevance, consistency and understandability. In the absence of these elements in segmental disclosure, markets tend to value companies in a broad-based manner and discount segment-level competitive advantages. This is punitive to both the company and investors. The company’s investment case slowly diminishes over time, which is reflected in weak valuation metrics and makes raising capital expensive. Investors, on the other hand, may miss potential returns, as weak market sentiment inhibits a re-rating in the stock.
Why segmental reporting needs to be improved
Customer appetites, expectations and behaviours are changing. With extreme economic and market conditions accelerating these changes. In response, companies are driving customer-centric organisational change underpinned by large-scale digital transformation journeys. Traditional governance structures, which are hierarchical in nature, face challenges from decentralised decision-making structures. Legacy organisational boundaries have purposely been made porous to incorporate “agile methodologies” and “new ways of working” into internal operating models.
In my view, this dynamic seems to be driving disconnects between the ways in which a company implements its business strategy and is subsequently run, compared to the way in which it is reported on. Prevailing segmental reporting seems dated given these complexities.
Another example is IFRS 8 highlighting that segments should be based on the way measures are reported to the chief operating decision maker (CODM) in internal management reports. However, who is the CODM? Some companies have invested significantly into robust governance structures, which delegate significant capital allocation decisions to strategic business units (SBU) or subsidiaries. These significant strategic decisions, taken at an SBU or subsidiary level, are measured against a centrally agreed set of strategic principles and performance measures. Those measures, although regularly reviewed by the Group CODM, may not be suitable for the needs of investors and analysts. Also, in a “digital” organisation, it is likely that performance measures are not reported on as static cross-sections of the company in monthly “packs”. Nor, given the richness of available internal company data, are risks (competitive, regulatory etc.) evaluated through a single lens at predefined meetings.
Companies prototype, test and experiment with minimally viable products to deliver new products and experiences in incrementally shorter periods to customers. Under this dynamic, it is hard to reconcile the rapid evolutions in business and operating models to the lack of change we have observed in segmental reporting. Management teams continue to advocate that they are making significant changes to the business. But this is often not reflected in incremental improvements in segmental reporting. Often we find the key issues, at a segment level, are included in the footnotes. This is not useful.
Making the case for change
Segmental information usefulness will remain a contentious point among investors, in perpetuum. The investor community will continue to demand disclosures that are investor centric. And like changes in consumer expectations this will become a market reality. Investors’ disclosure expectations will continue to change, and in particular in an operating environment that has become data rich, insights will become more easily accessible through inexpensive data visualisation tools.
We find it hard to believe that companies can continue to rely on the clichéd “it’s too costly” argument, when the rest of the organisation transitions to granular real-time reporting. We expect such responses to be a natural consequence of the stressed reporting environment preparers operate within. As users, we recognise that companies already find it challenging to meet the increasing number and rising complexity of disclosure requirements set out by global and national standard setters, regulatory authorities, and the capital markets industry, but, that does not mean we cannot expect a higher standard of segmental reporting that supports a compelling investment narrative.
Kevin Harding is the Chair of CRUF South Africa and joined Investec securities in 2017 as an Equity Research analyst covering African banks. Prior to joining Investec, Kevin was a Senior Manager in PwC’s Financial Services Risk and Regulation consulting practice in South Africa. He worked as part of a senior team, providing direction and support in the different phases of risk and regulatory projects for financial services clients, with a specific focus on the banking sector. Through these roles he gained specific knowledge and insight into the business and operating models underpinning financial services firms. Kevin is a chartered accountant, CA (SA).
Disclaimer: The views expressed in the blog are those of the author(s) and do not necessarily represent the views of all CRUF participants. To read more about the CRUF’s views on this and other topics, please visit the comment letters section of the CRUF website.