Corporate Selfies and Changing Company Reporting
This week’s unexpected move by Google to create a new parent company called Alphabet and to split the core Google operations from a variety of other internal businesses under that umbrella has been widely dissected this week (my own take is here). But today, I wanted to broaden out the topic a bit and talk about how companies report more generally and why.
The corporate selfie
I think one of the best ways to think about company financial reporting is by analogy to the selfie. I would think most people who take selfies do so with some specific objectives in mind: showing off the best possible side of themselves, whether that’s highlighting a particular facial feature or body part; or perhaps hiding the bits of ourselves we don’t particularly like; or presenting ourselves in a particularly flattering light or context. Another analogy might be our social network profiles or personal blogs we keep, where some people tend to present the best possible version of themselves through the things they choose to reveal (and keep hidden).
Company financial reporting is to some extent the same – each company reports in such a way that it will be shown in the best possible light and that often means making decisions about which elements of the business to highlight and which to keep hidden. Obviously, though there are no government regulations about selfies, there are such regulations and guidelines about reporting standards. The SEC and the Financial Accounting Standards Board are the keepers of such rules. But those rules, in turn, provide significant leeway as to how exactly companies report, how they segment their businesses, and to what extent (and in how much detail) they report results for those various segments.
Segment reporting rules
Caveat: I’m not an accountant. I do spend a lot of time poring over financial statements in my role as an industry analyst, but I’m not a certified expert. Please take what follows in that context.
One of the things I see bandied about frequently in media coverage of financial reporting is a rule (usually referred to as an SEC rule) about reporting segments over 10% of a company’s revenues or profits. There is such a rule, encapsulated in the FASB’s Statement of Financial Accounting Standards No. 131 (passed in 1997) and backed up by SEC action later. Paragraph 5 of that FASB statement explains what an operating segment is:
The management approach facilitates consistent descriptions of an enterprise in its annual report and various other published information. It focuses on financial information that an enterprise’s decision makers use to make decisions about the enterprise’s operating matters. The components that management establishes for that purpose are called operating segments.
Paragraph 18, on the other hand, contains the requirement that segments that account for 10% or more of revenue, profits, or assets of the company must be broken out, while paragraph 17 provides for a major exception to this rule. This paragraph states:
Two or more operating segments may be aggregated into a single operating segment if…the segments have similar economic characteristics, and if the segments are similar in… [t]he nature of the products and services, [t]he nature of the production processes, [t]he type or class of customer for their products and services, [and t]he methods used to distribute their products or provide their services…
In other words, every segment over 10% of revenues/profits only has to be reported separately if the company can’t make an argument that it’s similar enough to another segment to be lumped together with it. That’s really important because several big technology companies do just this with some of their major segments.
No two companies report the same way
Given that context, let’s return to our analogy of company reporting as selfies. As we’ve seen, the rules governing financial reporting provide quite a bit of latitude for companies as to how they define their segments. However, there’s nothing in these regulations that prevents companies from providing other breakdowns of their businesses if they choose to do so. So let’s look at some examples from among major tech companies:
- Amazon’s operating segments have, until very recently, been solely geographic in nature. The company has historically reported a North America segment and an International segment. However, it recently broke out a third segment (hitherto in the North America slice) in the form of Amazon Web Services (AWS). Amazon has also provided a breakdown of revenues by product/service category, in the form of Media, Electronics and other general merchandise, and latterly AWS.
- Apple’s operating segments are now purely regional in nature, with five geographic segments reported, although it had earlier reported its retail operations as a sixth segment. Apple additionally provides reporting on a product/service basis in the form of revenues for iPhone, iPad, Mac, Services, and Other Products.
- Google has, until now, only ever had a single reporting segment, although it has also broken out “revenues by source” into Google websites, Google Network Members’ websites, and Other, and provided a geographic breakdown.
- Microsoft has six reporting segments, and actually signaled in its most recent 10-K report it may change these segments in future in keeping with its new organizational structure. Once a year, Microsoft also reports external revenues from several major product categories such as Windows and Office.
As you can see, these companies are, in some cases, using the wiggle room provided by the applicable regulations to report certain things while keeping some significant businesses largely under wraps. Perhaps the best example is Google with search advertising and YouTube. YouTube may not cross the 10% threshold and search certainly does, but it’s all been lumped into one big segment and Google has voluntarily provided just a very high-level split between advertising on its own site and others’ sites, and its catch-all Other category. Each of these companies though, has chosen to report certain things while keeping others buried in larger categories – Amazon chose to keep AWS hidden until it crossed the threshold into reportable territory, while Google keeps search advertising one layer down from its reported segments and Apple has recently removed the iPod from its reporting while placing the Apple Watch into the Other Products category for the time being. (Because Apple’s segments are geographic in nature and not product-based, it technically doesn’t have the same obligation to report results for individual product lines as a company reporting segments based on products and services.)
Google and Alphabet
Google’s Alphabet move is a complex one, but one of the things it will do is create a new reporting structure for the company, with (as I understand it based on the latest reporting) two operating segments – Google, and essentially everything else under the Alphabet umbrella. I know some people have assumed the new reporting structure would mean we’d start to see detailed results for several of Google’s subsidiaries such as YouTube and Android and possibly for the individual Alphabet companies too, but I don’t think that’s the case. I think we’ll continue to see the same three categories broken out for the Google segment (Google sites, Network, and Other). I suspect the rest will be something of a black box and we’ll be none the wiser until Google chooses to provide more insight. However, I do think Google’s move to this new structure is motivated, at least in part, by the same imperatives as we’ve been discussing here – the desire to show off its best features in their best possible light. By separating out the reporting for the core Google segment, I believe that segment will actually look considerably better than it has in the past. The rest, by contrast, will likely not look so good, but because it’s such a hodgepodge of companies and includes things like Google Ventures (which likely do OK financially), it’ll be hard to read too much into that segment’s performance.
In time, I would expect Google to start to break out other segments, either because they cross that 10% threshold and are different enough in nature from the other businesses or because they’ll make Google look good. After all, isn’t that what selfies are for?