Do the Changes in Segment Reporting Rules Under SFAS No. 131 Enhance or Reduce Value Relevance of Segment Disclosures and Firm Level Data? Comparative Analysis between Pre- and Post-SFAS No. 131 Periods

Abstract

At the writing of this paper, the international community is considering following the lead of the United States by changing its segment disclosure requirements. Segment information has traditionally been disclosed along objectively determined industry lines, but new disclosure requirements in the U.S. (SFAS No. 131) require firms to disclose segment information as it is used by the firm's chief operating decision maker for internal decision making, resource allocation, and performance evaluation. SFAS No. 131 is believed to enhance the quality of segment reporting in two ways. First, it allows investors to see the company as management does. This should enable investors to more carefully evaluate the strategic decisions of managment and the performance of the firm's different activities. Secondly, recent research (see Botosan and Stanford 2005 and Nichols and Street 2007) has shown that the rules of the prior reporting regime, SFAS No. 14, allowed management to conceal information about under (or over) performing segments of the firm more easily than under the new reporting regime of SFAS No. 131. The international community is therefore considering the adoption of IFRS 8. This study addresses the following question: Did the change in segment reporting requirements in the U.S. significantly alter the market valuation process for the better? Following Francis and Schipper (1999), we conduct both portfolio return and price-level regression tests to examine changes in the value relevance of accounting information from segment disclosures and in the underlying pricing process itself. Our analysis confirms prior findings that segment disclosures are value relevant and also demonstrates that while the market value of a firm's book value is constant across the two reporting regimes, the market value of its firm level earnings changes when the management approach to segment disclosure is required. Our study also contributes to the extant literature by establishing the newly developing option theory of valuation for segment operations as a valuable tool for understanding the market pricing process. We use an options based summary measure of segment information which was developed by Chen and Zhang (2003), the divergence of profitability, to examine changes to the value relevance of segment information and firm level earnings across segment reporting regimes. Empirical results of both portfolio returns and price-level regression tests using three-year windows before and after the change in reporting requirements show that the divergence of profitability measure captures valuable information about the market pricing process and that the new disclosure rules alter the way investors value firm level earnings performance.