Causes and Consequences of Discretionary Allocation of Corporate Income to Segments

Abstract

Under a controversial provision of FAS 131, 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 and consequences of Gaps. The results suggest that Gaps shield segment-level managers from risk by excluding transitory income items from segment earnings, and by excluding 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 likely to exhibit higher 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. Our results suggest that aggregated segment income is incrementally useful to investors when companies disclose negative Gaps.

Keywords: Segments, FAS 131, persistence, proprietary costs, agency costs, discretionary disclosure, earnings response coefficient

JEL Classification: M41, M44