Simulated Mergers of Existent Autonomous Firms: A New Approach to Segmentation Research

There have been new guidelines for segment reporting issued by the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC), after a decade of debate and experimentation. The guidelines prescribe various subentity disclosures, including segmented sales and earnings. In this analysis, a new approach to evaluating segmental disclosures has been suggested. The simulated mergers of existent, autonomous, single-product firms have been used to provide evidence regarding differences in predictive ability between income forecasts based on consolidated (CN) earnings and corresponding forecasts based on segmented (SG) earnings. The analysis relies on aggregated subentity data provided by simulating mergers of actual, single-product firms. Allocations and segment ambiguities can be avoided through the simulation of mergers. The simulated merger approach also helped circumvent problems of intersegment transfers and common costs. This approach also allows the use of quarterly net income as the variable of prediction. The results of the study tend to corroborate those from previous CN-SG research; the studies of Kinney (1971) and Collins (1976) found that SG profitability data was not particularly useful, while Fried (1978) found nonsignificant CN-SG differences in predictive ability. These studies appear to imply that SG earnings may be of limited usefulness in making predictions of enterprise profits.