Aggregation is a central issue in financial re-
porting and to some extent is determined by mandated standards. Where a mandated
standard exists, however, considerable managerial discretion is often allowed in how the
standard is applied. We argue that, with respect to the number of segments firms report,
this was the case to a great extent under SFAS No. 14 and is so to a lesser extent under
the current SFAS No. 131. 1 We therefore exploit the change to SFAS No. 131 segment
reporting to examine two possible motives for discretionary nondisclosure (i.e., aggregation)
of segments under SFAS No. 14, namely, proprietary costs and agency costs.
Our investigation of segment reporting contributes to the empirical literature on discre-
tionary disclosure choices. Empirical tests of voluntary disclosure often aim to test the
predictions of theoretical models. The traditional motive offered by the literature to explain
nondisclosure in general (e.g., Verrecchia 1983) and aggregation of segments in particular
(e.g., Hayes and Lundholm 1996) is that disclosure reveals proprietary information. 2 This
motive is also the one most often put forward by managers. For instance, Ettredge et al.
(2002) report that 86 percent of the industrial firms that commented on the Exposure Draft
for SFAS No. 131 opposed the new standard on the grounds that ‘‘it would put them at
competitive disadvantage.’’ It is therefore not surprising that prior empirical studies focus
primarily on examining the proprietary costs of segment disclosure (e.g., Harris 1998;
Piotroski 2003; Botosan and Stanford 2005). These papers generally find evidence consis-
tent with disclosure being constrained by proprietary costs.
We argue that much of the prior evidence consistent with the proprietary cost hypothesis
is also consistent with an alternative ‘‘agency cost’’ hypothesis that posits disclosures are
withheld as a result of conflicts of interest between managers and shareholders. Neverthe-
less, prior segment reporting papers do not attempt to directly test whether managerial self-
interest plays a role in segment aggregation decisions. Even in the broader empirical dis-
closure literature, scant evidence exists on the agency cost motive for withholding
disclosure. 3
Segment reporting is potentially fertile ground for examining the impact of agency
conflicts on disclosure decisions. Prior research provides evidence that multi-segment firms
trade at a discount relative to stand-alone firms (the ‘‘diversification discount’’) and that
internal capital markets in firms with diversified LOB transfer funds across segments in a
suboptimal manner (e.g., Lang and Stulz 1994; Berger and Ofek 1995; Lamont 1997; Shin
and Stulz 1998). Moreover, Berger and Hann (2003) find that firms that started reporting
multiple segments (as opposed to one segment) when SFAS No. 131 came into effect
experienced an increase in their diversification discount in the year of the disclosure change.
If greater disclosure more fully reveals the extent of value-destruction at an underperforming
firm, then the potential for corporate governance and control mechanisms to discipline the
1 SFAS No. 14 is FASB Statement No. 14, Financial Reporting for Segments of a Business Enterprise (FASB
1976). SFAS No. 131 is FASB Statement No. 131, Disclosures about Segments of an Enterprise and Related
Information (FASB 1997).
2 Theory also suggests that under reasonably broad circumstances greater disclosure can result in capital market
benefits. Prior research finds evidence consistent with higher disclosure resulting in capital market benefits (see,
e.g., Sengupta 1998; Hail and Leuz 2006). Nevertheless, the evidence that increased disclosure creates a capital
market benefit remains controversial (see, e.g., Francis et al. 2006).
3 One exception is Boehmer and Ljungqvist (2004), who find that German firms are less likely to go public when
controlling shareholders enjoy large private benefits of control. Another exception is Leuz et al. (2006), who
find evidence suggesting that Securities and Exchange Commission deregistrations are often motivated by the
desire of controlling insiders to protect private control benefits and decrease outside scrutiny.Segment Profitability and the Proprietary and Agency Costs of Disclosure 871
The Accounting Review, July 2007
underperforming manager may increase. Consistent with this conjecture, Bens and Monahan
(2004) find that within a 17-year U.S. panel, firms with more disclosure experience smaller
diversification discounts. These findings together suggest that managers face potential costs
from segment disclosures that reveal underperformance associated with agency problems.
The primary purpose of this study is to provide evidence on this agency cost impact of
disclosure.
In particular, we study managers’ proprietary and agency cost motives to hide abnormal
segment profits, which we define as a segment’s rate of return relative to that of its industry.
Given the limited set of items that are disclosed in segment footnotes, we argue that segment
profitability is likely the most valuable piece of information managers might wish to with-
hold from competitors and investors. Managers face proprietary costs of segment disclosure
if the revelation of a segment that earns high abnormal profits attracts more competition
and, hence, reduces the segment’s abnormal profits. On the other hand, managers face
agency costs of segment disclosure if the revelation of a segment that earns low abnormal
profits reveals unresolved agency problems and ultimately leads to heightened external
monitoring. We therefore hypothesize that managers tend to withhold the segments with
relatively high (low) abnormal segment profits when the proprietary (agency) cost motive
dominates (hereafter, the proprietary (agency) cost motive hypothesis).
We test these two hypotheses using a sample of 796 firms (with 2,310 segments) that
report multiple segments based on SFAS No. 131 restated segment reporting for the year
prior to the adoption of SFAS No. 131 (hereafter, the lag adoption year). We hand-collect
restated SFAS No. 131 data from lag adoption year 10-Ks to compare the segment infor-
mation reported under the two reporting regimes for the same firm at the same point in
time. The restated SFAS No. 131 and historical SFAS No. 14 segment data allow us to
identify a set of ‘‘new’’ and ‘‘old’’ SFAS No. 131 segments and, hence, examine managers’
reporting choice at the segment level. The new segments consist of those that were previ-
ously aggregated under the old regime, presumably because of the relatively greater dis-
cretion afforded under SFAS No. 14 and the desire to obscure the performance of the
individual segments, whereas the old segments consist of those that were already reported
as separate LOB segments under the old standard. The proprietary (agency) cost motive
hypothesis therefore predicts that within the sample of firms in which the proprietary
(agency) cost motive dominates, the new segments tend to have higher (lower) abnormal
profits than the old segments.
Because the proprietary and agency cost motive hypotheses have opposite predictions
about the new and old segments’ abnormal profits, we partition our sample into two samples
such that one cost consideration is likely to dominate the other and we test each hypothesis
separately within each sample. Throughout the study, we refer to the set of firms for which
the agency cost motive is likely to dominate as the ‘‘AC motive sample’’ and to the set for
which the proprietary cost motive is likely to dominate as the ‘‘PC motive sample.’’ Then,
using a logit regression analysis, we test whether the new segments tend to have higher
(lower) abnormal segment profits than the old segments within the AC (PC) motive sample.
Our results are consistent with the agency cost hypothesis. Within the AC motive
sample, the new segments are associated with lower abnormal profits than the old segments,
suggesting that managers avoid revealing poorly performing segment information when
agency costs are the primary motive. We do not find evidence consistent with the proprietary
cost hypothesis. Finally, we perform various sensitivity tests to ensure that our inferences
are not affected by measurement error in our abnormal segment profit measures. Our in-
ferences are robust to these sensitivity tests.872 Berger and Hann
The Accounting Review, July 2007
Our results make two main contributions to the literature. First, the hand-collected
restated SFAS No. 131 segment data allow us to study managers’ reporting decisions at the
segment level using segment profitability, which is conceptually a more relevant measure
of the proprietary or agency costs of segment disclosure than the measures used in prior
studies. Specifically, we argue that it is how well a segment performs relative to its industry
that managers try to hide. Previous papers assume instead that segment aggregation aims
to hide the profitability of the industry that the segment operates in. We view such an
assumption as unrealistic because industry-wide information is likely already available to
both competitors and the market. Put differently, in studying managers’ motives to withhold
segment data, one needs to consider not only what managers want to hide, but also what
they can hide. If the information is already available to competitors and the market, then
there is no proprietary or agency cost of disclosing such information. Conceptually, neither
industry profits (Harris 1998; Botosan and Stanford 2005) nor firm-level profits (Piotroski
2003) serve to capture the underlying proprietary costs of segment disclosure as they are
likely already known by competitors. Therefore, segment profitability is a more relevant
Aggregation is a central issue in financial re-porting and to some extent is determined by mandated standards. Where a mandatedstandard exists, however, considerable managerial discretion is often allowed in how thestandard is applied. We argue that, with respect to the number of segments firms report,this was the case to a great extent under SFAS No. 14 and is so to a lesser extent underthe current SFAS No. 131. 1 We therefore exploit the change to SFAS No. 131 segmentreporting to examine two possible motives for discretionary nondisclosure (i.e., aggregation)of segments under SFAS No. 14, namely, proprietary costs and agency costs.Our investigation of segment reporting contributes to the empirical literature on discre-tionary disclosure choices. Empirical tests of voluntary disclosure often aim to test thepredictions of theoretical models. The traditional motive offered by the literature to explainnondisclosure in general (e.g., Verrecchia 1983) and aggregation of segments in particular(e.g., Hayes and Lundholm 1996) is that disclosure reveals proprietary information. 2 Thismotive is also the one most often put forward by managers. For instance, Ettredge et al.(2002) report that 86 percent of the industrial firms that commented on the Exposure Draftfor SFAS No. 131 opposed the new standard on the grounds that ‘‘it would put them atcompetitive disadvantage.’’ It is therefore not surprising that prior empirical studies focusprimarily on examining the proprietary costs of segment disclosure (e.g., Harris 1998;
Piotroski 2003; Botosan and Stanford 2005). These papers generally find evidence consis-
tent with disclosure being constrained by proprietary costs.
We argue that much of the prior evidence consistent with the proprietary cost hypothesis
is also consistent with an alternative ‘‘agency cost’’ hypothesis that posits disclosures are
withheld as a result of conflicts of interest between managers and shareholders. Neverthe-
less, prior segment reporting papers do not attempt to directly test whether managerial self-
interest plays a role in segment aggregation decisions. Even in the broader empirical dis-
closure literature, scant evidence exists on the agency cost motive for withholding
disclosure. 3
Segment reporting is potentially fertile ground for examining the impact of agency
conflicts on disclosure decisions. Prior research provides evidence that multi-segment firms
trade at a discount relative to stand-alone firms (the ‘‘diversification discount’’) and that
internal capital markets in firms with diversified LOB transfer funds across segments in a
suboptimal manner (e.g., Lang and Stulz 1994; Berger and Ofek 1995; Lamont 1997; Shin
and Stulz 1998). Moreover, Berger and Hann (2003) find that firms that started reporting
multiple segments (as opposed to one segment) when SFAS No. 131 came into effect
experienced an increase in their diversification discount in the year of the disclosure change.
If greater disclosure more fully reveals the extent of value-destruction at an underperforming
firm, then the potential for corporate governance and control mechanisms to discipline the
1 SFAS No. 14 is FASB Statement No. 14, Financial Reporting for Segments of a Business Enterprise (FASB
1976). SFAS No. 131 is FASB Statement No. 131, Disclosures about Segments of an Enterprise and Related
Information (FASB 1997).
2 Theory also suggests that under reasonably broad circumstances greater disclosure can result in capital market
benefits. Prior research finds evidence consistent with higher disclosure resulting in capital market benefits (see,
e.g., Sengupta 1998; Hail and Leuz 2006). Nevertheless, the evidence that increased disclosure creates a capital
market benefit remains controversial (see, e.g., Francis et al. 2006).
3 One exception is Boehmer and Ljungqvist (2004), who find that German firms are less likely to go public when
controlling shareholders enjoy large private benefits of control. Another exception is Leuz et al. (2006), who
find evidence suggesting that Securities and Exchange Commission deregistrations are often motivated by the
desire of controlling insiders to protect private control benefits and decrease outside scrutiny.Segment Profitability and the Proprietary and Agency Costs of Disclosure 871
The Accounting Review, July 2007
underperforming manager may increase. Consistent with this conjecture, Bens and Monahan
(2004) find that within a 17-year U.S. panel, firms with more disclosure experience smaller
diversification discounts. These findings together suggest that managers face potential costs
from segment disclosures that reveal underperformance associated with agency problems.
The primary purpose of this study is to provide evidence on this agency cost impact of
disclosure.
In particular, we study managers’ proprietary and agency cost motives to hide abnormal
segment profits, which we define as a segment’s rate of return relative to that of its industry.
Given the limited set of items that are disclosed in segment footnotes, we argue that segment
profitability is likely the most valuable piece of information managers might wish to with-
hold from competitors and investors. Managers face proprietary costs of segment disclosure
if the revelation of a segment that earns high abnormal profits attracts more competition
and, hence, reduces the segment’s abnormal profits. On the other hand, managers face
agency costs of segment disclosure if the revelation of a segment that earns low abnormal
profits reveals unresolved agency problems and ultimately leads to heightened external
monitoring. We therefore hypothesize that managers tend to withhold the segments with
relatively high (low) abnormal segment profits when the proprietary (agency) cost motive
dominates (hereafter, the proprietary (agency) cost motive hypothesis).
We test these two hypotheses using a sample of 796 firms (with 2,310 segments) that
report multiple segments based on SFAS No. 131 restated segment reporting for the year
prior to the adoption of SFAS No. 131 (hereafter, the lag adoption year). We hand-collect
restated SFAS No. 131 data from lag adoption year 10-Ks to compare the segment infor-
mation reported under the two reporting regimes for the same firm at the same point in
time. The restated SFAS No. 131 and historical SFAS No. 14 segment data allow us to
identify a set of ‘‘new’’ and ‘‘old’’ SFAS No. 131 segments and, hence, examine managers’
reporting choice at the segment level. The new segments consist of those that were previ-
ously aggregated under the old regime, presumably because of the relatively greater dis-
cretion afforded under SFAS No. 14 and the desire to obscure the performance of the
individual segments, whereas the old segments consist of those that were already reported
as separate LOB segments under the old standard. The proprietary (agency) cost motive
hypothesis therefore predicts that within the sample of firms in which the proprietary
(agency) cost motive dominates, the new segments tend to have higher (lower) abnormal
profits than the old segments.
Because the proprietary and agency cost motive hypotheses have opposite predictions
about the new and old segments’ abnormal profits, we partition our sample into two samples
such that one cost consideration is likely to dominate the other and we test each hypothesis
separately within each sample. Throughout the study, we refer to the set of firms for which
the agency cost motive is likely to dominate as the ‘‘AC motive sample’’ and to the set for
which the proprietary cost motive is likely to dominate as the ‘‘PC motive sample.’’ Then,
using a logit regression analysis, we test whether the new segments tend to have higher
(lower) abnormal segment profits than the old segments within the AC (PC) motive sample.
Our results are consistent with the agency cost hypothesis. Within the AC motive
sample, the new segments are associated with lower abnormal profits than the old segments,
suggesting that managers avoid revealing poorly performing segment information when
agency costs are the primary motive. We do not find evidence consistent with the proprietary
cost hypothesis. Finally, we perform various sensitivity tests to ensure that our inferences
are not affected by measurement error in our abnormal segment profit measures. Our in-
ferences are robust to these sensitivity tests.872 Berger and Hann
The Accounting Review, July 2007
Our results make two main contributions to the literature. First, the hand-collected
restated SFAS No. 131 segment data allow us to study managers’ reporting decisions at the
segment level using segment profitability, which is conceptually a more relevant measure
of the proprietary or agency costs of segment disclosure than the measures used in prior
studies. Specifically, we argue that it is how well a segment performs relative to its industry
that managers try to hide. Previous papers assume instead that segment aggregation aims
to hide the profitability of the industry that the segment operates in. We view such an
assumption as unrealistic because industry-wide information is likely already available to
both competitors and the market. Put differently, in studying managers’ motives to withhold
segment data, one needs to consider not only what managers want to hide, but also what
they can hide. If the information is already available to competitors and the market, then
there is no proprietary or agency cost of disclosing such information. Conceptually, neither
industry profits (Harris 1998; Botosan and Stanford 2005) nor firm-level profits (Piotroski
2003) serve to capture the underlying proprietary costs of segment disclosure as they are
likely already known by competitors. Therefore, segment profitability is a more relevant
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