Segment Disclosure Transparency and Internal Capital Market Efficiency: Evidence from SFAS No. 131

• Author: YOUNG JUN CHO
• Date: 01 September 2015
• Published date: 01 September 2015
• DOI: http://doi.org/10.1111/1475-679X.12089

DOI: 10.1111/1475-679X.12089

Journal of Accounting Research

Vol. 53 No. 4 September 2015

Printed in U.S.A.

Segment Disclosure Transparency

and Internal Capital Market

Efficiency: Evidence from SFAS

No. 131

YOUNG JUN CHO

∗

Received 2 November 2013; accepted 28 May 2015

ABSTRACT

Using the adoption of SFAS 131, I examine the effect of segment disclo-

sure transparency on internal capital market efficiency. SFAS 131 requires

firms to define segments as internally viewed by managers, thereby improv-

ing the transparency of managerial actions in internal capital allocation. I

find that diversified firms that improved segment disclosure transparency by

changing segment definitions upon adoption of SFAS 131 experienced an

∗School of Accountancy, Singapore Management University.

Accepted by Christian Leuz. This paper is based on my dissertation at the Johnson Graduate

School of Management, Cornell University. I am indebted to the members of my dissertation

committee: Sanjeev Bhojraj, Julia D’Souza (co-chairs), Robert Bloomfield, and David Ng for

their continuous guidance and support. I am grateful to the editor and an anonymous referee

for their constructive suggestions. I thank Neil Bhattacharya, Jeffrey Callen, Qiang Cheng, Ji

Woong Chung, Khwan Jaroenjitrkam, Jimmy Lee, Hao Li, Lynn Li, Gerald Lobo, Steven Mat-

sunaga, Jeffrey Ng, Tharindra Ranasinghe, Dan Segal, K.R. Subramanyam, Holly Yang, Han Yi,

and workshop participants at Cornell University, Georgia Institute of Technology, SUNY Buf-

falo, National University of Singapore, Singapore Management University, Nanyang Techno-

logical University, and University of Hong Kong and video conference participants at Univer-

sity of Chicago for their helpful comments and discussion. I thank Partha Sengupta for provid-

ing me with hand-collected data. I thank Samsung Scholarship, the Johnson Graduate School

of Management at Cornell University, and the School of Accountancy at Singapore Manage-

ment University for financial support. An online appendix to this paper can be downloaded at

http://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

669

Copyright C, University of Chicago on behalf of the Accounting Research Center,2015

670 Y.J.CHO

improvement in capital allocation efficiency in internal capital markets after

the adoption of SFAS 131. In addition, I find that the improvement in inter-

nal capital market efficiency was greater for firms that suffered more severe

agency problems before the adoption of SFAS 131 and also for firms whose

managers faced stronger incentives to improve efficiency after the adoption

of SFAS 131. My results suggest that more transparent segment information

can help resolve agency conflicts in the internal capital markets of diversified

firms, thus improving investment efficiency.

JEL codes: M41; G31; G34; L20

Keywords: SFAS 131; segment disclosures; transparency; agency costs; inter-

nal capital markets

1. Introduction

Using the mandatory adoption of SFAS 131, this study examines the effect

of segment disclosure transparency on internal capital market efficiency. Ef-

fective for firms with fiscal years beginning after December 15, 1997, SFAS

131 requires that segments be defined as internally viewed by managers,

thus enhancing the quality of segment information in financial reporting.1

More specifically, SFAS131 improves the transparency of capital allocations

across segments characterized by different opportunities, thereby improv-

ing shareholders’ ability to monitor managers.

This study is motivated by the observation that SFAS 131 renders

managerial actions more transparent. Studies have reported that SFAS

131 has achieved its goal of providing investors with better information

about organizational structures and segment performance (Herrmann and

Thomas [2000], Street, Nichols, and Gray [2000], Berger and Hann [2003],

Ettredge et al. [2005], Botosan, McMahon, and Stanford [2009]). For ex-

ample, Berger and Hann [2003] find that single-to-multiple firms (i.e.,

those reported as single-segment firms under SFAS 14 but as multiple-

segment firms under SFAS 131) suffered a value decrease upon adoption

of SFAS 131, indicating that SFAS 131 revealed agency problems associated

with the internal capital markets of diversified firms that were previously

hidden under SFAS 14.2Their result is consistent with SFAS 131 improving

the monitoring of managers.

Building on the internal capital markets and agency cost literature, I ar-

gue that, if improved monitoring reveals agency problems associated with

1Superseding SFAS 14 (Statement of Financial Accounting Standards No. 14, “Financial

Reporting for Segments of a Business Enterprise”), SFAS 131 (“Statement of Financial Ac-

counting Standards No. 131, “Disclosures about Segments of an Enterprise and Related Infor-

mation”) requires firms to define their segments in a manner consistent with their internal

organizational structures for financial reporting purposes.

2I use the terms “diversified firm” and “multiple-segment firm” interchangeably throughout

this study to refer to a firm that reports multiple operating segments in its 10-K. In addition, I

use the terms “stand-alone firm” and “single-segment firm” interchangeably to refer to a firm

that does not report multiple operating segments.

SEGMENT DISCLOSURE:EVIDENCE FROM SFAS NO. 131 671

diversification (as shown in Berger and Hann’s [2003] study), it should

also reduce them and thereby improve the efficiency with which firms allo-

cate capital across segments in internal capital markets. SFAS 131 provides

a strong setting in which to investigate this issue. Past research indicates

that, under prior reporting rules that allowed for greater opacity, diversified

firms suffered a value discount presumably arising out of inefficiencies in

internal capital markets (e.g., Berger and Ofek [1995], Scharfstein [1998]).

However,given that such inefficiencies are more transparently revealed and

thus more heavily penalized by the market under the new accounting stan-

dard (Berger and Hann [2003]), managers are likely to have reduced inef-

ficient capital allocations during the post-SFAS 131 period. The results of

this study provide evidence of the effect of reporting transparency on inter-

nal capital market efficiency, an issue that has received scant attention in

the literature.

However,under the competing hypothesis of proprietar y costs, incentives

to obscure segment information arise primarily due to the proprietary costs

of disclosures, not the agency costs (e.g., Hayes and Lundholm [1996]).

Preparers expressed concerns about proprietary costs during FASB delib-

erations over SFAS 131 (FASB [1997], para. 62), and empirical evidence

confirms that proprietary costs drive segment aggregation (Harris [1998],

Botosan and Stanford [2005], Bens, Berger, and Monahan [2011]). Un-

der this competing hypothesis, diversified firms may have already allocated

capital efficiently in their internal markets (as predicted by Maksimovic

and Phillips’s [2002] conglomerate model), and the adoption of SFAS 131

may not necessarily result in an improvement in internal capital market

efficiency.

To examine the effect of SFAS 131 on internal capital market efficiency,

I construct a measure of the efficiency with which firms actively allocate

capital from low- to high-opportunity segments. The construction of this

measure involves two steps. First, I calculate the extent to which capital

allocation deviates from a hypothetical level of passive allocation, thereby

capturing the degree of active capital allocation. I regard capital allocation

as passive if it is determined proportionately using a benchmark such as

segment sales. Second, for each segment, I regard a positive (negative) de-

viation from passive capital allocation as efficient if the segment has higher

(lower) opportunities relative to its sibling segments in the same firm.3

To isolate the effect of changes in segment disclosuretransparency, I take

a difference-in-differences approach with firm-fixed effects. The treatment

firms (labeled change firms) are a group of diversified firms that improved

their segment disclosure transparency by changing their segment defini-

tions upon adopting SFAS 131, and the control firms (labeled no-change

firms) are those that did not. Although SFAS 131 adoption was mandatory,

3Segment opportunities are proxied for by the qs of industries in which the segments

operate.