*Represents results of Collegiate Text Publishing division which was acquired on a pooling-of-interests basis during the current year. Growth calculated on the basis of this year's results and the previous three-year period before acquisition. **Common to camping equipment and fishing equipment only.

Financial statements generally report not only current year's results, but prior year's results as well. We believe that the inclusion of comparative prior year's figures in segmented earnings statements would aid the investor. It should also be emphasized that the proposed segmented earnings statement should be viewed as an essential supplement to the consolidated or aggregated income statement and not as a substitute for it.

Disclosure of other income statement data

Primary emphasis has been placed throughout this discussion upon the reporting of earnings contributions. Other conventional income statement data are also likely to be required by investors. For example, the most important income statement data about a corporation, other than its earnings contributions, are the sales that arise from the firm's basic activities. These figures are important for they reveal how successful the firm has been in penetrating various markets. Moreover, when the sales figures are read in combination with the earnings figures, they show how efficiently the firm used its resources in meeting sales commitments. The format of these sales reports, like that of earnings, should also be by industry and growth rate.

It is doubtful whether any other figures than sales and earnings

contributions are particularly useful to investors. This is not to say that other interested readers of a firm's financial statement, such as regulatory bodies and bankers may not require additional breakdowns of common expenses. For example, these readers may want specific data on lease expenses, interest expenses, and general administrative expenses. The models most investors use at this time, however, are probably not sufficiently rich in detail to indicate what the functional relationship is between, say, leasehold expenses, interest expenses and security prices. As a consequence, the reporting of these data on a segmented basis would be of limited value. It should be pointed out, nevertheless, that such expense accounts are likely to be reported on an aggregated basis in the company's consolidated income statement.

IN

Chapter 4

Further Considerations in Disclosure of
Segmented Earnings

N CHAPTER III, we addressed ourselves to the question of how a diversified company should partition or segment itself for purposes of reporting earnings to investors. More specifically, we attempted to provide broad guidelines for developing reports on "basic activities." The results of the operations for these activities serve as cell entries in the "Segmented Earnings Matrix." In order to aid the investor's basis for prediction, only traceable revenues and expenses were used in calculating the earnings contribution of a given "basic activity." There still remain several questions that require consideration in the development of relevant earnings measurements. Among these are:

• Should earnings contributions for "basic activities" be stated in absolute dollars or on a per-share basis?

• Should Federal income taxes be allocated to "basic activities"? • Should earnings contributions be stated before or after extraordinary items?

1. Earnings contributions on an absolute dollar versus a per-share basis.

If the number of shares outstanding remains constant over the period under consideration, it makes no difference whether earnings contributions are measured on a per-share or absolute basis. To illustrate, consider the case of a company showing the following results for the past

two years:

Suppose, however, that the number of shares does not remain con

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The change from the earlier illustration lies in the increase in the number of shares outstanding in the second year. This change results in 122% and 7% growth rates for absolute earnings and earnings per share, respectively.

To calculate a higher valuation based upon a 12% growth in absolute earnings necessarily assumes that this growth can be sustained without further capital contributions from residual equity-holders. However, if future earnings growth will entail an increase in the number of shares, then growth calculated on a per share basis is more pertinent to the investor.

When a corporation's total earnings grow rapidly, almost invariably a change in capitalization of the firm occurs. If the earnings increase arises from a merger, the change in capitalization is often immediate. If the change in earnings arises from internal growth, it may well be accompanied by the sale of additional shares, a stock dividend, or a stock split. In either event, the per share earnings are more relevant to investors than the absolute level of earnings.

It does not follow from these remarks, however, that the earnings contribution of the firm's basic activities should be reported on a per share basis. Rather, quite the reverse is true. The earnings of a basic activity should be reported on an absolute basis. To illustrate the type of problem that could arise if a per share basis of reporting were adopted for basic activities, consider the following example. The hypothetical company in question has a relatively large number of "basic activities” spread over several industry classifications. The results of two "basic activities" have been isolated for detailed analysis.

*Total-firm shares outstanding for each year 100 and 120, respectively.

Suppose that the proceeds from the sale of the twenty shares in Year 2 were used exclusively to finance expansion within "basic activity #2." If this were the case, the reporting of the earnings contribution per share for "basic activity #1" in the zero growth column of the "Segmented Earnings Matrix" would be clearly misleading. The fact that "basic activity #l's" year-to-year growth was 20% without benefit of any cash transfers from corporate headquarters would not be reported to the investor unless the absolute earnings contribution basis were used.

The foregoing illustration shows graphically the two sources of change in a firm's earnings per share-changes in absolute earnings contribution of the various segments of the firm and changes in the firm's number of shares outstanding. The basic shortcoming in calculating earnings contribution per share for "basic activities" is that the calculation implicity assumes that each "basic activity" is equally responsible for any change in the number of shares outstanding for the compny as a whole. This is not a tenable position. A more reasonable approach suggests that changes in the company's capitalization structure result from joint effects of the total portfolio of "basic activities" and are not traceable to individual basic activities.

In light of the foregoing, we propose that companies report absolute earnings contribution for each "basic activity." Such information, along with information from sources external to the company, will provide the investor with a basis that may be more useful for forecasting changes in the level of earnings from the company's various operations.1 The investor interested in forecasting a company's earnings per share must assess the company's probable financing plans as well as its expected operating plans. In Chapter V it will be shown that a segmented source and application statement, when used in conjunction with a segmented earnings statement and other relevant data external to the firm, can provide valuable insights into the probable direction of a company's financing and operating plans alike.

2. Before or after taxes?

Should the earnings contributions for "basic activities" be reported on a before or after-tax basis? Our recommended approach for the treatment of taxes is based on the same criterion established for any 1 Ideally, it may be argued that if variable and fixed expenses traceable to a "basic activity" were separately reported, the investor would be in a better position to forecast. While we recognize that disclosure by cost behavior characteristics may well be useful to the investor, such a proposal should be applicable to all reporting companies and not solely to diversified companies, i.e., those companies with more than one “basic activity."