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Describing the business model can help reveal the story behind the numbers, but let’s just make sure that the story isn’t used to obscure the numbers, says Jane Fuller

In this era of angst about the form and purpose of company accounts, one of the more down-to-earth concepts is that of the business model.

We all think we understand this. It is the story behind the numbers. The starting point is a snapshot of the company. Is it in manufacturing, service or finance? Domestic or international? Mature and stable or immature and growing fast? And so on.

Definitions of business model have cropped up in a couple of important papers this year. The draft international integrated reporting framework offers the ‘chosen system of inputs, business activities, outputs and outcomes that aims to create value over the short, medium and long term’. EFRAG, the European advisory group on financial reporting, focuses on ‘the value creation process of an entity, ie how the entity generates cashflows’ (see the June 2013 bulletin in the Getting a Better Framework series and the Financial Reporting Council’s headline projects).

The International Accounting Standards Board (IASB) has increasingly been swayed by business model arguments. In its discussion paper on the conceptual framework, it proposes to make it explicit that it will ‘consider how an entity conducts its business activities’.

So should we all applaud an outbreak of common sense? Not so fast. Describing what goes on in the business world is not the same as setting a standard to deliver consistent, comparable and neutral information.

The first caveat is that the model is closely associated with presenting a company’s performance ‘through the eyes of management’. In the review of IFRS 8 on segment reporting, which gives considerable leeway to managements, the IASB found that preparers were happy, but by no means all users were. The latter pointed to inadequate breakdowns of activities and the latitude to obscure company structure and cross-subsidies, or losses.

Many users of accounts reckon that there is quite enough management spin in the front half of the accounts, in the narrative reporting section, and that the financial statements provide a reality check. The place for sector-based performance indicators, non-GAAP numbers and non-financial reporting – all potentially useful information – is in management commentary, not the statutory accounts.

The second drawback is in the use of the business model argument to create unsatisfactory compromises in proposed standards. In IFRS 9 on hold-to-collect loans and in the latest leasing exposure draft, new categories reflect business models. But they also compromise the underlying logic, create opportunities for companies to manipulate the P&L and undo attempts to simplify the standards. For ‘business model’ read ‘business pushback’.

To be fair, as EFRAG points out, business models tend to focus on the larger picture, are relatively stable and not difficult to verify. This makes them a better basis for standards-setting than management intent, which may bend with the wind. It is also clear that the business model is highly relevant to users and encourages entity-specific reporting as an antidote to boilerplate tracts. And I am less hung up on spreadsheet-friendly comparability than other analysts.

I would also argue that when financial statement presentation is finally revisited an important definition will be that of operating profit, which is essentially a business model issue.

The fine line to tread is between providing neutral information that lets management and investors compose a story about the company and allowing the story to drive the numbers. The latter needs to be resisted.

Jane Fuller is former financial editor of the Financial Times and co-director of the Centre for the Study of Financial Innovation think-tank

Last updated: 10 Oct 2013