Using the business model of a company to help analyse its performance
Understanding the business model of an entity is helpful in analysing and communicating the essence of a business and for predicting the implications of a change in circumstance on a business. Strategic Business Reporting (SBR) candidates should use this technique to improve their answers to SBR questions and this article should help them to do this.
The business model in the context of Integrated Reporting is a company’s system of ‘transforming inputs, through its business activities, into outputs and outcomes that aim to fulfil the organization’s strategic purposes and create value over the short, medium and long term’. The definition may seem quite theoretical but there are a number of entities who use this definition to disclose the resources (also known as capital) that the organisation draws on as inputs to its business activities, and how these are converted to outputs (products, services, by-products, and waste), which then have a further impact on the various capitals and stakeholders. The business model describes the entity’s activities, asset configuration, and the way in which the business adds value including the generation of its cash flows and its customers, products and services. The aim is to provide users with insight on the ability of the business to adapt to changes, for example, in the availability, quality, and affordability of inputs, and how these changes can affect the organisation’s longer-term viability.
Business model information can be fundamental to investor analysis. It provides context and understanding to the other information in the annual report. The provision of business model information can demonstrate an entity’s understanding of its business and key drivers which can create investor trust and reduce risk. Additionally, investors need to understand the business, how the business has performed, and how this performance has been affected by various factors. There is an argument that the information regarding the business model should be presented outside the financial statements, such as in the management commentary. Investors will need to know how the business model is responding to market trends and how the strategy supports the key components of the business model. They will wish to know how management considers the risks and opportunities across the business model and how money is made and value generated and re-distributed. Investors will look at the Key Performance Indicators (KPIs) and how they reflect the key components of the business model. Having the business model play a role in financial reporting presumes that investors have a good understanding of it prior to assessing the entity’s financial position and performance.
There has been discussion as to whether the business model should be considered in standard setting and in particular whether the term should be defined in the Conceptual Framework for Financial Reporting (the Conceptual Framework). The International Accounting Standards Board (the Board) has decided not to define the business model in the Conceptual Framework even though there was reference to the business model in an early Exposure Draft. However, the term has been implicit in International Financial Reporting Standards (IFRS®) for a while. For example, International Accounting Standard (IAS®) 2 Inventories generally requires inventories to be measured at the lower of cost and net realisable value. However, IAS 2 includes an exception that allows commodity traders to measure their inventories at fair value less cost of sale with changes in fair value less cost to sell recognised in profit or loss. The justification for this different treatment is that the inventory of commodity traders is principally acquired with the purpose of selling in the near future and generating a profit from the fluctuation in prices.
IFRS 9 requires classification and measurement of financial assets based on an entity’s business model. Although IFRS 9 does not contain a definition of the term ‘business model’, it does include some implicit assumptions about its meaning. IFRS 9 views the business as based upon how the entity’s assets and liabilities are managed.
It states that an entity should classify financial assets as subsequently measured at either amortised cost or fair value on the basis of both:
(a) The entity’s business model for managing the financial assets and
(b) The contractual cash flow characteristics of the financial asset.
To qualify for an amortised cost classification, the financial asset must be held to collect contractual cash flows rather than be held with a view to selling the asset to realise a profit or loss. For example, trade receivables held by a manufacturing entity are likely to fall within the 'hold to collect' business model if the trade receivables do not contain a significant financing component in accordance with IFRS 15 Revenue from Contracts with Customers.
A debt instrument is classified as subsequently measured at fair value through other comprehensive income (FVOCI) under IFRS 9 if it meets the 'hold to collect' and the 'sell' business model test. The asset is held within a business model whose objective is achieved by both holding the financial asset in order to collect contractual cash flows and selling the financial asset. This business model typically involves greater frequency and volume of sales than the hold to collect business model. Integral to this business model is an intention to sell the instrument before the investment matures.
Fair value through profit or loss (FVTPL) is the residual category in IFRS 9. If the business model is to hold the financial asset for trading, then it is classified and measured at FVTPL. Some stakeholders have suggested that the requirements for equity investments in IFRS 9 could discourage long-term investment. Their view is that the default requirement to measure those investments at fair value with value changes recognised in profit or loss may not reflect the business model of long-term investors.
The term ‘business model’ has also been used in other standards. IFRS 8 Operating Segments defines an operating segment as a ‘component of an entity that engages in business activities from which it can earn revenue and incur expenses’. An entity with more than one business model is likely to also have different segments. If an entity has a business model, it would have internal reporting information which measure the performance of the business model which may in fact be the business segments.
IAS 40 Investment property distinguishes a property that is held by entities for investment purposes from the one that is intended to be occupied by the owner. An investment property differs from an owner-occupied property because the investment property generates cash flows largely independently of the other assets. IAS 40 sets out the two main uses of property (owner occupied and investment) which implicitly correspond to different business models. An owner-occupied property should be measured at depreciated cost less any impairment loss, which is an appropriate way of reflecting the use of the property. Whereas, investment property is measured at either fair value with fair value changes recognised in the statement of profit or loss, or on the same cost basis as for an owner-occupied property. These different accounting treatments reflect the different uses of these assets.
If the business model continues to play a significant role in standard-setting, it could give insight into how the entity’s business activities are managed and help users assess the resources and liabilities of the entity. Alternatively, it can be argued that this approach may reduce comparability as it could result in different classification, measurement or disclosure of the same transaction. This may introduce bias in the way the financial statements of an entity are reported, and therefore make comparisons between entities difficult. It could encourage less neutral reporting as preparers may present the most favourable outcome which creates a conflict with faithful representation. This approach can make financial statements of entities with similar business models and in the same industry, more comparable. Thus, the difficulties with the definition of the business model and its consistent application should not constitute a reason for excluding it because it has relevance in terms of the financial decision-making needs of the users of the accounting information. It has always been the case that different businesses will account for the same asset in different ways depending on what its role is within the firm’s business model. A change in the entity’s business model is a significant event, because it implies a change in how assets and liabilities are used in the cash flow generation process, that is when and how gains and losses are recognised
So, although the ‘business model’ concept first appeared in IFRS 9, there had been an implicit use of the concept in IFRS for a long time. The business model is not discussed in the latest Conceptual Framework and, as a result, it may be argued that there is no consistency of its use in IFRS. The United Kingdom’s decision to leave the European Union highlights the unpredictability and disruptive nature of the business environment. However, it also illustrates the need for business models to be resilient and flexible to what is happening inside and outside an organisation and to help stakeholders better understand how a company will adapt to significant change. SBR candidates should be aware of these issues and be able to provide examples of these inconsistencies in an exam context.
Written by a member of the Strategic Business Reporting examining team