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Should business model play role in financial reporting?

Whether or not the business model should play a role in financial reporting has been a controversial topic for some time, with many commentators arguing that referring to the business model would enhance relevance, while others oppose the idea claiming that it introduces bias that would be detrimental to transparency and comparability of financial reporting.

The European Financial Reporting Advisory Group (EFRAG), the French Autorité des Normes Comptables (ANC) and the UK Financial Reporting Council (FRC) have been proactively researching this topic and recently published a research paper on the subject.

For the time being the term ‘business model’ is an undefined term in International Financial Reporting Standards (IFRS) literature. However, the researchers have adopted an assumed meaning of the term for financial reporting purposes that focuses on the entity’s value-creation process: that is, how the entity generates cash flows. In the case of non-financial institutions, it represents the entity’s end-to-end value-creation processes within the business and geographical markets in which it operates.

To assess whether the business model could, or even should, play a role in financial reporting, the researchers looked at whether this role enhances the response to the fundamental qualitative characteristics of useful financial inform-ation – relevance and faithful representation – as well as the enhancing qualitative characteristics – comparability and understandability – in the International Accounting Standards Board Conceptual Framework.

According to the Conceptual Framework, financial information is relevant if it is capable of making a difference to those who use the financial information in making decisions. Having the business model play a role in financial reporting would presume that investors have an understanding of the business model before assessing an entity’s financial position and performance. Academic research shows that this is indeed the case in practice, in particular for long-term investors.

The need to understand an entity’s business model is further increased by development of integrated reporting, where one of the elements is disclosure about the business model. Some argue that ignoring the business model in financial reporting would reflect changes in value that are irrelevant to the financial position and performance of the entity. Some others note that 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. Therefore, it is necessary to inform users of this change and the impact on future cash flows.

Some argue that it is difficult to imagine how a dialogue between investors and management on the financial statements could be fruitful, if it did not have a primary focus on the results of the business world

Faithful representation dictates that financial information must faithfully represent the pheno-mena that it purports to represent. Those who oppose the view that the information presented in financial statements needs to reflect and respond to the business model consider that this brings bias in financial reporting and is therefore undermining neutrality in financial statements. In other words, it creates a conflict with faithful representation.

Those who promote the relevance of the business model notion believe that reflecting financial information on a basis that is not aligned with the entity’s business model is failing to be faithfully representative because they strongly believe that financial information should be prepared from the perspective of the entity.

Comparability enables users to identify and understand similarities in, and differences between, items. Those who oppose the business model and the use of entity-specific information believe that this introduces bias in the way the financial position and performance of an entity are reported, and therefore make comparisons between entities difficult. Supporters of the business model hold the view that such an approach to comparability is more akin to calling for uniformity, rather than comparability. Ignoring the effects of the business model is, in their view, misleading to users as it makes investors expect that future economic benefits will arise or be sacrificed as they are reflected in the primary financial statements, although there is observable evidence that the pattern of economic benefits will behave quite differently.

Understandability deals with the clear and concise classification, characterisation and presentation of information on economic phenomena. Some argue that it is difficult to imagine how a dialogue between investors and management on the financial statements could be fruitful, if it did not have a primary focus on the results of the business model. While agreeing with the need for users to know the business model, others argue that this does not automatically mean that this notion should play a role in the financial statements themselves.

To conclude, in the researchers’ view, the business model should play a role in financial reporting, including the financial statements. Not doing so results in less relevant inform-ation, does not lead to a faithful representation of economic reality, harms comparability, and makes the financial statements less understandable. For this reason they believe that the business model notion should be incorporated in the IASB literature.

The researchers support the development of a proper rationale as part of the Conceptual Framework, with appropriate guidance for standard-setting purposes rather than the business model being referred to in financial reporting requirements only on an ad hoc basis.

Mark Abela is the technical director at the Malta Institute of Accountants.

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