08 July 2013

EFRAG/National Standard-Setters publish two Bulletins in relation to the revision of the IFRS Conceptual Framework

The two new Bulletins are: The role of the business model in financial reporting and The role of a Conceptual Framework.

The role of the business model in financial reporting

This Bulletin presents their assumed meaning of the term ‘business model’, which is, at the moment, an undefined term in the IFRS literature. The document also provides a conceptual discussion as to whether financial statements based on the business model meet the qualitative characteristics in the IASB Conceptual Framework. Their tentative view is that this is the case. The following section discusses the distinction between the business model and management intent, presenting their view that a valid distinction exists. The Bulletin concludes by considering the implications of the business model for financial reporting under IFRS.

The following example puts the discussion in a practical context.

Suppose an entity purchases a quantity of cotton for CU100. It still owns the cotton at the reporting date, when it is worth CU120 (and the entity could readily sell it at that price). If the entity is a shirt manufacturer and will use the cotton in its operations, current practice would be simply to report the cotton as ‘inventory’ at its cost of CU100. But if the entity is a commodity trader that seeks to make profit from short-term price movements, that accounting may not reflect fairly the entity’s financial position or financial performance: current practice reflects this view by stating the asset at its current selling price of CU120, with the gain of CU20 included in profit. However there might be other ways in which the business model might impact the financial statement: if the transaction is a non-recurring speculation that is outside the normal activities of the entity, it would probably have to be separately presented, whatever the accounting treatment. Thus the nature of an entity’s business may affect the measurement of assets, the reporting of profit and presentation.

Whilst there is no universal defined meaning of the term ‘business model’, academic literature evidences that the term is increasingly referred to in corporate reporting to describe an entity’s activities, its asset configuration (for example, capital intensive or heavy reliance on R&D), and its customers, products and services.

The literature also shows that there is no universal view on the relationship and distinction between business purpose, strategy, management actions, management intent, and similar notions.

It could be difficult to arrive at a universally acceptable definition of the term that could be consistently applied by those who prepare financial information and adequately understood by those that use financial information. For example, there is no agreement as to whether there are two business models such as a trading and a holding model, or if there are more business models that reflect how each entity tries to differentiate itself from its competitors.

For the purpose of this Bulletin, they have adopted an assumed meaning of the term for financial reporting purposes. Financial reporting is meant to provide the basis for assessing the financial position and performance of an entity. It assesses and understands how the entity is ‘making money’, how it provides capital providers with appropriate returns on the resources invested in the entity, and how it is exposed to risks and organised to mitigate those risks.

Their assumed meaning of the term ‘business model’ focuses on the value creation process of an entity, i.e. how the entity generates cash flows. In case of non-financial institutions, it represents the end-to-end value creation process or processes of an entity within the business and geographical markets it operates.

The role of a Conceptual Framework

In this Bulletin they focus on the rational for a Conceptual Framework for IFRS (the ‘Framework’), rather than discussing the specific accounting concepts and definitions that arise within the Framework. They discuss the following issues that should be considered in the context of the ongoing IASB project:

(i) The purpose of the Framework for the IASB;

(ii) The completeness of the Framework for setting requirements;

(iii) The role of the Framework for preparers;

(iv) The decision-making process derived from the Framework; and

(v) The consequences of a revised Framework for existing IFRS.

Those who take the view that the IASB should not invariably follow the Framework also advocate that:

(i) The Framework should be aspirational (i.e. the Framework should aim to improve financial reporting); and

(ii) Whilst the IASB should consider the Framework in the development of accounting standards, it should also consider economic expediencies not addressed in the Framework - such as the desire to avoid revolutionary change - and it may validly conclude that these outweigh conformity with the Framework.

It would be consistent with this view to insist that all IFRS should clearly explain how they relate to the Framework, and especially whether a departure is made on pragmatic grounds or shows a defect in the Framework that the IASB does not wish to address before issuing the IFRS.

Press release

The role of the business model

The role of a Conceptual Framework

© EFRAG - European Financial Reporting Advisory Group