26 May 2014

EBF comments EFRAG’s Research Paper: The business model in financial statements

EBF published its comments on EFRAG’s Research Paper: The role of the business model in financial statements. Using a business model is an effective way for entities to present financial information to investors in a way that is appropriate to that entity’s operating environment.

The business model approach has always played an important role in standard setting (e.g. revenue recognition for recognising income and in classification; IAS 2 or IAS 16 contra IAS 40). However, lately it has been explicitly mentioned in standard setting e.g. by the new classification and measurement provisions of IFRS 9 ‘Financial Instruments’, and the concept of Integrated Reporting.

However, given the wide range of aspects of value creation the business model affects, a common understanding of the concept of business model is needed. Therefore it is appropriate that this concept is also addressed by the Conceptual Framework.

As banking entities typically have different characteristics as to other commercial or industrial entities, the EBF would like to emphasise the relevance of the consideration of the business model for entities in the financial sector. Essentially, this is inherent in the relationship between assets and liabilities and how these are managed to create value.

It is EBF´s view that the consideration of the business model approach is necessary to present financial information in the most relevant context, and should be given a prominent place, both in the Conceptual Framework, and on an standard-by-standard basis where appropriate.

The EBF welcomed the introduction of the term “business model” and the use of this concept in IFRS 9 as, in EBF´s opinion, the “business model” should, in most cases, be the real driver for the classification and measurement of a financial instrument. Only through consistency between the management of a financial instrument and its measurement criteria, can the financial statements provide an adequate representation of an entity’s financial performance and position.

In circumstances where financial instruments are managed on fair value basis this information alone is sufficient for management to explain the business model and performance of the entity and for users to fully understand the future expected cash flows. Fair value reflects both the business model and the expected future cash flows for financial instruments that are actively traded in liquid markets.

If the instrument is held for use in the business to generate cash flows and there is no current or future intention to sell significant amounts, the aim is to achieve a stable income flow earned on an ongoing basis over a certain period. In this case, material profit from short-term market movements will not arise. The assets are expected to be held until maturity and this means that the future cash flows are readily identifiable. Holding a financial instrument to maturity is similar to holding inventory, where it is considered inappropriate to recognise any increase in market value until the item is sold and the revenue is earned (although it is appropriate to recognise impairment).

Some other financial instruments are not managed on a short-term taking profit basis and may not be held until maturity. They are held with the objective of medium or long term holding horizon detention in order to maximise the return of the collection of principal and interests or the appreciation of capital. An appropriate measurement should be considered in the balance sheet and profit and loss statement consistently with their characteristics and their holding purpose.

In the view of EBF, sales cannot be the sole driver of the business model assessment. Retaining the sale criterion as the only criteria to determine the measurement would imply that loans held by bank B would be measured at fair value. Fair value measurement could in this case lead to misleading information for users, introducing volatility where not appropriate. Asymmetry between the accounting treatment and the way loans are managed should be avoided.

Information about the sales should be considered in conjunction with other information when assessing the way financial assets are managed such as how revenue is generated, how risk is managed, historical sale information, reasons of the sales including regulatory requirements, conditions of the sales, and expectations about future sales activities. This can be demonstrated by the objective of banks to achieve a stable interest margin, for example. A certain interest margin is often constantly maintained using so-called replicating portfolios. In this case, and with a view to refinancing with matching maturities, the liability structure is reflected by securities on the asset side (according to the repayment periods). Changes in liability structure, for instance due to withdrawals of customer deposits, have then to be carried out on the asset side in order to maintain the structure resulting in regular sales. While this does not change the original objective of generating contractual cash flows, in order to keep the interest margin constant, adjustments are necessary in the form of sales. The bank's intention with the portfolio is still to collect the contractual cash flows rather than to achieve short-term profits.

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