16 September 2013

EBF comment letter on the EFRAG Bulletin, 'The Role of the Business Model in Financial Reporting'

Financial statements should provide information about the financial position of the entity and the effects of its transactions and other events, so that users can evaluate the prospects for future net cash inflows, and also how management are discharging their responsibilities for the entity’s resources.

A properly articulated business model will be helpful in communicating management’s understanding of the business to the market. The business model should describe how the entity creates, delivers and captures value, reflecting how the business is managed. For financial services firms the business model will include a broader consideration of the relationship between assets and liabilities, and how these are used to create value. The purpose of this paper is to explore this concept and to articulate the EBF’s view of the use of the business model as a basis for accounting.

The concept of a business model and relevance to banks

The fundamental qualitative characteristics in the 2010 Conceptual Framework are relevance and faithful representation and these are enhanced by their relationship to the business model concept. Recognising the business model in standard setting is that it creates financial information that is measured on a basis that is more relevant to how the entity operates in its economic environment and provides a more faithful representation of an entity’s financial position and performance.

The business model approach recognises that there are different ways in which a combination of asset and liabilities can be used to create value for shareholders. Since the business model sets out how value is created and delivered to customers, understanding how financial assets and financial liabilities will be used, whether individually or managed together to create and deliver value is critical. Recognising the business model in financial reporting means that an entity’s financial statements contain information that reflects the entity’s specific circumstances and is more likely to be useful in predicting future cash flows. For example, entering into a contract to receive a commodity creates different expectations of future cash flows for a commodities trader than for an energy provider. Another example would be when an entity holds a property, and the value to the entity would be different depending on whether an entity intended to use the property in its business or to obtain rental income or capital gains.

Clearly if different measurement bases are used by different entities then there could be a reduction in comparability, however there is a difference between comparability and uniformity. If two entities have different business models, then differences can be expected to arise in their future cash flows and reflecting this in the financial reporting should be more useful for investors than a single approach which would be less reflective of these differences.

The business model approach is already utilised in IFRS 9 ‘Financial Instruments’ which takes account of the fact that banks use different portfolios for different purposes. Where a portfolio of instruments is held for trading, then fair value provides the most useful information for investors. Where a portfolio will be held to collect cash flows, fair value is less relevant and amortised cost is more representative of the value to an entity (the usefulness of fair value is explored further in the next section). In addition to having strategies for using financial instruments in the business, banking institutions have different strategies for mitigating risks. Financial instruments are complex instruments containing different risks which are often managed in different ways. It is crucial to provide transparency of the results of risk mitigation strategies in the financial statements. While some risk mitigation techniques are focused on reducing volatility in the fair values reflected on the balance sheet, other techniques are focused on ensuring stability of cash flows and income. Hedge accounting is another example of where different measurement rules are permitted in certain circumstances, because this better represents an entity’s risk management objectives in the financial reporting.

In summary, using a business model is a way for entities to present financial information to investors in a way that is appropriate to that entity’s operating environment, and is an approach already used in several IFRSs, most notably in IFRS 9.

Full response

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