Contemporary issues in narrative reporting for financial reports – the business model

by Carol A Adams

There are some interesting contemporary debates in narrative or non-financial reporting.  As ICAS notes  that the term non-financial reporting refers to information which is included in those parts of corporate reports outside the financial statements. But much of that information does in fact have the potential to have a financial impact and may be critical to understanding financial information.

The UK’s Financial Reporting Council categorized narrative reporting that it felt was done well (financial review, performance and position; Financial KPIs; strategy) and not so well (principal risks, trends and factors, contractual and other arrangements, non-financial KPIs). The European Financial Reporting Advisory Group (EFRAG) argues that the notes to the financial statements are too complex and increasingly less understandable.  So clearly there are some issues.

This article considers reporting on business models and its relevance to financial information.

Reporting on business models

In its report on The role of business models in financial statements, The European Financial Reporting Advisory Group argues that the business model should play a role in financial reporting [1] and be considered in the IASB’s Conceptual Framework, noting that their views are shared by financial reporting standard setting bodies in France, Germany, Italy and the UK.

EFRAG argues that an understanding of the business model is essential to follow the fundamental principles of IASB’s Conceptual Framework, relevance and faithful presentation and that its absence reduces the comparability and understandability of financial information.  An understanding of the business model, they argue, is necessary to: determine future cash flows from long term assets; produce accounts which reflect economic reality; and, inform about changes in the business model and hence changes in how assets and liabilities are used. The EFRAG report argues that the business model is ignored by IAS 16 Property, Plant and Equipment where the chosen deprecation policy is applied to a whole class of assets regardless of how they are used.

EFRAG went through a similar exercise to Gould et al when writing the Business Model Background Paper for <IR> to examine what the term meant. Whilst EFRAG uses the term “value creation” which is central to the <IR> Framework, the focus of their discussion of the business model is much more about the process of driving profitability and generating revenue, than is the broader definition used by the IIRC:

 An organization’s business model is its system of transforming inputs, through its business activities, into outputs and outcomes that aims to fulfil the organization’s strategic purposes and create value over the short, medium and long term. (p 33)

where value creation reflects changes in multiple capitals (not just financial capital):

The process that results in increases, decreases or transformations of the capitals caused by the organization’s business activities and outputs. (p33)

The UK’s Financial Reporting Council have similarly defined the business model in narrow terms as:

 what the company does, how it does it, and how it creates economic value now (page 6, emphasis in original)

The IIRC’s broader definition is reflective of the increased importance of narrative reporting, driven by a need for non-financial information to assess an organisation’s ability to create value in the future. This definition, and the thinking behind it about the substance of how an organization does business and creates value, deserves consideration as a basis for a “new financial reporting” as well as non-financial reporting. The focus for “new financial reporting” would be on cash flow generation and profitability but with the understanding that transformations of other forms of capital could drive cash flow generation and profitability, particularly in the medium and longer term.

Definitions of the business model as focusing solely on cash generation or short term economic value fail to: 1) address the focus of significant investors (such as pension funds) on long term returns; and, 2) recognize the importance of non-financial capitals in generating financial capital.

A way forward…

Rather than starting with a narrow definition of the business model, financial reporting standard setters could start with a broader definition of the business model, such as that of the IIRC, and identify what part of that is important in understanding financial statements.

[1] This was also the topic of a report published by the Institute of Chartered Accountants of England and Wales.

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Comments

  1. Reflecting on Carol’s views, which are well described, points to the lack of use of context and carrying capacity. A business model without proper context is does not provide an adequate framing of the assumptions or expected outcomes. Not including a clear reference to the business impacts in relation to the carrying capacity of the business’s jurisdictions masks any means of relating the impacts and outcomes to any form of comparability. In essence, greenwashing. A means to move forward is the focus of Reporting 3.0 and related Blueprints. See http://reporting3.org/ and the Blueprints launched at the recent meeting in Amsterdam.

    • Nicely articulated Glenn. Reporting 3.0 (and I’m one of the authors of the accounting blueprint), UNCTAD ISAR, the CDSB, the IIRC and others are all actively engaged in finding a way forward. The imperative of Agenda 2030 is providing an impetus. Reason to be optimistic.

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