What an entity’s business model is (Agenda Paper 15A)

In the October meeting, staff presented their research relating to and identified three questions for the Board to consider when developing guidance relating to an entity’s business model in the revised Practice Statement.

Those were:

• What an entity’s business model is.
• What the objective of describing business model in management commentary is.
• Which types of information about business model should be discussed in management commentary.

This paper discussed the first of these three questions (the other two will be discussed in future meetings). The staff also provided clarifications regarding terminology used and illustrative drafting for the explanation of an entity’s business model.

Staff recommendations and questions for the Board

1. That the revised Practice Statement explain the meaning of an entity’s business model by reference to:
   • a) value creation for the entity itself—and that the explanation clarifies that the notion of value created for the entity is related to the entity’s ability to generate cash flows and can be affected by value created or destroyed by the entity for those parties with which the entity has relationships that the entity depends on for its future success;
   • b) the entity’s purpose that the entity’s business model seeks to achieve;
   • c) the elements of a business set out in IFRS 3—inputs, processes and outputs; and
   • d) business model being a matter of fact and observable through the entity’s actions.
2. In addition, the staff recommend that the revised Practice Statement requires management to discuss the impacts of the operation of the entity’s business model if those impacts could affect the entity’s ability to generate cash flows in the future.

Discussion and voting

The staff introduced the papers and each of their recommendations before asking the Board to comment and vote thereon.

Recommendation 1 (a):

There was general support for the sentiment and direction of the staff’s recommendation. However, there were many requests for simplified language and a clarity regarding ‘which’ cash flows and their link to value creation. It is important for the staff to consider sustainable, longer-term cash flows and not just short-term cash flows and an entity’s competitive advantage (if relevant) when considering value creation. A number of other issues and concerns were raised for consideration by staff including: cost of capital’s effect on cash flows, the idea that cash flows always lead to value creation, the definition of value creation and the effect of relationships on value creation. Staff said that a number of these items will be clarified and discussed in future papers to be brought to the Board.

It was decided that the Board would vote on the ‘general idea’ of the staff’s recommendation (the idea of a link between ‘cash flows’ and ‘value creation’) but knowing that this would be redrafted and explained. There were 13:1 votes in favour of this.

Recommendation 1(b):

The comments raised, questions posed to staff and related discussions led to general agreement regarding what the relationship, for the purpose of this project, should be between a company’s purpose or mission and its business model. The discussion highlighted that there were differing views on the definition and importance of an entity’s purpose in relation to its business model.

The Board voted on the staff’s recommendation on condition that this topic (and related discussion points) was fed back to the Consultative Group at its December meeting and that the recommendation was reworded. Effectively, the information in management commentary should attempt to explain how the entity’s business model seeks to achieve its stated purpose (if this is stated). In other words, it would be useful to explain an entity’s business model in the context of its purpose (if this is stated).

On this basis, there were 12:2 votes in favour.

Recommendation 1 (c) and recommendation 2:

These two recommendations were discussed together. Concerns were raised regarding the words used—some Board members felt that referencing to IFRS 3 would result in preparers using the words as defined. These ‘narrow’ definitions may result in the omission of important information. It was suggested that removing the reference to IFRS 3 in the recommendation would allow for the terms (and broader understanding thereof) to be retained.

When asked to vote, 13:1 votes were received in favour of recommendation 2, as drafted and 6:8 votes were received in favour of recommendation 1 (c), as drafted.

Recommendation 1 (c) was voted on again. With the reference to IFRS 3 removed, this recommendation received 12:2 votes in favour.

Recommendation 1(d):

The idea of a business model ‘being a matter of fact’ and observable through an entity’s actions was discussed over the course of the other discussions.

When asked to vote, all Board members voted in favour of the staff’s recommendation.

Terminology clarifications

In addition to providing their recommendations and reasoning, staff also provide clarifications relating to the terms they used in their recommendations.

• Staff noted that the term ‘business model’ does not exist in the existing Practice Statement. Different terms, including ‘business’, business activities’ and ‘business model’ are in a number of existing Standards and seek to describe the same thing (i.e. what an entity does and how it does it).
• The term ‘cash flows’ would be simpler for users to understand rather than the more commonly used term (in existing Standards) ‘net cash flows’. ‘Cash flows’ can be positive or negative, whereas ‘net cash flows’ being the difference between inflows and outflows is more technical and rarely used in management commentary.
• ‘Elements’ and ‘components’ are both used to discuss parts of a business model. The staff recommend using ‘elements’ to be consistent with IFRS 3. ‘Processes’ has been used for similar reasoning.
• Despite other frameworks referring to the notion of ‘outcomes’, staff have used ‘impacts’ given that it is being used consistently with the generally accepted meaning of the word.

Illustrative drafting

Staff, to illustrate how their recommendations can be implemented in the revised Practice Statement, provided the following draft explanation of business model (this will be supported by further guidance which is to be discussed in the future) — no voting on this illustrative drafting was required at this stage:

A business model of an entity is an integrated set of processes that:

• a) involves obtaining inputs, transforming inputs into outputs and generating cash flows for the entity by distributing those outputs to customers or in other ways; and
• b) seeks to create value for the entity in pursuit of its purpose. An entity creates or maintains value by enhancing or maintaining its ability to generate cash flows. An entity’s ability to generate cash flows can be affected by value created or destroyed by the entity for other parties if an entity depends on relationships with those parties for its future success.

An entity’s business model is a matter of fact and is observable through the entity’s actions.