What is a Business Model and how to ensure its effective application?
The CNC stressed in its comment letter on the exposure draft « Financial Instruments :
Classification and Measurement » sent to the IASB on the 14th September 2009, that accounting categories and related measurement bases should be determined by reference to
Business Models used in managing financial instruments in order to provide a faithful economic representation of such Business Models.
A Business Model describes and determines the operational process for a certain type of activity covering a certain number of transactions. Applied to financial instruments, it not only defines the objective of the operational process for these instruments but also how this operational process should be implemented. The monitoring performed by the management through internal reporting reflects the different business models by segregating the data. It is therefore possible to verify in practice both currently and historically if a Business Model is effectively implemented according to the description of its operational process.
A legal entity may apply different Business Models to its activities. Generally, different operational processes are housed in separate Business Units with their own teams and resources to implement the different Business Models. The internal organisation of an entity should in any case reflect the Business Models implemented.
There may be transactions between two business units responsible for implementing different
Business Models. These transactions are generally kept to a strict minimum and correspond to an operational need which can best be satisfied technically and cost-wise in this way. For example, a business unit which is not specialized in market transactions may request a business unit specialized in market transactions to hedge on its behalf a risk arising from its
Business Model using a financial instrument traded on the market. This type of transaction should be carefully identified and documented by the units concerned.
Implementing a Business Model generally requires a certain number of conditions to be fulfilled. For example, a “held-for-trading” Business Model can only effectively be implemented if an entity is in a position at all times (or at least in the very short term) to purchase and sell financial instruments (or components of financial instruments) on accessible markets where counterparties are easy to be found without the entity being obliged to propose a transaction price outside the published market rates.
Situations may arise where changes in the economic or technical environment make it impossible to continue applying the operational process of a particular Business Model. In these circumstances, presumed to be rare, provided it is possible to establish objectively that the conditions for applying the Business Model are no longer met on an ongoing basis, it is necessary to demonstrate that the Business Model is no longer applicable and requires changing while recognizing the related accounting consequences. The financial instruments concerned will require reclassification according to the applicable new Business Model.
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Why is a third accounting category necessary?
In the CNC comment letter on the exposure draft “Financial Instruments : Classification and
Measurement” sent to the IASB on the 14th September 2009, a Business Model was defined for financial instruments measured at amortized cost
1
and two others for financial instruments measured at fair value through profit or loss
2
.
However, all financial instruments are not necessarily managed according to a Business
Model for which measurement at amortized cost or fair value through profit or loss is appropriate. In effect many financial instruments are not managed according to an operational model based mainly on the collection of contractual cash flows, so that measurement at amortized cost is not relevant, nor are they actively traded on an active liquid market with a view to realizing short term profit or in order to fulfil an obligation to settle a debt of an amount equal to the fair value of these instruments. These instruments are on the contrary managed according to an operational model based on long or medium term holding periods for which immediate recognition in profit or loss of variations in fair value is not appropriate for the reasons set out below.
A third accounting category - with an appropriate measurement base - is therefore considered necessary for these instruments held on a medium or a long term basis in order to take into account the liquidity and the duration of holding in determining the measurement principles for financial instruments as requested by the G20 in April 2009. This third category would be measured at fair value through equity (“Other Comprehensive Income” - OCI).
What is the rationale for measurement at fair value through “OCI”?
The application of a different measurement principle, whereby variations in fair value are recognized in OCI rather than through profit or loss, is justified because it is uncertain that these variations will be converted into cash flows as a result of the Business Model applied:
•
In a medium or long-term operational process, short-term variations in fair value are not intended to be converted immediately into cash. Therefore, the volatility of these variations over time makes the amount of future cash flows which will finally be realized uncertain;
•
Where there is a restricted market with low liquidity for the instruments, the risk of being unable to immediately convert them into cash at the indicated price and the risk of modifying the market price on conversion also make this amount uncertain;
•
The medium and long term management of certain financial instruments may be linked to the lack of active market and reliable market prices resulting in a measurement method based on models and non-observable data with a low level of reliability, this low reliability of the data and measurement methods results in uncertainty in respect of the variations of fair value produced by these calculations;
1
Financial instruments held/issued with the (main) purpose of collecting/settling contractual cash flows.
2
Financial instruments actively traded on active liquid markets held for short-term trading, or financial instruments compulsorily held by the entity in order to comply with contractual or regulatory commitments which are required to settle a financial liability, the value of which depends on the fair value of these underlying financial assets.
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•
When the medium or long-term relationship with an issuer of financial instruments may affect the expected future benefits from an investment in these financial instruments, the short-term variations in fair value do not reflect the expected potential value of these items which are difficult to estimate prospectively.
Recognition in OCI enables the user of the financial statements to be informed of the uncertain nature of the observed changes in fair value. On the other hand, when these changes are converted into cash flows they become certain and must be recycled through profit or loss.
This is the case when interest or dividends are paid or when financial assets are disposed of or financial liabilities transferred or settled.
Nevertheless, a method of impairment for financial instruments (equity and debt instruments) measured at fair value through OCI should be determined to reflect those situations where there is a high probability of an impairment loss occurring, even if there is no immediate effect on cash flows. This model should take into account the holding period of the investor in order to avoid recognizing in profit or loss changes in fair value which may reverse in the short term as this presentation would not be relevant. As far as debt instruments are concerned, this model should recognize in profit or loss impairment due only to the deterioration of credit risk, as this is the only risk which can bring about a decrease in the amount of future contractual cash flows. This requirement would introduce greater comparability with impairment recognized in respect of debt instruments measured at amortized cost. Additionally, the impairment model should allow for the possibility of reversing through profit or loss previously recognized impairment provisions for all types of financial instruments (equity and debt instruments) when there is an improvement in the circumstances that led to setting up the provision
As indicated in the CNC’s comment letter sent to the IASB, the need to make a distinction between fair value changes through OCI and those dealt with through profit or loss is the basis for the CNC’s disagreement with dealing with both items through a single statement of comprehensive income as proposed by the IASB in the project on “Financial Statement
Presentation”.
Business Models included in the third category
The Business Models for which this category and this measurement principle are suitable are characterized by medium or long term holding periods. The financial instruments concerned are essentially financial assets but may include financial liabilities linked to these assets, especially in the case of global portfolio management. Certain derivative instruments whose characteristics are consistent with the operational process of the described Business Models may also be included in this type of portfolio.
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Two main types of Business Models can be identified:
1) Groups of financial instruments (debt or equity) managed in a medium and long term
perspective, generally as part of portfolios composed essentially of financial assets:
•
The medium and long-term asset management perspective is generally designed to meet commitments arising from liabilities with an equivalent time horizon, either on the investor’s own account
3
, or as part of an investment or management contract
4
;
•
Diverse cash collection techniques are utilised: collection of contractual cash flows
(provided it is not the main management process) or management on a medium or long term fair value basis, investment and disinvestment of non liquid instruments depending on possible transactions, disposals and occasional reinvestments within a portfolio (unsystematic i.e. does not alter the objective of medium or long term holding of the relevant portfolio);
•
The disposals and occasional reinvestments within a portfolio are used for liquidity management either for the investor’s own account or under contract with third parties, for adjusting the duration of financial assets to that of the financial liabilities they cover or for anticipating the deterioration of an issuer’s credit risk.
2) Groups of securities, generally equity instruments, targeted (individually) and acquired in a medium and (especially) long-term investment perspective:
•
Either to enjoy the medium and long term economic benefits which are not necessarily linked to an immediate and direct return on the securities themselves; the economic benefits may be linked to the development of a relationship with the issuing entity or to the implementation of a common strategy;
•
Or as part of an institutional mission aimed at a long-term commitment to targeted sectors in application of general long term policy objectives; the entities carrying out this kind of mission and investment have the financial resources that enable a long term commitment taking into account the prospect of long term profitability.
3
As reinvestments of financial liabilities issued with medium or long term maturity dates or to back medium and long term non-financial liabilities such as those arising from decommissioning industrial installations or site restoration .
4
Except where there is an obligation to repay the debt on demand and with a link to the fair value of the related assets, as this Business Model implies instead classification in the category fair value through profit or loss.
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