A better model, for disclosing the model

“FRC Lab report confirms the importance of business model disclosure to investors,” announces a recent news release:

Here’s more:

  • “The Financial Reporting Council’s (FRC) Financial Reporting Lab has published a report on Business Model Reporting which provides valuable insight for companies on the importance of business model information to investors, and the type of information they are seeking.
  • This report forms part of the FRC’s Clear & Concise reporting initiative that promotes transparent and accessible reporting. The report reflects the views of 19 companies, 36 investors from 27 investment and analyst organisations, and two retail shareholders who contributed to this Lab project.The Lab found:
  • Business model information is fundamental to investors’ analysis and understanding of a company and a lack of good disclosure on business model raises concerns over the quality of management;
  • As business model information provides context to the other information in the annual report most investors want it positioned towards the front of the Strategic Report;
  • Where a company operates a number of business models, disclosures of each significant business model is desired;
  • Investors are looking for better natural linkage of business model information to other sections of the Strategic Report, and consistency with disclosure in the annual report; and
  • Investors are looking for more detail than is currently provided by most companies. In particular investors find disclosures are often lacking information that answers questions such as:
  • What are the key revenue and profit drivers and how do profits convert to cash?
  • Are there any key asset and liability items that support the business model?
  • What is the company’s competitive advantage?”

In case you might be wondering whether all this is based on some radical or novel concept of a “business model,” the report actually uses the most straightforward definition imaginable: “what the company does, how it does it, and how it creates economic value now.” As such, a reader might wonder: how could anyone argue against disclosing something so obviously fundamental to an investor’s assessment of the company’s prospects? But the report cites an odd disconnect. On the one hand: “in the early stages of this project, many companies were not convinced that investors use the business model disclosures included in the annual report. Some companies feel that business model disclosure is only a compliance exercise (and) think they receive no questions from investors on their business model.” But on the other hand: “Investors are unanimous that business model information is fundamental to their analysis and understanding of a company and its prospects.”

The report tries to bridge the gap by observing that “companies may not immediately recognize when business model related questions are asked” (as if evoking a romantic comedy where the two protagonists are never on quite the same page). But it seems implausible that this alone can explain such a mismatch. It seems more likely that a basic difference exists between what investors assert as being important when responding to questions on the matter, and what their actions actually evidence on a day to day basis. After all, one continually identifies similar gulfs between (say) all the arguments about what investors need from financial statements, and the perception of corporate management that stakeholders really care about little beyond a few core non-GAAP measures. We appear to be in perpetual need of some rigorous empirical evidence on the extent to which stock prices truly represent detailed rational study of formal disclosures.

Anyway, the FRC Lab report provides some excellent real-life disclosure examples and other reference points.  Much of its content, of course, is comparable to what might be appropriate in implementing integrated reporting principles, although it observes among other things: “some note that the way in which companies have implemented the International Framework is not helpful as they cover too much information, at a high level, without indicating which information is the most significant.” This sounds though like a symptom of inadequately thinking through the details of how to present the information, rather than an inherent deficiency in the <IR> framework.

On that same topic, it’s clearly easier to craft some pieces of disclosure that look good in isolation than to pull all those pieces into an integrated whole. With regard to the IFRS financial statements and their relationship to everything else, the FRC report notes some areas where logical linkages may often seem to be lacking:

  • segmental reporting – how do the reported segments relate to the business model(s)?
  • main Income Statement items – do they correlate well with the description of drivers of profitability indicated in the business model description?
  • key Balance Sheet items – is the composition of the balance sheet in line with expectations from the business model description?
  • accounting policies – e.g. does the revenue recognition policy gel with business model disclosure?
  • cash flow statement – do cash flow disclosures support assertions of a highly cash generative business model and conversion of profits to cash?
  • employee numbers and cost disclosure – does the business model explain how human resources are employed?

Of course, the FRC report displays some of the tensions that often inhabit publications of this kind, for example in the observation that: “Investors want more detail than most companies are currently providing, although they note that this should not lengthen the disclosure significantly.” By this version, it’s all in the better use of current space, just as balancing government budgets is always claimed to be a matter of eliminating waste and inefficiency. Personally, it seems to me that complex things can only ever be made so easy, and that much of the persistent dissatisfaction with corporate reporting largely reflects a reluctance to acknowledge that…

The opinions expressed are solely those of the author

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