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Breakthrough in Financing Circular Business Models Shows Need for Accountants
by Stathis Gould, Head of Professional Accountants in Business and Integrated Reporting, IFAC | February 12, 2018 |
In 2014, I reflected that the circular economy and circular business models would be essential in moving the old industrial economic model into the 21st century – fit for purpose and able to respond to the negative impacts that production and consumption have on society and the environment (see A Circular Economy Must Drive Management Accounting in the 21st Century). Today, circular business models are not the norm but are beginning to challenge various industries around the world. Fundamentally challenging existing ways of doing things takes time. It involves dealing with a range of strategic and technical challenges, and demonstrating to potential providers of capital how value can be created by a new approach.
To help address the challenges, a multi-stakeholder “Community of Practice” launched its innovative thinking and practical toolkit, The Circular Phone, on developing a circular “Product as-a-Service” business model for producing mobile telephones using Fairphone as a leading example. The Community involves The Royal Netherlands Institute of Chartered Accountants (NBA), Sustainable Finance Lab, Circle Economy, Fairphone, PGGM, ING, ABN AMRO, Allen & Overy and Circularise. Product-as-a-Service business models incentivize providers to create value by offering high-quality, durable products that can be easily upgraded, repaired, refurbished and returned at the end of their useful life.
Fairphone’s approach radically transforms the relationship with the customer from a one-off transaction to an ongoing engagement which provides ongoing maintenance and updates – a reuse rather than resale model - for a fixed price through a service agreement (see How New Cellphones Could Help Revolutionize the World). Fairphone’s business model is based on a service based contract, and its work with the Community of Practice shows how it can be financially as well as environmentally and socially sustainable.
Professional accountants can play a critical role in facilitating a shift toward more sustainable business models that decouple growth from scarce resource use. The Community’s open source toolkit helps them by highlighting solutions that bridge the gap between businesses and financiers by showing how a Product-as-a-Service approach is financeable. One of the main impediments to making such business models viable is attracting capital investment (see Jeans, phones, engines: circular business models are growing, but how to finance them?). The tool includes a Circular Service Contract and cash flow tool (a 5-year cash flow projection enables financiers to assess the benefits and risks of an investment), as well as advice on the financial reporting implications.
To achieve a financeable model for the Circular Fairphone Service, the Community of Practice created a blueprint for Fairphone's business model. Professional accountants can use the approach and toolkit to help companies provide financiers with the financial consequences of investments in circular business models. The approach involves 6 steps:
- Estimate the service fee
- Define a realistic scenario
- Model cash flows
- Identify financing needs and solutions
- Model the profit and loss statement
- Model the balance sheet.
When reaching steps 5 and 6, specific accounting challenges need to be considered. Given optimizing value creation depends on the economic life of individual phone modules rather than of the entire device, modelling financial statements on a module level is necessary. Given that Fairphone’s seven modules have different lifetime expectations, to accurately estimate book value on a module level with different cycles, it is essential to have data that can track and trace modules with their cycling behavior, lifetimes, generated revenues and handling costs. Without this, it is impossible to record asset value on a module level on the balance sheet. Furthermore, accounting regulations are not clear on how to deal with lifetime calculations within a circular model for depreciation purposes. The tool usefully highlights the elements of the profit and loss statement and balance sheet for the Product-as-a-Service model.
According to Circular Advantage, there are five circular business models of which the Product-as-a-Service model is one (elements of these business models can be used in combination). The Product-as-a-Service model shifts the incentive for companies away from sales volume of final product to engineering on quality and durability. The value proposition in Fairphone’s circular business model is based on the ongoing services rather than the physical device. These services include maintenance, repairs, refurbishment, and recycling to prolong the lifetime of devices and optimize value creation for the customer as well as other stakeholders including the environment.
The distinction between a service-based circular business model rather than a leasing arrangement has important implications in terms of financing with financial value being derived from cash flow based financing from a portfolio of contracts.
Ultimately, financial modelling that enables an understanding of how a Product-as-a-Service model can be viable and represented by financial statements will help to unlock new investment in new innovative and sustainable business models. The professional accountant can also usefully provide insights on managing the business and finance opportunities and risks in the transition to service contracts that ultimately shift the ownership and responsibility for a product to the end of its life, and potentially to a rebirth. This is a fundamental change leading to a different relationship with customers and suppliers and sustainable outcomes for society.
For more information on the work of the Community of Practice and the practical toolkit, please contact Lucas Geusebroek, project lead circular economy, Royal NBA, firstname.lastname@example.org.
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