Business Activity Codes: An Instant Way to Classify Companies?

Industry classification systems are an important nomenclature for categorizing companies on the basis of their economic activities. The system exclusively provides a framework for regulatory compliance and risk assessment by giving companies an industry-specific business activity code. The most notable classification systems are the North American Industry Classification System (NAICS) in the United States, Canada, and Mexico (previously the Standard Industrial Classification (SIC) system in the U.S), the Nomenclature of Economic Activities (NACE) in the European Union, and the International Standard Industrial Classification (ISIC) used by the United Nations.

Read this blog to explore everything from history and development to the significance of these classification systems for your business during KYB checks.

Historical Context & Evolution of Industry Classification Systems

• Standard Industrial Classification (SIC) System

The SIC system was established in the 1930s by the U.S. government to create a uniform structure for classifying industries. Initially developed by the Office of Management and Budget (OMB), SIC business activity codes consist of four digits and are designed to identify the primary business activity of an enterprise. The system was widely adopted by various government agencies, businesses, and researchers for statistical and regulatory purposes.

However, despite the widespread use of the SIC system, it faced limitations as the nomenclature was unable to keep pace with the evolving economic landscape. The rapid growth of service industries and technological advancements highlighted the need for a more dynamic and comprehensive classification system. Consequently, the SIC system was gradually replaced by the NAICS, although it remains in use by certain companies and for historical comparisons.

• North American Industry Classification System (NAICS)

Introduced in 1997, NAICS was developed collaboratively by the statistical agencies of the United States, Canada, and Mexico to address the shortcomings of the SIC system, such as outdated details, geographical limitations, and inconsistent classification. 

NAICS employs a 6-digit hierarchical structure that allows for a more detailed and flexible classification of industries. The economic sector is represented by the first two numbers, the subsector by the third, the industrial group by the fourth, the particular industry by the fifth, and country-specific information by the sixth.

NAICS reflects the modern economic structure, emphasizing the significance of service industries and technology-driven sectors. It is regularly updated to incorporate new industries and changes in economic activities, ensuring its continued relevance and accuracy. Government agencies, businesses, and researchers for statistical reporting, regulatory compliance, and economic analysis use NAICS business activity codes.

• Nomenclature of Economic Activities (NACE) in EU

NACE, the classification system used by the European Union, standardizes the classification of economic activities across member states. Developed by Eurostat, NACE codes enable the comparability of statistical data across different countries within the EU. The system has undergone several revisions in Regulation (EC) No 1893/2006, with the most recent being NACE Rev. 2.1, set to be implemented in 2025.

Regulation (EU) 2023/137 (NACE Rev. 2.1) amending Regulation (EC) No 1893/2006 (NACE Rev. 2) is crucial for organizing economic activities in the EU. This updated system features four distinct levels: sections, divisions, groups, and classes. Each level is identified by a unique business activity code: one letter for sections, two digits for divisions, three digits for groups, and four digits for classes. By improving the accuracy and reliability of economic information, this organized approach helps firms and governments make better analyses and decisions.

• International Standard Industrial Classification (ISIC) by the UN

The ISIC system, maintained by the United Nations, serves as a global standard for classifying economic activities. Established in the 1940s, ISIC provides a comprehensive framework for international economic comparisons and statistical reporting. This industry classification system is periodically revised to reflect changes in the global economy, with the current version being ISIC Rev. 4.

ISIC employs a four-level hierarchical structure, similar to NAICS and NACE:

• Section: Represented by a letter (e.g., A for Agriculture, Forestry, and Fishing)
• Division: Denoted by two digits (e.g., 01 for Crop and Animal Production).
• Group: Indicated by three digits (e.g., 011 for Growing of Non-perennial Crops)
• Class: Designated by four digits (e.g., 0111 for Growing of Cereals)

The European Union (EU), consisting of twenty-seven (27) countries, and the United Nations (UN), with one hundred ninety-three (193) member states, have consolidated the same nomenclature, such as ISIC for the UN and NACE for the EU. It is a significant step that they share the same nomenclature. 

For verifying business activities, NACE (Regulation (EU) 2023/137 (NACE Rev. 2.1)) has made it a compliance requirement to check the industry code. In the future, as everyone observes the benefits of this system, the UN is likely to implement it as well.

Importance of Industry Classification System for Businesses

Industry classification systems play a vital role in the functioning and success of businesses. The following are key reasons why industry codes are essential:

• Regulatory Compliance

NACE’s latest regulation, which is going to be implemented in January 2025, requires businesses to verify the business activity codes of companies as an integral part of KYB compliance.

Industry codes are crucial for compliance with various regulations, including tax reporting and industry-specific requirements. Accurate classification ensures that businesses adhere to the legal standards applicable to their sector. For example, NAICS codes are used in the U.S. for filing tax returns, obtaining business licenses, and complying with industry-specific regulations.

• Risk Assessment

Industry-specific business activity codes assist in the assessment of the risk associated with potential partners or clients during Know Your Business (KYB) checks. Certain industries may be more prone to fraud or regulatory scrutiny, and accurate classification helps businesses focus their due diligence efforts accordingly. Financial institutions, for example, utilize industry-specific business activity codes to assess the risk profile of those they serve and make sure that anti-money laundering (AML) laws are being followed.

How The KYB Can Help?

Consider a burger company whose billing system exclusively processes credit card payments. Since these transactions are trackable, the bank can monitor them. In this case, if the company’s reported revenues are significantly higher than the total value of its credit card transactions, it raises a red flag. This discrepancy could indicate that the company is involved in money laundering or engaging in activities outside of its assigned business activity.

That’s where business activity codes come in. Accurate classification according to the North American Industry Classification System (NAICS) or the Nomenclature of Economic Activities (NACE) ensures that both companies meet specific legal requirements applicable to their respective sectors. For instance, NACE’s upcoming regulation, set to be implemented in 2025, mandates that businesses verify industry codes as part of the Know Your Business (KYB) compliance checks. 

We at The KYB help companies ensure regulatory compliance, enhance risk assessment, and ensure that all business activities are accurately classified and reported. Stay compliant and make efficient partnerships with the Know Your Business solution.