The Center for Audit Quality (CAQ) and Deloitte have each issued papers on the relationship between climate change and financial reporting. On September 9, the CAQ released Audited Financial Statements and Climate-Related Risk Considerations. In a press release announcing the publication, the CAQ explained that it is intended to provide “investors and other stakeholders with a foundational understanding of current climate-related reporting and auditing requirements in the U.S. and how they are applied.” In a September 30 Financial Reporting Alert, Deloitte explains the potential impacts of climate-related matters on accounting and reporting. Financial Reporting Considerations Related to Environmental Events and Activities (Alert) is a detailed analysis of ways in which regulatory developments in response to climate change and company climate change strategy can affect financial reporting under existing accounting guidance and SEC requirements.
Carbon Tracker, a non-profit organization that analyzes the impact of energy transition on capital markets, has a somewhat different perspective on the intersection of climate change and financial reporting. It has released Flying blind: The glaring absence of climate risks in financial reporting. This report examines whether 107 carbon-intensive firms and their auditors considered material climate-related risks in their financial reporting. Carbon Tracker concludes that, “[d]espite significant financial risks faced from the climate crisis, and net-zero pledges made by many we found little evidence that companies or their auditors considered climate-related matters in the 2020 financial statements.”
Together, these three reports illustrate that company strategies and commitments related to climate change (or other ESG matters) can have immediate, material financial reporting implications. In light of the SEC’s focus on climate-related disclosures, audit committees should consider whether their company’s sustainability disclosures and commitments are consistent with its financial reporting.
CAQ: Audited Financial Statements and Climate-Related Risk Considerations
The CAQ observes that “[w]e are at a pivotal moment for climate and other environmental, social and governance (ESG) reporting,” particularly because the SEC will soon propose ESG-related disclosure requirements. See The SEC’s Agenda – ESG Tops the List, July 2021 Update. Despite uncertainty about the specifics of SEC ESG rulemaking, the CAQ believes “it is important for users of the audited financial statements to be aware of what climate-related reporting is currently required under US Generally Accepted Accounting Principles (GAAP). Understanding current financial statement requirements can be a useful starting point for investors and others as they consider how and where to obtain their desired climate-related information to make capital allocation decisions * * * .”
The CAQ states that forward-looking climate-related risks that could impact financial statements fall into two categories: (1) physical risks (e.g., the risk that an entity’s facilities will be damaged by a severe weather event or that a company will need to relocate its facilities away from low-lying coastal areas) or (2) the risks associated with the transition to a low-carbon economy (e.g., regulatory risk associated with required changes to a company’s business and/or the impact of a company’s net-zero commitments on management’s evaluation of impairment or the useful lives of assets). The CAQ report includes examples, involving a manufacturing company that announces a commitment to achieve net-zero carbon emissions by 2030, of how a climate-related commitment can impact financial reporting.
The CAQ also describe four aspects of the audit that may be affected by climate-related matters:
Risk assessment. The auditor’s risk assessment includes consideration of climate-related risks and their potential impact on the financial statements. The CAQ lists a series of questions auditors might consider asking to understand potential climate-related risks.
General audit considerations. Although auditors are not required to perform procedures with respect to climate-related disclosures outside of documents that contain the financial statements, they have a responsibility to consider the financial statement implications of such disclosures.
Critical audit matters. Climate-related considerations may be included in the auditor’s discussion of critical audit matters. For example, auditing climate-related assumptions could be especially challenging or require complex auditor judgment.
Other information. Auditors have a responsibility to read other information included in documents that contain the audited financial statements for consistency with the financial statements and to consider whether such information contains material misstatements of which the auditor is aware. Therefore, the auditor must read and consider climate-related disclosures in SEC filings that contain the financial statements.
Deloitte: Financial Reporting Considerations Related to Environmental Events and Activities.
Deloitte notes that many companies are considering how climate and other ESG matters will affect their business strategies, operations, and long-term value. Business strategies designed to address these issues need to be “considered in a consistent manner for both sustainability reporting and the preparation of the financial statements.” The Alert discusses eleven specific financial reporting issues that may arise as a result of climate-related matters:
Potential Accounting and Reporting Implications of Environmental Objectives. Companies frequently make public statements regarding their plans to address the impacts of climate change, such as commitments to become carbon neutral by a specified date or to reduce greenhouse gas emissions by a target amount. Deloitte explains the impact of these types of commitments on the valuation and useful life of existing assets and on the creation of obligations that should be accounted for as liabilities. Entities should also evaluate whether their climate-related public statements, plans, or actions require financial statement foot-note disclosure, even if they conclude that there is nothing to record in current-period statements.
Developing Estimates and Maintaining Consistency of Assumptions and Estimates. Accounting for climate-related initiatives may require companies to select assumptions and to develop estimates that are used for more than one purpose. “When a single assumption is used in multiple analyses, entities should verify that the same assumption is being used in each analysis unless the guidance in U.S. GAAP permits otherwise. In addition, entities should verify that assumptions and estimates outside of the financial statements (e.g., sustainability reports) are consistent with those used when preparing estimates required by U.S. GAAP.”
Use and Recoverability of Long-Lived Assets. Entities need to continuously evaluate the accounting and reporting impact of climate-related goals or targets on the use and recoverability of long-lived assets, including goodwill, other indefinite-lived intangible assets, and property, plant, and equipment.
Inventory. Climate-related events could materially affect net realizable inventory value estimates. “For example, wildfires could significantly damage crops, or floods could significantly damage goods held in a warehouse. In addition, an entity’s operations may be affected by new regulations, customer preferences, or its own initiatives related to environmental concerns — for example, a ban on the use of plastic bags * * * .”
Taxes. Environmental initiatives could result in changes to operations that affect profitability and thereby affect income tax accounting.
Leases. Both lessees and lessors may encounter situations in which leased assets are impaired as a result of climate-change driven technological advances or changes in customer preferences. The Alert discusses the accounting implications for such events. Similarly, energy service agreements and virtual power purchase agreements raise a variety of accounting issues, including the possible existence of embedded leases.
Insurance Recoveries. Climate-related events may raise issues concerning accounting for insurance recoveries. For example, business interruption insurance may provide coverage for lost profits caused by a suspension of operations due to weather-related events.
Financial Instruments and Contract Assets. To demonstrate their commitment to ESG, companies may issue sustainability-linked bonds or loans (debt instruments with terms tied to environmental factors). Both issuers and holders of such debt need to consider whether the arrangement contains embedded features that must be separately accounted for as derivatives.
Environmental Obligations. Changes in laws and regulations may affect the timing and cost of environmental remediation obligations and thereby impact liabilities.
Asset Retirement Obligations (AROs). Climate strategy may affect AROs -- legal or contractual obligations to perform remediation activities resulting from the intended use of a long-lived asset. “Changes in operations that result in a change in management’s intended use of an asset — including a change in its plans to maintain the asset, extend its useful life, or abandon the asset earlier than previously expected — may affect the recorded amount of an ARO associated with the asset, including the timing associated with the retirement activities.”
Compensation Arrangements. Companies may link incentive pay for executives and employees to environmental (or other ESG) metrics. Such arrangements raise a variety of accounting issues. Among other things, entities should have a clear method of measuring and monitoring performance against these metrics so they can calculate the bonus accrual throughout the year.
Carbon Tracker: Flying blind: The Glaring Absence of Climate Risks in Financial Reporting
Carbon Tracker examined whether 107 publicly traded carbon-intensive firms considered material climate-related risks in their 2020 financial reporting. The report notes that the International Accounting Standards Board (link here), the International Auditing and Assurance Standards Board (link here), and the Financial Accounting Standards Board (link here) have issued guidance on consideration of climate change issues in the preparation and audit of financial statements. Carbon Tracker asserts that climate-related matters
“can impact current financial reporting since many of the numbers in the financial statements include estimates and assumptions about the future. For example, climate matters can lead to shorter estimated useful lives for productive assets or changes to the assumptions used to determine expected future cash flows for impairment testing, resulting in impairments and altering the reported amounts of assets and liabilities. Similarly, shifting product demand may result in inventory obsolescence, leading to increased costs, reduced revenues and profits and lower returns on capital which can impact a company’s ability to continue as a going concern. If a company ignores the clear signs that dramatic changes lie ahead, it runs the risk of overstating assets, or understating liabilities, all to the detriment of the company and ultimately its investors.”
Carbon Tracker’s analysis concludes that the companies it studied did not adequately consider climate-related matters in the preparation of their financial statements, nor did their auditors consider such matters. The report’s “key findings” are:
There is little evidence that companies incorporate material climate-related matters into their financial statements. Over 70 percent of the 107 companies did not indicate that they considered climate matters in preparing their 2020 financial statements, “despite the fact that significant institutional investors have identified these companies as highly carbon exposed.”
Most climate-related assumptions and estimates are not visible in the financial statements. Only 25 percent of the companies provided disclosure of at least some of the quantitative assumptions and estimates used in preparing the financial statements.
Most companies do not tell a consistent story across their reporting. For 72 percent of the companies, the treatment of climate matters in the financial statements appeared to be inconsistent with disclosures of climate-related risks and commitments in other reporting.
There is little evidence that auditors consider the effects of material climate-related financial risks or companies’ announced climate strategies. Eighty percent of these companies’ auditors “provided no indication of whether or how they had considered material climate-related matters, such as the impact of emissions reduction targets, changes to regulations, or declining demand for company products, in their audits.”
Even with considerable observable inconsistencies across company reporting (‘other information’ and financial statements), auditors rarely comment on any differences. “We had significant concerns for 59% of the consistency checks that the auditors were required to perform. For the remaining 41%, around half of the companies’ discussions of and responses to climate matters were consistently limited across their reporting.”
Companies do not appear to use “Paris-aligned” assumptions and estimates. None of the companies used assumptions and estimates that were “Paris-aligned”. (“Paris-aligned” refers to the Paris Agreement, an international treaty on climate change adopted in 2015, which calls for limiting global warming to no more than 1.5°C and reducing emissions to net zero by 2050.)
Comment: Audit committees should consider whether their company’s disclosures and commitments concerning climate change and other ESG matters have material accounting implications and, if so, whether those implications are properly reflected in the financial statements. As the CAQ and Deloitte reports make clear, public commitments to achieving carbon neutrality or net zero emissions can have significant financial statement consequences, particularly with respect to the value and impairment of existing assets. Commitments to make major changes in the company’s products or supply chain for climate-related reasons may also affect financial reporting. Senior executives who make such commitments are not always aware of the financial statement implications for their public declarations.
Audit committee attention to the links between corporate sustainability policies and financial reporting is particularly important because of the increasing attention that investors, interest groups, and regulators are paying to these issues.The Carbon Tracker report is a good example. Similarly, both the SEC’s Division of Corporation Finance and Division of Enforcement have announced initiatives to review company climate and other ESG disclosures for consistency with other corporate disclosures and for compliance with existing SEC climate disclosure interpretations. See, e.g., SEC Announces Enforcement Task Force Focused on Climate and ESG Issues. On September 22, the SEC Corporation Finance staff released a sample letter that highlights the types of comments it may issue to public companies regarding climate-related disclosures. It would not be surprising if the SEC were to bring one or more enforcement actions based on allegations that companies have made climate-related commitments without reflecting those commitments in their financial statements in accordance with GAAP