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How to reflect climate risks in the financial statements

Author: ICAEW Insights

Published: 16 Dec 2021

As the 2021 reporting season approaches, businesses increasingly face questions from investors about how their accounts reflect climate-related matters. Here’s how businesses, audit committees and auditors can address them.

We are at the beginning of a journey of momentous significance, and it’s time for all parties in the corporate reporting ecosystem to play their part.

We need to make decisions about the nature, scale and pace of the changes needed to reduce emissions to net-zero. Until more reliable quantification is possible, efforts need to focus on filling the information gap. To achieve this, attention is turning to financial statements.

The recent Carbon Tracker Initiative review of the accounts of over 100 major companies highlighted an absence of climate risks in financial reporting. Investors say they want to be equipped to assess companies’ exposure to climate-related matters, and their progress towards addressing them. Against this backdrop of increasing scrutiny, what can be done to move things forward?

While historical financial statements cannot be expected to provide a comprehensive source of information about climate-related matters, they have a very important role to play. Indeed, as transition, and, regrettably, climate change accelerates, these matters will tend to become more and more material to the financial statements.

Climate-related matters will be reflected in the financial statements where companies conclude that they are relevant to the financial statements and are ‘material’. Materiality is company-specific and, importantly, takes into account the nature as well as the magnitude of information. Boards need to assess what is material by considering what could reasonably be expected to influence decisions that primary users of the accounts make based on the financial statements. Investors are growing increasingly impatient with the paucity of climate-related information disclosed. ICAEW thinks there is much more that companies can do now in this regard. As the Carbon Tracker Initiative highlights, companies are still not disclosing enough on climate risks.

Implementation of new UK regulations aligned with the recommendations of the Taskforce for Climate-related Financial Disclosures (TCFD) will provide new information about climate-related matters. But early indications are that these new regulations, effective from 6 April 2022, will not immediately meet all of investors’ information asks.

There are some important developments in the reporting framework that should encourage progress. The UK government has indicated that it will seek to adopt the standards of the new International Sustainability Standards Board as soon as they are available. The first standard, on climate, may be available as early as the tail end of 2022, for the 2023 reporting cycle. The standards, which will address the narrative information provided within the annual report, will provide further helpful information and should help to ensure the consistency of reporting throughout the annual report that is often lacking at present. TCFD reporting should help companies prepare for this next stage of reporting.

The role of companies

The Carbon Tracker Initiative has highlighted areas that deserve particular attention. These include the three areas discussed below.

Evidence that material climate-related risks are reflected in the financial statements

Companies must consider climate-related matters when applying accounting standards where their effect is material in the context of the financial statements as a whole. When climate-related matters are considered material, disclosures are required in accordance with those standards.

Investors want to be confident that companies have considered climate risks in their financial statements. The Institutional Investors Group on Climate Change (IIGCC) suggest starting with a simple affirmation that this is the case (see Investor Expectations for Paris-aligned Accounts). There is no current requirement to disclose whether the accounts are ‘Paris-aligned’, and at this stage it may be difficult to do so, based on current information and understanding. Indeed, there is at present no profession-wide consensus around the definition of ‘Paris-aligned accounts’ - this is something ICAEW is currently exploring. Nonetheless, directors may wish to comment on their general approach to these matters. For example, some businesses may have completed a climate risk assessment and concluded there was nothing which requires adjustments to the financial statements. Simply disclosing that this exercise has been undertaken and explaining the conclusions could be useful information.

Visibility of climate-related assumptions and estimates in the financial statements

The International Accounting Standards Board has published guidance on the effects of climate-related matters on financial statements. This recognises that while there is no single IFRS standard dealing specifically with climate, climate risk could be relevant to many areas of a company’s financial reporting. In particular, it may affect forward-looking assumptions and estimates.

When making these assumptions and estimates, companies should focus on whether climate-related matters are relevant – and if they are, where specific disclosures could help. Sensitivity analysis and related disclosures will often be key. The FRC completed a Climate Thematic in November 2020 and has already announced that its 2022/23 ‘thematic reviews’ will specifically look at disclosures around sensitivities and ‘ranges of outcomes’.

Transparency is the key to progress. Financial reporting by business cannot provide certainty over outcomes affected by significant unknowns over political, customer, and supply chain responses to climate change and transition pathways to achieving net-zero carbon emissions by 2050. Nevertheless, there is likely to be information that could be usefully disclosed, for example about current plans and contingencies. Useful information may be available even where companies have not yet performed, or currently are unable to perform, detailed modelling of decarbonising their business models or the effects of extreme weather events.

A consistent story throughout the annual report and financial statements

Alongside transparency, the need for consistency is paramount as climate-related matters increasingly feature in the annual report and financial statements. The IIGCC has asked companies to confirm that the narrative information in the annual report is consistent with accounting assumptions, with any divergence explained. Where companies are at an early stage in the process of identifying, planning and committing to actions, there may not yet be a corresponding effect on the financial statements, but without further explanation this may not be apparent. Coordination of disclosure between the narrative information in the annual report and the financial statements could help to address this.

The forthcoming reporting season presents a fresh opportunity for companies to - at the very least - start to consider the impact of climate-related risks on their accounts. This may be where sensitivity disclosures can play an important part. While climate risk may be a new area of reporting for companies, progress is often best achieved in incremental steps, and consideration of the three matters outlined above may be a good place to start.

The role of audit committees and auditors

Audit committees should ask management about the company’s climate risk assessment and, where necessary encourage this to be improved or progressed. Further guidance on the tough questions audit committees should consider asking about the impact of climate-related matters on the financial statements could help here. Auditors need a clear understanding of the response of the business to climate-related matters, which they can then audit against. Audit committees can help ensure that this is available.

Auditors should be asking searching questions of companies they audit about the potential implications of climate-related matters for the financial statements. They should apply professional scepticism and should be alert to the risk that evolving regulatory and market responses to climate risk may require companies to reassess the judgements on which the financial statements are prepared.

The auditor is required to assess whether the financial statements are true and fair and have been prepared in accordance with accounting standards and UK law. The auditor is also required to read all financial and non-financial information included in the annual report and to identify whether it is materially inconsistent with the financial statements or the auditor’s knowledge obtained in the audit. While the auditor’s report cannot provide the disclosures that should have been included in the annual report or financial statements, a responsibility that sits firmly with management, auditors are uniquely placed to encourage companies to consider additional disclosures beyond the minimum required. These could help illuminate how the company is assessing climate risk, and the scenario analysis and judgements around its transition pathway. While government and company transition plans and strategies will evolve over time, that does not preclude the provision of decision-useful information on the judgments, uncertainties and assessment of risk by the company at a point in time.

Where a board has made commitments without any supporting actions, a failure by management to begin to take steps toward decarbonisation, or to meet investor expectations about the pace of such steps, does not in itself mean that the accounts are misstated, or that they should be qualified by the auditor. Nevertheless, there will be some companies for which climate-related matters represent a higher risk of material misstatement or require significant auditor judgement. A climate-related ‘Key Audit Matter’ (KAM), or the inclusion of climate-related procedures in a KAM on, for example impairment or provisions, will not be merited in all audit reports. But with climate risk more evident than ever, ICAEW strongly encourages auditors to consider in the coming reporting season whether there are any such matters that they should now highlight to investors and other users of company reports.

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