Properly Done Financial Audits Are A Powerful Tool For Addressing Climate Change

I realize this title isn’t a very enticing one to most readers. But please bear with me. I promise that the story gets more interesting as it goes along.

As I noted in a previous post, the Trustees of the IFRS Foundation had a meeting on March 2-4 and discussed their proposed “Sustainability Standards Board (SSB).” The current plan is a formal announcement at COP 26 in November of this year. Its top priority will be disclosures regarding climate change. I obviously don’t know how long this will take—hopefully not too long.

In the meantime, there is an elephant in the reporting room—and one which is beginning to make its presence felt. The most important disclosures which companies make are in their Annual Accounts, which calculate profits and solvency. Extraordinarily, these reports usually ignore climate issues. So an oil well is valued as though the oil extracted from it will be sold for $80 per barrel in 2050. On that basis companies invest in stranded assets, declaring profits that must never be realized if we are to live in a sustainable world.

When these companies are challenged, they note, (correctly) that U.S. and International Financial Reporting Standards (IFRS) don’t directly mention climate change. But that doesn’t mean that climate can be disregarded in calculating the value of assets and liabilities, any more than any other external event. What is needed is guidance on climate change disclosure when it is a material issue, and how it affects asset values and profits. That applies to many, if not most, companies.

In November 2019, the elephant began to make its presence felt. Nick Anderson, a member of the International Accounting Standards Board (IASB) published: “IFRS Standards and climate-related disclosures.” Anderson’s article “provides an overview intended to help investors understand what already exists in the current requirements and guidance on the application of materiality, and how it relates to climate and other emerging risks.” On September 16, 2020 investor groups including  the Principles for Responsible Investment (PRI) representing over $100 trillion in assets issued a statement calling “companies to ensure that their financial reports and accounts reflect the recent opinion from the International Accounting Standards Board (IASB) and are prepared using assumptions consistent with the Paris Agreement on climate change.” If that were done, it would put an end to stranded assets.

In response to stakeholder requests for more information on this topic, on November 20, 2020 the IFRS Foundation published educational material  as a complement to Anderson’s article. That same month, the UK’s Financial Reporting Council published its “Climate Thematic” report which makes recommendations for how boards, companies, auditors, and professional bodies and regulators can better address the issue of climate change.

The “Effects of climate-related matters on financial statements” begins by noting that “IFRS Standards do not refer explicitly to climate-related matters. However, companies must consider climate-related matters in applying IFRS Standards when the effect of those matters is material in the context of the financial statements taken as a whole.” In other words, even before the SSB establishes explicit standards for climate reporting, climate is an important topic that needs to be considered in preparing a company’s financial statements. The educational document notes some key areas for consideration: such as:

·     IAS 1: Presentation of Financial Statements (sources of estimation uncertainty and significant judgements and ability of the company to operate as a going concern, where climate change is obviously related to both

·     IAS 2: Inventories (Climate-related matters may decrease the value of inventories or even make them obsolete)

·     IAS 16: Property, Plant, and Equipment (e.g., additional investments to mitigate the effects of climate change)

·     IAS 36: Impairment of Assets (e.g., emission-reduction legislation might increase manufacturing costs, thereby decreasing the cash flows from this asset)

·     IAS 37: Provisions, Contingent Liabilities and Contingent Assets (e.g., restructuring costs necessary for redesigning products and services to achieve climate-related targets)

·     IFRS 13: Fair Value Measurement (e.g., potential climate-related legislation could affect the fair value of an asset of liability), and IFRS 17: Insurance Contracts (e.g., the extent to which the company’s climate risk is covered by current insurance contracts).

Interesting, right? There’s more. Financial statements need to be approved by an external auditor. Towards that end, on October 1, 2020 the International Auditing and Assurance Standards Board (IAASB) issued a staff audit practice alert on climate-related risks. IAASB Technical Director Willie Botha stated that “This Staff Audit Practice Alert shows that while the phrase ‘climate change’ does not feature in the ISAs, the auditor’s responsibilities under the ISAs encapsulate the consideration of events or conditions relevant to the susceptibility to misstatement of amounts and disclosures in an entity’s financial statements, which would include climate-change risk.” This supports the PRI’s request “That auditors only sign off financial statements which are consistent with the IASB opinion in the letter and the spirit, which include showing the key assumptions that have been made with regard to climate-related risks.”

It keeps getting better. On December 17, 2020 the Global Public Policy Committee (GPPC) published a letter that was sent to Hans Hoogervorst and Sue Lloyd, Chair and Vice-Chair, respectively of the IASB. (The GPPC is the global forum of representatives from the six largest accounting networks: BDO, Deloitte, EY, Grant Thornton, KPMG, and PwC, which has as its public interest objective the enhancement of quality in auditing and financial reporting.) The letter welcomes both the IFRS Foundation’s educational materials and the IAASB staff audit practice alert.

Now here’s the punch line. For any company reporting according to IFRS Standards, which is most of the world except for the U.S. where companies reporting according to U.S. Generally Accepted Accounting Principles (U.S. GAAP), investors can now hold the company to account for taking climate change into consideration in preparing its financial statements. Should they decide that the company has not done so, they can vote to remove the Chair of the company’s Audit Committee and/or to not reappoint the audit firm.

In an interview with David Pitt-Watson, a Visiting Fellow at Cambridge Judge Business School who has been leading the investor groups’ work on accounting standards, he further explained to me the significance of the work of the IASB and IAASB.  

“The reason companies invest in climate-destroying assets is because they look profitable. The rules by which that profitability is calculated are determined by the accounting standards bodies. Those bodies are now clear that climate must be taken into account, and assumptions shown. Then investors are demanding that those assumptions should be sustainable ones. If that is done, it puts an end to investment in ‘stranded assets’—those which are valued in a way which is incompatible with climate sustainability. It also makes sure that our financial system is not fooled into believing companies are solvent and profitable when they are not. So it is game changing. We don’t need any new standards, but we do need to insist on the enforcement of these rules.”

This is a powerful tool for groups like Climate Action 100+ and the “Say on Climate” campaign. Financial reporting should reflect reasonable assumptions about climate risk and the transition to a low carbon economy. Where they do not, investors who are committed to sustainability should vote against the financial statements, the auditor and/or the directors who are responsible. As noted by Anne Simpson, Managing Investment Director, Board Governance & Sustainability at CalPERS and a member of the Climate Action 100+ Steering Committee,“Company accounts need to be based on sustainable assumptions. Without that, investors are getting a false read on risk and return. Audit committees need to take this up. Auditors too. No doubt the shareowners will be paying attention. Accountability on accounting is the missing link in the capital markets.”

I find the work that Pitt-Watson and others are doing on the “auditing for climate change” front very exciting. There’s just one thing missing and it’s not hard to figure out what this is—similar guidance from the Financial Accounting Standards Board (FASB) which is in charge of U.S. GAAP. The U.S. remains the home of 130 of Fortune’s list of the largest 500 companies in the world. Investors need and want the same quality of audits from these companies as for those reporting according to IFRS. There is nothing intrinsic to U.S. GAAP that makes its financial statements immune to the effects of climate change.

Samantha Ross, a former SEC staffer and Chief of Staff of the U.S. Public Company Accounting Oversight Board, who now leads an initiative to help investors get the most out of audits, says auditors see the risk, which is why we have begun to see write-downs of long-lived oil and gas assets.  “Financial accounting requires numerous estimates about the future. Estimates of future cash flows underlie the carrying value of long-lived assets, impairment tests, and current depreciation, depletion and amortization expenses, not to mention liabilities,” Ross says. “These are basic concepts, and like any other disruptive business force, the uncertainty of climate change and the energy transition impact them.” Ross has recently published a paper “The Role of Accounting and Auditing in Addressing Climate Change” and I will be writing about that in a subsequent post.

I appreciate the constraints that FASB was under in the previous administration that thought climate change was a Chinese hoax. But we now have President Biden for whom climate change is a top priority. We also have an SEC that is very supportive of improved climate disclosures, as well as the proposed Sustainability Standards Board. I urge them to instruct FASB to quickly follow the lead of the IASB. This will change the incentives to management, aligning them with a sustainable world. It will improve the quality of financial statements and the quality of audits to the benefit of investors who represent their ultimate beneficiaries. Which is people like you and me.