A Critical Audit Matter: It’s Time For Auditors To Come Clean On Climate Change

In a previous post, “Properly Done Audits Are A Powerful Tool For Addressing Climate Change,” I wrote about recent guidance from the International Accounting Standards Board (IASB) and the International Auditing and Assurance Standards Board (IAASB) regarding climate change the preparation and auditing of a company’s financial statements. The basic point is that this guidance sets the right rules for companies calculating their profits, and gives investors a powerful tool to engage with portfolio companies on their climate transition strategies. To the extent a company’s financial statements do not take into account the material climate risks posed to their assets and ability to operate as an ongoing concern, they risk presenting a misleading view. Investors should use their votes on corporate board members and the company’s auditor to signal demand for reliable financial reports that make climate impacts clear.

At the end, I also raised the issue of whether the same is true for the United States where companies use U.S. Generally Accepted Accounting Principles (U.S. GAAP) instead of the International Financial Reporting Standards (IFRS) issued by the IASB. In doing so I referenced a recent paper by Samantha Ross: “The Role of Accounting and Auditing in Addressing Climate Change.” Ross is well-qualified to opine on this question. She is a former special counsel at the U.S. Securities and Exchange Commission; a former chief of staff and special counsel at the Public Company Accounting Oversight Board (PCAOB); and the founder of AssuranceMark, the Investors’ Consortium for Assurance.

Her paper is well-informed and worth a careful read. Ross states that “There are four steps the SEC can take, entirely within its own authority, to bring those tools to bear in addressing the climate crisis.

1. Fully enforce existing accounting and related disclosure requirements to reflect the financial impacts of the climate crisis and the transition to a low-carbon economy.
2. Update disclosure, through a staff accounting bulletin and other guidance and rulemaking, to spread identified best practices about material climate-related information across industries and markets.
3. Leverage the audit to build a solid bridge between climate-related risks and corporate financial reporting.
4. Address the ways in which the existing U.S. accounting standards exacerbate systemic climate risks.”

I would like to focus on (3). And in the spirit of my previous post showing a taste for the arcane, I would like to drill down on just one point: The Critical Audit Matter (CAM). “A CAM is any matter arising from the audit of the financial statements that was communicated or required to be communicated to the audit committee, and that 1) relates to accounts or disclosures that are material to the financial statements; and 2) involved especially challenging, subjective, or complex auditor judgment.” The Public Company Accounting Oversight Board, the U.S. regulator of audit firms, adopted this requirement in 2017 for audit reports of the financial statements of large, accelerated filers for periods ending on or after June 30, 2019, that are filed with the SEC.

While I consider myself reasonably well-versed on the topic of disclosure—and in complete agreement with all of the recommendations Ross makes regarding what the SEC should do in this domain—I had never heard of the CAM concept, so this caught my capital market activist (CMA) eye and I read the PCAOB’s Staff Guidance “Implementation of Critical Audit Matters: The Basics.” It states that “The description of the principal considerations should be specific to the circumstances and provide a clear, concise, and understandable discussion of why the matter involved especially challenging, subjective, or complex auditor judgment. The communication should be tailored to the audit to avoid standardized language and to reflect the specific circumstances of the matter.”

Wow, I said to myself, if I’ve got this right, auditors already have a simple and powerful tool to convey to investors what they did to assess how climate change affects a company’s accounts and to describe the work they did to test the appropriateness of the assumptions made. I am hard pressed to think of a topic that would more closely fit this bill than the impact of climate change, which invokes not just physical risks but also a host of governmental, political, competitive and consumer actions to limit global warming. There is a massive energy transition underway. It is highly disruptive, as with everything else about climate change, and has a range of financial consequences for companies. Consider the fact that more and more companies are making commitments to how they are going to achieve net-zero status by 2050 in accord with the Paris Agreement. How is that being reflected in their financial statements?

I asked Ross if the CAM is as important as it seems to be for putting the spotlight on the financial impacts of climate change. Her reply was: “Critical audit matters are a valuable communication tool, especially in times of disruption and uncertainty. A good audit report should be the starting point for investors looking to understand the areas of the audit that required the most judgment and what the auditor did to ascertain whether the financial statements as a whole are free of material misstatement. Climate risks and the energy transition can have a pervasive effect on financial reporting today and may well trigger critical audit matters. This is so whether or not a company has made a climate pledge. 

“For example, the energy transition can affect the assumptions that many companies use for basic accounting estimates, such as how long a company will use an asset that may become obsolete or estimates about the future cash flows that an asset will generate. These assumptions and estimates can require a lot of auditor judgment and testing, making them prime candidates for critical audit matters to be discussed in the audit report.” 

I also wondered if audit regulators in other parts of the world have anything equivalent to the CAM. For insight on this, I turned to David Pitt-Watson, Visiting Fellow at Cambridge Judge Business School, the person who first drew my attention to the importance of the audit in the financial statements as they are today even before new disclosures are developed and become mandatory. He explained to me that “Outside the USA, these are known as Key Audit Matters. There are some differences, but the underlying concepts are the same. The global rule for auditing, which all the big accounting firms say they accept, is that ‘if climate change affects the entity, the auditor needs to consider whether the financial statements appropriately reflect this . . . in accordance with the applicable financial reporting framework.’ So if companies are declaring profits and solvency based on important assumptions relating to climate this should surely be a critical audit matter and be reported accordingly. Companies and their auditors need to be held to account on this. It is the best way to stop enterprises declaring profits on activities which destroy the climate.”

Central banks are worried that the climate crisis could become a financial crisis. CAMs will not save the world. We still need robust greenhouse gas reporting to hold companies accountable for reducing emissions and transitioning to a lower-carbon economy, and as Ross says in her paper, emissions reporting should be audited. Moreover, we need markets and “universal owners” to steer capital toward solutions to reduce global warming, provide for sustainable energy and reduce overall market risk. As explained by Rick Alexander, founder and CEO of The Shareholder Commons:

“Universal owners rely on the return of the markets overall, and alpha that comes at a cost to critical social and environmental systems is a poor trade for these diversified investors. Strictly speaking, auditors focus on numbers that underlie the business case of each individual company, but a deeper discussion of the role a company plays in systemic threats, including the climate crisis, can signal whether a company is optimizing its returns (even over the long term) by exploiting important common resources or vulnerable communities. Universal owners may legitimately choose to reject such practices, for the benefit of their beneficiaries and their portfolios.” 

CAMs should help, by providing important insights about the impact of disruptive, systemwide risks in company accounts, giving markets much needed transparency on which to act.

It seems some auditors are starting to give investors true insights about climate impacts, but more need to follow suit. As Ross explained, “Some auditors have played a leading role in providing clear communication that directly links a critical audit matter with a climate issue, such as when the auditor for National Grid highlighted the relationship between the company’s climate strategy and its estimates of the length of useful life for certain assets. That resulted in real insights about the range of material effects the climate strategy could have on asset depreciation.”

National Grid is a U.K. power company with securities trading on the NYSE. Let’s hope its example lights the way for auditors of more companies on U.S. markets to consider climate impacts as a CAM. I think that every audit report should include a CCAM. If it does not, investors should vote against the firm and/or the Chair of the Audit Committee. Of course, what I think isn’t all that important. So, I asked someone whose opinion counts, Anne Simpson, Managing Investment Director, Board Governance & Sustainability at CalPERS.  Her view is:

“For an investor like CalPERS, we have a demanding day job. We need to allocate capital for the long term to pay pensions to our members. The valuation of assets and the financial flows that follow is vitally important to that task. Investors need accounts to be prepared on the basis of sustainable assumptions. That much is clear. We then need auditors to bring their independent expertise to bear and set out in their report how they have considered the challenge climate change brings to those stocks and flows. We have supported the inclusion of Critical Audit Matters in audit reporting from the outset. Climate change is both critical, and unarguably an audit matter. Audit committees and auditors need to prepare.”

This is wise counsel from Simpson. Audit committees and auditors will do well for the company (and good for society and the planet) by heeding it. It’s time for auditors to come clean on how they take climate change into account in their work.