Accounting standards such as FRS 102 and IFRS offer no specific climate change advice. But businesses need to consider climate change implications when preparing their financial statements. Here are seven key areas of concern.
Businesses can expect both increasing pressure from investors and growing scrutiny on how they reflect climate-related matters in their financial statements. The Financial Reporting Council (FRC) has made it clear that climate-related reporting in financial statements will be an area of focus for the regulator this year.
This represents an opportunity to get ahead of the curve on both managing and reporting climate change. Doing so will set up your business for a much smoother transition when the financial and non-financial aspects of climate change reporting become embedded within corporate reporting systems and processes.
But there is more to reporting on climate change than noting the uncertainty and significant judgements made in calculating the amounts appearing in financial statements. It can affect how assets and liabilities are recognised and measured in financial statements. Below, we've outlined a number of questions you should ask if you want to get ahead on climate change reporting.
But first, what guidance has been issued by the standard-setters?
Climate change guidance and sustainability reporting
In November 2021, the FRC published a factsheet to support preparers of FRS 102 financial statements with the impact of climate-related matters when preparing accounts under UK GAAP. It offers guidance on:
how climate-related matters can apply to the general requirements of FRS 102
how the recognition and measurement of items can be affected
subsequent impact on disclosures in the financial statements
In November 2020, the International Financial Reporting Standards Foundation (IFRSF) also published educational material to highlight how existing requirements in IFRS standards require companies to consider climate-related matters when their effect is material to the financial statements. It contains a non-exhaustive list of examples of when companies may need to consider climate-related matters in their reporting and is aimed at supporting the consistent application of IFRS standards.
In November 2021, the IFRSF announced its new International Sustainability Standards Board (ISSB). The creation of the ISSB is a move which aims to provide global financial markets with good quality and comparable disclosures on climate and other sustainability matters, marking a new chapter for sustainability reporting globally.
The formation of the ISSB is part of a ‘building blocks’ approach to sustainability reporting. The foundations are financial reporting whereby sustainability-related matters are reflected in the monetary amounts in the financial statements. The ISSB's formation will enable reporting on those sustainability-related matters that may reasonably create or erode enterprise value over the short, medium and long-term. This is likely to place a greater focus on the financial reporting impact of such matters with regulators, investors, and auditors alike.
What areas of your financial statements could climate change affect?
Check the following seven areas of concern to see if and how climate change might affect your financial statements. We've also raised a series of questions for businesses to consider to help move their climate-related and sustainability reporting forward.
IN THIS SECTION
1 Property, plant and equipment (PPE)
“Climate-related matters may require an entity to direct its expenditure in ways not previously expected,” states the FRC's FRS 102 Factsheet 8, p9. Aspects of this include purchasing new, ‘greener’ assets or making alterations to existing assets. However, the impact of climate change reaches beyond future capital expenditure. Businesses need to consider whether the useful economic life (UEL) has changed as a result of legislation, advancing technology or even a commitment to reaching net zero carbon emissions.
Do you need to reconsider the useful economic life of assets?
Yes, this should be reviewed annually and should consider changes that might arise as a result of climate-related matters. For example, changing to greener assets could mean current PPE has a substantially reduced UEL, or advancing technology or legislation could see businesses have to move on from older PPE sooner than previously anticipated.
A change in the UEL would be considered a change in accounting estimate rather than a correction of error. This change should be applied prospectively for any current and future periods and will have a knock-on effect on the depreciation (or amortisation) expense.
Any revisions to the UEL should look forward. Questions to ask include:
Are any further legislative changes likely that could have a greater or lesser impact?
Do we have a replacement plan in respect of assets?
What will our forecasting look like with a revised depreciation or amortisation charge?
Has a commitment to net zero carbon emissions accelerated the useful life of less green assets?
When considering climate-related matters, impairment is high on the agenda as it reaches into areas such as financial instruments, PPE, intangible assets and inventory. These areas could be materially affected by impairments arising as a result of climate change.
Do you need to write-down your fixed or intangible assets?
PPE and intangible assets with a finite useful life should be reviewed for impairment only when indicators of impairment are identified. Climate-related matters could trigger an indicator event that would require a business to carry out an impairment assessment. For example, government legislation may mean assets become obsolete or the generated output is greatly reduced.
Management will need to carry out both a value in use (VIU) calculation and a fair value less costs to sell calculation (FV:CTS) to determine the recoverable amount and compare this against the carrying amount of the asset. Where the carrying amount exceeds the higher of the VIU and FV:CTS an impairment charge will need to be recorded to write-down the value of the asset.
Climate change could affect both indicators of impairment and the calculation of the recoverable amount. Questions to ask include:
Does any new or expected legislation accelerate the obsolescence of PPE or intangible assets?
Does the carrying value reflect the impact of customer demand for more green products?
Is there price pressure from customers or suppliers based on more environmental resourcing?
Value in use
Are outputs reflective of reduced demand for less green products?
Does your VIU calculation reflect a complete picture of associated costs with usage?
Fair value less costs to sell
Do cash flow projections consider a reduced demand for less green products or changes in consumer behaviour?
Is the disposal value too high for a less green asset?
Do you have a complete picture of all of the costs to sell a less green asset?
Can you still comfortably justify an applied growth rate to your forecasts if climate change has affected obsolescence?
3 Provisions and contingent liabilities
Both FRS 102 and IFRS require businesses to recognise provisions when an obligation arises from a past event, and it is probable that the entity will need to transfer economic benefits as a result with the amount being able to be reliably measured. If it cannot be reliably measured, it may fall into scope of being a contingent liability.
From explicit scenarios where failure to meet climate targets leads to levy provisions to contracts becoming onerous due to climate-related legislation, it is clear the importance of considering climate change when reporting provisions and contingent liabilities. A key area of this is likely to be around decommissioning items of PPE whereby increasingly stringent regulations might increase financial obligations.
Has your business failed to recognise and measure any provisions or contingent liabilities?
Do any sites have any environmental conditions you need to consider for decommissioning provisions? Should you consider sites on a case-by-case basis, or would a weighted portfolio approach more accurately report decommissioning costs?
Do any of your current contracts have a climate change component?
Could contracts become onerous or loss-making if climate change legislation changes adversely?
Have you made a commitment to have net zero carbon emissions that could mean a liability is required to fulfil the obligation?
4 Government grants and tax credits
To encourage businesses to invest in green projects and activities, governments around the world are offering various grants and tax credits to support the success of those projects and activities. With an increasing focus on green initiatives, more and more businesses may become eligible for government grants or tax credits. If businesses are unfamiliar with the treatment of such grants and credits or are new to undertaking green projects, there is a risk they are not accounting for these grants and credits correctly.
A key attribute to government grants is whether conditions are likely to be met. Where it is unlikely to be met, some grants can become repayable. For example, a grant for a green project could result in an undisclosed liability if the business is unable to deliver its commitments. Businesses should therefore consider whether they can meet the criteria in determining whether to recognise income from such grants.
5 Going concern
Climate-related issues involve a high degree of future planning. You may need to consider the impact government action, legislation or even social responsibility would have beyond the 12 months from the date of signing as required for the going concern basis. FRS 102 Factsheet 8 identifies reaching net zero carbon emissions or prohibiting sale of fossil-fuelled vehicles as examples of scenarios that could have a going concern level impact on businesses.
Even if you reach the conclusion that the business is a going concern, disclosure of material uncertainties over going concern must be made. Even when not considered a material uncertainty, reaching this conclusion could also require significant judgements to be disclosed. Be mindful that if this is not explicitly reported on in financial statements, you risk giving the impression that the impact of climate change on going concern might not have been appropriately or adequately considered. This is an aspect of financial reporting that requires careful drafting to manage expectations.
There are many ‘big picture’ questions businesses should ask when it comes to the impact of climate change on going concern:
Could unexpected change to legislation completely change the business outlook?
Could natural disaster have a long-term impact on supply chain and how are you managing supply chain risk?
Does the business need to adapt to trends in order to stay a going concern?
6 Significant judgements
Both FRS 102 and IFRS require disclosure of the measurement bases used in accounting policies. This includes the judgements applied by management, any key assumptions and any sources of estimation uncertainty with risk of material impact.
Where climate change provides risk of material uncertainty and leads management to make a judgement within an accounting policy, this needs to be disclosed accordingly.
Businesses should consider the uncertainty caused by climate-related matters and its impact on their current accounting policies:
Does new or upcoming climate change legislation mean you have had to make assumptions that have a material impact?
Does an assumption applied to the useful economic life of assets have a material impact on carrying amount or annual depreciation?
Does an assumption over climate change built into the impairment calculation have a material impact on an impairment charge?
Do any provisions or grants have critical assumptions over whether criteria is met and amounts can (or should) be recognised?
7 Carbon offsetting
Carbon offsetting is a method for businesses to offset their carbon emissions by investing in environmental projects. These projects can vary from planting trees to distributing low-energy products. While this is usually outsourced, a business could carry out its own projects as opposed to paying another party.
To account for carbon offsetting activities, you need to consider the nature of the outflows and whether it is creating an expense or an asset by reviewing the requirements of FRS 102 or IFRS as appropriate. You also need to consider whether a liability arises from present obligations to purchase offsets.
Preparing for your next reporting season
Climate change has historically been overlooked in many industries when it comes to financial reporting. However, with increasing pressure on businesses to disclose information on sustainability matters, the next few years could prove pivotal to both financial and non-financial reporting and disclosure requirements.
Businesses of all sizes and complexity should now prepare themselves to report fully on the impacts of climate change. Those who do will be in a much better position, while also enabling a smoother transition to future reporting requirements. The reality is, it will take time to comprehensively consider such matters.
If you answered yes any of the questions raised this in article then climate change could be material not only to what you include in your financial statements but to the ongoing viability of your business.
To discuss how climate change may impact your financial and non-financial statements (eg, annual report), get in touch with Laura Tibbetts or Giles Mullins.