Environmental, social, and governance (ESG) matters continue to be important to investors and capital markets, and the possibility of Securities and Exchange Commission (SEC) regulation mandating additional disclosures remains a hot topic.
But the potential effects of ESG matters on a company’s financial accounting and reporting are not a future consideration. Existing accounting guidance and the current regulatory environment call for companies to evaluate ESG and incorporate related risks into their financial reporting today, regardless of what future changes to standards or regulations might occur.
“The current ESG discussion is largely from an operational standpoint, about future business goals and objectives, like reducing carbon footprint to net zero by 2030, and what sustainability reporting and disclosure requirements will look like in the future,” said Eric Knachel, partner at Deloitte and co-author of a recent publication on this topic. “What is particularly important but is not often talked about in the media is the potential implications of environmental issues as it relates to accounting and disclosure requirements under the rules that exist today.”
The Financial Accounting Standards Board (FASB) has not added ESG reporting to its technical agenda, and no accounting standard revisions on this topic are imminent. FASB did include ESG as an emerging area in financial reporting in an invitation to comment on future standard-setting issued in June. In March, FASB staff published an educational paper addressing the connection between ESG matters and existing accounting standards and SEC disclosure requirements.
“The key to reporting ESG matters is consistency between the company’s narrative of its plans and objectives and the assumptions used in the financial statements.”
Eric Knachel, Partner, Deloitte
ESG broadly affects all companies, although risks will be different by industry. “There has recently been a specific focus on climate change because we are seeing the physical risks and impacts on businesses, along with the transition risk of expected infrastructure changes as we try to move to a low-carbon economy,” said Maura Hodge, partner and national ESG assurance leader at KPMG IMPACT.
Both physical risks and transition risks of climate change can affect financial statements. Current GAAP includes a requirement for a reporting entity to consider changes in its business and operating environment when the changes have a material direct or indirect effect on financial statements and notes. Management judgment is required in making this evaluation, including the use of estimates to determine the effects.
Companies are required to include these uncertainties and risks in their estimates of future cash flows and consider disclosing them.
“Estimation uncertainty is significant when it comes to climate risk,” Hodge said. “There are the risks of severe weather events; timing and rate of changes in consumer preferences; potential changes in packaging; energy transition; and raw material and labor supply chain issues, among others.” She noted a challenge with ESG reporting is the time horizon—financial statements generally look out about a year, while the impact of ESG issues can go out on average three to five years.
Knachel noted companies need a deliberate approach over their sustainability strategy and reporting that may involve many different people within the organization, along with related processes and internal controls. “Some regulated industries, like oil and gas or power and utility companies, might be more in tune with these issues and have been discussing them for some time, but maybe others are becoming more cognizant of ESG because it’s in the news,” he said.
“The key to reporting ESG matters is consistency between the company’s narrative of its plans and objectives and the assumptions used in the financial statements,” he said. “If a company announced it is planning to close a manufacturing plant and replace it with a new one, for whatever reason, it wouldn’t make sense for the financial statement estimates about the assets’ useful lives and residual values not to reflect these events.” Knachel added companies typically have internal controls focused on accounting and financial reporting, but they might not have the same controls and processes around sustainability initiatives.
Management’s plans related to ESG initiatives can have a direct or indirect effect on financial statement amounts, and companies need to think this through. “Are there accounting implications today if a company states it has an objective to reduce its carbon footprint by 50 percent or wants to be ‘net zero’ by 2030?” Knachel asked. “There is no one-size-fits-all. A company’s plans can have accounting implications today because, for example, they have to take actions now or there may be a need for forward-looking disclosures without any accounting.”
While there is no specific GAAP for ESG matters, current standards do address multiple issues that come about because of the effect of companies’ ESG plans and actions and require management judgment about relevant facts and circumstances. Examples include:
Asset lives and valuation. Changes in business plans can cause a reduction in the remaining estimated useful lives of tangible or finite-lived intangible assets that are depreciated or amortized or the need for asset write-downs.
Regulatory action or changes in operations can create an indicator of impairment of indefinite-lived intangible assets or goodwill, requiring evaluation and the need for write-down or potential disclosure.
Inventory, which is required to be valued at the lower of cost and net realizable value, can have its realizability negatively affected by changes in consumer demand, damage from weather events, higher costs to complete work in process because of raw material supply chain issues or changes in technologies, or regulatory changes.
Forecasts. Estimates of future cash flows are required for valuation and fair-value estimates under current GAAP in multiple areas. “There are a lot of moving factors for ESG-related items that can impact forecasts,” Knachel said. “These include revenues, costs to convert, changes in technologies and efficiencies, and implications of regulatory actions.”
Revenue forecasts can be affected by changes in consumer behavior and preferences, including current and future customers making decisions about doing business with a company based on its ESG commitment and impact on the environment. Certain industries, like real estate and airlines, might have their revenues negatively impacted by their customers’ decisions to reduce their real estate footprint or employee travel because of ESG considerations.
The new lease accounting standard has requirements for accounting for lease abandonments and modifications that can result from ESG-driven strategies. Another accounting consideration is the realizability of deferred taxes can be impacted by changes in forecasts of future revenues and taxable income.
Contingent liabilities. Required accounting and disclosure of environmental contingencies have not changed but might need more attention with increased regulatory focus and changes in company plans related to ESG matters.
New ESG-related transactions. There are some new transactions specifically linked to ESG initiatives that have direct effects on financial statements. These can create new accounting challenges, including measurement of future cash flows and the potential for embedded derivatives.
“ESG can make businesses better, and talking about ESG and integrating it into your business strategy is really about value creation in a way that mitigates risk, helps build stakeholder trust, and delivers on a company’s competitiveness.”
Maura Hodge, Partner, KPMG
“Power purchase agreements are not new, but companies that might not have entered into them before are now considering them to be able to procure more renewable energy,” Hodge said. “There are related accounting considerations around derivative accounting or the creation of variable interest entities. We are also seeing service companies buying land or forests to offset their emissions, and there are questions about how this should be accounted for.”
“Banks are issuing sustainability-linked bonds where the interest rate depends on whether or not environmental metrics are met, requiring consideration of whether this creates derivative accounting under existing accounting models,” said Knachel.
In addition, there has been a trend toward companies linking executive bonuses and stock compensation awards to meeting sustainability objectives and environmental metrics.
“The challenge is how to measure and estimate achievement of these metrics using both objective and subjective criteria,” Knachel said. “It’s likely that the number of these transactions will increase as they become more popular.”
“There are direct effects on financial statements of companies incorporating a net-zero commitment, changing their capital investments and manufacturing facilities, or sunsetting product lines that are not green,” Hodge said. She noted the European Union’s Corporate Sustainability Reporting Directives already have a proposal to have companies separately disclose green revenues; capital expenditures; and operating expenses, similar to additional disclosures by segment under U.S. GAAP.
All reporting entities should evaluate their ESG-related financial accounting and reporting implications based on current requirements. Beyond making sure a company’s financial statements are fairly stated, there can be additional benefits.
“ESG can make businesses better, and talking about ESG and integrating it into your business strategy is really about value creation in a way that mitigates risk, helps build stakeholder trust, and delivers on a company’s competitiveness,” Hodge said. “People understand this, and that’s why it’s in the social consciousness right now. Companies are still challenged by how to act on it—how to envision a strategy, implement and operationalize it, and tap into the value that is created.
“Historically, a lot of people consider reporting as a compliance exercise. We believe ESG reporting is how businesses can prove they are achieving their ESG goals and having a positive impact on the environment and society. It’s a way to tell your story, weaving it together with the standards and regulations you need to follow.”
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