How on earth do I audit the climate?
Climate risk disclosures are here to stay - but the pervasive nature of the climate crisis can affect all aspects of a business, and its financial statements. In this post Ancoram explores how auditors can approach climate risk on their financial statement audit engagements.
Over recent years we’ve observed a steady increase in the number of listed businesses and public interest entities (PIEs) reporting their exposure to climate risk. In the UK, the FCA requires all listed businesses and FCA-regulated financial services firms to comply with the TCFD disclosure requirements on a ‘comply or explain’ basis, but climate risk isn’t restricted solely to those entities. If anything, climate risk will hit smaller entities the hardest, as they have fewer financial resources to manage the physical risks as well as the transitional risks (we explain these terms below).
In November 2021, the UK Financial Reporting Council published FRS 102 Factsheet 8 Climate-related matters, which explains the pervasive extent of climate change on a company’s financial statements. This factsheet can also serve as a useful guide to direct auditors to key audit risks in relation to climate.
Going concern
Going concern is, in our view, the best place to start - and finish - at least, as far as climate change is concerned! Businesses are exposed to both transition and physical risks which could cause significant detriment to their ability to remain a going concern. Examples include:
Physical risks: acute event-driven risks, such as extreme weather events (e.g. floods), or chronic risks arising from long-term shifts in climate patterns, such as rising sea levels, temperatures or increased precipitation
Transition risks: risks arising from policy shifts to address the climate crisis, emergent technology to reduce carbon or energy usage, market shifts in supply and demand, and reputational exposure
These risks, which may appear as somewhat nebulous or ethereal to some businesses, could cause very significant financial impacts, including:
Increased costs of compliance
Asset impairments, write-offs, obsolescence, early retirement or decommissioning
Reduced demand for products and services
Increased R&D into emergent technology and processes
Reduced revenue due to changing consumer patterns
Abrupt changes in energy costs
Loss of facilities to extreme weather events
Loss of investment or increased borrowing costs
These financial impacts can in turn be pervasive through the economy, presenting a system-wide issue. As such, auditors need an in-depth understanding of not just their clients, but the complete environment their clients operate in and the pressures faced by their clients’ investors, lenders, suppliers and customers to identify any material uncertainties. Audit teams should consider the impact of these risks on the overall engagement audit risk at the start of the engagement, and revisit their consideration when the audit fieldwork is substantially complete.
Balance sheet
-
Climate risks can affect the both the classification and measurement of financial instruments.
Classification issues arise where the instrument is linked to ESG criteria, for example the interest rate is dependent on certain actions taken by the business, or the cash flows are linked to an external index.
Measurement impacts relate to fair values, any judgements or estimation uncertainties, and the risk of impairment / bad debts caused by climate change. Audit teams should consider the risk of default by a material debtor due to climate risk.
-
Climate risks can disrupt a company’s liquidity profile, its investment exposure due to concentration risk, and market risk exposure. These require disclosure under FRS 102 and IFRS 7 and so auditors should consider whether the disclosures provided are sufficiently clear and comprehensive for the primary users of the financial statements.
-
As production costs increase, so too does the cost of inventory on the balance sheet. However, the critical risk is whether this value is recoverable through future revenues - does an active market exist that is willing to pay for these higher costs? Is there an increased risk of obsolescence? UK accounting rules and IFRS require inventory to be valued at the lower of cost and net realisable value (estimated sales price less costs to complete and sell), so the risk of impairment from climate risk can be a material audit area.
-
The risk of ‘stranded assets’ is particularly relevant - this is the risk of an asset becoming obsolete or needing to be impaired / written off due to climate change. In some cases, the decommissioning costs may require a provision elsewhere on the balance sheet.
Audit teams should identify whether any assets are at risk of impairment, a shorter useful life, or obsolescence and tailor their audit approach accordingly.
-
Climate risks can severely reduce forward cash flow projections, particularly the growth rate. As with PPE assets, there is the risk of other intangibles having a shorter useful life or no longer providing a benefit to the business. Audit firms should pay special attention to the assumptions applied by their clients.
R&D expenditure is likely to increase as companies consider ways to reduce their greenhouse gas emissions and carbon footprint. Auditors need to understand how their clients have ensured that research costs are expensed and not capitalised under FRS 102 / IAS 38, and that accounting policies in this area have been consistently applied.
-
Many climate risks can give rise to a legal obligation, but they can also give rise to a constructive obligation, particularly where a business has made public commitments to reduce its carbon footprint.
Auditors should consider:
whether any onerous contract provisions are required
whether any stranded or older assets require a decommissioning provision
how future cash flows have been estimated and whether these are adequate, given the risks identified
Employee benefits and share-based payments
Remuneration packages, bonuses and incentive schemes are increasingly including a component that is conditional on certain ESG-related targets being achieved. For example, a share incentive plan might contain specific clauses dependent on reducing greenhouse gas emissions. Auditors need to be aware of the performance conditions in these schemes, and reflect on whether their clients’ calculations adequately reflect the conditions in their valuation and accounting treatment. While such performance conditions may have been considered ‘trivial’ in the past, they can no longer be regarded as such given the urgency of the climate crisis.
Narrative commentary
Certain companies are subject to Streamlined Energy and Carbon Reporting (SECR) requirements and stakeholder engagement disclosures. Others are required to prepare a strategic report and comment on the impact of the company’s operations on the community and the environment. PIEs, AIM registrants, companies with more than £500m revenue or 500 employees also need to prepare a ‘non-financial and sustainability information’ (NFSI) statement. Some of these disclosures will require audit, others merely need to be read for consistency with the financial statements. We recommend that audit firms apply their professional scepticism to these disclosures and challenge management on whether the disclosures are sufficiently accurate, complete and present climate-related matters fairly, without undue bias.
Next steps
The FRC’s factsheet is an excellent source of information. We are happy to provide audit firms with a pro bono consultation on auditing this area - click here to book a consultation.