Weathering the storm of reporting: factoring climate change into audited financial statements

By Gilly Lord, Global Leader, Public Policy & Regulation, PwC UK

Putting businesses on the path to a low carbon economy will require access to funding throughout the transition. But for investors to be comfortable that they know what types of activities they are financing, they need transparent and reliable information about the threats posed by climate change and business’ response. Financial reporting is a critical information source for helping achieve the change the world needs, and [PwC] auditors are adapting their own practices to play their part.

Climate change is the most critical issue facing the world today. While society currently faces a multitude of calamities — the Covid-19 pandemic, wars, poverty, economic disruptions and inequities, and social injustices — climate change has the potential to exacerbate each of them.  The planet is already experiencing extreme weather events which wreak havoc, including hurricanes, blizzards, floods, wildfires, heat waves and droughts; these of course are increasingly seen to be linked to climate change, with the dangerous consequences to society and business expected to worsen in the coming years.

In April, the UN Intergovernmental Panel on Climate Change (IPCC) released its latest report, reiterating its previous findings: that climate change is a grave and mounting threat to our well-being and a healthy planet; that severe impacts are already happening; and that today’s actions will shape how people adapt to climate change and how nature responds to increasing climate risks.

It’s no wonder, then, that investors around the world have been growing increasingly concerned about the far-reaching economic implications of climate change and, as a consequence, are intensely focused on business’ responses. The costs of managing climate risk can come in many forms, and range from making operational modifications for improved energy efficiency; to relocating operations to reduce exposure to, for example, wildfires or floods; to completely shifting the business model to one that is less carbon intensive. The resulting financial implications also vary widely – from the operating and capital expenditures needed to make changes within the business, to shutting down factories because of reduced customer demand or legal prohibitions. Profits, cash flows, liquidity and solvency can all be impacted. In extreme cases, businesses that cannot adapt will fail.

Savvy investors, therefore, need information on the financial implications of material climate risk to the businesses they invest in. If information on the potential impact of material climate risk isn’t complete and accurate, investors could unknowingly allocate their capital to businesses exposed to climate risk – and ultimately could be left with worthless investment portfolios if that risk is badly managed.  The implications for the investing public, through their pensions and mutual funds, are potentially severe.

Despite the obvious importance of this area, “climate change” is not mentioned by name in accounting and auditing standards, although the standard setters would say that its effects are covered – just like any other risk factor that is financially material to a company.  To eliminate any possible doubt, standard setters including the International Accounting Standards Board (IASB), the Financial Accounting Standards Board (FASB) and the International Auditing and Assurance Standards Board (IAASB) have each published guidance summarising how climate risk might impact judgements taken in preparing financial statements, and in judgements taken by auditors of the financial statements.  This guidance has been helpful in raising awareness, ensuring that both financial statement preparers and auditors think even harder about how a company’s climate risk exposure could materially impact financial reporting. 

So what’s the problem with financial statements?  

Even with this guidance, though, some users of financial statements aren’t finding the information on the impact of climate risk that they’re looking for. Where climate risk isn’t mentioned, investors are left wondering whether climate risk just hasn’t been considered, or whether it was considered, but isn’t material - or whether it is material but hasn’t been disclosed.  The confusion means that some investor groups have been engaging with companies and auditors about what they expect to see in financial statements and the associated audit reports. They are particularly focused on ensuring that a lack of disclosure does not indicate that the company (and its auditor) have not considered material climate risk exposure, where relevant, in the preparation (and audit) of the financial statements.  PwC auditors welcome this engagement - it helps companies and auditors better understand the needs of users of financial statements, and that means that the quality of corporate reporting will continue to improve.  But I’d caution anyone from concluding too quickly that if climate risk hasn’t been mentioned, then it must have been overlooked.  

To understand why the effects of climate risk on a business might not be immediately evident in the financial statements (and therefore in the audit report) it’s important to remember the primary purpose of financial statements: to set out the financial performance of a company over a specific past period and its financial position as of a particular past date. Although climate risk might be critically important to a company’s future, there may be no material impact of climate risk on its financial statements today. This is because financial statements aren’t designed to predict a company’s performance or financial position in the future.  

There are also some specific constraints in accounting standards which mean that the layperson’s expectations of how climate risk might appear in financial statements cannot be met. Accounting standards are written to minimise opportunities for speculation about the future. For example, accounting for provisions requires upcoming laws to be “virtually certain” before any associated costs of compliance can be provided for.  So although a company may expect that national legislation requiring reduced emissions may be passed in the future, no provision for costs associated with that change can be recognised until that legislation is virtually certain to be enacted.  Balance sheet amounts that are measured using assumptions about future income, expenses and other sources of cash flows must be based on today’s expectations of those future amounts, and wherever possible should be based on market-based evidence that exists at the balance sheet date.  For example, this means that forward oil price curves observable today should be used as the basis for a valuation, even though actual oil prices in the future might be very different.  Auditors, of course, are charged with considering if financial statements follow these standards.  

Even where climate risk has had a material impact on financial statements, it may not always be obvious from a quick glance.  For example, let’s imagine that extreme weather damages a factory or results in loss of inventory; the resulting charge will likely be described as an “impairment loss” or “write down of inventory”.  It will probably not be described as a “loss due to climate change”.  Often it will not be straightforward, or even possible, to isolate the effects of climate change from the effects of other risks on the business and therefore on the financial statements.

Some have suggested, therefore, that there is a need to update the accounting and auditing standards to include specific mention of climate risks and to require consideration of those risks over longer time horizons. But we at PwC don’t believe this is the right approach; principles-based standards cannot by their design anticipate every eventuality. In fact, it is precisely because they are based on principles that they can accommodate emerging business practices and risk exposures without needing to amend the accounting rules each time something new comes about. Accounting standards recognise that the significance of a particular risk changes over time; new risks emerge, some risks go away. There are, however, new areas of accounting arising from climate risk exposures that are not covered in sufficient detail by current accounting standards and need to be considered in the standard setting process. These include, for example, accounting for carbon offsets or emission trading schemes. 

Some confusion can be resolved through a company’s narrative reporting, which should give information about the risk exposures that companies face today and that might arise in the future, as well as the implications of the commitments made – even if they are not (yet) explicitly captured in the financial statements.  And we can expect this type of “non-financial reporting” to develop very quickly -  the proposals that have been put forward by the US Securities and Exchange Commission (SEC), the International Sustainability Standards Board (ISSB) and the European Financial Reporting Advisory Group (EFRAG) are welcome steps. These proposals also highlight the importance of showing the direct link between a company’s risk exposure and the resulting financial implications, giving a holistic picture of business performance and risk exposure.

What should auditors be doing?  

Investor expectations about the auditor’s role in assessing whether climate risk is appropriately factored into financial reporting are high and increasing. This is a positive development; it recognises the relevant role that auditors can play in supporting the financial ecosystem to tackle really important problems.  However, some investors have expectations which go beyond the auditor’s role in financial reporting. For example, some expect auditors to ensure companies are effectively managing the material climate risks they face. But auditors don’t run the business; high quality audit depends on maintaining a truly independent mindset, which precludes advising a company on whether or how to change the way it operates. Some investors equate business risks (which the company manages) with the risk that financial statements don’t accurately portray a company’s performance (which the auditor focuses on), but they are not the same thing. The auditor provides an independent perspective to assess whether the financial statements are materially misstated.  Remember that the primary purpose of financial statements is to set out the financial performance of a company over a specific past period and its financial position as of a particular past date.  If the auditor concludes that a business risk doesn’t impact the company’s past performance, financial position or disclosures in a material way, the business risk won’t need to be reflected in the company’s financial statements.  

So, what are auditors doing?

The objective of a financial statement audit is to issue an opinion which concludes whether or not the financial statements give a true and fair view of the performance and financial position of the company being audited, in accordance with accounting standards. If the opinion is unqualified, then the shareholders can take “reasonable assurance” from that opinion that the financial statements are free from material misstatement.  Auditors begin their audit planning by assessing the risk of material misstatement of the financial statements, and that risk assessment is based on an understanding of the factors that could prevent an organisation from achieving its goals and objectives.  Those factors may well include climate risk, and so that means that investors can expect most auditors to consider the potential impact of climate risk, to some extent at least, as part of their planning and risk assessment procedures.  As explained above, in some audits, this consideration could conclude that climate risk doesn’t translate into a risk of material misstatement, but in some audits it certainly will.

It’s also worth mentioning that auditors are required to read the narrative information disclosed in the annual report (referred to in the auditing standards as “other information”, and includes, for example, information about the company’s business model, strategy and risk exposures).  The purpose of this requirement is to enable the auditor to consider whether there are any material inconsistencies with the audited financial statements, or with information obtained during the audit. Although this “read requirement” is not an audit of that “other information”, any material inconsistencies are discussed with management and if needed the auditor will request that the information be corrected.

At PwC, we have worked hard to provide auditors across our global network with access to training, tools and methodologies to ensure they can confidently assess material climate risk, and its potential impact on the financial statements being audited. From virtual educational eLearns to one-to-one meetings with our sustainability and climate change experts, our auditors are getting up the learning curve quickly so that they can have informed conversations with audit committees and finance teams. In some cases, auditors are raising the issue before a company has had a chance to think about it – and that can lead to challenging conversations about the potential effects of material climate risks. In other situations, PwC auditors are encountering situations where climate risk might be significant to a company’s business model in the future, but where there is no material impact on the financial statements today.  

Fundamentally, an auditor’s role in the corporate reporting system is to provide trust in the financial statement information that capital market participants use in decision making. In today’s world, that information includes a company’s material climate risk exposure, where relevant. That is why PwC became a founding member of the Net Zero Financial Services Providers Alliance (NZFSPA), a global consortium of firms that are furthering their commitments to a science-based approach to addressing climate change and establishing a net zero global economy. We’re working hard to provide training and tools to our auditors to help them identify and assess risks arising from climate change that could potentially cause a material misstatement of a company's financial statements as a whole. NZFSPA is aligned with the Glasgow Financial Alliance for Net Zero (GFANZ), which represents hundreds of major financial institutions across the globe, controlling assets in excess of US$130 trillion, with the common goal of achieving net zero GHG emissions by 2050. By working together with others in the corporate reporting system, auditors are better able to support the changes needed to ensure shareholders have the reliable information they need to direct capital to the sustainable activities that can make a difference to the future of our world.

Where do auditors go from here?

Although many companies are now making commitments to achieve net zero emissions in the coming years, it’s increasingly clear that investors want more transparency about how they reach that goal, both in the financial statements, where they’re impacted, as well as in narrative reporting. But it’s known that transparency in reporting isn’t going to be enough. Investors also expect companies to make changes to their business, not only to mitigate the effects climate change has on their operations, but also to lessen their impacts on the environment and communities around them.

It’s important to remember that no individual party in the corporate reporting ecosystem can change the system on their own. Climate change has implications for operational decision making, financial reporting, auditing and investment analysis, which are all interlinked. It is all the more challenging when as a society our knowledge about climate change is constantly evolving and auditors can’t possibly anticipate the multitude of effects it may have on businesses. Nonetheless, the audit profession can work hard to stay abreast of this complex area so that shareholders can rely on and trust our audit opinions. This is the case for any developing risks that could give rise to material misstatement of financial statements, whether as a result of climate change, cybersecurity breaches, geopolitical events or other developments. At the same time, investors are learning more, asking the right (albeit challenging) questions and engaging with companies and auditors to raise awareness about what they expect to see in financial statements and the associated audit reports. They also are increasingly using their power to vote to make their wishes known to executives and boards.

One thing is clear: the effects of climate change have potentially far reaching implications for many businesses, some that will result in new and material risks that must be managed.  Ensuring that those risks are transparently identified, reflected and understood will help investors make better-informed decisions.  However, not all climate risks will have a material impact on financial statements, which is why the new reporting standards coming from the ISSB, for example, will be helpful in providing investors with a holistic view of the impact of climate and other sustainability risks.  Transparency will enable all parties in the system to have the information they need to play their part in achieving the behaviour changes the world needs.

_{¹ The definition of materiality in US GAAP is: “The omission or misstatement of an item in a financial report is material if, in light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgement of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.” Although the wording in IFRS and US GAAP differs, the principle behind each is the same.}