What auditors need to know about ESG issues

By Anita Dennis

Environmental, social, and governance (ESG) issues are coming to the forefront for financial statement preparers and auditors with the formation of an International Sustainability Standards Board and the SEC's work to prepare a climate risk disclosure rule.

Preparers and auditors in the United States need to stay on top of these issues. Risks and opportunities related to climate, human capital, and other ESG-related factors are required to be considered by preparers and auditors when they affect the business and operating environment and have a material effect on the financial statements.

"Auditors should be aware of the need to improve their ability to identify the risk of material misstatement" when it comes to ESG issues, said Richard Davisson, CPA, director of the Northeast Regional Professional Practice Office at RSM US LLP and chair of the Assurance Services Executive Committee ESG Working Group, which has developed a chapter of an ESG practice aid that addresses the auditor's consideration of climate-related matters in audits of financial statements.

The practice aid highlights what the auditor needs to know about management's policies and procedures related to:

  • Capturing information about climate-related matters that may affect the entity's financial statements;
  • Assessing the risks of material misstatement of the financial statements resulting from such matters; and
  • Assessing the risks of material misstatement of the financial statements resulting from such matters.

In addition, the practice aid sheds light on how the auditor may consider and evaluate management's response to climate-related matters in an audit of financial statements conducted in accordance with auditing standards generally accepted in the United States (GAAS).

Factors to keep in mind

Companies are required to consider issues that reasonably have an impact on their financial statements, a Center for Audit Quality (CAQ) report noted. Situations in which financial reporting requirements may apply to ESG issues can vary based on factors that include the nature of the business, the industry, the company's geographic footprint, types of underlying transactions, and the significance of the risk to the entity's business. For example, forward-looking climate-related risks that could affect financial statements can include physical risks — such as potential damage to facilities due to severe weather or flooding — or risks associated with the transition to a low-carbon economy, resulting in changes to the evaluation of impairment or the useful lives of assets, according to the AICPA practice aid.

"A consideration of climate-related matters may be critical in relation to projections that may impact fair value or other accounting estimates," Davisson said. These issues need to be considered in the assessment of going concern or the possibility of impairment of inventory or assets, for example, he said. And, given the possibility that lenders or investors may expect companies to follow certain environmental practices, climate-related matters may also have an impact on a company's ability to raise capital, he said.

It's important to know that companies may report ESG information in a variety of places and following one of several available frameworks, according to Jim Burton, CPA, partner and leader of Grant Thornton LLP's ESG & Sustainability services. The CAQ, which is affiliated with the AICPA, found that 95% of S&P 500 companies published detailed ESG information and that most of the information disclosed was "primarily outside of an SEC submission in a standalone ESG, sustainability, corporate responsibility, or similar report. Of the remaining 5%, most companies published some high-level policy information on their website." ESG information may also be reported in the management discussion and analysis section of an organization's quarterly or annual reports. When included in a report with the company's financial statements subject to review or audit procedures, "the auditor is responsible for considering risks within the entity and its environment, which includes considering whether other information is consistent with the financial statements," Burton said.

Considering planned ESG-related actions also is important. An organization's climate-related commitments, such as achieving net-zero carbon emissions at some future point, can drive capital spending as well as require changes to product lines, distribution channels, and inventory valuation. "The auditor needs to be aware of those commitments and whether they add risk or contradict financial statement information," Burton said.

A company's business partner's ESG plans may also affect an organization. For example, a company whose customer makes an ESG commitment may be required to revamp its manufacturing environment to meet the customer's expectations, such as lowering its carbon output. Burton pointed to the auto industry, "where an automaker's decision to get out of gas-powered vehicles by a certain date can affect the entire supply chain."

Keeping up with change

Although ESG concerns can bring new considerations to audits, the requirements that auditors must follow to address them already exist in the standards, Davisson said. Auditors will need to be knowledgeable of specific underlying ESG factors to understand if they will have a material impact on the financial statements or create a risk of misstatement, he said. Using their knowledge of the industry, auditors' questions might include whether management has done a proper risk assessment that takes relevant ESG matters into account, whether the assessment is complete, and if any supplementation of the assessment is needed.

To keep ESG issues top of mind, his firm creates dashboards that break down overall ESG considerations for its clients and the industries in which they operate. "We give them to our teams to help them identify risks facing the entity that might cause material misstatements," Burton said.

The best advice is to be proactive in understanding the current and evolving impact of ESG issues. That requires maintaining an understanding of ESG factors within the company as well as in the environment in which it does business, including the regulatory and business landscape for the industry. Pointing to the changes and commitments that organizations are making today, "this is not an issue to be addressed in a decade or so," Burton said.

A session presenting the practice aid is scheduled to be held at the AICPA & CIMA Online ESG Conference on Dec. 13. For more information, visit the AICPA website.

Anita Dennis is a freelance writer based in New Jersey. To comment on this article or to suggest an idea for another article, contact Ken Tysiac, the JofA's editorial director, at Kenneth.Tysiac@aicpa-cima.com.

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