How climate risks are reflected in current financial statements

By Ken Tysiac

Climate-related risk considerations are continuing to evolve for financial statements as environmental, social, and governance (ESG) issues receive increasing attention from investors and others who use financial statements.

Regulatory developments are driving change in this area, as SEC Chair Gary Gensler has asked the SEC staff to develop a mandatory risk disclosure rule proposal by the end of the year, and the IFRS Foundation is considering creating a new International Sustainability Standards Board.

Although it's impossible to know what new regulations and standards might emerge, users of financial statements need to understand what climate risk information is currently required to be included in company reporting.

The Center for Audit Quality (CAQ), which is affiliated with the AICPA, has published a resource that describes management and auditors' responsibilities related to climate-related risk reporting.

"What we're trying to achieve with this resource is foster a dialogue on climate-related measures and disclosures among all the stakeholders in the financial reporting ecosystem," said Dennis McGowan, CPA, vice president, Professional Practice for the CAQ.

"The goal is to provide investors and other stakeholders with a foundational understanding of how the key elements of the current accounting and auditing requirements in the U.S. today are applied by company management and auditors with respect to climate-related risks and the audited financial statements."

Management responsibilities

U.S. GAAP requires management to disclose any risks whose effect might be material for the financial statements. While GAAP doesn't refer specifically to climate-related risks, these are understood to be included in the risk disclosure requirements.

Specific to climate issues, these risks typically consist of either:

  • Physical risks, such as a factory located in a low-lying coastal area that's at risk of flooding; or
  • Risks of a transition to a low-carbon economy, such as regulatory risk or the reduction of the useful life of an asset.

The timing of low-carbon risks may vary depending on the company and the commitments it is making. For instance, the CAQ's resource shows an example of a company that has made a net-zero carbon promise by 2030 that has a greater climate-related impact on its current financial statements than another example where the deadline for a similar commitment is 2050.

"Climate-related risks, like any other risk, will vary from company to company," McGowan said. "The time horizon and plan for implementing climate-related commitments plays a role in whether or not they're having a material impact on a company's financial statements, which we're trying to demonstrate with the examples," McGowan said.

Auditor responsibilities

Under PCAOB standards, auditors are required to perform a risk assessment that includes gaining an understanding of the company and its environment.

This includes an understanding of climate-related risks.

"It's going to be the facts and circumstances," McGowan said, "but certainly the more prevalent these commitments are, or these physical risks are, and the more material they are, the more they are going to intersect with risk assessment."

Although PCAOB standards don't require auditors to perform procedures over disclosures outside of the audited financial statements, auditors are responsible for considering the appropriateness of management's consideration of potential risks of material misstatement, which includes climate-related risks.

Ken Tysiac (Kenneth.Tysiac@aicpa-cima.com) is the JofA's editorial director.

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