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Accounting for climate risk

Michelle Byrne and Sinead McHugh set out the climate-related areas of focus for preparers of financial statements.

Do you know how climate has impacted your accounting?

It is quickly becoming apparent that climate change is likely to drive some of the most profound and persistent changes to business in our lifetimes. Earlier this year, Ireland signed into law its “Climate Action and Low Carbon Development (Amendment) Act 2021” which is a legally binding path to net-Zero emissions no later than 2050 and to a 51% reduction in emissions by the end of the decade. We have seen increased discussions as to how climate related matters will affect a company’s current and future business strategies, operations, and long-term value during the recent Ireland Climate Finance week and more recently at the 26th UN Climate Change Conference of the Parties (COP26).

Furthermore, from a corporate perspective, investors, regulators, and other business stakeholders are increasingly demanding increased disclosures on climate change matters and are challenging companies who are not factoring the effects of climate change into their critical accounting judgements. The SEC, FRC, and IAASA have all recently issued statements emphasising the importance of considering the impact of climate change when preparing financial statements. They have also emphasised the importance of consistency between a company’s targets and assumptions disclosed in the front half, and assumptions and estimates used in preparing the back half of the financial statements. To a greater or lesser extent, the risks and uncertainties arising from climate change are likely to have an impact on the financial statements of all companies. Some areas of focus for all companies in preparing their financial statements are set out below.

 

Impact on the financial statements

While asset impairment may potentially be the most obvious area impacted in the financial statements, companies should also consider other areas which may be impacted by climate related factors, for example, useful lives of assets, fair value of assets, and provisions. The following table provides a summary of some of the key areas we see impacted by climate-related factors:

 

Financial Statement Area 

Key considerations

Carrying value of assets

Cash flows play an important part in assessing the recoverability of an asset. During the impairment process
consideration needs to be given as to whether value-in-use (“VIU”) calculations need to be adjusted for climate-related risks. 
For example, companies may need to factor the following into their calculations:

  • Changing customer preferences, technology, and market trends may need to be reflected in the revenue and growth forecasts.
  • Energy intensive industries will likely need to incorporate higher costs in future cash flows as a result of carbon taxes and general climate related increases in energy costs.
  • Increasing costs of compliance with new policies or legislation, (for example, carbon budgets, stricter environmental controls, or increasing costs of insurance due to climate factors).
  • Increased capital expenditure to develop or acquire more energy-efficient production assets.

The key climate related assumptions applied in the VIU calculation together with a description of management’s approach to determining the value assigned to each key assumption should be disclosed. Increasingly this information is considered to be material for disclosure even if the climate related impact on VIU assumptions is not significant.

Useful economic life of assets

In order to meet emission targets companies may need to replace some of their asset base with equipment that is more energy efficient or powered from alternative sources. In addition, climate factors may indicate that an asset could become physically unavailable or commercially obsolete earlier than previously expected. As a result, certain assets may have reduced useful economic lives.

In some cases, a company may develop a more energy-efficient product to substitute a legacy product, resulting in a change in the estimated useful life of the client relationship intangible asset associated with the legacy product.

Any change to the useful economic life is recorded in the financial statements prospectively. Disclosure of the change in estimate in the financial statements is required. Even if the amounts are not considered material companies may wish to include disclosure of the revision to useful lives to demonstrate consideration of climate related factors in the preparation of the financial statements.
 

Fair valuation of assets

Climate change risks or changes to laws and regulations due to climate change actions may impact the measurement of assets measured at fair value. These risks and actions could affect inputs into valuation models in a number of ways. For example, similar to VIU calculations, cash flows may be impacted by changing revenue, growth, and cost assumptions due to climate risks and actions. Alternatively, if cash flows are not adjusted the discount rate may instead be adjusted for these risks through a relevant risk premium or discount factor.

Any changes in assumptions that are critical to the valuation of the asset need to be clearly disclosed and the impact quantified.
 

Changes in expected credit losses (“ECL”)

Given the short-term nature of trade receivables the impact on receivables in companies operating in non-financial industries is likely to be less severe.

Conversely, the long-term nature of some financial assets held by lending organisations may mean that assets held at the current balance sheet date could be exposed to severe adverse economic conditions. This could be due to exposure to customers in more significantly impacted industries such as oil and gas, and mining, or due to climate-related events, such as floods and hurricanes. Such events can impact the creditworthiness of borrowers due to business interruption, decline in asset values, and unemployment. Lenders could suffer increased credit losses through exposure to assets that become stranded or uninsurable, as these assets will no longer offer suitable collateral. These risks will need to be incorporated into the expected credit losses (“ECL”) model.

Disclosure of the effect of climate-related matters on the measurement of expected credit losses or on concentrations of credit risk may also be necessary.
 

Provisions, contingencies and onerous contracts

The pace and severity of climate change, as well as accompanying government policy and regulatory measures, may impact the
recognition, measurement, and disclosure of provisions, contingencies, and onerous contracts. For example:

  • New provisions or contingencies may need to be recognised or disclosed due to new obligations (for example, fines levied for failing to meet climate-related targets).
  • The timing of when an asset may need to be decommissioned may change due to regulatory changes or shortened lives, accelerating the required cash outflows for asset retirement obligations.
  • Cash flows and discount rates used in measuring provisions may need to take into account the risks and uncertainties of climate change and accompanying regulations.
  • Existing contracts may become onerous due to an increase in the costs of fulfilment, for example due to an increase in the cost of energy or water.

Carbon
trading schemes

There are currently different acceptable approaches to accounting for carbon trading schemes. This is an area that may evolve as such arrangements become more common and they apply to more companies. It will also be necessary to consider whether the acceptable approaches will be equally acceptable for any new schemes when implemented.

 

Conclusion

It is becoming increasingly apparent that investors and regulators are expecting more company specific information on the impact of climate risks on the company’s financial statements. Given this increased focus, there is a high level of expectation that directors, preparers, and auditors will have considered how and where climate related actions may impact on the financial statements. Even if the conclusion reached is that climate-related risks do not have a material impact on a company there is a growing expectation that the company discloses how these risks were considered and why they were not considered material for the company.
 

This article first appeared in Accountancy Ireland on December 1st, 2021.

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