Accounting and financial implications of ESG initiatives

In simplified terms, a liability is a present obligation that exists as of the financial statement date and requires the transfer of resources to another party. Careful consideration should be given to (1) the point in time at which the entity’s obligation begins and (2) whether the obligation exists as of the financial statement date. Liabilities arise as a result of a past event; therefore, it is important to consider the obligating event for a liability and when that obligating event occurs. Likewise, it is also important to determine whether any liabilities result from a reciprocal transaction whereby one party exchanges a good or service with another party.

For instance, as employees render services to a company, the company incurs a liability to pay them; the rendering of services in exchange for payment is an example of a reciprocal transaction. The company would not incur a liability to pay for the employees’ services before the employees provided them. Similarly, a company may intend to purchase a new environmentally friendly manufacturing facility but would not incur a liability until a contractual obligation exists and the manufacturing facility has been transferred to the company.

However, obligations arising as a result of a government action or a company’s climate-related public statements, plans, or actions may not be reciprocal transactions. And assessing the point in time at which the company has incurred a liability that is not the result of a reciprocal transaction may require significant judgment. For example, if a company incurs an obligation as a result of future carbon emissions, the obligation may not have existed as of the financial statement date.

Companies should evaluate the existence of legal obligations on the basis of current laws, regulations, contractual obligations, and related interpretations; they should not forecast changes in laws or in the interpretations of such laws and regulations. The impacts of any changes in laws or regulations should be considered in the period in which the new or amended laws or regulations are enacted.

As is the case with the considerations noted above regarding liabilities, understanding how a company shifts its business to support its environmental goals or targets is critical to evaluating the ongoing use and recoverability of its long-lived assets, including goodwill, as well as other indefinite-lived intangible assets; property, plant, and equipment; inventory; deferred tax assets; and lease assets. On the basis of these business shifts, an entity may need to reassess the useful life of an asset or test assets for impairment.

For example, if a company plans to reduce its greenhouse gas emissions by replacing its current manufacturing equipment with new technology and equipment that emits fewer greenhouse gases, it should evaluate whether such plans affect the recoverability of its existing manufacturing equipment and also reassess whether the current useful life of that existing equipment remains appropriate. Further, if a company has goodwill related to a reporting unit that includes the product lines produced by the existing equipment, it should assess whether its future manufacturing process will result in a different profit margin profile, which could affect the expected future cash flows of the reporting unit and ultimately alter the results of the entity’s goodwill impairment test. Likewise, a different profit margin could have an impact on the recoverability of inventory and deferred tax asset balances.

Forecasted revenues or cash flows may be an assumption that a company uses in multiple impairment tests. When a single set of assumptions is used in multiple analyses, companies should verify that the same set of assumptions is being used in each analysis unless the applicable accounting rules permit otherwise. They should also verify that assumptions and estimates used outside of the financial statements (e.g., sustainability reports) are consistent with those used when preparing estimates in the financial statements.

Companies will need to consider which disclosures are required for items recorded in the financial statements (e.g., asset impairments or liabilities) on the basis of existing accounting rules. Current rules also require companies to disclose information that helps financial statement users assess major risks and uncertainties—such as the use of estimates in the preparation of financial statements, including certain significant estimates, and current vulnerability due to specific concentrations. In addition, on the basis of current accounting rules, companies need to disclose certain items that are not recorded in the financial statements, including commitments.

Companies should evaluate their plans to reduce their carbon footprint to determine whether they have any major risks, uncertainties, or commitments that should be disclosed in their financial statements. In addition to the disclosure requirements set forth by accounting rules, companies should consider SEC reporting requirements as discussed above in the SEC activities related to environmental matters section.