- Dee S Kothari
Climate Change Accounting under IFRS… are you ready?
Background
The impact on climate change have never been more significant then right now, with pressure to clearly articulate commitments on attaining net-zero by 2050. Therefore, the UK Financial Conduct Authority (FCA) requires companies with UK-listed shares to complete mandatory annual Task Force for Climate-Related Financial Disclosure (TCFD)-aligned climate disclosure reporting.
UK sustainability disclosure requirements (SDR) has yet to finalise and officially implement its legislation that will emerge as the definitive UK sustainability reporting standard in 2023. SDR may also introduce a UK Green Taxonomy, like in the EU sustainability legislation, which came into force on the 5 January 2023. So watch out!
Climate-related issues under IFRS impact several areas in accounting. While the impact to the financial statements may not be significantly material, transparency to explain how climate-related matters are considered in preparing the financial statements are material from a qualitative perspective. I am alluding to disclosures on significant assumptions, estimates and judgements made relating to climate change.
The Task Force on Climate-Related Financial Disclosures (TCFD) highlighted that:
‘More urgent progress is needed to improve transparency, especially when considered within the broader global focus on climate change.’
What is the impact?
Well, IAS 1 requires companies to disclose climate-related matters, which is not specifically required by IFRS standards and not presented elsewhere, but which is relevant to the understanding of financial statements. It is important to note that the integration of climate risks into risk governance frameworks comes with numerous challenges too, such as:
Uncertain, where Climate-related risks can be non-linear and sporadic;
There are limited projections for economic and financial effects for climate change;
Data projections are not always comparable, given divergence in taxonomies and standards globally;
The need to collect new types of data on customers and put in place new processes and governance can be difficult;
Identifying the right metrics to measure climate risk exposure can be challenging, without adequate knowledge and external support; and
Incorporating climate scenario analysis into risk assessments isa new concept.
Estimates and Judgment
Assumptions in respect of climate related matters may not result in material adjustments in the short-term, but the chance of material adjustments in the longer-term could be significant. In that context, it is important to acknowledge that organisations must provide additional disclosures beyond the specific requirements in IFRS standards when those requirements are insufficient to enable users to understand the impact of transactions, other events and conditions on a company’s financial position and performance. This inevitably requires updating processes., systems and training people.
Appropriate explanation on how such factors have impacted the estimations made by the company, by including details about the assumptions relied upon, as well as sensitivity disclosures to reflect the impact would add clarity to the user. Some consider that the impact of climate risk and potential future developments on the Company, including the sustainability of its current business model, is too uncertain to allow for meaningful representation, through measurement and quantified disclosures. Where there is a high level of uncertainty, thought on disclosing sensitivity should be included.
Climate-related matters may impact judgements made when deciding the appropriate accounting policies, cash flows expected to arise to achieve certain sustainability concerns. Targets in the future need to be considered for either asset maintenance or enhancements when determining value in use/ carrying value. Similarly, significant judgement may be required when determining whether an entity has a constructive and legal obligation.
Going Concern
In assessing whether the going concern basis of preparation is appropriate, information regarding climate-related matters should be considered in conjunction with other uncertainties. Climate-related matters may affect an entity’s going concern assessment, with assumptions regarding the nature of future business activities and restrictions on bank financing likely to be factored into the assessment. Additionally, companies will need to consider external factors such as issues regarding water, energy, land use and waste management that are crucial to the continued operation of the business.
When assessing the uncertainty associated with an entity’s ability to continue as a going concern, climate risk impacts beyond those expected to materialise in the short term, should be considered. It is also important that companies ensure consistency in both the disclosures about climate related matters outside the financial statements (e.g., in separate sustainability reports or management commentaries) and how they incorporate climate risk in the financial information (e.g., in measurements and disclosures in the financial statements).
Property, Plant and Equipment (PP&E)
Climate-related matters have the potential to significantly impact the useful life, residual value and decommissioning of PP&E. Climate change, and the associated legislation to promote sustainability, increase the risk that items of PP&E become ‘unusable assets’ whose carrying value can no longer be recovered within the company’s existing business model.
Given the uncertainties around the impact of climate change, disclosures should be included to allow the users of the financial statements to understand and evaluate the judgements applied by management in recognising and measuring items of PP&E.
Asset impairments
Impairment is assessed at the end of each reporting period (either year-end or interim reporting date), whether there are any impairment indicators for a company’s assets. If there are, the standard requires an entity to perform an impairment assessment, under IAS 36.
Future cash flows are estimated for the asset in its current condition and do not include estimated future cash inflows or outflows that are expected to arise from future restructuring to which an entity is not yet committed or that improves the asset’s performance over and above its originally intended use. This raises the question to what extent such cash flows should be included where an entity is trying either to achieve certain sustainability targets or to cut their CO2 emissions, which would require capital investments. It is key to understand whether the investment is required to continue operating the assets and therefore would be akin to maintenance- opex. Conversely, if such capital investments, in effect, would represent improvements or enhancements to the asset, they should only be included when the entity is committed to and has substantively commenced the investment.
Significant uncertainty and judgement also arise when considering how different scenarios of environmental change may materialise, for instance, the speed of decarbonisation and the extent to which the average global temperature is increasing. Where significant uncertainty and judgement exists, an expected cash flow approach, based on probability-weighted scenarios, may be more appropriate than a single best estimate for determining value in use. In practice, this could mean probability weighting scenarios (i.e., worst case, base case and best case), as well as factoring in different pricing curves. Even where a probability-weighted scenario approach is used, a company would still need to consider adjusting the discount rate for the general uncertainties and risks not reflected in the cash flows. Scenario analyses will be particularly relevant for highly impacted industries, such as extractives and manufacturing industries. Industries impacted to a lesser extent, could instead consider incorporating the exposure from environmental change through the discount rate and perform sensitivity analysis.
Significant assumptions and judgements to reflect the climate risk in impairment testing should be reflected in the disclosures. It is important to disclose how climate change and climate-related goals have been translated into assumptions and are reflected in the impairment test.
Provisions
IAS 37 does not allow a company to recognise a provision for future operating losses due to climate change.
Except in the case of an onerous contract, the amount required to be recognised as a provision is the best estimate of the expenditure required to settle the present obligation at the end of the reporting period. In the case of an onerous contract, the amount required to be recognised as a provision is not based on an estimate of an expected outcome. Instead, the provision must reflect the lower of the costs of fulfilling the contract and any compensation or penalties from a failure to fulfil it (regardless of what the entity expects to do).
If any of the conditions for recognition are not met, no provision is recognised, instead a contingent liability may exist. Contingent liabilities are not recognised, but an explanatory disclosure is required, unless the possibility of an outflow in settlement is remote. Under IAS 37, only those obligations arising from past events that exist independently of a company’s future actions should be recognised as a provision.
Given the significant uncertainties involved in assessing the extent and impact of climate change, companies should ensure that sufficient disclosures are provided to allow users of financial statements to understand those uncertainties, how climate transition has been considered in the measurement of a provision or disclosure of a contingent liability and the assumptions and judgements made by management in recognising and measuring provisions.
Financial Instruments
IFRS 9 also requires Companies to classify and measure financial assets based on the business model in which they are held and their contractual terms.
With sustainability-linked loans are becoming increasingly prevalent, the contingent rate adjustments inherent in these loans may introduce additional variability to the cash flows of the loan that is inconsistent with a basic lending arrangement and fail the Solely Payment of Principal and Interest (SPPI) test. This would result in the asset being classified as at fair value through profit or loss (FVPL)! Moreover, the expected credit losses on these instruments can also potentially lead to higher allowances for expected credit losses, where greater the tenor/ term, the greater the extent to which the counterparty is likely to be affected by climate change.
Climate transition risk to net-zero will create the risk of financial loss due to the economic transition toward a more sustainable economy, where it could also result in a rapid deterioration of credit quality in sectors and/or countries affected, particularly if policy changes are radical or quickly implemented and these factors should be considered in a borrower’s ability to repay and service debt.
Sustainability-linked debt instruments
Sustainability-linked debt instruments are structured such that their interest rates vary based on whether the borrower achieves pre–determined sustainability targets defined in the loan agreement. For instance, a reduction or increase in the interest rate if the borrower does, or does not, attain a certain rating on a type of green–sustainability targets.
Some sustainability features may affect the borrower’s credit risk over the long-term but not necessarily the loan’s credit risk. For example, continuous failure to meet sustainability targets in the long term might lead to the borrower’s business becoming unsustainable and result in its demise, but this may have negligible effect on the borrower’s ability to repay the loan in the short term over its expected remaining life. ch are unrelated to a basic lending arrangement, (e.g., exposure to changes in energy prices or commodity prices), do not give rise to contractual cash flows that are SPPI.
Instruments are more likely to meet the SPPI requirements if the attainment (or non-attainment) of the sustainability target is likely to result in the improvement (or the deterioration) of the borrower’s credit risk during the life of the loan such that the change in interest rate is commensurate with the change in credit risk of the borrower. IFRS 9 acknowledges that clauses that allow changes to the timing and amount of contractual cash flows may not fail the SPPI test if there is a relationship between the changes and an increase in credit risk.
Some sustainability features may affect the borrower’s credit risk over the long-term but not necessarily the loan’s credit risk. For example, continuous failure to meet sustainability targets in the long term might lead to the borrower’s business becoming unsustainable and result in its demise, but this may have little effect on the borrower’s ability to repay the loan in the short term over its expected remaining life.
In short, ESG-linked features that are included to compensate the lender for ESG risks would fail the SPPI requirements, whereas those that are included not as compensation for bearing ESG risks, but as an incentive for the borrower to meet certain ESG targets, could pass the SPPI requirements.
For a further dicussion on this area and how we can help you benefit from our epertise, feel free to enquiry via our home page form.
Dee Singh Kothari is a senior partner in Kothari Partners
For further reading, please refer to the following articles:
4. Impact of Climate Change on Operational and Stakeholder Risks and how to adapt and evolve - Part 2
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