Expert Analysis from Kevin Prendergast, Chief Executive, Irish Auditing and Accounting Supervisory Authority (IAASA). This article has been written exclusively for IoD Ireland members.
Now that autumn has arrived, thoughts begin to turn to the year end, and the preparations for the annual report can begin. Annual reports have traditionally been divided into two parts. The front half is a narrative report, with key statistics setting out strategy and performance, promoting how the company has achieved its operational and strategic outcomes, and setting out its future plans. The back end are the financials, complied in accordance typically with International Financial Reporting Standards (IFRS), with a wealth of detail for informed readers to pore over.
The Annual Report
The detail in the financials will of course need to wait until after the year end, but the structure of the front end will already be being considered by finance and investor relation departments. Those carrying out these preparations need to be aware that just because the front end is not covered by the audit report, it is not carte blanche. Auditors will check the entire report to ensure there is nothing that is inconsistent with what they have found in the course of their audit. And where management use so-called alternative performance measures (APMs), such as “adjusted profits” or “core earnings” these cannot be presented with any greater prominence than their IFRS counterparts, and a reconciliation also needs to be provided.
The front end is also typically the repository for a company’s ESG (environmental, social and governance) disclosures, increasingly focusing on climate disclosures. Moreover, as the focus of Government, the EU and wider stakeholders on the impacts of climate change become ever more intense, the numbers in the financials will also increasingly be affected by how a company is or is planning to respond.
Climate Change Disclosures
The Irish Auditing and Accounting Supervisory Authority (IAASA) recently issued its 2021 observations document. This report helps those preparing financial statements by highlighting some of the areas the IAASA suggests needs focus. Some of these come up repeatedly, such as the use of judgements and estimates, fair value measurement, and the aforementioned APM’s. This year will also need to include how companies have responded to COVID-19. But the report also suggests that companies need to consider how climate change will influence the valuation of fixed and current assets, and whether any contingent liabilities need to be recognised.
So what sorts of things should management, directors and audit committees consider? Well firstly there are the basic disclosure requirements required so that the financial statements give a true and fair view. In short, if there is information out there that would influence how readers interpret the financials, then this needs to be disclosed, even if it is not specifically referenced in financial reporting standards. So if you know of impending challenges to the business model, or to site location, or regulatory costs that may arise from climate change, even if they haven’t yet crystallised, then these need to be disclosed.
A key part of asset valuation is assessment of future cash flows, and the judgements and estimates that are an intrinsic part of these assessments. Again, those responsible for the preparation of financial statements need to look at those expected cashflows and assess what impact climate change may have. For example, if you have an asset that make intense use of fossil fuels, and you have a residual value built into your cashflow projections, is that still valid where those fuels will become increasingly expensive, leading to less demand for that asset?
European Commission Plans
So, plenty for companies to think about. And there is more to come. As part of the European Commission’s Green Deal, all large companies as defined under the Companies Act will be required to make a whole new range of climate related disclosures. The Commission is currently consulting on its proposed Corporate Sustainability Reporting Directive. The new disclosure standards are currently being drafted by a European expert group with a view to being issued by autumn 2022, and to apply for the 2023 financial year.
Until the draft standards are issued it isn’t clear how far-reaching the requirements will be, but the information available at the moment points to wider rather than a narrow set of requirements. Among the principles on which the standards are to be based are that information must be both retrospective and forward looking, and that the double materiality principle must apply. Double materiality means that you don’t just look at whether the item is material in the context of the reporting entity. You must also assess whether it is material in the contest of its potential impact on people and the environment.
Building on these principles are proposals that the new standards will in time encompass both cross-cutting and sector specific issues. They are also being developed in consultation with the other global bodies currently working on sustainability standards, of which there are several.
Furthermore, when a company makes these disclosures, the draft proposals state that the auditors will be required to audit them, firstly on a limited basis but in time in the same way as they currently audit the financial statements.
So, these standards will apply to all large companies reporting in 2024. But their impact will in all likelihood be much wider than that. For example, if you are a large company, you will need to look up and down your supply chain to ensure that you are fully compliant with the standards, especially in the context of the double materiality as defined above. In practice that means even if you are an SME, but you are dealing with a company who will be subject to the new requirements, then you will probably need to be able to measure and potentially disclose the environmental impact of your business. Increasingly also, banks and other financiers will be looking for your climate related measures before they lend, indeed there is some evidence of this happening already.
What to Do Now?
For this year end, companies need to consider the potential impact of climate change on their year-end results.
- What are the company’s assets actually worth? Do the cashflow predictions prepared to support asset values actually hold up?
- What contingent liabilities do you need to consider disclosing in the light of proposed government policies on climate change and carbon neutrality?
- Moving forward, you will need to analyse your business, your customers, your suppliers, your market, your regulation, your physical location, all of these and more that could potentially be impacted by climate change. Will you be directly impacted by the proposed EU Sustainability Directive? Will anyone in your value chain be impacted?Do you think you will need to access external finance in the short to medium term? Do you have the capability either in house or through access to external support to measure your climate impact?
What is clear is that change is coming, imminently for large companies but in time for every business. Your sustainability reporting will require similar input and effort as you currently apply to your financial reporting. Reporting standards will require that financial statements make appropriate disclosures. Auditors will audit those disclosures. Ultimately, your business will have to join the journey to climate neutrality, and be able to demonstrate that it has done so. The sooner you start preparing for this the better.