While we individually and collectively grapple with the threat of sustained environmental challenges, corporates and other reporting entities need to consider the impact of climate change on their ongoing business sustainability and how that is reflected in financial statements.
The impact and the changes required by transitioning to sustainable future will vary by industry and individual reporting entity, but there are some common considerations all organisations need to think about based on current accounting requirements.
Where are the challenges?
Climate change commonly impacts the following areas in annual financial statements:
- Useful life and asset impairment
- Estimates, exercise of judgement and disclosure considerations
- Sustainable finance
The key challenges here are assessing these areas within our current accounting framework while we wait for more climate specific accounting standards.
Useful life and asset impairment
Climate change will likely require an entity to direct its expenditure in ways not previously expected. This can include purchasing new, more sustainable assets, like a new electric or hybrid vehicle fleet or making alterations to existing assets. However, the impact of climate change reaches beyond future capital expenditure. Organisations need to consider whether the useful economic life of existing assets has changed because of legislation (such as proposed changes to the Resource Management Act), advancing technology or even a commitment to reaching net zero carbon emissions.
The economic useful life of assets should be reviewed annually and consider changes that might arise because of climate-related measures. For example, changing to more sustainable assets could mean current property, plant, and equipment (PPE) has a reduced useful economic life, or advancing technology or legislation could see organisations have to move on from older PPE sooner than previously anticipated. Or the life of infrastructural assets in a flood prone area may be shortened by the effect of climate change.
A change in the useful economic life of assets would be considered a change in accounting estimate rather than a correction of error. This change should be applied prospectively for any current and future periods and will affect the depreciation (or amortisation) expense.
- Any revisions to the useful economic life should look forward. Questions to ask include:
- If further legislative changes are likely, will this have a greater or lesser impact?
- Do we have a replacement plan for our assets?
- What will our forecasting look like with a revised depreciation or amortisation charge?
- Has a commitment to net zero carbon emissions accelerated the useful life of less green assets?
Impairment is now high on the agenda as it reaches into areas such as financial instruments, PPE, intangible assets, and inventory - areas all of which could be materially affected by losses caused by climate change.
PPE and intangible assets with a finite useful life should be reviewed for impairment only when certain indicators are identified. An increase in the frequency of environmental damage, such as the likelihood of flooding, could be a trigger to complete an impairment assessment. As part of this assessment organisations might consider the impact of a 1.5 degree rise in mean temperatures, or a more extreme scenario such as a 2.5 degree rise in mean temperatures. This could also include the introduction of new environmental legislation, such as a requirement to phase out certain types of plastic, which would trigger an assessment if assets became obsolete or the generated output is reduced.
Consumer demand and a move from linear to circular production and consumption models might also impact the value and future economic life of existing assets.
Management will need to carry out a value in use (VIU) calculation and/or a fair value less costs to sell calculation (FVLCTS) to determine the recoverable amount and compare this against the carrying amount of the asset. Where the carrying amount exceeds the higher of the VIU and FVLCTS, an impairment charge will need to be recorded to write-down the value of the asset.
Climate change could affect both indicators of impairment and the calculation of the recoverable amount. Questions to ask include:
- Does any new or expected legislation accelerate the obsolescence of our PPE or intangible assets?
- Does the carrying value reflect the impact of our customers’ demand for more green products?
- Is there price pressure from our customers or suppliers based on more environmental resourcing?
Value in use
- Are outputs reflective of reduced demand for less green products?
- Does our VIU calculation reflect a complete picture of associated costs with usage?
Fair value less costs to sell
- Do cash flow projections consider a reduced demand for less sustainable, single-use or high waste (linear) products or changes in consumer behaviour?
- Is the disposal value too high for a less sustainable asset?
- Do we have a complete picture of all the costs to sell, dispose of, dump a less sustainable asset in a responsible manner
- Can we still comfortably justify an applied growth rate to our forecasts if climate change has affected obsolescence?
Organisations are required to recognise provisions when an obligation arises from a past event, and it is likely the entity will need to transfer economic benefits; if this cannot be reliably measured, it might fall into scope of being a contingent liability.
From levy provisions due to failure to meet climate targets, to contracts becoming onerous due to climate-related legislation, the importance of considering climate change when reporting provisions and contingent liabilities is clear, particularly if stringent regulations increase costs when your PPE must be decommissioned.
If your organisation is struggling to recognise and measure any provisions or contingent liabilities, here are some key considerations:
- Do any sites have environmental conditions you need to consider for decommissioning provisions? Should you consider sites on a case-by-case basis, or would a weighted portfolio approach more accurately report decommissioning costs?
- Do any of your current contracts have a climate change component?
- Could contracts become onerous or loss-making if climate change legislation changes adversely?
- Have you made a commitment to have net zero carbon emissions that could mean a liability is required to fulfil the obligation?
Estimates, exercise of judgement and disclosure considerations
Both IFRS and PBE standards require disclosure of the measurement bases used in accounting policies. This includes the judgements applied by management, any key assumptions, and any sources of estimation uncertainty with risk of material impact.
Where climate change provides risk of material uncertainty and leads management to make a judgement within an accounting policy, this needs to be disclosed accordingly.
Organisations should consider the uncertainty caused by climate-related matters and its impact on their current accounting policies:
- Does new or upcoming climate change legislation mean we have had to make assumptions that have a material impact?
- Does an assumption applied to the useful economic life of our assets have a material impact on carrying amount or annual depreciation?
- Does an assumption over climate change built into the impairment calculation have a material impact on an impairment charge?
- Do any provisions or grants have critical assumptions over whether criteria are met, and amounts can (or should) be recognised?
Green or sustainability-linked bonds are becoming increasingly popular as a means of raising finance. These debt instruments are usually linked to funding or promoting corporate social responsibility by meeting either environmental, social or governance (ESG) targets.
A key accounting consideration is whether these bonds contain an embedded derivative that will require separation under New Zealand accounting standards.
Do these bonds contain an embedded derivative?
- When making this assessment, first, an issuer will consider whether the green or sustainability-linked bond is a hybrid contract – i.e., one that includes both a non-derivative host instrument and one or more embedded derivatives. It then assesses whether an embedded derivative requires separation from the host contract (bifurcation).
- In a typical sustainability bond structure, it will be necessary to assess whether the interest step feature is a separable embedded derivative. If it is, the reporting entity will have two financial instruments – a host instrument (the bond) measured at amortised cost and a derivative (the interest step-up feature) measured at fair value through profit or loss (FVTPL). If the fair value of the embedded derivative cannot be measured reliably, then it will be necessary to measure the whole hybrid contract at FVTPL.
How does an organisation know when to separate an embedded derivative?
- An organisation separates an embedded derivative in a hybrid contract containing a financial liability host if:
– the economic characteristics and risks of the embedded derivative are not closely related to those of the host;
– a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and
– the hybrid contract is not measured at FVTPL.
A word about XRB climate related standards
In September 2020, the New Zealand Government proposed mandatory reporting on climate risks for many of the country’s largest organisations and tasked the XRB with developing reporting standards to support the new regime. Once the XRB issues its first climate standard, climate-related disclosures will be mandatory for large, listed companies with a market capitalisation of more than $60 million; large-licensed insurers, registered banks, credit unions, building societies and managers of investment schemes with more than $1 billion in assets; and some Crown financial institutions, commencing in 2023.
The accounting concepts discussed in this article will impact the financial statements of all entities and need to be assessed in addition to any obligations that might arise from the XRB climate standards in development.