Suits The C-Suite
By Aris C. Malantic
In our last article, “IFRS S1 and IFRS S2: Game changers in global sustainability reporting,” the author discussed the first two global sustainability reporting standards published by the International Sustainability Standards Board: IFRS S1 General Requirements for Disclosure of Sustainability-related Financial Information and IFRS S2 Climate-related Disclosures. These standards can be game changers by helping companies identify material sustainability risks and opportunities that will help investors, lenders, and creditors assess the entity’s resilience against changes and uncertainties driven by sustainability-related issues. In response to these new disclosure standards, the International Accounting Standards Board (IASB) republished in July 2023 a document on the effects of climate-related matters on financial statements.
Due to the ubiquitous effects of climate change, there is an increased focus on the measurement and disclosure of climate-related matters in an entity’s financial statements. In effect, investors and stakeholders are keen to understand the potential impact of climate change on an entity’s business models, cash flows, financial position, and financial performance.
While International Financial Reporting Standards (IFRS) do not explicitly touch on climate-related matters, businesses must consider the latter in preparing their financial statements when the effects of those matters are material. The determination of the effects of climate change on an entity’s financial statements may require significant effort and judgment.
At a minimum, entities are required to follow the specific disclosure requirements in each IFRS standard. Entities may need to provide additional disclosures in their financial statements to meet the standards’ disclosure objectives. Hence, in determining the extent of disclosure, entities are required to carefully evaluate what information is required for users to be able to assess the effects of climate change on their financial position, financial performance, and cash flows.
Key points for entities to consider are summarized below:
Going concern, sources of estimation uncertainty, and significant judgments
As a major source of estimation uncertainty, climate risk could add complexity to the application of IFRS. Entities have to consider uncertainties associated with future climate-related developments when assessing an entity’s ability to continue as a going concern. They should therefore ensure they make the relevant disclosure of assumptions and estimates. Those disclosures must be entity-specific and avoid using boilerplate-type or generic language. Entity-specific disclosures include quantifiable information about assumptions, if relevant, and explanations of deviations from known market expectations regarding the same assumptions.
If relevant, quantified sensitivity disclosures should be made to illustrate the uncertainty embedded in the estimates relied on by entities. It is also important that entities stay consistent 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). Long-term climate risk impacts should also be considered when assessing the uncertainty associated with an entity’s ability to continue as a going concern.
Inventories
Climate-related matters may cause inventories to become obsolete, selling prices to decline, or costs-to-complete to increase. This may result in inventories needing to be written down to their net realizable values.
Income taxes
An entity’s estimate of future taxable profits may be impacted by climate-related matters, resulting in the entity being unable to recognize deferred tax assets. The entity may also be required to derecognize deferred tax assets that were previously recognized. Moreover, an entity may find that climate-related matters affect its future taxable profits potentially resulting in the entity not being able to recognize deferred tax assets for any deductible temporary differences or unused tax losses.
Property, plant and equipment, and intangible assets
To adapt business activities, climate-related matters may lead to a change in expenditures. An entity will need to determine whether these expenditures satisfy the definition of an asset and can therefore be recognized as either property, plant and equipment or as an intangible asset.
Both IAS 16 Property, Plant and Equipment and IAS 38 Intangible Assets require entities to review the estimated residual values and expected useful lives of assets at least annually. For example, climate-related matters may impact both of these estimates due to legal restrictions, obsolescence, or asset inaccessibility. Additionally, estimated residual values, expected useful lives, and changes thereto will also require disclosure.
Asset impairment
Significant judgment may be required in determining the extent to which certain assets, processes, or activities will be impacted by climate-related business requirements and how climate-related risks and opportunities will affect an entity’s forward-looking information, such as cash flow projections in the prognosis period. Entities must consider what information users rely on in assessing the entity’s exposure to climate-related risks.
Provisions/contingent liabilities and assets/levies
The recognition and measurement of provisions, as well as the need for disclosure of contingent liabilities, can be significantly impacted by climate-related matters. However, under IAS 37 Provisions, Contingent Liabilities and Contingent Assets, only the obligations arising from past events that exist independently of an entity’s future actions can be recognized as a provision. Due to the significant uncertainties involved in assessing the extent and impact of climate change, entities should ensure that sufficient disclosures are provided to allow users of financial statements to understand said uncertainties. Sufficient disclosures are also necessary to allow users to understand how climate transition has been taken into account in the measurement of a provision or disclosure of a contingent liability, and the assumptions and judgments made by management in recognizing and measuring provisions.
Financial instruments
Climate-related matters such as environmental calamities or regulatory change may affect a lender’s exposure to credit losses, affecting a borrower’s ability to meet its debt obligations to the lender. This makes climate-related matters potentially relevant in the calculation of expected credit losses if, for example, they impact the range of potential future economic scenarios or the assessment of significant increases in credit risk.
Climate-related matters may also affect the measurement and classification of loans as lenders may include terms linking contractual cash flows to an entity’s achievement of climate-related targets. The lender will have to consider the loan terms in assessing whether the contractual terms of the financial asset give rise to cash flows that are solely payments of principal and interest on the principal amount outstanding. Those climate-related targets may also give rise to embedded derivatives that have to be separated from the host contract.
IFRS 7 Financial Instruments: Disclosures requires entities to disclose the nature and extent of risks arising from financial instruments and how the company manages them. It may be necessary for lenders to provide information about the effects of climate-related matters on the measurement of expected credit losses or on concentrations of credit risk. For holders of equity investments, on the other hand, it may be necessary to disclose their exposure to climate-related risks when disclosing concentrations of market risk.
Fair value measurement
Market participant views of potential climate-related matters, including legislation, may affect the fair value measurement of assets and liabilities in the financial statements. Climate-related matters may also affect the disclosure of fair value measurements where relevant, particularly those categorized within Level 3 of the fair value hierarchy.
Since IFRS 13 Fair Value Measurement requires disclosure of unobservable inputs used in fair value measurements, those inputs should reflect the assumptions that market participants would use, including assumptions about climate-related risk.
Insurance contracts
Since climate-related matters can increase the frequency or magnitude of insured events, there may be an impact on the assumptions used to measure insurance contract liabilities. Similar to other areas, disclosure of the judgments made in applying IFRS 17 Insurance Contracts and relevant risks is required.
Final thoughts
The IASB document provides guidance to preparers of financial statements about the areas they need to consider in relation to climate-related matters. Although it does not introduce any new requirements, knowing how climate-related risks can impact financial statements can help remind its preparers about the scope of existing requirements in IFRS.
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinions expressed above are those of the author and do not necessarily represent the views of SGV & Co.
Aris C. Malantic is the Financial Accounting Advisory Services (FAAS) leader of SGV & Co.