Paris Aligned assumptions are a key focus of stakeholders. This In brief summarises the various considerations for companies reporting under IFRS.
What is the Paris Agreement?
The Paris Agreement 2020 was signed by 190 countries plus the European Union and has the objective of substantially reducing Greenhouse Gas (GHG) emissions and thus the impacts of climate change.
Many countries adopted the Paris Agreement and by 2020 also submitted their plans to reduce GHG emissions as part of their related nationally determined contributions (NDCs). NDCs normally include targets of net-zero GHG emissions by 2050 at the latest with interim targets for 2025 and 2030.
Countries may have implemented detailed laws and regulations relating to GHG reductions which may or may not be sufficient to meet their NDCs. Depending on the requirements and expected impact, entities will have varying degrees of detailed plans in place to address these requirements.
The term ‘Paris Aligned Assumptions’ refers to the use of inputs to estimates that consider the application of the Paris Agreement targets by a company.
What are the expectations from users?
Increasingly users of financial statements are challenging companies, their management and directors and their auditors regarding whether and how climate change is incorporated into financial statements. Although the Paris Agreement will in some cases have a material impact on financial statements, the answer to the question ‘Are these financial statements Paris Aligned?’ is often more complex than the question appears and is fundamentally driven by the technical requirements of various accounting standards within IFRS.
What guidance needs to be considered under IFRS?
The IASB is also considering whether to add a project on climate-related risks to its agenda. In the IASB’s Third Agenda Consultation, the Board noted that during outreach on their agenda consultation request they heard from certain investors the perception that:
(a) they need better qualitative and quantitative information about the effect of climate-related risks on the carrying amounts of assets and liabilities reported in the financial statements. The disclosures and information should be comparable and consistent.
(b) climate-related risks are often perceived as remote, long-term risks and may not be fully considered in areas of financial statements that require estimates of the future (for example, in testing assets for impairment).
The Agenda Consultation raises various areas that might be improved including considering the threshold for disclosing information uncertainty required by IAS 1 - Presentation of financial statements, broadening requirements for value in use when testing assets for impairment and developing additional guidance on the accounting for pollutant pricing mechanisms. Improving the standards will require the IASB to add the project to its agenda and go through its due process for amending IFRS.
That being said, in the meantime, there are still various impacts of the Paris Agreement that need to be considered under existing standards.
What is the expected impact?
The Paris Agreement will impact each company differently, however those companies in the higher risk climate industries are more likely to be impacted than those in other industries. The impact on the accounting and disclosures will vary depending on the individual facts and circumstances (for example, the company’s plans and the regulations in the relevant countries) or in some cases based on how a market participant would view the impact of the Paris Agreement on the company. Accordingly, although one may ask whether a company reflects ‘Paris Aligned’ assumptions in their accounting records, the answer is generally not as straightforward as the question implies.
Broadly speaking, the implications of the Paris Agreement on an entity could impact the recognition or derecognition of assets and liabilities as well as the measurement of such assets and liabilities, along with the presentation and disclosures. However, the impacts will vary depending on the nature of the asset or liability because different accounting standards have different recognition, derecognition and measurement approaches, as well as disclosure requirements.
What are some of the measurement considerations?
Different measurement considerations may be applicable depending on the facts and circumstances. The examples below are not meant to be an exhaustive list, but merely illustrate the point that different impacts might result from the application of the relevant IFRS.
Fair Value Measurement
IFRS 13 - Fair value measurement for an asset would be based on a hypothetical sale transaction for that particular asset. A simple example would be an investment in shares of a public oil and gas company accounted for under IFRS 9 at fair value through profit and loss. Fair value of such an investment would generally be determined by reference to the quoted price in an active market (i.e. a level 1 fair value measurement) and therefore would reflect market participants' assumptions on different risks including climate-related risk. Since the quoted price has to be used and should reflect market participants assumptions about climate-related risk no further adjustments can be made.
In situations where quoted prices in an active market are not available, the fair value model (level 2 or 3) will need to incorporate assumptions about how a market participant would take into account climate change in a hypothetical exit transaction. In other words, entity specific assumptions that are more conservative or more optimistic than what market participants would consider should not be used. Clearly, determining fair value for items not traded in an active market may involve significant management judgement and the appropriate disclosures about inputs / assumptions (including Climate) should be considered.
IAS 36 - Impairment of non-financial assets
IAS 36 requires an entity to assess non-financial assets for indicators of impairment. Such indicators may take into account estimates of likely negative impacts of the Paris Agreement on the recoverability of an asset or cash generating unit. Therefore the Paris Agreement may impact whether and how frequently assets in the scope of IAS 36 are evaluated for impairment (see EX 24.12.2
However, the recoverable amount of assets under IAS 36 is determined as the higher of fair value less cost of disposal and value in use. The higher of these amounts is then compared to the carrying amount of the asset or cash generating unit. As discussed above, fair value measurement is a market-based measurement, not an entity specific measurement. Accordingly, an entity would be required to estimate what the asset (or cash generating unit) could be sold at in an orderly transaction in its principal market or in the absence of a principal market, the most advantageous market. A fair value measurement can take into account future improvements in the operation of an asset, if this is what would be assumed by a market participant (for example, repurposing a combustion engine plant into an electric vehicle plant).
Value in use contains certain restrictions which do not allow future improvements to an asset to be taken into account until such changes are committed. However, value in use would take into account other estimates about climate change and how these may impact the future cash flows relating to an asset or cash generating unit.
Standards requiring best estimates
Several IFRS Standards require best estimates to be incorporated into measurement. For example, IAS 16 requires the best estimate of useful life of an asset to be considered. As discussed below if best estimates are being used there needs to be consistency in the financial statements. Where there are multiple potential outcomes for the useful life it may be that the most probable assumption is used.
In other cases, the best estimate might be a probability weighted average. If significant climate impacts need to be incorporated into the scenarios, but an entity might probability-weight those impacts to derive the entity’s best estimate.
Consider an asset that has a 75% chance of being used for its physical life of 40 years and a 25% chance of having a life of 25 years due to potential future changes to laws and regulations that might result from the Paris Agreement. The entity might use 40 years for the useful life of the asset based on its best estimate. On the other hand, if the entity used a probability weighted outcome it would use approximately 36 years as the estimated useful life.
Where there are outcomes that are significantly different than the best estimate (i.e. there is significant variability in the estimates) entities should consider whether it is more appropriate to use a probability weighted approach for estimating the useful life or where a best estimate approach is used consider the need for additional disclosure about the risk of changes in the estimate. In addition, entities should ensure that they are reassessing probabilities as new information becomes available and where there is significant uncertainty this may need to be done on a more frequent or more detailed basis.
What are the disclosure considerations?
Entities should evaluate whether disclosure is required under IFRS to enable investors to understand the climate-related assumptions underlying the preparation of the companies’ financial statements.
The starting point should be the disclosure requirement in the standard that specifically applies to the measurement of the asset or liability. Additionally, the general requirements in IAS 1 regarding disclosure of significant judgements and estimates need to be considered including consideration of the sensitivity of estimates made. When evaluating the need for disclosures for Paris Aligned Assumptions and related NDCs, companies should consider whether application of such assumptions to reduce GHG emissions could:
- Require significant changes to the company’s current plans;
- Require significant cost and time to implement;
- Generate more uncertainties and increase the number of scenarios applied in determining the measurement of an item; and
- Have a significant impact on suppliers’ costs or products or operations.
Entities need to ensure consistency between financial and non-financial reporting on key assumptions where such consistency is necessary for compliance with IFRS. For example, where entities publicly discuss a best estimate about the impact of the Paris Agreement on the entity in a sustainability report and an IFRS standard requires a best estimate approach to be used in measurement, the company would need to consider consistency between the estimates used for financial reporting and those disclosed in the sustainability reporting.
Where there are comments in the sustainability report that have not been reflected in financial reporting (for example, because the entity is relying on a market participant’s assumptions which differ) the entity should consider the need for additional commentary on why such items have been reflected on a different basis in financial reporting.
In summary, it is important that companies understand the expectations of their stakeholders and carefully consider the requirements for measurement and disclosures in IFRS.
There is no single approach to reflect Paris Aligned Assumptions in an entity’s financial statements prepared under IFRS. However, this certainly does not mean that Paris Aligned Assumptions should be ignored, on the contrary, it simply means that the use of those assumptions needs to be carefully considered and evaluated for compliance with the relevant IFRS.
Entities should continue to have an open dialogue with stakeholders, standard setters and regulators on these financial reporting considerations, and their consistency with the non-financial reporting considerations.
Where do I get more details?