Key points

  • Management needs to consider climate change and associated risks when preparing financial statements.
  • Disclosure on how climate change and associated risks have been incorporated into the financial statements is required.
  • Areas particularly impacted are disclosures around judgements and estimates; impairment models; consistency and linkage between different parts of the annual report.
What is the issue?
The Financial Reporting Council (FRC) has recently issued two thematic reviews that deal, at least in part, with the impact of climate risk on financial statements . Specifically they highlight what entities should consider with regards to this topic for disclosures within the financial statements. The expectations from users and the regulator are high.
What is the impact?
Management should consider the following areas in particular:
Consistency and linkage
The annual report as a whole needs to tell a consistent story regarding the impact of climate risk. So there should be a coherent link between the strategic report and other narrative disclosures, including any discussion of specific net zero commitments or plans, and the financial statements. For example, there should be a clear explanation of how a net zero commitment discussed in the strategic report has been taken into account in impairment review calculations or the assessment of assets’ useful lives. Similarly, the degree of emphasis placed on climate-related risks and uncertainties in the strategic report should be reflected in the extent of disclosure in the financial statements. In their thematic reviews, the FRC came across many examples of companies presenting voluminous narrative disclosures in the ‘front half’ of the annual report, but making little or no mention in the financial statements. It could be that management does not currently consider there to be a material impact on the financial statements, but they should clarify this where investors and other stakeholders might expect there to be an impact. This is especially the case where the breadth and depth of narrative disclosure have raised those expectations.
Management needs to assess financial statement materiality in relation to climate risk in the same way as for other accounting and disclosure matters.
The FRC makes several references in both thematic reviews to paragraph 112(c) of IAS 1, which requires disclosure in the notes to the financial statements of information that might not be required by a specific IFRS standard, but is nonetheless relevant to an understanding of the financial statements. A similar principle is established by paragraphs 17(c) (“provide additional disclosures when compliance with the specific requirements in IFRSs is insufficient to enable users to understand the impact of particular transactions, other events and conditions on the entity's financial position and financial performance”) and 31 (“consider whether to provide additional disclosures when compliance with the specific requirements in IFRS is insufficient to enable users of financial statements to understand the impact of particular transactions, other events and conditions on the entity’s financial position and financial performance”) of IAS 1. Accordingly, when considering the extent of disclosure regarding the impact of climate risk, entities should consider whether disclosure is required beyond that explicitly required by specific IFRS standards. Examples might include disclosure of:
  • Sources of estimation uncertainty that are expected to have a material impact over a timeframe that goes beyond one year.
  • Additional information about how management has taken into account Paris-aligned outcomes when preparing the financial statements.
Paris alignment
The FRC observes that some commentators have called for entities to prepare ‘Paris-aligned’ financial statements, based on assumptions and estimates that are consistent with the Paris Agreement. However, financial statements must also comply with IFRS standards (or UK GAAP, as appropriate). These standards often specify the use of ‘best estimates’ when measuring assets and liabilities, and these estimates might not be consistent with any of the possible global warming pathways targeted by the Paris Agreement. Extant accounting standards might also prohibit entities from reflecting certain future developments associated with a Paris-aligned climate transition in their financial statements. For example, where anticipated future obligations do not yet meet the criteria for recognition of a liability or where entities cannot reflect asset enhancement expenditure in impairment assessments. Accordingly, although one may ask whether an entity reflects ‘Paris Aligned’ assumptions in its financial statements, the answer is generally not as straightforward as the question implies (see also In brief INT2021-14).
The FRC expects management to understand the extent to which the global warming outcomes targeted by the Paris Agreement, and relevant government and regulatory plans to reduce carbon emissions in accordance with that agreement, need to be taken into account in measuring assets and liabilities. If an entity has not used assumptions consistent with a Paris-aligned scenario in preparing its financial statements, the FRC considers that it might be helpful to disclose that fact, particularly if the entity
has made its own net zero commitment. In addition, if management considers a Paris-aligned scenario to be reasonably possible, then disclosure of sensitivities might be required (see under ‘Judgements and estimates’ below). More generally, in the context of investor interest in more meaningful climate change disclosures, the FRC encourages entities to consider whether additional information regarding the impact that Paris-aligned assumptions would have on the financial statements would be useful.
Judgements and estimates
Climate related judgements and estimates affect many financial statement line items. Climate related sources of estimation uncertainty may pose a significant risk of material adjustment of the carrying amount of assets and liabilities in the next financial year. In such cases, IAS 1 paragraph 125 requires specific disclosure. However, there might also be instances where such estimation uncertainties only have a material impact over the longer term, such as where government regulation is expected to be introduced in the future. In this case additional disclosure might be required, as explained in the section on ‘Materiality’ above.
Asset impairments and useful lives
Climate risk might have a particular impact on forecast models, such as those used for impairment testing (for example, the impact of changes in consumer behaviour, carbon taxes or energy prices). Where significant, entities should explain the basis for reflecting climate-risk in cash flow forecasts and discount rates used in value in use calculations. Management should avoid boilerplate statements such as ‘climate has been incorporated into our impairment review assumptions’ which provide limited insight without describing the relevant assumptions, uncertainties and the position taken.
There may be instances where entities have not identified any impairment indicators. In such cases, management should consider explaining how they have reached this conclusion, particularly where users might reasonably expect that an indication of impairment exists.
With regards to the assessment of assets’ useful lives, management should explain plans to replace long-lived assets or to transform the business in which they are used. Furthermore, if applicable, management should consider whether an explanation that transition plans or potential regulatory changes do not impact assets’ useful lives is likely to provide useful information.
Segment reporting and revenue disaggregation
IFRS permits or requires aggregation in various areas (such as segment reporting and disclosures concerning revenue). The varying impacts of climate risk might prompt management to rethink whether more disaggregation is now required given changes in risk exposure.
When does this apply?
There is no new or specific standard that deals with climate risk. Rather the extant IFRS standards already provide a clear framework for incorporating any risk - including climate risk - into the financial statements.
What about UK GAAP?
There is no difference between IFRS and UK GAAP in this regard.
Where do I get more details?
1 The reviews are: (i) CRR Thematic Review of TCFD Disclosures and Climate in the Financial Statements (see In brief UK2022-43) and (ii) Judgements and Estimates: Update (see In brief UK2022-42), both from July 2022.
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