Climate change will affect future financial reporting after the global community set targets to tackle global warming, PwC Thailand points out.
Environmental action such as purchasing carbon credits may result in asset impairment, while using green financial instruments may have a big impact on bookkeeping. PwC advises companies to understand and assess the risks of setting green targets on corporate financial reporting to properly plan their environmental activities.
Sinsiri Thangsombat, Assurance Leader and Partner at PwC Thailand, says that the world is currently waking up to fight climate change.
Governments and private sectors are working together on an urgent agenda of reducing greenhouse gas emissions.
This follows on from the 26th United Nations Climate Change Conference (COP26) where the global community agreed on goals and measures to limit the global average temperature rise to no more than 1.5 degrees Celsius. It’s an issue that’s changing our environment, government regulations and what consumers expect from businesses. It will also impact financial reporting.
“Climate change not only affects the physical environment, regulation issuance and consumer behaviour but also financial statements,” Sinsiri said.
“The organisations involved in issuing international accounting standards have disseminated educational material related to accounting issues. These include commitments to net zero carbon emissions and carbon credit purchasing that may result in asset impairments and the issuance of environment-linked financial instruments. It’s important for companies to study the details of these issues and the possible impacts on financial statements before setting climate-related targets,” she said.
Impact of climate goals on asset impairment
Taking action on climate change could result in indications of asset impairment for some businesses, which would then need to perform impairment testing, Sinsiri said.
If governments set limits on their carbon emissions and emissions rise beyond those limits, carbon credits will need to be purchased, increasing production costs. Changing consumer behaviour may also cause reduced demand for some products, which has been seen in the growing popularity of electric cars over conventional cars, she said.
Companies will need to assess whether their machines can generate cash flows that cover the carrying value of the assets.
Some companies may go public about their vision to conduct a socially and environmentally responsible business without being forced to by law. If, for example, a company makes a public statement that it intends to switch to machines powered by renewable energy within the next three years, it will create expectations amongst society and stakeholders.
So, making cash flow projections from using the machines from the normal useful life may be shortened which in this case may result in impairments, Sinsiri explained.
Understand the terms of green financial instruments
Companies need to understand the terms of financial instruments linked to environmental development and climate change targets, according to Sinsiri.
Financial instruments like green bonds and green loans are linked to a company’s carbon emissions. Meeting these terms may affect interest rates, so the company needs to understand how interest rates and carbon emissions are linked.
“If the company is operating under rules governing carbon emissions, it must comply with these rules or risk being closed down. This suggests the interpretation that interest rates are directly linked to the company’s overall or credit risks. If that’s the case, the company must record interest by using the effective interest rate and change the interest rate according to the time when the risks change.
“On the other hand, if the interest rate isn’t directly linked to the company, management must assess the embedded derivatives in the loan agreements. The derivatives must be separated or included in loan instruments and then be measured at fair value. The accounting method depends on the analysis of the agreement. This is quite complicated and takes time to understand,” she added.
When it comes to provisions, the impact of any environmental commitments needs to be assessed.
For example, if a company is committed to replacing an old machine with a new one earlier than expected for environmental and social responsibility reasons, the company needs to assess the impact on the decommission period and the decommission provisions in the financial statements.
Other issues also need to be looked into. These include whether the net realisable value of inventories has been reduced due to higher production costs.
Issues could also include a decrease in product prices due to changes in consumer behaviour causing reduced demand, or whether deferred income tax will be used if future profits decrease because of the impact of taking action on climate change.
The importance of disclosure
As important as the financial results are information disclosures because multiple accounting entries rely on estimations and assumptions, according to Sinsiri.
An entity should disclose information so that people reading the financial statements understand where the numbers come from, data sensitivity, changing assumptions, and various risks being faced and risk management.
It’s also important for both accounts staff and corporate social responsibility staff to use consistent information. This ensures that the estimates are made in the same direction.
“The company should assess whether its operating business poses any environmental risk that may affect the figures in the financial statements and to what extent. This is to acknowledge the impact and prepare the financial reports appropriately,” Sinsiri said.
“Action on climate change will become an increasingly important issue for all organisations and businesses. More businesses will be under pressure to set targets to combat climate change under the new global agreements.
“Their goal should be to generate profits responsibly, based on shared social and environmental targets,” she concluded.