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Effects of Climate-related matters on Financial Reporting

Accounting for climate change refers to the process of incorporating the potential financial risks and opportunities associated with climate change into financial reporting. This includes evaluating the financial impacts of climate-related matters, including carbon emissions, changes in weather patterns and rising sea levels, as well as changes in regulations and the potential benefits of investing in clean energy and other climate solutions.


As climate change becomes a topic that investors, lenders and other stakeholders are increasingly interested in, because of its potential effect on companies’ business models, cash flows and financial performance, there will be a corresponding increase in focus on the measurement and disclosure of climate-related matters in an entity’s financial statements.

Although there is no single explicit standard on climate-related matters under FRS, entities are required, at a minimum, to follow the specific disclosure requirements in each FRS standard. We set out below some examples where the application of the requirements of FRS may be affected by climate-related matters.

FRS 1 PRESENTATION OF FINANCIAL STATEMENTS

FRS 1 sets out the overall requirements for financial statements, including how they should be structured, presented and disclosed. Climate-related matters can have an impact on the financial statements and information disclosed in them. For example, companies may need to disclose information about their greenhouse gas emissions, the financial impacts of climate change on their operations, and their plans for managing these risks.


Additionally, the impacts of climate-related matters may also have an effect on a company's financial performance and position, which will have to be reflected in the financial statements. For instance, a company may incur additional costs as a result of complying with regulations to reduce greenhouse gas emissions or may need to make significant investments to adapt to the effects of climate change. These costs and investments should be reported in the financial statements in a transparent and comparable manner.


It is also important for entities to ensure consistency in both the disclosures on climate-related matters outside the financial statements (for e.g., in sustainability reports) and how they incorporate climate risk in the financial information (for e.g., in measurements and disclosures in the financial statements).


Climate-related matters can also have an impact on a company's going concern disclosures, which are the disclosures that a company makes about its ability to continue operating as a going concern for at least 12 months from the date of its financial statements. The going concern principle is a basic assumption in the preparation of financial statements, and if a company is unable to continue as a going concern, it must disclose that fact in its financial statements.


Climate-related matters may affect a company's ability to continue as a going concern in various ways. For example, a company may face increasing costs as a result of complying with regulations to reduce greenhouse gas emissions or may suffer financial losses due to the effects of climate change on its operations. Another example is that a company’s main business may no longer be viable in the future due to changes in demand arising from climate-related concerns, which, in turn, can make it difficult for the company to continue as a going concern.


Lastly, in making their going concern assessments, many entities only consider the next 12 months. However, according to FRS 1, an entity needs to look at a period of at least 12 months from the end of the reporting period when assessing whether to prepare financial statements on a going concern basis. In other words, considering going concern for only 12 months, if known uncertainties impact the assessment over a longer term, is not consistent with the requirements in FRS 1.


FRS 2 INVENTORIES

FRS 2 sets out the accounting treatment for inventories, which are assets that a company holds for sale in the ordinary course of business or in the process of production for such sale.


Climate-related matters can have an impact on the measurement and disclosure of inventories in the financial statements. For example, a company may face an increase in costs associated with raw materials or production processes due to the effects of climate change. This may result in a decrease in the value of the inventories, and the company may need to record a write-down in the value of its inventories. Additionally, if a company operates in an industry that is particularly susceptible to the effects of climate change, such as agriculture, it may need to estimate the potential impairment of its inventories based on possible climate-related risks.

In addition, if the company is involved in activities that causes significant carbon emissions, and if there is a potential increase in carbon taxes or regulations, it may also have an impact on the financial performance of the company, and on the inventory values.


Furthermore, companies should also consider the disclosure requirements under FRS 2 related to inventories, such as providing information about the nature and amount of inventories, their carrying amount and net realisable value, and any write-downs or write-offs. This will help users of the financial statements to understand the company's inventory and the potential impact of climate-related matters on it.


FRS 12 INCOME TAXES

FRS 12 sets out the accounting treatment for income taxes, including recognition and measurement of current and deferred tax liabilities and assets.


Climate-related matters can have an impact on the recognition and measurement of income taxes. For example, a company may face increased income tax liabilities as a result of new regulations or taxes related to carbon emissions.


In addition, if a company is actively engaged in mitigating the effects of climate change, such as investing in renewable energy or carbon capture technology, it may be eligible for tax incentives or credits. This could result in deferred tax assets, which would have to be recognised and measured in accordance with FRS 12.


FRS 16 PROPERTY, PLANT AND EQUIPMENT

FRS 16 sets out the accounting treatment for property, plant and equipment (“PPE”), which are tangible assets that are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes.


Climate-related matters can have an impact on the measurement and disclosure of PPE in the financial statements and the going concern disclosures. For example, a company may face increased costs associated with maintaining or replacing PPE that is damaged or destroyed due to extreme weather events, such as floods or storms, as a result of climate change. This could also affect the company's liquidity and solvency and impact its ability to continue as a going concern.


Additionally, a company may be required to make significant investments to adapt its PPE to the effects of climate change or the enacting of laws and regulations due to climate change. These investments may have to be capitalised and depreciated in accordance with FRS 16, which would affect the company's financial performance and position.


In summary, climate change, the legislation enacted to address it, and growing societal pressures have the potential to significantly affect the value of an item of PPE. In particular, companies should consider how these factors can affect their PPE in connection with the useful lives, business models, residual values, research and development costs and possible overhauls.

FRS 36 IMPAIRMENT OF ASSETS

FRS 36 sets out the accounting treatment for impairment of assets, which is the process of assessing whether the carrying amount of an asset exceeds its recoverable amount (the higher of its fair value less costs to sell and value in use).


A company may face decreased revenue or increased costs as a result of the effects of climate change on its operations. This could result in the impairment of assets such as PPE or intangible assets.


In making such an assessment, companies should look out for indications of impairment. Some examples of factors that could lead to impairment of assets include:

  • A decline in the value of an entity’s asset due to climate-related matters;

  • An adverse change to the environment in which the entity operates (e.g., a legal requirement that results in the companies’ activities becoming less profitable);

  • Changes in technology;

  • An increase in market interest rates that will affect the discount rate used in calculating an asset’s value in use; and

  • The carrying amount of the entity’s net assets exceeding its market capitalisation, such as, when investors move away from industries with high emissions, thereby affecting its share price and, correspondingly, its market capitalisation.

FRS 37 PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS

FRS 37 sets out the accounting treatment for provisions, which are liabilities of uncertain timing or amount, and contingent liabilities and assets, which are potential liabilities and assets that depend on the occurrence or non-occurrence of one or more uncertain future events.


A company may face increased costs as a result of new regulations or taxes related to carbon emissions, or as a result of potential legal claims related to the effects of climate change on its operations. These costs may have to be recognised as provisions in accordance with FRS 37, which would affect the company's financial performance and position.


FRS 109 FINANCIAL INSTRUMENTS

FRS 109 sets out the accounting treatment for financial instruments, including the recognition, measurement, and disclosure of financial assets and liabilities.


A company may face decreased revenue or increased costs as a result of the effects of climate change on its operations. This could result in the impairment of financial assets such as loans or investments. This could also affect the company's liquidity and solvency, and impact its ability to continue as a going concern.


Other examples in which climate-related matters may affect the accounting for financial instruments include:

  • Loan contracts that include terms linking contractual cash flows to a company’s achievement of climate-related targets, i.e., sustainability-linked financing; and

  • Effect of climate change on a lender’s exposure to credit losses.

In conclusion, climate-related matters can have an impact on the application of the requirements of FRS. Therefore, companies need to consider whether the current disclosures they are making are sufficient to comply with the specific requirements of FRS standards to enable users to understand the impact of climate-related matters on their financial position and financial performance.


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