ESG: The Financial Reporting Implications

In a KPMG survey of 3,300 financial professionals, more than half of respondents indicated climate change-related financial disclosures were an opportunity to demonstrate their environmental, social, and governance (ESG) edge to employees and investors while distancing themselves from competitors. However, only 32% saw these disclosures as mostly a compliance exercise.

Yet, just last year, a KPMG global survey showed that only 40% of firms acknowledged climate change in financial disclosures, with just 1 in 5 reporting in line with the standards from the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD).

Scott Flynn, KPMG

Why the gap? Companies struggle to move from answering “why” they will embed ESG into their strategy to “how” they will make that happen and “what” they will report in telling their story.

For example, another KPMG survey, of technology leaders, found that 82% wanted to lock in sustainability gains, but more than half said they do not have a decarbonization strategy in place.

Moving from aspiration to reality explains only part of the challenge. For reporting, and in particular ESG issues within financial reporting, the reality is complex. Liabilities may not be recognized, assets may not be written down, and estimates may not be adjusted until the company meets the criteria in the relevant standards. New disclosure requirements may change the level of transparency about a company’s strategy and its actions relating to environmental factors. Fundamental changes will be very challenging, and global standard setters and regulators are still reviewing new disclosure rules.

The Waiting Strategy

The strategy some organizations may default to is to wait for regulators to mandate disclosures. The European Union, for example, proposed the Corporate Sustainability Reporting Directive to put the reporting of sustainability information on par with standard financial information. The Securities and Exchange Commission, meanwhile, is navigating a historic effort to require public companies to release investor-facing climate-related disclosures.

But we believe this wait-and-see approach should be replaced by a mindset of being prepared for three reasons:

Maura Hodge, KPMG

1. Investors may be the tip of the spear when it comes to demanding action on climate change. Still, environmental factors are becoming increasingly urgent for a wide range of stakeholders, including lenders, suppliers, and customers.
2. Businesses need to prepare now — before final regulations — so they can tell their own story instead of others telling it for them.
3. Engaging on ESG makes business better because it has the power to transform. A well-developed strategy that identifies risks and opportunities and is embedded into operations can mitigate risk, build stakeholder trust, and deliver competitive advantages.

KPMG’s recent “Climate risk in the financial statements” handbook focuses on the “E” in ESG, outlining key questions CFOs must ask to (1) understand the landscape of climate risks (2) analyze the potential financial impacts of the organization’s decarbonization actions and (3) consider which information to disclose and how to disclose it.

Pressure Points

There are three kinds of climate risks: physical, regulatory, and transition-related. Physical risks include the effects of climate change in flooding, hurricanes, and other weather pattern changes that threaten company infrastructure and supply chains. Regulatory risks include being subject to new policies that limit revenue opportunities or increase exposure to litigation. Finally, transition-related risks reflect potential challenges during a shift to a low-carbon economy, including changing consumer preferences, stranded assets, and capital costs.

While all companies should assess those three risks, the TCFD has spotlighted five industries as high risk: finance; energy; transportation; materials and buildings; and agriculture, food, and forestry products.

As a starting point, CFOs of all industries and sectors should strive for honest insight into the multidimensional pressure points faced by their organization. Beyond typical questions on investor sentiment, CFOs should ask:

• Will the company be affected by country or jurisdictional plans to reduce emissions? KPMG’s Net Zero Readiness Index details a country’s ability to reach net-zero by 2050, including a review of its policies and legal mandates. Norway, the United Kingdom, and Sweden are the highest ranked, and nine countries have binding net-zero commitments. Ten countries have set net-zero targets, accounting for a total of 51% of global emissions.
• What is the exposure from the wider supply chain and customer base? Each party potentially puts pressure on its suppliers to reduce emissions. CFOs should also ask whether key customers are making inquiries about emissions reduction plans.

Effects of Decarbonization

Decarbonization is the reduction of carbon dioxide emissions through the use of low-carbon power sources. As companies set decarbonization strategies, CFOs must monitor impacts on existing assets, inorganic growth strategies, and financing opportunities, along with the accounting impacts for financial reporting. Doing so drives discussion across the organization to best embed an ESG lens into the organization’s future.

• Has the organization committed to reducing emissions? While a commitment to reduce emissions may begin as a statement of intent, the actions that flow from that strategy will likely have widespread finance and accounting implications. These decisions potentially affect the reported value of long-lived assets, the approaches used to estimate future cash flows, and the accounting for revenue contracts or leases. As a result, the CFO may need to closely track market changes to understand the potential financial risks of environmental factors. And they will need to understand termination or modification clauses in contracts, as well as substitution rights.
• Is the organization planning acquisitions or disposals? We often talk about transforming with ESG in mind. For acquisitions, ESG due diligence can help ensure new targets are aligned with a company’s ESG strategy to avoid actions that create unforeseen financial risks.
• Will the company issue debt instruments containing an ESG feature — such as sustainability-linked bonds? Unlike typical green bonds, which directly finance green investments, sustainability-linked bonds incentivize companies to make a positive ESG-related impact by reducing interest rates based on hitting specific ESG goals. The accounting for sustainability-linked bonds is complex and may require bifurcating the bond from an embedded derivative depending on the nature of the contract.

Considering All Impacts

After understanding the external landscape and formulating the organizational strategy, CFOs should explore and plan for wide-ranging accounting matters. For example, considering environmental factors in testing a wide range of nonfinancial assets for impairment is increasingly essential. Looking at the reporting strategy, CFOs should ask whether current disclosures meet rising demands, including SEC staff concerns about the robustness of disclosures outside the financial statements, and whether the company’s decarbonization strategy affects individual reporting segments.

These assessments may not significantly alter financial reporting today but setting up processes and establishing expectations for the financial statement disclosure committee will enable greater reporting sophistication down the road. Whether it’s new low-cost ways to raise capital, attractive M&A opportunities, or benefits typically outside a CFO’s scope — brand reputation, customer acquisition, and access to talent — companies have the potential to gain an ESG advantage.

Scott Flynn is the audit vice chair at KPMG and Maura Hodge is audit leader at KPMG IMPACT.

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