In February, then-Acting SEC Chair Allison Lee directed the staff of Corp Fin, in connection with the disclosure review process, to “enhance its focus on climate-related disclosure in public company filings,” starting with the extent to which public companies address the topics identified in the interpretive guidance the staff issued regarding climate change in 2010. (See this PubCo post.) In March, the SEC announced the creation of a new Climate and ESG Task Force in the Division of Enforcement. (See this PubCo post.) How else does this new ESG focus play out? On Wednesday, Bloomberg reported, Lindsay McCord, Corp Fin Chief Accountant, in remarks to the Baruch College spring financial reporting conference, said that the SEC staff are also “scrutinizing how public companies account for climate-related risks and impacts to their business based on existing accounting rules.” So, in addition to refreshing their understandings of the 2010 guidance, companies will also need to take a hard look at the how environmental issues could affect their financials.
According to McCord, as they conduct reviews of SEC filings, the staff will consider the impact of environmental matters in the application of current accounting standards, such as the standards for asset retirement, environmental obligations and loss contingencies. In that regard, at the same conference, Acting SEC Chief Accountant Paul Munter referred the audience to FASB guidance, issued in March, regarding the intersection of ESG and financial accounting standards, which addresses accounting as well as management disclosures. In that guidance, the FASB staff set the stage by observing that
“[w]hen applying financial accounting standards, an entity may consider the effects of certain material ESG matters, similar to how an entity considers other changes in its business and operating environment that have a material direct or indirect effect on the financial statements and notes thereto. Some industries may be more affected than others (for example, some industries may be more affected by certain environmental matters, such as changes in environmental regulations). The way in which an entity may consider the effects of ESG matters varies based on the accounting standard being applied and the nature and significance of the ESG matter. Some ESG matters may directly affect amounts reported and disclosed in the financial statements, for example, through the recognition and measurement of compensation expense. Other ESG matters may indirectly affect the financial statements; for example, an entity may suffer reputational damage from an environmental contamination that reduces sales. Other ESG matters may not have any material effect on the financial statements. In addition, an entity may consider certain ESG matters as an input to an accounting analysis; for example, a material decline in demand during the reporting period may be a consideration when estimating future cash flows used in a long-lived asset or goodwill impairment analysis. Lastly, risks and opportunities related to ESG matters may have an unfavorable, favorable, or neutral effect on financial statements.”
As discussed below, the FASB guidance addresses a number of GAAP topics and provides illustrative examples of how they might “intersect” with ESG.
Going concern. Management is required to evaluate regularly whether there is substantial doubt about an entity’s ability to continue as a going concern within one year. In a “going-concern” evaluation, in addition to other relevant material factors, the new FASB guidance indicates that management “may consider the effects of environmental matters (for example, increased compliance costs related to enacted emissions regulations).”
Risks and uncertainties. Existing FASB guidance requires qualitative disclosure about risks and uncertainties that could significantly affect the amounts reported in the financial statements in the near term (one year or less). Unsurprisingly, this new staff guidance suggests that a company may determine that environmental matters present material risks to the company in the near term and, therefore, may need to provide disclosures under that guidance. In addition, disclosure may be required regarding significant estimates that may be particularly sensitive to change. If it is reasonably possible that assumptions about the future will result in a material change to the carrying amount of assets and liabilities in the near term, the company may need to disclose the nature of the uncertainty and indicate that it is at least reasonably possible that the estimate will change in the near term. Companies are encouraged to disclose the factors that could cause the estimate to change, as well as any risk reduction techniques (such as insurance).
Inventory. Inventory that is measured using a method other than LIFO or the retail inventory method is subsequently valued at the lower of cost and net realizable value. The guidance provides that estimates of “net realizable value could be materially affected by, for example, a regulatory change that renders inventories obsolete, a significant weather event that causes physical damage to inventories, a decrease in demand for an entity’s goods resulting from changes in consumer behavior or an increase in completion costs because of raw material sourcing constraints.”
Impairment. The guidance states that the direct or indirect effects of an environmental matter could give rise to an impairment of intangibles, such as goodwill or other indefinite-lived intangibles, as well as tangible assets. For example, the guidance provides that changes in environmental regulations could adversely affect an entity’s operations or could affect the assumptions used to calculate fair value. Environmental matters could also affect the estimated useful life of a finite-lived intangible asset, such as client relationships or developed technologies. For example, a more energy-efficient product could have been developed in replacement of a legacy product based on a less energy-efficient technology, or a green technology may have been acquired but may not have been as successful commercially as expected. Tangible assets, such as property, plant and equipment, are subject to depreciation. In that case, the estimated salvage value or useful life of those assets could be affected by the introduction of more energy-efficient products. In addition, when impairment indicators are present, a long-lived asset must be evaluated for recoverability. Environmental matters that could indicate impairment of a manufacturing plant might include, for example, material declines in market demand for products or changes in regulations that adversely affect the company.
Contingencies/asset retirement obligations. The guidance addresses environmental matters in the context of loss and gain contingencies. When accounting for environmental obligations, the company is required to consider relevant regulatory, legal and contractual requirements. Although general or unspecified business risks are not eligible for loss contingency accruals, certain environmental obligations, such as “regulatory requirements to remediate land contamination or fines imposed by the government for failure to meet emissions targets,” could require accruals, obligating the company to disclose the nature of the contingency as well as, where applicable, that the amount accrued could change in the near term. For unrecognized loss contingencies, the company must estimate the possible loss or range of losses or state that an estimate could not be made. Environmental matters could also affect the accounting for asset retirement obligations, such as “those related to (a) a legal obligation to remove a toxic waste storage facility at the end of its useful life or (b) a regulatory requirement to decommission a nuclear power plant or an offshore drilling platform.” Gain contingencies, such as a potential insurance recovery, are typically not recognized “until all contingencies are resolved and the amount is realized or realizable.”
Tax/Other. Environmental regulations could affect estimates of future taxable income, for example, where costs are projected to increase to comply with environmental regulations. Environmental matters could also affect fair value measurements as well as accounting measurements under various industry guidance.