In response to increasing global demand from investors and other financial markets stakeholders for information about public companies’ climate-related risks and opportunities, the US Securities and Exchange Commission (SEC) has released a proposed rule that would enhance and standardize climate-related information disclosed by public companies in their SEC filings. The SEC’s proposed rule would also require third-party assurance over some of the new disclosures.
The SEC has received more than 4,000 individual comment letter responses to their proposed requirements. While we wait for the SEC to adopt a final rule, it is important for all stakeholders in the financial reporting ecosystem to do what they can to get ready for new climate-related disclosure requirements. There are three things audit committees can do to prepare:
Gain an understanding of the key aspects of the SEC’s proposed requirements.Put climate on the audit committee’s agenda.Seek perspectives from the external auditor to understand the auditor’s climate capabilities.
Understand Key Aspects of the SEC’s Proposed Climate Rule
Greenhouse gas (GHG) emissions attestations. The proposed rule would require certain companies to subject their scope 1 and 2 GHG emissions disclosures to third-party assurance from an assurance provider that meets certain minimum requirements described in the proposed rule.
This assurance requirement would phase in over time, starting first with limited assurance (similar to the level of assurance many boards would be familiar with from interim quarterly reviews). The requirement would then transition to requiring reasonable assurance after a couple of years of limited assurance.
Obtaining any level of assurance by a public company auditor will involve an auditor gaining an understanding of the company’s processes, systems, and data, as appropriate, used to arrive at the company’s GHG disclosures. Auditors will also need to consider risks of material misstatement of the subject matters, and then develop an appropriate approach to obtaining the level of evidence necessary to support their conclusion (limited assurance) or opinion (reasonable assurance).
Material climate impacts on financial statements. Under current rules, climate-related risks are considered and assessed by management and auditors during the preparation and auditing of financial statements and may have a direct impact, an indirect impact, or in some cases no impact at all on the financial statements.
In an analysis conducted by the Center for Audit Quality (CAQ), we observed that 18 S&P 500 companies have climate-related mentions in the financial statements included in their most recent 10Ks.
The requirements in the SEC proposed rule could increase this number dramatically. For each line in the financial statements, using a 1 percent threshold, a company would be required to disclose in the footnotes the negative and positive impacts from physical climate-related hazards (e.g., flood and fire zones) and transition risks (e.g., regulation, actions to reduce emissions). Companies would also be required to disclose in their financial statements the risks and uncertainties associated with climate-related risks that impact the development of estimates and assumptions.
In comment letter responses to the SEC, stakeholders have expressed concerns about this aspect of the proposal, including that the 1 percent threshold may place disproportionate prominence on climate-related financial statement metrics over more significant financial statement metrics and that it could ultimately result in inconsistent disclosures. As we await the final rule from the SEC, it will be important for public companies to understand this proposed footnote disclosure and think about how their own material climate risks impact their financial statements.
Put Climate on the Audit Committee’s Agenda
The CAQ published a report on audit committee practices which found that 66 percent of audit committee members’ companies issue a sustainability or environmental, social, and governance (ESG)-related report, and 69 percent obtain or are actively discussing obtaining third-party assurance on one or more components of ESG or sustainability data.
Individual boards of directors will need to discuss the proper board committee(s) to be involved in overseeing a company’s climate-related reporting. However, given the role audit committees play in overseeing financial reporting and a company’s internal controls, it is prudent for audit committees to talk to the management team to understand where the company is today with respect to its climate-related reporting and where it wants to be in the future. Audit committees can consider adding the following topics to discussions with company management:
the connection between the organization’s ESG strategy and financial statement impacts and how management considers these impacts, including any impacts on estimates and assumptions;expectations regarding responsibilities for climate reporting and assurance, including oversight of management’s selection of the attestation provider; andthe people, process, and plan to prepare for the SEC’s disclosure requirements.
Seek Perspectives from the External Auditor
Audit committees should also ask their independent auditors for their views on climate-related reporting. Audit committees can consider doing the following in discussions with external auditors:
Ask the external auditors for perspectives on how the company’s climate-related disclosures generally compare to those of other companies. Audit partners report that a lack of tools supporting the collection, collation, and analysis of ESG data presents the greatest challenge in terms of climate and other ESG reporting.Discuss the external auditor’s views on the company’s climate-related disclosures and how the auditor has considered climate-related risks in the audit of the financial statements.Ask the external auditors what their responsibilities are for climate-related disclosures and whether that responsibility is different depending on where the climate-related information is disclosed.
Public company audit firms can also help public companies prepare with a readiness assessment, which may be performed in advance of a review or examination engagement of a company’s climate information. A readiness assessment provides an independent view as to whether the company’s reporting processes, internal controls, evidence available, and governance related to the climate-related information provide the foundation on which to obtain the desired level of assurance.
Julie Bell Lindsay is the CEO of the Center for Audit Quality.
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