Footnotes
- IFRS S2, Climate-related Disclosures, Appendix A.
- Presentation of Financial Statements
The impact of climate risk on the financial statements
How climate risks manifest in financial statements – and related disclosures – under IFRS® Accounting Standards.
From the IFRS Institute – December 08, 2023
Climate risks (and opportunities) dominate ESG reporting headlines. Climate is the point of commonality across all ESG reporting frameworks, the only topical standard issued to date by the International Sustainability Standards Board (ISSB), and the focus of the SEC. But the question of how climate risk affects the financial statements themselves is a more difficult conversation. In this article, we explore examples of how climate risks can impact the financial statements, discuss disclosure requirements related to climate change, and provide an update on activities of the International Accounting Standards Board (IASB).
In the absence of specific requirements, there is growing scrutiny of – and different opinions about – the extent to which the financial statements should acknowledge climate risk and its impact on a company’s financial position, financial performance and cash flows. It is therefore timely that the IASB has taken on a project to explore how climate (and other) uncertainties should be reported in the financial statements. These developments come at a time when more companies are committing to reduce their greenhouse gas (GHG) emissions and transactions linked to emissions reductions are increasing.
Defining climate risk
The two components of climate risk are defined in the climate standard issued by the ISSB.1
| Type | Definition | Examples |
Physical risks | Risks resulting from climate change that can be event-driven (acute physical risk) or from longer-term shifts in climatic patterns (chronic physical risk) |
|
| Transition risks | Risks that arise from efforts to transition to a lower-carbon economy | Policy, legal, technological, market and reputational risks |
Example financial statement impacts: recognition and measurement
Many climate-related factors can affect a company’s financial statements, such as whether it operates in a high-risk industry, how vulnerable its locations and those of its suppliers are to extreme weather, its emission reduction policies, and customer attitudes toward and preferences for sustainable products and services.
The following are some common examples of climate risks and how a company might consider their impact on the financial statements. Further discussion and examples under IFRS Accounting Standards can be found in the KPMG Resource Center; in-depth discussion about the general application of the accounting standards can be found in our flagship publication, Insights into IFRS®.
| Topic | Potential impacts and examples |
Plant, property and equipment (PPE) IAS 16, Plant, Property and Equipment and IAS 36, Impairment of Assets | Physical and transition risks often impact the valuation of PPE and other nonfinancial assets. For example, damage (physical risk), changing equipment in a manufacturing process to meet targets (transition risk) or complying with GHG emissions regulations (transition risk) can materially change the useful lives of that PPE or even lead to impairment. Example A transport company is performing an annual review of the useful life of its diesel trucks in one country of operation. There are newly introduced restrictions on the use of diesel vehicles in several large cities in that country. The company has no plans to upgrade its country fleet immediately. However, it expects that many more cities will introduce similar restrictions in the future, which will create significant difficulties for transporting goods using the current diesel fleet. Consequently, the company estimates that it will dispose of all of its diesel trucks after 4 rather than 10 years of service. Therefore, it revises the useful lives of its diesel trucks accordingly. At the same time, the company adjusts the residual values of the trucks because it expects the new restrictions to result in a lower than expected sale value at the end of the revised useful lives of the trucks. The shorter useful lives and lower residual values result in higher depreciation expense in the current and future periods. The company also assesses whether the restrictions (and other potential consequential effects such as customer preferences) are an indication that the carrying amount of the trucks may be impaired. The company concludes that there is an indication of impairment and tests the cash-generating units to which the trucks belong. The testing does not result in recognition of an impairment loss. |
Inventory IAS 2, Inventories | Like PPE, estimates and judgments around inventory should be examined using a climate risk lens. For example, damage from an extreme weather event (physical risk), costly regulations to improve the safety of products (transition risk) or changing customer preferences driven by concerns about high emissions (transition risk) can all impact inventory valuation and the classification of related expenditures. Example A consumer products manufacturer is experiencing decreased demand for a number of its products as consumers shift spending toward more sustainable options. As a consequence, the company is losing market share to competitors and has been increasingly selling certain products at a steep discount. The company is in the process of upgrading its entire manufacturing ecosystem to reduce its carbon footprint, but has considerable stocks of certain inventories that have been affected by changing customer preferences. Following a detailed review, the company concludes that the net realizable value of two of its products is less than their carrying amounts. Accordingly, the company recognizes a write-down in profit or loss. |
Share-based payments IFRS 2, Share-based Payment | Companies are increasingly introducing climate-related targets into their share-based compensation. Linking executive and employee awards to a net-zero strategy is one way for a company to promote coordination of operational objectives throughout its value chain. In our experience, a key determination is whether the performance conditions relate to the company’s own operations or activities (or those of another company in the same group) – i.e. a non-market performance condition. This determination can be particularly difficult in assessing certain scope 3 (indirect) emissions. Non-market performance conditions are not reflected in measuring the fair value of the award, but rather in the number of instruments that are expected to vest. Example 1 A company grants share options to senior executives. Vesting occurs if the company reduces its scope 1 and scope 2 GHG emissions by 50% at the end of eight years; the base year for measuring reductions is Year 1. The company concludes that the condition is a non-market performance condition because reducing these emissions relates to its own operations / activities. The company further determines it is probable (i.e. more likely than not) that the target reduction will be met at the end of Year 8, so the effect of the condition is reflected in the number of shares expected to vest. Example 2 A company grants share options to senior executives. Vesting occurs if the company reduces its scope 3-category 6 (business travel) GHG emissions by 30% at the end of five years; the base year for measuring reductions is Year 1. The company concludes that the condition is a non-market performance condition because reducing these emissions relates to its own operations / activities. The company further determines it is more likely than not that the target reduction will be met at the end of Year 5, and the effect of the condition is reflected in the number of shares expected to vest. |
Financial statement impacts: disclosures
Investors and other stakeholders are becoming increasingly interested in understanding how the key assumptions and judgments underlying the information disclosed in the front part of the annual report on climate-related matters reconcile with the financial statements – in particular, when they are not consistent. This has increased the need for companies to bridge the information gap by providing enhanced disclosures on the impact of climate-related matters in their financial statements.
In addition to the disclosures required by specific standards, companies need to consider the overarching disclosure requirements of IAS 12. Particularly relevant to the potential effects of climate-related matters are disclosures about:
- assumptions about the future, and other major sources of estimation uncertainty, that have a significant risk of causing a material adjustment to carrying amounts in next financial year;
- other judgments that have the most significant effect on amounts recognized in the financial statements; and
- the impact of specific transactions, other events and conditions that may be necessary to provide an adequate understanding of the entity's financial position and financial performance.
In some cases, changes in key assumptions related to climate-related risk may not be expected to result in material adjustments in the measurement of assets and liabilities in the next financial year, but the chance of material adjustments in the longer term may be significant. In these circumstances, and given the expectations of investors, companies may need to consider disclosing key assumptions related to climate-related risk even though the risk of material adjustments in the next financial year may be considered to be low.
The following continues the earlier recognition and measurement examples. In addition to making the disclosures required by the specific topical standards, the respective companies consider additional disclosures that respond to the above requirements of IAS 1.
| PPE example | In addition to following the specific disclosure requirements of IAS 16 and IAS 36, the company discloses information about the newly introduced restrictions and its expectation that more cities will introduce similar restrictions in the future. The company discloses that further changes in the regulatory environment may result in residual value and useful life estimates being revised further downwards, and might result in impairment. Lastly, the company discloses that while it has no plans to upgrade its fleet immediately, management continues to monitor the regulatory environment and that decision may change. |
| Inventory example | In addition to following the specific disclosure requirements of IAS 2, the company discloses:
|
| Share-based payment examples | After following the specific disclosure requirements of IFRS 2, the company concludes that no further financial statement disclosures are necessary. |
| Note: In all cases, it is assumed that there are no material uncertainties affecting the company’s ability to continue as a going concern or significant judgments in concluding that there is no material uncertainty. | |
IASB project: Climate-related and other uncertainties in the financial statements
In September 2023, the IASB decided to add a project to its agenda for “targeted actions to improve application of the requirements in IFRS Accounting Standards related to reporting on the effects of climate-related and other uncertainties in the financial statements.” In other words, the effect of climate will be considered as just one way in which uncertainty can manifest in the financial statements.
The IASB staff is now exploring examples illustrating how to apply the requirements in IFRS Accounting Standards, and whether any accounting standards should be clarified or enhanced in terms of disclosures about estimates. The direction of the project is expected to be determined in Q1 2024.
In addition, the IASB agreed to refer the following questions to the IFRS Interpretations Committee:
- When does a climate-related commitment result in a liability being recognized?
- How is value in use as part of impairment testing under IAS 36 measured when a company is subject to highly variable future cash flows over an extended period?
Key takeaways
These are our recommended actions.
1 | Consider climate-related risks and opportunities and their financial impacts when preparing financial statements |
2 | Consider materiality from both a quantitative and qualitative perspective in relation to disclosures of key judgments and assumptions related to climate risk |
3 | Provide clear and robust disclosures, especially of the key judgments and estimates affected by climate-related matters |
4 | Ensure consistency of assumptions used in relevant areas of the company’s financial statements and that they are in sync to the extent appropriate with information related to climate-related risks discussed elsewhere in the annual report. Consider providing additional explanations in the annual report where inconsistencies arise |
5 | Consider relevant regulatory guidance |
6 | Stay abreast of sustainability and financial reporting developments |
KPMG resources
IFRS Accounting Standards: KPMG Climate Change Resource Center
US GAAP: Handbook, Climate risk in the financial statements
GHG emissions under the GHG Protocol: Handbook, GHG emissions reporting
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