Marie Pupecki Date published: Mar 01, 24

Critical audit matters provide the opportunity for auditors to explain their view of the risks and financial implications of climate change and ESG. According to an AASB report, potential implications often arise from (but are not limited to) assumptions and models for

• Asset impairment
• Changes in the useful life of assets
• Changes in the fair valuation of assets
• Increased costs and/or reduced demand for products and services affecting impairment calculations
• Potential provisions and contingent liabilities arising from fines and penalties
• And changes in expected credit losses for loans and other financial assets

ESG notes in CAMs according to Ideagen Audit Analytics report

Ideagen Audit Analytics Report found that the issues of valuation of acquired assets and impairment, combine to a total to 5,764 or 28% of all CAMs in annual reports for the fiscal years 2020-2022. However, there are only 42 CAMs that mention climate change or ESG.  Thirty nine of the forty-two are non-US headquartered companies.  One is a company that sells to the ESG and climate segments. Thus, remaining we have two years of critical matters from one US based company that mention climate change in the valuation context.

Let's revisit the definition of a critical matter.  According to PCAOB, a critical audit matter is “…any matter arising from the audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved especially challenging, subjective, or complex auditor judgment.” 

PCAOB considers climate matters in assessment process

In the PCAOB's recent Spotlight Report the target team reviewed 10 additional audit engagements with a focus on material climate related matters. All of the engagement teams considered the potential impact of climate matters as part of their planning and risk assessment process. The five firms reviewed also:

"...authored and issued internal guidance highlighting, among other things:

The importance of the key assumptions and judgments used by management in both climate-related commitments and in the preparation of the financial statements.

Relevant disclosure considerations related to potential impairment of nonfinancial assets; the estimates used by management in determining the estimates useful lives of property, plant, and equipment; the measurement of financial assets;"

The PCAOB has provided us with confirmation that climate related matters are considered in the planning and risk assessment process. However, to see that focus reflected in audit procedures and the related CAMs, we need to look to Europe. An example of comprehensive climate related CAMs are from Shell PLC, a UK based petroleum company audited by Ernst & Young. Shell PLC, has a number of critical matters over the three year period that reference climate change under a variety of topics.

Climate change references in critical audit matters

In the CAM for the impairment of exploration and productions assets and manufacturing supply and distributions assets, was the following:

“We considered management's long-term price assumptions including the extent to which the pricing scenarios incorporated the potential impact of climate change and the energy transition by comparing the assumptions to the International Energy Agency price outlook in the Energy Outlook scenarios."

For impairment of property plant and equipment and Joint venture and associates:

"We considered potential impairment triggers related to climate change and energy transition by estimating the carbon intensity of Shell’s Upstream and Integrated Gas fields and identifying the most carbon intensive assets. We used our Climate Risk data analytics tool to identify correlations between reserves, production and emissions data and assessed management’s plans to reduce the carbon intensity of these assets in the future to determine whether there is a material risk that reserves recognised will not be produced or if the carbon intensity limited the expected useful lives of the assets.

We also performed a risk assessment on Shell’s assets from a climate change physical risk perspective, considering asset and geographical specific factors to assess whether the existence of any increased physical risks represented a trigger for impairment.

This included evaluating the sensitivity disclosures in Note 4 of the carrying value of Shell’s Upstream and Integrated Gas PP&E assets against a range of future oil and gas price assumptions, reflecting reduced demand scenarios due to climate change and the energy transition, including the IEA Net Zero Emissions by 2050 scenario.”

And lastly, related to the recognition and measurement of deferred tax assets:

“In addition, auditing the recognition of DTA balances that are supported by the expectation of future taxable profits arising beyond Shell’s 10-year planning horizon required significant audit judgement, which was of heightened complexity given the future demand and price uncertainty due to climate change and the energy transition.”

Is climate change relevant in other industries?

Climate change would seem relevant to many other industries valuation judgments, such as property and casualty insurance. How do you forecast insurance losses without a climate change assumption? How could that not meet the critical matter criteria of an especially complex judgment for an auditor?  I looked specifically at impairment related critical audit matters. Insurance companies - No mention of climate change. I took a deeper dive into US headquartered oil and gas companies. Not in those critical audit matters either. Utilities?  None. 

I returned to my original search to identify the one company that mentioned climate change and found an energy producer.  AES’s stated strategy from their latest 10-K is: “developing and operating the solutions that will enable the transition to zero and low-carbon sources of energy and achievement of the Paris Agreement's goal of net-zero emissions by 2050.” I assume it's low risk for them as climate change is part of their business model and coal is easy to pick on.

The critical matters for AES in 2020 and 2021 audit opinions by  Ernst & Young LLP included:

“… auditing the Company’s re-evaluation of useful lives required a high degree of subjectivity, particularly as it relates to the Company’s coal generation assets given the Company’s decarbonization initiatives and the potential risks associated with climate change that have led to increased regulation and other actions.”

Climate change isn't on the list of significant assumptions

I suspect that CAM resulted in lively discussions for the audit committee and maybe includes a marketing touch as well. I was still wondering whether it just isn’t as common in the US to discuss details of the significant assumptions. So I searched on assumptions on the US impairment critical matters in the industries noted above. In my sample, I did not see major differences between US headquartered companies and their international peers in the nature, occurrence or response to CAMs. Perhaps international companies put more detail into their critical audit matters in general. Many US examples discussed assumptions and provide a truncated list of significant assumptions. Climate change is not one of them.  Strange isn’t it?    

There is investor support for climate related CAMs as demonstrated from a Council on Institutional Advisors letter to the PCAOB. In it they state:

 “Another topic that is likely to resonate with many investors are environmental related CAMs.  With the growing momentum for environmental, social, and governance themes, CAM environmental related disclosures may provide investors with a lens into an important governance dimension that also have implications for proxy voting decisions.”

Echoing this sentiment in a speech by  J. Robert Brown, a PCAOB board member at an investor conference in 2020:

"We are only in the early days of a new and important disclosure requirements. ESG CAMs will presumably increase as the financial impact of ESG matters continues to accelerate.  The evolution of ESG CAMs, however, requires vigilance. Any number of disclosure requirements, over time, have devolved into boilerplate or, what an SEC official once labeled as "elevator music." Investors and regulators have an important role to play to make sure that this does not occur."

His concern may have come to fruition, at least in the US.  Oil and gas, coal mining, property insurance, power generators- how is climate change not a major area of judgment in forecasts, asset valuations, impairments, contingencies and deferred taxes?

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