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The Financial Accounting Standards Board (FASB) and Securities Exchange Commission (SEC) have been providing guidance, making statements and delivering speeches about accounting and financial reporting considerations for environmental, social and governance (ESG) matters since the beginning of spring to address growing interest and concerns from investors, credit rating agencies, lenders, financial statement preparers, and a host of other stakeholders. The media has covered this regulatory activity, while also focusing much of the discussion about how ESG matters will affect a company’s business strategy, operations, and long-term value.
Lost, however, or what could be viewed as a blind spot in the coverage is a discussion about any related impact on a company’s current accounting conclusions and financial reporting. Accordingly, there have been some questions about whether a company needs to incorporate ESG considerations when preparing its current financial statements. The answer, is a resounding “yes.”
In this article, we’ll look at certain potential effects of ESG matters on a company’s financial accounting and reporting in the context of the existing accounting guidance and the current regulatory environment. While these effects will vary depending on the company’s industry along with factors such as relevant regulatory, legal, and contractual obligations, all entities should evaluate ESG-related financial accounting and reporting implications.
Following numerous questions raised by stakeholders ranging from investors to regulators, the FASB published “Intersection of Environmental, Social, and Governance Matters With Financial Accounting Standards” (known as the FASB ESG Paper) to highlight the connection between ESG matters and their direct or indirect effect on the financial statements. The paper illustrates how an entity may consider the effects of material ESG matters when applying existing accounting standards.
The FASB staff noted that many current accounting standards require a company to consider “changes in its business and operating environment when those changes have a material direct or indirect effect on the financial statements and notes thereto.” Often, these considerations are related to aspects of accounting for which management judgment and estimation are required.
Consider these three examples1 of how certain ESG matters may materially affect an aspect of management judgment or estimation, ultimately resulting in a direct-or-indirect impact on the financial statements and notes to the financial statements:
- Impairment of Goodwill and Indefinite-Lived Intangible Assets: Under current accounting standards, goodwill, and indefinite-lived intangible assets (e.g., trade names) are generally not amortized, but are instead tested for impairment at least annually or more frequently if impairment indicators exist.
The direct-or-indirect effects of an ESG matter could give rise to an impairment indicator (e.g., changes in hazardous waste management regulations that adversely affect an entity’s operations).
ESG matters may also affect the measurement of an impairment loss when, for example, the matter materially affects the assumptions used to calculate the fair value of the reporting unit associated with goodwill or the fair value of the indefinite-lived intangible asset.
- Useful Lives of Finite-Lived Intangible Assets and Property, Plant and Equipment: Current accounting standards require an entity to amortize a finite-lived intangible asset (e.g., client relationships or developed technologies) and property, plant, and equipment over its useful life, which is the period in which the asset is expected to contribute directly or indirectly to an entity’s cash flows. An entity is required to evaluate the remaining useful life as of each reporting period and reflect any changes to the estimate in the financial statements prospectively.
The effect of an environmental matter may be one of many factors that affect the estimated useful life of a finite-lived intangible asset or property, plant, and equipment. For example, an entity may develop a more energy-efficient product to substitute a legacy product, resulting in a change in the estimated useful life of the client relationship intangible asset associated with the legacy product. In addition, if the equipment used to manufacture the legacy product will be phased out in favor of new equipment, a change in the estimated useful life of the equipment may likewise be required.
- Inventory: Under current accounting standards, inventory is often valued at the lower of cost and net realizable value (i.e., the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation).
When estimating net realizable value, management is required to consider all relevant facts and circumstances. 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.
Financial Reporting Considerations
Like the FASB, the SEC has been active in evaluating the impacts of ESG matters on accounting and financial reporting, issuing several public statements in the first quarter of 2021 to emphasize the importance of ESG disclosures to investors and the capital markets. In short, SEC activities point to the Commission’s increased attention on how companies apply existing rules to account for ESG risks and impacts to their business and ESG disclosures based on existing SEC requirements.
As a result of the SEC’s publicly announced focus on ESG matters, an increase in SEC comment letters related to ESG matters is likely.
Eric Knachel is a senior consultation partner in the professional practice network at Deloitte & Touche LLP.