Many businesses are making voluntary net zero pledges. As part of ensuring that these commitments are ‘Paris-aligned’, these pledges need to be backed by meaningful and measurable action. Directors and senior managers will need to align strategies and operations with the Paris Agreement objectives while preparers (eg, the finance team) consider how to reflect the outcomes and risks of these changes in the annual report and accounts. 

As businesses work towards Paris alignment and a transition to net zero carbon emissions, and even if they have not yet started, auditors will play a key role in reviewing how progress and the related risks are reported in annual reports and accounts. Although international auditing standards do not explicitly require auditors to consider climate change related risks, auditors are required to identify and assess risks of material misstatement within the accounts, and factor this into how they design and perform their audit and the IAASB’s Staff Practice Alert, The Consideration of Climate-Related Risks in an Audit of Financial Statement. highlights areas of focus related to the consideration of climate-related risks when conducting an ISA audit. As auditors begin to grapple with how net zero and the energy transition impacts the audit, the following five questions may help. 

1. How significant is carbon to the business model? How exposed is the business you’re auditing to transition risks as well as the effects of achieving net zero carbon emissions?

ISA 315 requires auditors to understand the business and its environment. Some businesses will face greater risks from climate change and/or the transition to net zero operations. You may find it help to consider:

• How reliant is the industry and/or the business model on carbon?
  
  For example, carbon intensive industries such as mining, manufacturing, and construction will likely need to consider widescale operational changes and the impact of potentially winding down parts of their business to reach net zero. For example, this could result in impairments, reduced asset lives and residual values, onerous leases or other contracts and provisions for decommissioning their assets.
  
  Businesses that sell carbon-intensive products, such as automotive companies will likely need to consider the effects on their business of changing demand or increasing regulations.
  
  Businesses may also have to consider increasing costs of carbon or emissions allowances.
  
  Businesses which rely on carbon-intensive supply chains may also be impacted. Auditors should consider both the upstream and downstream supply chains. For example, the cost of raw materials may increase if suppliers cease or alter operations. If customers change suppliers to reduce carbon footprint, this could result in overvalued inventories especially if they are not able to pass the costs on to the end user.
  
  Financial service entities holding investments and/or loan balances with carbon intensive industries or businesses or carbon reliant supply chains may need to consider impairments of asset values/increased expected credit losses longer term.
• How might other external risk factors impact the business? Consider for example, the ability to use productive assets, regulatory changes, stakeholder pressures, the cost of financing, and consumer preferences.
  
  While the Paris Agreement is not binding on businesses or individuals, governments may begin to introduce net zero or other low carbon/climate-related requirements in law. For global businesses this could mean multiple – and possibly differing regulations required to be met and reported on. This could increase the risk of non-compliance with laws and regulations, resulting in fines.
  
  Businesses who have not yet made meaningful steps to net zero or addressing the energy transition may face higher future financing costs as banks prioritise green financing. This may have a longer-term impact on solvency.
  
  Increasing public support for net zero policies may also increase risks, for example, if a business is seen as ‘green washing’. This could reduce demand for products and services due to reputational damage. 

There may be other issues that you will need to consider beyond these examples. You will need to assess how significant the risk of material misstatement associated with these risk factors are and what response is needed to address the risks. More guidance is available from ICAEW here.

2. Do you need to factor in climate or net transition risks to your materiality calculations?

Materiality is fundamental to an audit and is applied in planning and performing audits, as well as evaluating the effect of misstatements on the accounts. You will need to think about whether changes to businesses because of net zero transition impacts how you determine materiality. The following questions may be helpful:

• Have investors signalled an increased interest in net zero transition/climate-related risks?
  
  ISA 200 defines material misstatements (including omissions) as those that could reasonably be expected to influence the economic decisions of users. Auditors need to consider the users of the financial statements when setting materiality. Investors are increasingly interested in net zero transition. Management’s strategy and assumptions for reach net zero may be key for investment decision making. 
• Has the underlying business remained the same and is the business a similar size to previous years?
  
  For example, if net zero transition plans have progressed to restructuring or closures, this will likely impact materiality levels. Changes to revenue and/or profitability, for example, from changing consumer preferences or increased supply chain costs would also need to be considered.

ICAEW’s guide, Materiality in the audit of financial statements provides further information on the requirements in auditing standards.

3. What methods, assumptions and data has management used in determining accounting estimates? How will you review and challenge these?

Estimates and forecasts are inherently uncertain. As the world progresses on its journey to meet the goals of the Paris Agreement, there is likely to be significant uncertainty in how countries and companies are impacted. This is likely to lead to an increased risk in estimate and forecast accuracy for net zero scenario planning. 

In particular, auditors may wish to consider the following financial statement areas:

• Asset valuations – all asset class valuations could be impacted. For example, plant and machinery may have a reduced life due to operational changes to meet emissions goals or requirements. Inventory, like oil and gas, may have reduced market values in a low carbon economy. Investments in carbon intensive industries may decline in value as a result of lower profits or as lower carbon replacements decline in cost. 
• Recoverability of deferred tax assets – a reduction in profits due to increased costs and/or reduced revenues could mean deferred tax assets may need to be written off. 
• Going concern – certain business practices may no longer be viable in a net zero economy. Consider what scenarios and sensitivity analysis management has included in assessing the impact of its net zero transition strategy on going concern (and whether these align with the assumptions and estimates used in the financial statements).
  
  Has management considered a range of scenarios? How plausible are these scenarios, taking into account future regulatory changes and wider supply chain impacts, for example? Auditors will need to be mindful of going concern risks and also longer-term challenges requiring disclosure in viability statements. 

Our hub on auditing accounting estimates provides more guidance for auditors on the requirements of the standard.

4. Is the narrative in the annual report consistent with the financial statements?

Auditors are required to read the other information in the annual report and consider whether it is materially consistent with the financial statements or their knowledge of the business. If management reports a strong, positive net zero commitment, does this reflect the auditor’s understanding of the business based their audit? Has this been factored into how the financial statements have been prepared, for example, in estimates and accounting assumptions? 

If the narrative in the annual report tells a different story to the financial statements, auditors will need to consider whether this represents a material misstatement in either the financial statements or the other information, and how this impacts their audit report.

5. Will you need to report a key audit matter?

Key audit matters (KAMs) provide investors with greater transparency on the matters auditors view as most significant in the audit. Auditors will need to consider if issues relating to climate change, including net zero transition and ‘Paris-alignment’, should be included as a KAM in the audit report, as well as considering the impact these issues may have on other KAMs (eg. impairment). 

An example of recent practice can be found in EY’s 2020 Independent Auditor’s Report on Royal Dutch Shell plc.. They included two KAMs, one discussing climate risk and energy transition, and the other on investor expectations on ‘Paris-aligned accounts’.

The time for action is now! Our Climate Hub provides more resources and insights to help you on your journey.