The Securities and Exchange Commission’s proposed rule for climate-related disclosures would involve accountants and auditors more heavily in their clients’ efforts to provide assurance on sustainability reporting.
Last week, the SEC unveiled a heavily anticipated
The disclosures are part of the Biden administration’s efforts to respond to the impact of global climate change and as investment increases in environmental, social and governance funds. Various ESG standard-setters are moving to align their sometimes competing standards and frameworks more closely. The proposed rules point to the Task Force on Climate-related Financial Disclosures framework and the Greenhouse Gas Protocol, but don’t require the use of a specific set of standards.
The Center for Audit Quality welcomed the proposed rule. “We’ve long acknowledged the value of climate and other issue disclosures to investors, and think the proposal on disclosure of climate-related risks by public companies is a major step in giving both companies and investors clarity around the information that investors are increasingly asking for,” said Dennis McGowan, vice president of professional practice at the CAQ. “Companies in many respects are already providing [ESG disclosures] to the capital markets, maybe in some voluntary form outside of SEC filings, at least for the largest of companies.”
The CAQ plans to submit comments on the 506-page proposal. “What really stood out to me in the proposal would be the inclusion of the requirement that certain registrants subject certain of their greenhouse gas emissions to assurance," said McGowan. "For some time, including in our comment letter to the SEC last year, we acknowledged that public company auditors in their public interest role can enhance the reliability of a key metric, greenhouse gas emissions, for the benefit of investors who could use this information to make decisions. That long-awaited step from the SEC will hopefully foster comparable, consistent and reliable climate information.”
Some professionals were taken aback by the scope of the proposed disclosures. “One of the things that did surprise me was the addition of a financial statement footnote that disaggregates some climate-related metrics from certain financial statement line items,” said Steve Soter, senior director of product marketing and accounting industry principal at the technology company Workiva and an executive advisor to the SEC Professionals Groups. “Any time you’re adding things to financial statements and footnotes, that gets subject to internal controls over financial reporting, the full financial statement audit, and that really raises the profile and the risk, quite frankly, of adding these new disclosures. That’s something that I was a little surprised by. As a former SEC practitioner, that would definitely be very high on my radar of things to pay attention to.”
New processes
The proposed rule could mean that accountants would need to make some major changes in their usual processes. “If you think about an income statement and revenue, cost of sales, gross profit, SG&A expenses or whatever, you would then need to take certain impacted line items and then break out the impact of climate-related matters, whether those would be physical risks due to severe weather events or transition-related activities,” said Soter. “Inherently you’re going to need to start to weave in climate-related assumptions, judgments and analysis that maybe in the past hadn’t been part of the financial reporting ecosystem assumptions and metrics that you would use. Is that data and information in a position to be subject to full internal controls over financial reporting and full external audit scrutiny? That is the thing that would worry me the most, not that it’s insurmountable. It’s simply that those processes don’t exist today, and naturally they would need to be built out in such a way to mitigate the risk of error in financial statements, assuming that the proposal gets adopted.”
Auditors would need to adjust the way they deal with climate-related information. “The proposed footnote to the financial statements is going to include certain climate-related financial statement impacts,” said McGowan. “As part of the audit now, like any other footnote, that will be part of the auditor’s audit of the financial statements.”
The content of the 10-K annual report would also be affected by the SEC’s proposed rule. “Under the proposed guidelines, publicly traded companies are going to have to provide more information about climate in their 10-K,” said McGowan. “The state of play today is that a lot of this information is outside of documents that contain the financial statements. Putting this information in the 10-K, the document that contains the financial statements, means that auditors are going to need to reconsider whether that information contains a material misstatement of fact or is materially inconsistent with the audited financial statements. Today, since this information often isn’t in the document that contains audited financial statements, auditors have not been required to read and consider that information.”
Soter was surprised by the audit requirements in the proposal. “I didn’t think the SEC was going to go that far,” he said. “What’s interesting about that attestation requirement is that there are already two external audit opinions in a 10-K filing. You’ve got your internal controls over financial reporting, and you’ve got your financial statement audit opinion. Now you’re going to introduce a third. My reading of the proposal is that the auditor attestation of greenhouse gas emissions would not go in the financial statements and footnotes. It would go in the Reg S-K disclosures, kind of the front part of the document. There’s an interesting logistical question of what is the interplay going to be between your financial statement auditor that has the obligation to review and consider everything that’s in a 10-K, and then you have this other discrete attestation around greenhouse gas emissions. It makes me wonder if everything is going to ultimately end up being done by your financial statement auditor because they basically have to audit that audit if someone else did that audit of greenhouse gas emissions.”
The assurance requirements would change from voluntary to mandatory under the proposal. “Certainly the proposed requirements around large accelerated filers and accelerated filers subjecting to a certain degree greenhouse gas emissions to assurance is going to be an opportunity for the firms to bring their assurance skills and their independence and their expertise to greenhouse gas emissions, like the audits of financial statements and internal controls over financial reporting, and bring the same level of reliability to that information that they bring to financial statements,” said McGowan.
The CAQ did a
“We already see this happening to some degree in this voluntary system we currently have, and auditors have been providing assurance over certain ESG metrics when companies have engaged them to do so,” said McGowan. “We’ve seen them in large part using the AICPA attestation standards and they could potentially continue to provide that assurance over certain greenhouse gas emissions. What these proposed requirements do is potentially shift us from a voluntary system for reporting assurance to more of a mandatory system, which will certainly bring more consistency, comparability and reliability to the way companies report this information and whether or not they subject it to assurance. Certain metrics are going to be required to be subjected to assurance, versus now where it’s largely voluntary.”
Scope 3 emissions
There was some concern about whether the SEC would require companies to disclose so-called Scope 3 greenhouse gas emissions from their suppliers and customers in addition to their own direct emissions (Scope 1) and emissions from their energy suppliers (Scope 2).
“We see companies today reporting Scope 1, 2 and 3 greenhouse gas emissions, and you see in certain instances where they get assurance over Scope 1 and 2, and they may not always get assurance over Scope 3,” said McGowan. “We were expecting some level of prescription around the Scope 1 and 2 and potentially Scope 3 emissions, but because Scope 3 is a little bit more complex and there are more assumptions toward it, I’m not surprised to see where things landed.”
The Scope 3 requirements may leave companies some wiggle room, but they may also bring ambiguity about what to do. “From the SEC reporting standpoint, I like the fact that if you don’t consider Scope 3 emissions material, and if you have no publicly disclosed targets, then you have a way of keeping it out of your SEC filing,” said Soter. “What’s interesting to me, though, is that the way that the proposal is written, it says you have to disclose Scope 3 if it’s material or if you have some kind of a target. And if you don’t have a target, then fine, maybe you can get out that way.”
However, the concept of materiality could end up ensnaring many companies. “If Scope 3 is the majority of your emissions, meaning it’s material to your overall greenhouse gas emissions, then we would assume that to be material,” said Soter. “I’m scratching my head. If anybody knows anything about greenhouse gas emissions, Scope 3 is always going to be by far the biggest. It begs the question to me, when the SEC qualifies Scope 3 emissions disclosures as being you have to do it if material, I don’t know how it couldn’t be material.”
Companies may be hard pressed to decide whether they need to disclose their Scope 3 emissions. “If you were using a very specific financial reporting definition of materiality, I’m not actually sure how you’d connect the dots between what your Scope 3 emissions are into a strict financial reporting or SEC reporting or Supreme Court definition of what is material,” said Soter. “That to me is going to be hard for companies to connect the dots, particularly if you haven’t disclosed any Scope 3 targets or overall emissions targets, if you were going into this greenfield and wondering if I have to disclose or not. That’s going to be a tough question for companies to answer.”
Standards and frameworks
The SEC also didn’t require companies to use specific standards like those from the Sustainability Accounting Standards Board or the Global Reporting Initiative. Instead it recommended the broader TCFD framework and the Greenhouse Gas Protocol, which already align with those specific standards.
“We’ve been of the view for quite some time now that any proposed disclosure requirements should be based on existing standards and frameworks,” said McGowan. “Let’s not create something to compete with the standards and frameworks that are out there today. I was pleased to see that they did include TCFD. It’s an existing framework that companies could use today. It’s one that we saw referenced a lot in the analysis we’ve done of S&P 500 company reporting. The same with the Greenhouse Gas Protocol. That’s another standard we see used often. There’s nothing to preclude a company from using SASB to implement TCFD. It all works together.”
The SEC wanted to make sure the disclosures would be widely applicable. “Instead of mandating one particular framework, what they were trying to do was to create disclosure requirements that are very complementary to certain frameworks but could also be complementary to a wide variety of frameworks, definitely the TCFD,” said Soter. “The Greenhouse Gas Protocol is relatively straightforward. That’s actually very similar to financial reporting. You’re just reporting on emissions, so that seems like a very clear natural fit with how the SEC is viewing what those greenhouse gas emission disclosures ought to look like and the work that needs to go behind them in order to have robust, reliable disclosures.”
Talent and technology
Companies will probably need to bring on board new experts and technology to deal with the disclosures. “If I were looking at this proposal and looking at how I would comply, it really makes me think about whether I have the right talent in place and do I have the right technology,” said Soter. “It harkens back to some of the conversations we were having about Sarbanes-Oxley a long time ago or about revenue recognition or lease accounting, where there were some very specific process things that needed to be adopted in relatively short order in order to comply with the proposal. I realize this is a proposal, so we’ll need to see what the SEC does, but I do think that the technology and talent question becomes really important as we now have a first view of what this could look like.”
The SEC proposal includes information about the use of XBRL (Extensible Business Reporting Language) technology for reporting purposes. “With respect to the Inline XBRL tagging requirements, various preparation solutions have been developed and used by operating companies to fulfill their structuring requirements, and some evidence suggests that, for smaller companies, XBRL compliance costs have decreased over time,” said the proposed rule, citing a
Businesses are likely to need to improve their technology and bring in more experts to deal with the enhanced reporting requirements. “As companies are looking at this and digesting it, I don’t see how both talent and technology are not going to need to change,” said Soter. “Certainly you have sustainability individuals who have been working at this for a very long time, but they may not be used to or familiar with the rigors and the timing of SEC filings. Just as a practical question, if you’re doing your sustainability reporting in May or June every year, how in the world are you going to have that data ready in time to have it audited in time for a 10-K to be filed in February? That is a really big question."
"Then, if everything up to this point has happened in emails, spreadsheets and disconnected documents, how in the world is that going to withstand the scrutiny of external audits, up to and including internal control over financial reporting?" he asked. "Those are really difficult questions that companies would have to wrestle with. I think it boils down to talent and technology, and having a platform that facilitates that is going to be table stakes.”
Potential litigation and politics
There is likely to be litigation challenging any rule that ultimately emerges from the SEC, and Congress may even step in, particularly if control of the House or Senate changes after the midterm elections.
“I absolutely think it will get litigated,” said Soter. “Any rule will get litigated. I think there’s a philosophical question about whether it’s the SEC’s business to require these kinds of disclosures, and at least my understanding is that yes, when it comes to disclosure matters, the SEC has broad authority to require companies to disclose certain items. Maybe individual companies don’t have investors or stakeholders who care about climate or ESG metrics, but speaking about the market broadly, Chair [Gary] Gensler shared some stunning facts. Tens of trillions of dollars are going into ESG-minded investments, and it’s hard to say the SEC doesn’t have disclosure authority and there isn’t interest from stakeholders."
"What I do think will be interesting, though, is we have midterm elections coming up later this year," he continued. "If Congress flips and you’ve got a Republican-controlled House and Senate, it may be interesting to see if some legislative effort gets passed to try to take away some of that authority from the SEC or at least carve out climate disclosures. I do think that’s a distinct possibility. I think there’s going to be a fight about this, but I think some type of disclosure will ultimately prevail.”
