Revealing ESG in Critical Audit Matters

J. Robert Brown, Jr. is a Board Member at the Public Company Accounting Oversight Board. This post is based on his recent public statement. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here); For Whom Corporate Leaders Bargain by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here); Socially Responsible Firms by Alan Ferrell, Hao Liang, and Luc Renneboog (discussed on the Forum here); and Toward Fair and Sustainable Capitalism by Leo E. Strine, Jr (discussed on the Forum here).

It is a pleasure to be attending this virtual conference with investors from around the world. Perhaps, now more than ever, investors need advocates and these forums to discuss and further their perspectives and interests.

Before I continue, I should remind you that the views I am expressing today are my own and do not necessarily reflect the views of my fellow Board members or the staff of the Public Company Accounting Oversight Board (“PCAOB”).

I’m guessing that when you think about Environmental, Social and Governance or ESG disclosure, audit regulators are not usually top of mind. Today, though, I want to share some thoughts about why they should be. The PCAOB and other audit regulators have an important role to play in the ESG disclosure space.

We all know that ESG disclosure has undergone exponential growth, both in quantity and importance. These days it’s almost impossible to pick up a newspaper or read articles via the Internet without seeing the effects of climate change, whether disappearing polar ice, rising temperatures and sea levels, the increasing severity in weather patterns, the out-of-control fires in the Western United States, or the global discourse on mandating limits on carbon emissions. Given the importance of the area, investors and other participants in the capital markets are increasingly demanding high-quality disclosure that can be useful in making investment and voting decisions.

ESG-related disclosure, however, suffers from a number of qualitative concerns that limit its utility. Not subject to, or measured against, universally accepted reporting standards, concerns can arise with respect to the comparability and completeness of the information. Not subject to a mandatory system of assurance, concerns can exist about consistency and reliability.

Not all ESG matters raise these concerns: ESG matters can and do directly affect the financial statements. Financial statements may include assumptions, estimates, and valuations that are materially impacted by the effects of climate change. In these circumstances, accounting standards ensure some degree of consistency and comparability; independent audits provide some level of completeness and reliability.

These advantages notwithstanding, investors often are left unaware of the role of climate change and other ESG matters in the financial statements. Steps taken by audit firms to become comfortable with these often difficult, uncertain, and challenging matters have generally not been made public.

This, however, has begun to change.

Last year, audit firms for the largest public companies in the United States were required, for the first time, to include in their reports a discussion of “critical audit matters” (“CAMs”). This is a new source of disclosure for investors, emanating not from management but from audit firms. Critical audit matters are intended to extend to the areas of the audit that are particularly difficult and particularly important. The uncertainties and complexities associated with auditing the areas of the financial statements that contain assumptions and impacts of the effects of climate change and other ESG matters can certainly qualify as a critical audit matter under this standard.

The disclosure of CAMs brings with it a host of benefits. Not only is the firm identifying a difficult area of the audit, but the matter may receive increased attention from audit committees and be a catalyst for improved disclosures in the financial statements included in regulatory filings.

After one year of experience with this disclosure requirement, however, CAMs that address ESG matters, or ESG CAMs, remain uncommon, particularly those addressing the effects of climate change. Only three of the approximately 2,400 or so audit reports with CAMS appear to have included a meaningful discussion of the impact of climate change on the financial statements.

We are, however, at the early stages of the implementation of this important audit standard. The audit report and the discussion of ESG CAMs will presumably evolve in content, frequency, and usefulness. Both investors and regulators will have an important role to play in influencing the direction of this evolution.

So that’s my topic for today.

I want to talk about how an auditor’s discussion of critical audit matters, and in particular, ESG CAMs, can arm investors with new insights and information about uncertainties and judgments concerning the impact of climate change on the financial statements.

I will start with a brief exploration of the impact of ESG matters on various estimates and valuations and the role of the independent accounting firm in auditing these matters. I’ll provide some insight into the ESG CAMs that we’ve seen so far.

Then I’ll talk a bit about the evolution of ESG CAMs.

Investors and the PCAOB have an important, even critical, role to play in this evolution. In particular, the PCAOB is in a unique position to help ensure that ESG CAMs and other CAMs are disclosed in audit reports with the frequency required by the standard.

I will end by talking about ways you can participate in this evolution and encourage the degree of regulatory oversight that may be necessary.

I. Loitering in Winter while it is already spring: ESG Matters and the Financial Statements

ESG disclosure by public companies has become increasingly important to investors and other participants in the capital markets.

Some public companies include a variety of ESG metrics or information in periodic reports filed with the U.S. Securities and Exchange Commission (“SEC” or “Commission”). Many companies, however, disclose a host of ESG related data and information outside of the financial statements of required regulatory reports, such as in separate Taskforce on Climate-related Financial Disclosures (“TCFD”) and other types of sustainability reports.

ESG disclosure, however, can raise qualitative concerns. For one thing, the absence of universally accepted reporting standards makes consistency and comparability an issue. For another, the absence of mandatory requirements for assurance can raise doubt about the completeness and reliability of the information.

Not all ESG matters, however, suffer from these concerns. ESG matters can also directly affect the financial statements of a public company. When ESG matters affect the assumptions and estimates that are embedded in the financial statements, a common set of accounting standards that help ensure comparability of the financial statements. The financial statements that embody the estimates, such as assumptions about future events and circumstances, audits by an independent accounting firm reduce the concerns over reliability and completeness.

In some instances, accounting standards may explicitly require the disclosure of ESG matters. Environmental cleanup costs may need to be estimated and disclosed, whether as a result of environmental remediation or plant decommissioning.

Mostly, though, the financial statements do not include specific line items that address the uncertainties and complexities of climate change. Instead, ESG matters may “overlap” with financial reporting standards and must be considered when relevant to an account or disclosure in the financial statements. Any number of estimates and valuations can be affected by climate change and other ESG matters.

The effect of ESG matters, particularly climate change, on financial statements is increasing. Laws and regulations designed to address climate change by limiting greenhouse gas emissions are under active consideration and, in some cases, have already been adopted. Japan recently pledged to become carbon neutral; Sweden has already passed the required legislation.

In the United States, a number of states and other jurisdictions have addressed carbon emissions. Louisiana has announced efforts to achieve reductions by 2025; California is banning the sale of gas powered automobiles after 2035. Last week, the New York Department of Financial Services mandated that all regulated financial institutions integrate the financial risks from climate change into their governance frameworks, risk management processes, and business strategies.

The list only grows.

At the same time, the discretion used to analyze the effects of climate change on the financial statements has narrowed. The days of optimistically thinking that the effects of climate change would be insignificant or modest appear to be over for many public companies. Climate change is accelerating and the likely impact on estimates and valuations is becoming more pronounced. Analyzing the impact, therefore, requires consideration of scenarios or models with increasingly severe outcomes. Simply assuming no effect or assuming the least disruptive effect will not in many cases be reasonable.

Independent accounting firms examine these estimates and valuations as part of the audit. Increasingly, the failure to consider the impact of climate change or the unreasonable assumptions of the impact will make more and more difficult for firms the ability to obtain the necessary degree of assurance required for an audit.

II. Any truth is better than make believe: ESG CAMs

ESG matters that affect the financial statements may benefit from common standards and assurance but they suffer from a lack of transparency. It is difficult, or sometimes, impossible for investors to know what ESG matters impact the business or the financial statements.

With respect to the financial statements, investors are often left unaware of the impact of climate change. Investors also face opacity with respect to the steps taken by the audit firm to get comfortable with management’s approach to incorporating the effects of climate change in the financial statements.

Until recently, the reports issued by audit firms mostly gave a thumbs up or thumbs down perspective on the financial statements and provided little or no insight into the areas of the audit that were the most challenging.

That, however, has begun to change.

A. The Arrival of ESG CAMs

Beginning last year, independent auditors for the largest U.S. public companies were required to include in their audit reports a discussion of “critical audit matters” or CAMs. In a first, disclosure about an issuer’s financial statements would emanate not from management but from audit firms.

Critical audit matters were intended to include the areas of the audit that kept the auditor up at night. Investors and other participants in the capital markets would learn about some of the challenges confronted by firms in auditing financial statements and some of the steps they took to become comfortable with difficult, complex, or subjective areas of the audit.

CAMs were meant to provide “audit-specific” insight in order to “address the information asymmetry between investors and auditors. . .” That meant doing more than generating generic or boilerplate language or simply identifying areas under the accounting standards that were inherently difficult.

Importantly, the auditing standard required the auditor to describe how the critical audit matter was addressed in the audit. In describing how the critical audit matter was addressed in the audit, the auditor could also describe: (1) the response or approach that was most relevant to the matter; (2) a brief overview of the audit procedures performed; (3) an indication of the outcome of the audit procedures; and (4) key observations with respect to the matter, or some combination of these elements.

B. The Benefits of ESG CAMs

Assessing the effects of climate change and other ESG matters on the financial statements can be uncertain, complex, and highly dependent upon the particular assumptions used by management. These are the sorts of things than can keep an auditor up at night. The matters are therefore obvious candidates for consideration as an ESG CAM.

Disclosure in the audit report of an ESG CAM provides far reaching benefits.

Foremost, they are the views of the auditor, not management. Auditors are speaking directly to investors about the challenges associated with assessing the impact of COVID-19 or the challenges of testing, assessing, and verifying a company’s valuations or estimates concerning the impact of climate change. They may reveal concerns about management assumptions and scenarios. They may also reveal aspects the may not be readily apparent in the financial statements, such as reasonableness of assets lives and commodity prices used to support valuations or impairments, or management’s intent.

Second, ESG CAMs can shed some light on the audit committee’s role in considering the impact of climate change and related matters. Auditors are obligated under our standards to communicate certain matters to the audit committee, particularly about the risks associated with the audit and the financial statements. The hope is that these communications will generate a two way interactive discussion.

The standards require that CAMs will be discussed with the audit committee. As a result, inclusion of an ESG CAM means that the topic will have been communicated to, and discussed with, the audit committee. The discussion may be “robust” and audit committees may receive “further insights,” including comparisons with other companies in the same industry. This can cause audit committees to take a “fresh look” at “their own company’s disclosure.”

Third, ESG CAMs can result in improved corporate disclosure. Audit firms often discuss CAMs with management. The process can cause management to revisit its own disclosure. Given the recent implementation of this requirement, it may be a bit early to determine the collateral effects of the disclosure of CAMs on SEC filings. Nonetheless, some academic research has at least suggested the possibility that improvements in corporate disclosure may be occurring, a conclusion consistent with research on the effects of “key audit matters” of K-CAMs.

Finally, even the absence of an ESG CAM can provide some potentially useful insight. Given the growing inevitability of climate change and the uncertainties around the extent of the effect, the auditor’s principal consideration as to climate change was or was not an especially challenging, subjective, or complex judgment relating to material accounts or disclosures may be viewed as relevant in assessing a company’s financial statements, its disclosures, and ultimately audit quality.

C. The Experience with ESG CAMs So Far

So those are the benefits. How often have these benefits occurred with respect to ESG CAMs?

Particularly with respect to those addressing climate change, not very often.

As of October 2020, CAMs have appeared in audit reports for around 2,400 public companies, with each averaging 1.7 CAMs. The most common topics included goodwill, revenue recognition, other intangibles, and business combinations.

ESG CAMs, in contrast, appeared rarely. Some ESG CAMs addressed cleanup costs, whether environmental remediation, or asset retirement obligations. Others involved a discussion of the impact of COVID-19 on various assumptions and estimates in the financial statements.

Of the approximately 2,400 reports that contained CAMs, only three appear to have included a meaningful and explicit discussion of the impact of climate change on the financial statements.

In one report, the auditor discussed management’s estimates that were inconsistent with the 2050 “net zero” commitment ” The auditor also observed that deprecating the assets in line with net zero targets would result in additional reductions to net income that were not reflected in the financial statements. The report also discussed how the auditor challenged management’s assertion that carbon-emitting equipment could be used in alternative ways after a net-zero target date that supported management’s estimate of operation until 2070.

Another audit report discussed how climate change and the global energy transition impacted the capitalization of exploration and appraisal costs. The auditor also focused procedures on the risk that oil and gas price assumptions could lead to material misstatements of the financial statements. Another audit report described the effect that long-term price assumptions incorporating the potential impact of climate change could have on asset values and impairment estimates.

Considering the increasing frequency that environmental trends, events, and uncertainties, including the lower commodity prices and margins resulting from a COVID-19 economic environment, can affect material accounts or disclosures in a public company’s financial statements, I expected to see more auditor reports describing them in the future.

III. All the Branches and None of the Roots: Evolution and the Role of the PCAOB

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.

The PCAOB can assist in the evolution of this disclosure requirement through useful guidance, real time feedback, and timely comments made during the inspection process. The most important role for the PCAOB, however, may be to help ensure that CAMs, including ESG CAMs, are determined and communicated as required by the standard. Academic literature has suggested that the disclosures may not be disclosed with the frequency required by the standard. Moreover, ESG CAMs addressing climate change in a meaningful fashion have appeared only rarely.

The PCAOB is particularly well positioned to assess whether ESG CAMs are being disclosed with the frequency required under the auditing standard. Through the inspection process, the PCAOB has unique access to the approach taken by audit firms in deciding what should and should not be disclosed in a report.

Where climate change and other ESG matters were communicated to, or required to be communicated to, the audit committee but not included as an ESG CAM, the PCAOB may review the documented rationale for the decision. While the characterization of a matter as an ESG CAM can involve a high level of auditor judgment, there could be instances where the rationale was not documented or the documentation did not adequately support the decision to omit the matter from the audit report.

We also have a number of avenues available to share our inspection findings with the public. We can issue an anonymized report that describes what we learned. In addition, we can disclose these deficiencies in our public inspection reports. We just added a new section to the report that permits the disclosure of an expanded category of deficiencies, including those relating to critical audit matters.

Finally, I would add that ESG CAMs are not the only place where the PCAOB can play an important role in connection with ESG disclosures, including disclosure provided by public companies. The role of the audit firm role, if any, in providing assurance for ESG metrics as part of the audit, whether in SEC filings or in sustainability reports, is an important topic that should be addressed. The PCAOB, through possible revisions to our “other information” standard, could, in my view, bring the stakeholders together to discuss how best to resolve this issue.

IV. The Universe is Wider than our views of it: Evolution and the Role of Investors

Investors also have an important role to play a role in the evolution of ESG CAMs. Your role is really twofold.

Particularly with respect to ESG CAMs, you are the subject matter experts. You can provide feedback on the nature of the disclosure and areas where firms could provide more useful information.

Audit firms would benefit from this feedback. The requirement for auditors to directly speak to investors on critical audit matters is the first major change to the “thumbs up” audit report in over eight decades. In other words, this is a new requirement for them. Your feedback can help them determine the types of additional details that would render the critical audit matters more useful to you in making voting and investment decisions.

Your insight could also be useful topics for discussions with audit committees, including those at comparable companies where the audit report did not include an ESG CAM. The feedback could be helpful for those serving on these committees when they discuss the audit and the audit report with their independent accountant.

Your most important role, however, may be to encourage the PCAOB to apply the appropriate level of oversight to ensuring compliance with these new disclosure requirements. You can provide the PCAOB with qualitative feedback that may be useful in providing guidance. You can also discuss with the PCAOB your concerns, if any, over the frequency of disclosure. This can include instances where you have concerns that an ESG CAM may have been omitted.

But don’t wait for the PCAOB to ask you for input or advice. Our outreach to investors is not always what it should be.

Instead, be proactive.

Ask to meet with us, whether the staff or the full board to share your views. Tell us what you think of ESG CAMs and how they can be better. Talk to us about our role in the evolutionary process.

I personally favor meetings since I think the Board and staff benefit from the back and forth that usually occurs. We can do them virtually for now. If that, however, won’t work, write to us, whether by letter, email or other form of communication. Feel free to communicate with my office directly.

Finally, combine efforts. Talk with others in the various associations or organizations where you are members and encourage them to form a committee assigned to follow and interact with the PCAOB. The committee can follow issues, arrange meetings with the staff and board of the PCAOB, and lead the efforts of communications.

Let me end by saying that I am happy to further the conversation with those of you interested in these areas and look forward to our future interaction.

The complete publication, including footnotes, is available here.

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