This article was originally posted by Analysis Group in December 2022.
As investors continue to push for ways to align their investment strategies with environmental, social, and governance (ESG) criteria, the accounting profession has faced questions of whether and how reporting practices and requirements should change as well. What information should be reported to stakeholders, including investors and regulatory agencies, and how can accountants provide assurance regarding the accuracy of this information for a paradigm that is still evolving?
To probe these questions, Analysis Group Vice President John Drum and Manager Shelby Cameron spoke with affiliate D. Scott Showalter. Prior to joining academia, Professor Showalter, who directs the Master of Accounting program at North Carolina State University, spent more than three decades in public accounting. His clients included large and small corporations, government agencies, and several states and cities. Professor Showalter has been involved in shaping the accounting profession’s approach to ESG reporting through participating in standard setting, serving on sustainability task forces and committees, teaching sustainability issues in the classroom, and presenting on ESG issues at conferences. He spoke to Mr. Drum and Ms. Cameron about standards for and disclosures of ESG information, measurement uncertainty, and the accountant’s evolving role in ESG reporting.
What role has accounting played in ESG reporting, and how do you see that role evolving?
ESG reporting, also referred to as sustainability reporting, has been around since the late 1990s, and accountants and accounting firms have played a central role. Take, as an example, the 1998 Dutch Shell report “Profits and Principles – does there have to be a choice?”: It is regarded as one of the first sustainability reports and contained some level of assurance on the reliability of the information provided by two international accounting firms. Since then, companies have continued to evolve what information they report and how it is reported – for example, whether the ESG information is presented in standalone documents or included in the annual financial report, and whether it’s presented in a table, text, or infographics.
Accountants and accounting firms have also expanded their role in the preparation and issuance of ESG information. That role includes identifying metrics to report, developing ways to measure the metrics, developing processes and controls to produce and verify the information, and preparing ESG reports. Accounting firms have developed the capability to help organizations provide reasonable and limited assurance on ESG information.
Currently, there is no one set of mandatory, comprehensive ESG reporting requirements. How does that complicate the accountant’s responsibilities?
While investors’ demand for – and accountants’ capabilities for preparing – ESG information has expanded, that growth occurred with few corresponding regulatory requirements. During this time, a variety of organizations have issued guidelines on how to report ESG information. This diversity of guidelines and lack of consistency has, in turn, contributed to a demand by investors for standardization among companies’ disclosures. For example, many investors have expressed interest in better understanding the impact of climate change on business – a concept known as climate disruption – and what companies are doing to prepare for this disruption and its financial impact.
More recently, a number of organizations have joined the discussion by issuing guidelines and proposing standards governing ESG disclosures. These include the SASB [Sustainability Accounting Standards Board], GRI [Global Reporting Initiative], TCFD [Task Force on Climate-Related Financial Disclosures], and UNGC [United Nations Global Compact]. While helpful, this alphabet soup of organizations has contributed to confusion about which metrics a firm should report, as well as about the lack of comparability among the reported ESG metrics of the various organizations.
How are companies determining which ESG metrics to report?
Relevant ESG metrics can vary by industry and corporate strategy. However, this may change through efforts by the SEC [Securities and Exchange Commission], IFRS [International Financial Reporting Standards] Foundation (through its creation of the ISSB [International Sustainability Standards Board]), and EU, which have issued separate proposals for ESG standards and disclosure requirements. While there are some similarities between the three proposed regulatory standards, there are differences as well, which may lead to over-disclosure by organizations in multiple jurisdictions trying to comply with three different sets of standards.
As an example, one area in which the disclosure proposals differ is guidance surrounding the determination of materiality – the threshold at which companies are required to disclose a piece of information. Multinational corporations will have to develop processes to ensure they are meeting the specific requirements associated with a given jurisdiction, regardless of potential discrepancies in standards across jurisdictions.
What considerations are important regarding the measurement of ESG metrics?
There are significant estimations and judgments required in measuring ESG metrics once a firm has a grasp on what information is required or what information the company plans to present. These estimates can lead to measurement uncertainty, which increases with the lack of specific guidance on how to determine or calculate many of the relevant metrics presented. Professional judgment is required, which is nothing new in the accounting profession.
“[B]roadly speaking, restatements could indicate effort to improve the accuracy of the ESG information and willingness to be transparent about these efforts. That is, restatements could be evidence of an attempt to provide quality information, rather than of reporting failures.”
Some groups have criticized ESG information for its lack of reliability, often citing the numerous restatements in reported ESG information. I look at it differently. Of course, every restatement is unique to those circumstances, but broadly speaking, restatements could indicate effort to improve the accuracy of the ESG information and willingness to be transparent about these efforts. That is, restatements could be evidence of an attempt to provide quality information, rather than of reporting failures.
Due to the range of nonfinancial information underlying many of the ESG metrics, the accounting function needs to reach across the organization to obtain the information required to determine the information to be reported and the underlying data needed to calculate the ESG metrics.
An example of the measurement uncertainty and cross-organizational reach associated with reporting ESG information can be seen in the current proposals regarding disclosure of GHG [greenhouse gas] emissions. Accountants will have to work across company divisions to identify and measure direct and indirect energy expenditures, as well as coordinate with outside parties to measure upstream and downstream GHG emissions. Moreover, it is well understood that measuring GHG emissions requires significant estimation, which could result in uncertainty. And many companies will need to engage with engineers to measure and explain trends in GHG emissions.
What challenges exist when it comes to verifying ESG metrics disclosed in financial reports?
Companies are going to need to ensure they have proper processes and controls to produce high-quality ESG information. As I mentioned, much ESG information originates outside the accounting function, where an understanding of proper processes and controls may be absent. I have seen data provided, literally, on the back of a napkin to support the ESG information presented. The accounting and internal audit functions will have to work with outside departments to understand how to develop and monitor processes and controls.
Companies also are sometimes accused of only presenting favorable ESG information, given the lack of ESG standards as described above, so they will face the challenge of ensuring they are presenting a balanced picture. They will need to be able to explain to the auditor why they decided to report the information they did.
Lastly, auditors providing assurance on the information will be challenged, and they will need to determine and understand the criteria being used to prepare and present the ESG information and whether it is appropriate in the circumstances. The factors I’ve talked about will affect auditors’ assessments of this information.
For example, auditors will need to consider the effect of the lack of standardized disclosure requirements, the risks to the accuracy of the information provided by companies, the application of materiality, and how to appropriately consider challenges that measurement uncertainty may add. Evaluating how the information is presented to ensure that it is neither misleading nor incomplete is important.
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