While some might be gripped by the idea that the newly released blockbuster Civil War is perhaps not too far from non-fiction, Corporate Disclosures has been haunted by more art-house cinema in recent months, produced by the IFRS Foundation - of all people!
Far from Civil War's guns and the pseudo-philosophical question "what kind of Americans are you?", in the relative quiet of the IFRS Foundation meeting rooms, the IFRS Interpretations Committee (IFRIC) was asked the dauting question: why on earth are companies' net-zero commitments not accounted for in their financial statements?
Speaking at the first joint IASB/ISSB meeting in January this year, ISSB board member Richard Barker commented: "There is an expectation gap. [...] If a company makes a commitment to a significant sustainability transition that involves capital expenditure, the idea that this is not shown in the financial statements doesn't feel right. Understandably, many stakeholders feel unhappy with that as a conclusion."
A point echoed by David Wray, ESG chair at the International CFO Alliance and president of the DW Group, who told Corporate Disclosures: "I can understand the disconnect between a person who's looking at this from the outside, thinking 'you've made a commitment to net-zero, isn't it kind of obvious that it needs to be in the financial statement?' On the surface, yes, it is. But then you have to look at what that commitment means as it relates to the application of the IFRS accounting standards. That's where it becomes an interesting conversation."
Accounting purists look away as the rest of this article will aim to vulgarise recent developments at IFRIC and IASB – and hence may lose some of the technical nuances - so that the rest of the mortals, who do enjoy a stupid blockbuster movie every now and then, don't lose interest too soon in the narration.
So why?
Why are companies' net-zero commitments not accounted for in their financial reporting? An answer could be that there are no accounting standards or requirements to do so - yet.
A theory Rethinking Capital is challenging, through two submissions to IFRIC asking it to clarify how IAS 37 applies to net-zero transition commitments.
The background
Under IAS 37, a constructive obligation (i.e. one that is not legally binding) may lead to the recognition of a provision for that obligation, and that provision could then be recognised as an asset or a liability in the financial statement.
Rethinking Capital asked IFRIC if a company's net-zero pledge could be considered a constructive obligation, and as such become a provision in the financial statement.
To make its case, it used a fact pattern including two types of net-zero transition commitments: an emission reduction commitment by a specific amount by a specified future date; and a commitment to offset the entity's remaining annual greenhouse gas emissions after that future date by purchasing and retiring carbon credits.
In a second submission, Rethinking Capital explained what they regarded as limitations to the fact pattern in their first submission, and added information about various actions an entity had taken that affirmed its intention to fulfil its commitment.
After considering the first submission in November, IFRIC put its conclusion to a public consultation earlier this year.
In March, IFRIC considered the second submission and responses from the consultation, and decided not to add a standard-setting project to the work plan and instead chose to finalise an agenda decision.
As required by the IFRS foundation's due process, the agenda decision was put to the IASB at its April meeting and the board was asked whether it objected to the decision not to add a standard-setting project to the work plan, and to the conclusion that the agenda decision does not add or change requirements in IFRS Accounting Standards.
The board voted unanimously with no objections.
What does the agenda decision say
It is important to note that IFRIC aims to help maintaining and supporting the consistent application of IFRS Accounting Standards. It does that by responding to questions about the application of the Accounting Standards and through other work at the request of the IASB.
In this case, it wasn't tasked with assessing whether IAS 37 is fit for purpose for transition plan accounting, but rather if the standard is clear enough so that preparers can get to the right answer. In other words, does the fact pattern submitted to them meet the standard's requirements for a net-zero commitment to be recognise as a provision in the financial statement?
The short answer: potentially, it depends on the facts and circumstances of the commitment.
A slightly longer answer is: a net-zero commitment - a promise to someone that you are going to do something - might create a constructive obligation, but it doesn't automatically lead to the recognition of a provision.
For a provision to be recognise, according to paragraph 14 of IAS 37, three requirements need to be met.
First, the company needs to have a present obligation as a result of a past event. So simply to say one is going to do something doesn't give rise to an obligation. Something needs to have happened in the past.
Think for example of an oil spillage in the Gulf of Mexico. The oil company is not legally obliged to clean it up, but it is expected to and probably would have a policy saying it would. So an event – the spillage – causes the obligation to do something about it.
The second requirement is that it will generate an outflow of resources to settle the obligation, continuing our oil spillage example: the cost of cleaning up.
And the third is that a reliable estimate of the cost of that obligation can be performed.
So back to the case at hand: net-zero commitments. IFRIC concluded that, although they might form a constructive obligation, the fact pattern submitted would lack a past event that would 'trigger' the obligation and therefore lead to the recognition of a provision.
Real world applicability
For Andrew Watson, co-founder at Rethinking Capital, "the fact pattern that the IFRIC staff chose is not like any real-world net-zero commitment" that companies would have, where "the commitment and the plan never change" and where there is no transitional emission reduction targets.
"Therefore, the decision is very hard to apply in the real world, where companies make capital commitments to reduce emissions year-on-year to reach net-zero in the future," he said. "However, what is easy to apply is the principle [set by the agenda decision] that affirmative actions are powerful evidence that a constructive obligation has been created. What's then implicit and logical is that an affirmative action is recognising that something has already happened that is being affirmed. In other words, an acceptance that there's been a past event."
But for accountants and financial experts, that real world applicability will be determined on a case-by-case basis and might not be as straightforward as expected.
"A lot of companies might look at their net-zero commitments and say 'I have a constructive obligation because I've created a valid expectation in the minds of others that I'm going to do something', " an IFRS standards experts told Corporate Disclosures. "But what they have promised to do - that action - hasn't happened yet. Until you have that past event, you can't have a provision."
Although that is the outcome from the particular fact pattern submitted to IFRIC, "that doesn't mean you would never recognise a provision", the expert continued. "It is a facts and circumstances assessment: a company will have to look at what it promised, what that promise relates to, and what action that promise relates to. That will determine whether a provision is recognised."
The IFRIC decision concluded that, in and of itself, a statement committing to do something did not create a constructive or legal obligation, there must be a concrete action, Wray explained. "And then even if you are taking steps – actions – towards what you have committed to do, you still have to consider whether or not the costs are ones that relate to a future operating decision, as opposed to something that's already occurred and you're bound to pay it out no matter what actions you take in the future - that's the essence of the issue with respect to the application of IAS 37."
If, for example, a company sets out a transition plan which includes a change to its production process through the purchase of more energy efficient equipment and it expects its outlay for that equipment to be £2m, this amount wouldn't be a provision today, he said. "You can't recognise an outlay in anticipation of the purchase of an asset. You have to wait until you've purchased the asset (and obtained control of it). We don't provide 'in anticipation of', unless the event that gives rise to the obligation has already happened and it's the actions from either the law or the net-zero statement that gives rise to the event (under IAS 37), not the net-zero statement or the enacted law in and of itself."
"We don't provide 'in anticipation of', unless the event that gives rise to the obligation has already happened and it's the actions from either the law or the net-zero statement that gives rise to the event (under IAS 37), not the net-zero statement or the enacted law in and of itself."
Then there is the issue of the outflow of resources and the estimate of that cost. Of which the IFRS expert said: "You might make a promise about doing something that is so vague that nobody is going to know whether the thing you said you were going to do happened, so how are you going to measure it?"
But even in the case of a very precise – yet simplistic for purpose of illustration – scenario, things are not straightforward.
Let's imagine a ( again very simple) scenario where a company commits to buying a new factory and sunsetting its existing factory, and that alone will get the company to net-zero. Could this be a constructive obligation recognised as a provision under IAS 37?
"You would still need to consider which accounting standards are applicable to assets and impairment of existing assets before you would recognise a provision under IAS 37," Wray explained.
There wouldn't be a provision for the anticipated purchase of a new factory under IAS 37, he continued. "That would only be recognised on the balance sheet under IAS 16 as and when the asset started transferring (to the purchaser), either during construction or at the end upon completion, depending on how the contract was set up."
For the existing factory, under IAS 36, the company would consider whether it has some kind of impairment with its existing factory facility. For instance, does it need to reassess the useful life of its factory or look back at its prior assumptions to determine if any of what sitting on the balance sheet today may need to end up in the income statement as an expense, Wray continued.
"So you have to be really careful to apply the hierarchy of the IFRS standards properly, that's what makes it a bit more tricky and less obvious than what people might realise," he said.
The more things change....
At Rethinking Capital, Watson said the decision went beyond his expectations, for two reasons.
"One, the final decision does what we call 'flip the incentive'. By being able to recognise a provision, your investment can become assets," he said. "And second, it confirms our key point from our second submission, that affirmative actions are powerful evidence that the company itself accepts that it has created a constructive obligation."
Watson acknowledged that nothing changes in a sense - the standard is still the same - but the IFRIC decision provides guidance on how to interpret it.
He believes that a number of levers will enforce that guidance: audit firms, who he said have started to engage on this; boards, who will realise they need to follow this; and investors who are "unlocking hidden returns".
Rather than the IFRIC decision itself, he wants to focus on what it means in preparing for FY 24 year-ends.
"For boards, it means that a new decision on how to account for net-zero commitments must be made and a new judgement is needed. Boards must exercise their rights and duties to demand different 'normative' accounting scenarios be prepared," he said. "One that must be prepared is to recognise a provision—because by doing so, the provision would be unwound if investments purposed to meet it were capitalised as balance sheet assets—creating the pathway to make net-zero profitable and unlock new returns from a net-zero strategy and investment program."
Wray doesn't anticipate a swathe of net-zero commitment-related provisions to show up in the accounts on the back the IFRIC agenda decisions.
"In my experience, IFRIC agenda decisions always cause companies to go back and use the clarity on an interpretation to compare with how they've interpreted it to their own specific circumstances," he said. "That's where the IFRIC agenda decision will be helpful, because companies will realise if they have been too aggressive or not aggressive enough in their critical judgement of these various aspects."
Wray continued: "It won't change dramatically what companies are doing but it will require every company to reflect: 'Have we got the right process in place? Have we got the right controls in place? Have we made the best judgments? And do we have the right outcomes?'"
He believes this will lead to an improvement in what and how companies disclose. "They'll be clearer on their very specific statements in the considerations of past versus future operations and measurements, and thereby perhaps will clarify when they create an obligation versus those companies that don't. What might be interesting is to see how community groups react to companies that continue to choose open and vague statements that are not as clearly reflected in the financial statements."
...the more they stay the same
Despite Watson's optimism, other observers who have keenly followed the discussion concluded that the IFRIC decision emphasised that this type of disclosure does not yet have its place in the financial statement.
"If you don't meet the requirements for accounting purposes to recognise a provision, that is not to say that there are no other requirements to disclose those commitments that you have made," the IFRS expert said. "S1 and S2 have requirements around transition plans for example, and other sustainability reporting framework have that as well."
The expert concluded: "The financial statement might not be the right place, but we need to start looking at other reports – the information should be there, but maybe just not yet in the financial statement. When the event happens, it will come in the financial statement."
What gets in the financial statement and what doesn't is an age-old debate, Wray said. "There is a lot of literature that shows that markets and stakeholders react differently depending on whether something gets disclosed in or out of the financial statements."
In the case of climate-related disclosures, the tension arises from the conflict between on one hand the accounting system, which is essentially a snapshot at a point in time based on historical events, and on the other hand sustainability perspectives that are very much forward looking.
"There is a tension between the standards versus what stakeholders want in the context of them being within the financial statements themselves," Wray said. "That doesn't mean companies can't disclose sustainability information. It doesn't mean they can't project the effects, of course they can. They just wouldn't end up being in the financial statements necessarily, unless they meet the specific criteria within an existing IFRS accounting standard."
At the March IFRIC meeting, ISSB's Barker soberly commented: "IAS 37 is not designed to address climate related disclosures, but IFRS S2 is designed for that."
A sustainability reporting expert told Corporate Disclosures that, in essence, the IFRIC decision is "a great point in case for the ISSB's work".
"The conclusion is that there is nothing fundamentally broken that needs fixing with IAS 37," the expert said. "The critical gap is IFRS S2. It's not an accounting fix, this is a sustainability reporting fix."
The expert continued to say that, when ISSB reporting becomes as established as IASB reporting is today, there will be much greater "clarity and connection in corporate reporting".
"Then you see the whole picture: what's been promised, what's been planned, how well the plan is going, what is actually being done, and crucially how that affects the financial statements," the expert concluded. "That is the end goal."
In other words, this decision could become the catalyst for true integrated reporting.
As Wray described it: "A way that provides that balance by keeping the historical perspective on financial statements the way they need to be - because that is the measure we've all agreed on unless we want to revisit that measure, which is a much, much, broader conversation – and blending in this increasing, and understandable, desire for forward looking sustainability-related information."
"That is what is missing," he concluded. "The connectivity between the two. "