The Rise of ESG
The spotlight on environmental, social, and governance (ESG) continues to intensify as businesses are increasingly being called upon to disclose more about their ESG performance and strategies.
ESG, as we now know it, began to take form in the mid-2000s; however, the philosophy that drives it has been around much longer. Today, the ESG landscape is more mature in Europe and other parts of the world compared with the United States. In recent years, however, the momentum within the U.S. has gained speed.
Today, ESG is resulting in significant opportunities for auditors, fueled by the widening range of stakeholders calling for ESG prioritization, an influx of laws and regulations pertaining to ESG, and a rise in ESG investment products.
Quality and reliable ESG information starts with solid reporting by company management, and auditors are ideally positioned to help build that trust and credibility.
Given the increased focused on ESG, this blog marks the first in a series dedicated to ESG and its impacts on the accounting profession.
What is ESG accounting?
As a growing number of businesses focus on ESG-related initiatives, accounting is playing an increasingly important role. This is due to the fact that while ESG discussions often center on a company’s strategy and performance, ESG can also impact tax liabilities and financial reporting.
Shedding light on the tie between ESG matters and their direct or indirect impact on a company’s financial statements, the Financial Accounting Standard Board (FASB) published in 2021 the Intersection of Environmental, Social, and Governance Matters With Financial Accounting Standards.
As outlined in the FASB paper, possible impacts include:
- ESG matters may directly affect amounts reported and disclosed in the financial statements; for example, through the recognition and measurement of compensation expense.
- ESG matters may indirectly affect the financial statements; for example, an entity may suffer reputational damage from an environmental contamination that reduces sales.
- An entity may consider certain ESG matters as an input to an accounting analysis; for example, a material decline in demand during the reporting period may be a consideration when estimating future cash flows used in a long-lived asset or goodwill impairment analysis.
- Risks and opportunities related to ESG matters may have an unfavorable, favorable, or neutral effect on financial statements.
- Other ESG matters may not have any material effect on the financial statements.
Then there’s the tax implications. More specifically, ESG-related tax incentives. As outlined by accounting firm Warren Averett, examples include:
- Environment: Tax credits for energy-efficient buildings, electric vehicle charging stations, carbon recapture, and investing in and producing solar and wind power.
- Social: Tax credits for employer-provided childcare facilities or tax credits for investing in low-income neighborhoods and building affordable rental housing.
These are, of course, just a few of the tax and accounting considerations to keep in mind. Given the increased focus on ESG, firms would be wise to include tax and accounting considerations in ESG conversations to help identify opportunities and manage potential risks.
What is ESG reporting?
ESG reporting, sometimes referred to as ESG disclosures or sustainability reporting, makes known to the public a company’s ESG activities. This, in turn, holds companies accountable for their ESG performance and strategies. Currently, there are currently no mandatory ESG reporting requirements in the United States, though this is likely to change.
As outlined by the Center for Audit Quality (CAQ), ESG reporting enables companies to do the following:
- Communicate key ESG risks and opportunities and how these issues are managed.
- Organize business dependencies and impacts on the environment and society.
- Communicate their resiliency to shifts in the environment and society.
- Credibly demonstrate how they execute on their purpose to drive value for all stakeholders.
Investors are especially focused on ESG information because it can help them better manage investment risks and understand a company’s long-term approach to creating value. In fact, research suggests that investors place greater importance on requiring consistent and mandated standards than finance leaders do as preparers.
From a business standpoint, ESG reporting can help strengthen trust with stakeholders and the reputation of corporations, while also demonstrating how the company’s purpose — in other words, the role it plays in society in connection to its long-term value — is made real.
As CAQ noted, the challenge lies in that companies often struggle with what ESG information to report and where and how to communicate it to stakeholders.
What is the role of the auditor in ESG reporting?
Much like the audits of financial statements, third-party assurance from an audit firm can help ensure that a company’s ESG reporting is of high quality and reliable.
As explained by the AICPA and CIMA, “ESG assurance is a process whereby an independent practitioner performs procedures, obtains evidence and, after obtaining reasonable or limited assurance about the information, expresses an opinion or a conclusion designed to enhance the degree of confidence of decision-makers using that information.”
Companies can have public company auditors obtain reasonable assurance based on more extensive examination procedures, or limited assurance based on review procedures, which are not as extensive, noted CAQ.
The future of ESG accounting
The focus on ESG continues to intensify. As companies navigate the landscape of ESG reporting and the increased demand by investors and other stakeholders, the role of the auditor and ESG accounting will become increasingly vital.