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Climate change: Assessing how it could impact the financial statements

From 1 January 2021, the Financial Conduct Authority (FCA) requires all commercial companies with a UK premium listing to meet new reporting standards set out by the Task Force on Climate-related Financial Disclosures (TCFD). Businesses will also need to watch for ways in which the transition to a low-carbon or carbon-neutral world could impact their financial statements, today and in the future.

There are a number of climate-related reporting issues that companies might encounter. Below are a few examples and each company needs to carefully consider how climate change could impact it.

Of course, this is not an exhaustive list and the way climate change could impact your business, your financial statements and your TCFD disclosures could vary.

Wind turbine stands in a field of agricultural crops

Climate-related reporting issues that companies might encounter

Revision of useful economic lives and residual values of certain assets

Imagine your company has committed to becoming carbon neutral by 2030. This might mean replacing some of your asset base over the coming decade with equipment that is more energy efficient or powered by renewable sources.

As a result, the useful economic lives of some existing assets will need to be shortened or, in some cases, assets will need to be written off.

You make this adjustment prospectively, as a change in estimate, as required by IFRS or UK GAAP. Consequently, there is no ‘one-off’ adjustment to your financial statements, but you are required to disclose the effects of changes in estimates. Even if the estimated amounts are not material today, your organisation might voluntarily include a narrative explanation of this change in estimates in your note disclosure for property, plant and equipment. This demonstrates how you have aligned financial statement assumptions with your company’s environmental strategy and helps highlight to investors that you are aware of the issues and are taking action.

You might also revise downwards the residual value of the existing assets in question to reflect the fact that equipment that uses fossil fuels possibly has a lower resale value when you dispose of it. This means similar voluntary and mandatory disclosures to the change in useful economic lives will apply.

Updating cash flow forecasts

If your organisation operates in an energy-intensive industry, your ongoing carbon emissions are likely to involve higher future costs, perhaps through a carbon tax.

As a result, you might need to update your cash flow forecasts – for example those forecasts as used in your value in use impairment models – to reduce your operating margin by including higher expected outflows to factor in the incremental cost expected for carbon taxes. You might also consider whether some of this additional cost can be passed on to customers through higher pricing.

Factoring risk into impairment models

Say your company had in the past acquired a business in country X that led to a significant amount of goodwill being recognised along with a plant that has a remaining useful life of 10 years. The plant comprises a factory located near that country’s coastline, where sea levels are now predicted to rise considerably over the next 10 years.

You could address this issue by building costly water defences around the factory. But you might instead sell the facility, as it may eventually become unusable in this location, even with building ever increasing defence mechanisms. If you choose the second option, you will require expenditure to set up a factory elsewhere.

In the meantime, to maintain current production and capacity levels, the terminal value calculations for your goodwill impairment test will need to factor in your need to incur cash outflows – either to build water defences for the factory or to relocate the facility. Those expenses could mean that goodwill is impaired. But the current plant itself is not necessarily impaired if its recoverable amount covers the carrying values over the remaining useful life of only 10 years.

Expected credit losses

Consider a situation in which your company owns industrial storage units that it leases to customers under operating leases. You might offer lower rental amounts or rent-free periods in early years, then step up rental charges later in the lease period. But, as an operating lessor, your lease income is recognised on a straight-line basis, which means receivables build up in the early lease periods and are subsequently paid in later years.

You might consider your expected credit losses with reference to different categories of customers. This might be based on, among other things, the industry in which the customer operates. When considering the impacts of climate change on your customer base, you have identified higher risks associated with customers in the oil and gas and mining sectors.

As a result, your management team must consider whether it is necessary to increase the expected credit loss provision associated with receivables in those sectors. Specifically, you must consider whether the effects of climate change might cause oil and gas and mining customers to face liquidity issues and default on their rental payments. You would also consider the maturity of the receivables held on the balance sheet, which might range from, say, one to five years.

You may conclude that no adjustment is needed to the expected credit loss provisions. This could be because you expect that, within this timeframe, none of your customers will be so severely impacted by climate change that they will default on their rental payments.

However, you might want to consider including in your policy disclosures that – for expected credit loss purposes – customers are grouped into different categories, and that one element of risk you consider is that of your customers’ viability due to their exposure to climate risks.

The impact of climate change on operating margins

As a supermarket retail group, your company has promised to – by the end of 2035 – ensure that all your own branded products you sell can be reliably sourced from farms certified as carbon neutral.

This pledge will increase your input costs, say, by 5%. You expect that price increases of perhaps only about 3% will be viable to pass on to customers. As a result, you would adjust the gross margin in your forecast models – either for impairments or for going concern – by 2% in each period after 2035. This would also impact the terminal value.

Disaggregation disclosures

While preparing the narrative reporting section of your annual report, your organisation plans to discuss how climate change might affect your different business operations and revenue streams. You should also consider the disaggregation disclosures for revenue under IFRS 15 Revenue From Contracts With Customers.

That standard requires you to disaggregate revenues from customer contracts into different categories, based on how economic factors might affect the nature, amount, timing and uncertainty of revenue and cash flows.

The climate change effects might differ considerably for different revenue streams. For example, you may have determined that one revenue stream faces a particularly high risk of being adversely impacted by climate change in the medium term, while other revenue streams face different but less substantial risks over the same time period. Due to the different risk profile for this one revenue stream, you may conclude this requires disaggregation from other revenue streams for disclosure purposes to meet the IFRS requirements.

Segment aggregation

Imagine that your company has, until now, aggregated four of its operating segments as reviewed by the chief operating decision maker into one reportable segment, because of the similar economic and other relevant characteristics of the underlying operating segments. However, you are re-examining that approach in light of climate change.

For example, climate impacts could drive changes to the production processes and regulatory environments for the products offered in the operating segments, which could affect margins and other economics. Therefore, you might need to re-evaluate how you aggregate operating segments into reportable segments. If your current aggregation is no longer appropriate, you will have to update the segment disclosures. You will also need to consider how to discuss those operating segments and changes to the reporting segments in the front half of your annual report.

Decommissioning provisions

Consider that you operate a plant that is a heavy user of fossil fuels and for which you have recognised a decommissioning provision on construction. To meet your company’s sustainability strategy of, say, being carbon neutral by 2035, you realistically have to replace the plant with a newer hybrid model in the medium term. Your organisation might be able to substitute and decommission the plant later than 2035, but this would then require the purchase of carbon-offsetting credits.

Your financial reporting will need to disclose how you are taking the climate transition into account, regardless of the path you choose. In doing so, you should explain how the decommissioning provision has factored in the climate transition. You should also provide sensitivities for the impact on the provision of bringing forward the timing of the expected outflow due to an earlier decommissioning of the plant than originally envisaged when the provision was first set up.

Onerous contract provisions

Your organisation might have a contract to deliver a certain product to a customer in a given territory. You have recognised an onerous contract provision for that agreement and have calculated the provision based on probability-weighted outcomes.

While reviewing different probability-weighted circumstances, you conclude that one climate change scenario will lead to increased production costs for the product in question due to higher air freight shipping costs as well as higher production costs due to the need to acquire carbon-offsetting credits. By factoring in the increased cost, you will need to change the probability-weighted expected provision to account for those changes in inputs for the scenario.

Contact us

Olaf Pusch

Olaf Pusch

Director, Accounting Consulting Services Group, PwC United Kingdom

Tel: +44 (0)7740 241285

Lynne Baber

Lynne Baber

Partner, Governance, Risk and Compliance, PwC United Kingdom

Tel: +44 (0)7809 756065

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