How does ESG impact the function of audit?

So what are the main aims of ESG that auditors need to be aware of? Broadly, these include:

• Environmental: extreme weather, greenhouse gas emissions and carbonization, waste management, the rights of indigenous communities
• Social: workplace culture, employee relations, modern slavery
• Governance: broad structures, shareholders’ rights and relationships, audit arrangements and solvency.

Against a backdrop of growing expectation, regulation and litigation, lawsuits have been filed in the US against directors for failure to disclose climate risk, including the series of investigations and claims brought against ExxonMobil by US State Attorneys General and investors.[1]

Despite this mounting pressure, a recent report by the Carbon Tracker Initiative and the Climate Accounting Project [2] showed that over 70% of 107 global companies in carbon-intensive sectors did not indicate whether they had considered climate when preparing their 2020 financial statements. The report found that consideration of climate issues within financial statements “appeared to be inconsistent” with such disclosures made by the organization elsewhere, including when the company said climate risks were financially material.

Auditors rarely notice such discrepancies [3], and benchmarking by the UK’s Financial Reporting Council (FRC) has found they “need to improve their consideration of climate-related risks when planning and executing their audits.”[4]

Neglecting to do so could result in professional advisers – including accountants and auditors – facing litigation for failure to provide strategic advice and recommendations that consider and integrate climate risk.

Auditors have a significant role to play in maintaining trust in corporate settings, alongside directors, audit committees, shareholders and regulators. Where climate or other ESG risks are financially material, auditors must consider whether those risks are properly reflected in the accounts in order to report whether they provide a true and fair view of the financial position of the company. If sustainability reports and ESG information are included in the company reports with audited financial statements, the auditors will have responsibility for those statements. The same applies if a third-party assurance is provided by an audit company, particularly for annual ESG-related reports or other material ESG disclosures. Should a company or its shareholders suffer loss due to a failure to adequately report on climate or ESG risk, auditors may be at risk of a civil claim as well as regulatory intervention and shareholder pressure.

Even if claims can be successfully defended, the rise of investor and NGO activism with the aim of improving corporate reporting on ESG risks can result in negative publicity, regulatory scrutiny and the instigation of civil lawsuits.[5] This was seen in the UK in 2018, when environmental law charity ClientEarth submitted complaints to the FRC against four major UK companies and their auditors over alleged failures to address climate-change risks in reports to shareholders.[6]

The regulatory landscape in this area is evolving quickly. In the last few years, a growing number of disclosure obligations have been created related to climate change, and recognition of the benefits of alignment with the Task Force on Climate-Related Financial Disclosures (TCFD) requirements has increased. In the US, the Securities and Exchange Commission (SEC) rules and the Public Company Accounting Oversight Board auditing standards do not currently require an auditor to attest to ESG information. However, more and more regulators in specific countries and industries do require companies to report certain metrics. Applicable frameworks against which the disclosed information is evaluated by auditors, such as the SASB (Sustainability Accounting Standards Board) or GRI (Global Reporting Initiative) standards are also evolving, although there is some variation among the standards.[7]

ESG considerations can be material to a company’s financial position in a number of ways. These include changing assumptions in forecasts when considering asset impairment (including goodwill), changes in the life of assets or their fair valuation, altering provisions relating to fines, penalties and contingent liabilities, and new or altered financing arrangements and terms. The FRC cites the example of a manufacturer in areas subject to increase flood risk, which may impact the company’s impairment calculations, or a company that may have assets at risk of obsolescence as a result of greener policies or products.[8]

Climate-related matters could also create material uncertainties that cast doubt upon a company’s ability to continue as a going concern. A company with a large carbon footprint, such as a concrete manufacturer, could be vulnerable to changing customer habits if the current push to recycle materials and minimize concrete production took hold. This could not only impact the company’s cash flow forecasts as demand for goods reduces, but also result in financial challenges as lenders focus on managing their own climate-related risks. An auditor would then need to consider whether management’s use of the going-concern basis of accounting is appropriate and, if so, whether a material uncertainty exists.

Auditors must also be alive to the concept of ‘greenwashing’, which has the potential for an acute litigation risk if a company makes future representation about climate risk and mitigation that they do not have a reasonable basis for making at the time and which could be considered deceptive or misleading. This has been highlighted in Australia [9], where it is a potential trigger for a shareholder class action. It is becoming more common for class action lawyers to bring in auditors or accountants in securities class actions, particularly if the directors’ statements are based upon incorrect auditing advice.

The move towards enhanced reporting, particularly in areas that require forecasting into the future, raises the risk of directors and auditors being judged against an unrealistic standard in relation to their judgments on material uncertainty, even when they have acted reasonably.

While the liability and regulatory exposures affecting directors and officers (D&O) around ESG-related disclosures have been widely discussed, the same cannot be said for the professional-duty exposures impacting auditors.

Insurers will need to adapt their underwriting to the evolving ESG regulatory environment. Insurance carriers will be keen to assess the exposures of both the audit companies to whom they provide errors and omissions (E&O) coverage, as well as the D&O exposures of the audited entities. Where insurers offer management liability and E&O coverage, they will seek to minimize the potential impact of a single claims scenario triggering both types of coverage.

An insurance assessment will include an examination of the auditor’s portfolio and the industries in which the audited entity operates, where they are located, and whether they are exposed to specific ESG regulation. Negative media coverage and the impact of poor ESG practice on reputation will be taken into account, as well as the auditor’s retention practices, waivers and disclaimers in their engagement process, and how they balance the risks associated with their client’s ESG with audit rates and the size of the team involved.

The rapid ramping up of ESG disclosure requirements and the inconsistencies in related reporting standards are issues that listed companies and their auditors will need to grapple with.

“When companies suffer losses or fail, their auditor is often the subject of regulatory and public scrutiny, since they leave visible footprints on the work they have done,” says Diego Assef, Head of Global Practice Group for Professional Indemnity Claims at AGCS. “Furthermore, auditors are considered as gatekeepers and one of the last lines of defense against corporate wrongdoing. The increased attention on ESG-related subjects is continually shifting public opinion, influencing more stringent regulation, as well as encouraging shareholders and third parties that have been impacted by a corporate failure to look in greater detail at the auditor’s involvement in it.”

Climate change is often described as the defining risk of our times. Auditors can expect their assessments and assumptions to be examined under the harsh spotlight of the audit “expectation gap”.[10]