Originally posted by The Banker and reproduced with author's permission.
Accounting has a long tradition. In Europe, it can be traced back to the 15th century, when double-entry bookkeeping became more widely known through the publication of a book by friar Luca Pacioli, in 1494, where he described the practice that Venetian merchants had been using since about the 1300s. Some people point to even earlier evidence of double-entry bookkeeping in the Islamic world and in India.
Accounting is also a practice that tends to resist change – and this matters, particularly when it comes to environmental, social and corporate governance (ESG) concerns. If wider risks to society were explicitly and widely accounted for, analysing corporate sustainability would be a simpler and more meaningful task.
There are initiatives that are looking at this. These range from the Impact-weighted Accounts Initiative, led by the Global Steering Group and the Impact Management Project, which aims to create supplementary information to financial statements, to reflect companies’ impact on the broader society; to the Value Balancing Alliance, a not-for-profit organisation supported by several international groups, which works with the big four accounting firms to create a set of environmental generally accepted accounting principles.
Their work is important and necessary. But there is another point: existing standards already include principles that can be applied to ESG factors, most obviously to climate change. The International Accounting Standards Board’s principles include specific guidance on intangible liabilities: IAS37. Many IAS rules have been updated by the new IFRS code, in 2019; others, like IAS37, still stand.
IAS37 sets the standard on provisions, contingent liabilities and contingent assets, meaning it deals with assets whose existence is not yet confirmed, and with liabilities of an uncertain timing or amount, or where obligation will be confirmed by uncertain future events out of the direct control of the reporting organisation.
Paragraph 20 specifies that although an obligation always involves another party to whom the obligation is owed, this does mean that the specific identity of the other party must be known: “Indeed the obligation may be to the public at large.” You can see where this leads us. The Taskforce on Climate-related Financial Disclosures does specifically refer to IAS37, and other standards, in its recommendations.
WE SEE CLIMATE RISK LIKE THE TOBACCO INDUSTRY IN THAT, AT SOME POINT, CLASS ACTION LAWSUITS AND PUNITIVE DAMAGES WILL BECOME PROBABLE
Lack of disclosure
This is where things get “super exciting”, says Andrew Watson, founder of Rethinking Capital, a group of experts in intangible assets. “We see climate risk like the tobacco industry in that, at some point, class action lawsuits and punitive damages will become probable.”
Unless the liability is remote, corporate directors must either disclose a contingent liability in a detailed note, or recognise a provision. Yet, says Mr Watson, based on what his group is seeing, “organisations seem to conclude that climate risk is remote, and therefore neither disclose a contingent liability nor recognise a provision as they should under IAS37”.
This is at odds with global surveys that have rated environmental risk as a top concern across industries and around the world – it appears to be a risk that businesses believe is likely to materialise, too.
To refresh our memories: extreme weather events, failure of climate change mitigation and adaptation, major natural disasters, major biodiversity loss, and human-made environmental disasters are the top five most likely risks, according to the World Economic Forum’s 2020 Global Risks Report, which received nearly 13,000 responses, 38% of these from business. Failure of climate change adaptation and mitigation is also the top risk by impact, with biodiversity loss, extreme weather events and water crises among the other top five.
Slow-moving accounting rules may benefit from an ESG update, but there is also a wider debate on what can be done with existing standards.
This is a monthly column focusing on ESG principles and how they are reshaping banking, markets and investment. We would like to hear your views on sustainable finance, how it is changing your organisation, your work and your incentives structure. Contact firstname.lastname@example.org and, on Twitter, @Silvia_Pavoni