Climate risk analysis must be part of the audit process

Earlier this year, senior managers at the world’s six largest accounting firms were accused of failing to ensure climate change wsa ‘adequately’ addressed in financial reports and audits of their clients.

In a letter sent to the Global Public Policy Committee — a group made up of senior leaders from the Big Four firms PwC, Deloitte, KPMG and EY as well as BDO and Grant Thornton — Client Earth said it was “very concerned” that auditors were not fully considering climate-related matters when assessing corporate accounts.

The group said it also feared audit standards were not being properly followed.

Climate risks can significantly impact a company’s financial performance and long-term sustainability. Ignoring these risks in the auditing process can lead to inaccurate financial reporting and potentially significant financial losses.

For instance, a company that fails to disclose potential liabilities arising from climate change-related lawsuits could face significant financial and reputational damage. On the other hand, companies that proactively identify and address climate risks can enhance their long-term sustainability and attract investors who value responsible and resilient business practices.

A recent study found that only a quarter of CEOs have effective early-warning systems to prepare for climate-risk events, highlighting the urgent need for auditors to step in and fill this gap.

“The largest audit and accounting firms have a huge sphere of influence over the crucial issue of how climate risk is reflected in financial reporting and audit, yet it is hard to discern any meaningful leadership from the GPPC when it comes to climate change,” said Client Earth lawyer Robert Clarke.

Incorporating climate risks into audit processes

1. Risk Assessment

Begin by conducting a comprehensive risk assessment that includes climate risks. This involves understanding the company’s exposure to climate risks and assessing the potential impact on its financial performance. Consider factors such as physical risks, transition risks, and liability risks associated with climate change.

Investor group Climate Action 100+, which manages a collective $68 trillion in assets, found last year that 94% of 152 large companies it had assessed on a range of climate-related metrics had not met any of its audit-related criteria.

These included whether and how climate-related matters were incorporated into a company’s financial statements and whether auditors had assessed the effects of material climate-related matters.

“Most companies do not fully consider material climate matters when preparing their financial statements (and their auditors, in their audits thereof),” CA100+ said in a report published in October 2022.

2. Integration of Climate Risks into Financial Reporting

Once the risks have been identified, integrate them into the company’s financial reporting. This includes disclosing climate risks in the company’s financial statements and other public disclosures.

Provide clear and transparent information about the potential financial impacts of climate risks on the company’s operations, assets, and liabilities.

3. Continuous Monitoring and Review

Climate risks are dynamic and can change rapidly. Therefore, it is important to continuously monitor and review these risks and update the financial reporting accordingly.

Regularly assess the company’s exposure to climate risks and ensure that the financial statements reflect any significant changes or developments.

Leveraging technology for climate risk assessment

Technology can play a crucial role in identifying and assessing climate risks. Auditors can leverage off-the-shelf tools that encompass audit data analytics capabilities and artificial intelligence to seamlessly integrate climate risk assessment into their audit processes.

These tools can help analyse large volumes of data, identify potential climate-related risks, and provide valuable insights for auditors and companies.

Regulatory trends and best practices

Regulatory bodies worldwide are increasingly recognizing the importance of climate risks in financial reporting. For instance, the UK’s Financial Reporting Council (FRC) has published a blueprint outlining how audit firms should incorporate climate risks into their audits.

‘Good external audits are driven by robust risk assessment and supported by rigorous due process. They avoid conflicts of interest, and exercise professional judgment and scepticism,’ the FRC states.

Incorporating climate risks into audit processes is not just a regulatory requirement, but a business imperative. By doing so, auditors can provide stakeholders with a more accurate and comprehensive view of a company’s financial health and sustainability, thereby contributing to more informed decision-making and sustainable business practices.