Eighteen months on and we have seen further work by the FRC, NGOs and other organisations to scrutinise TCFD aligned disclosures, highlight the need for climate risks to be properly accounted for in financial statements, and explore the auditors' role in ensuring any material impacts of climate change are properly reflected in financial statements. We provide an update to our July 2022 article and give some practical tips to auditors on how to manage the evolving risks in this space.
The role of auditors
An auditor’s objective is to obtain reasonable assurance about whether the financial statements of an entity, as a whole, are free from material misstatement and to report on whether the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework. Given climate change can present material risks to companies, it is important that auditors consider whether any material impacts of climate change are properly reflected in the financial accounts, in accordance with the IFRS Accounting Standards. They must also understand how climate risks relate to their own professional standards, applicable laws and regulations, in particular, the International Standards of Auditing ("ISA"). We highlighted in our July 2022 article the importance of auditors considering their responsibility with respect to 'other information' under ISA 720. However, climate change also impacts auditors' responsibilities under other ISAs, as set out in the IAASB's Staff Audit Practice Alert.
As highlighted by Simon Konsta (Partner at DAC Beachcroft) here, parties on both sides of climate litigation will, in many cases, refer to audited financial statements in support of their position. Failures identified in this respect, leaving companies exposed to claims, could feed into follow on negligence claims against auditors, or be incorporated into FRC investigations. As set out in its 2023 ESG Statement of Intent, the FRC has said that its programme of audit quality inspections would pay particular attention to the auditor's work on climate-related risks, including the link between audited financial statements and climate-related disclosures elsewhere in the annual report.
We know that ClientEarth continues to focus on auditors, writing to the Global Public Policy Committee in May 2023. The letter appears to have been prompted by 2022 research by the Climate Action 100+ (an investor led initiative on climate change), whose results from its latest assessment pursuant to its Benchmark 2.0 Framework, released in October 2023, found that 82% of auditors do not provide evidence that they have incorporated climate-related risks into their audit of focus companies. This does not, by itself, mean that auditors have failed to meet their professional obligations, but it is likely to mean continued attention by NGOs and activists on auditors' work in this respect.
Managing the risk
If allegations are made by the FRC and / or audit client against an auditor for failing to properly consider climate risks in an audit, the auditor will want to be in a position to produce evidence to show that processes were in place and followed to identify whether a company faced material climate risks, and steps taken in those circumstances. The FRC's 7 December 2022 letter to the Heads of Audit ("2022 Letter") is a good place to start. Questions firms should ask themselves include the following:
- How does your team / firm's audit practice compare to others in the market?
- Are you aligned in 'common' and 'better practice' across each of the 9 areas identified by the FRC in its 2022 Letter?
- What evidence (procedures, processes, documentation) could you provide to show steps taken with respect to each?
- What training are you giving staff, to ensure they are following policies appropriately and able to implement them effectively? In particular the quality of completion of any climate risk assessment templates should be monitored and consideration given to whether industry specific templates for "high risk" industries could be used.
- How is the firm keeping up to date on developments on reporting and audit obligations related to climate, and how is that fed through to individual audit teams?
- Make sure systems to identify firms which have particular exposure to climate risks are in place and ensure that systems adequately monitors those clients' risks. This is where the legal risks to clients and auditors will be highest. What special measures (such as using specialists) are taken in those circumstances?
- Is there adequate training / resource to ensure teams are able to perform the work around climate change disclosure testing?
- Are decisions on climate risk recorded and reasons given? Reasons for decisions, including any uncertainties and assumptions made, need to be clear to justify decisions on climate risk if challenged in due course. Consider whether there is a clear firm wide policy, explaining when mandated/recommended consultation with the firm's quality team is needed in relation to climate change considerations.
- How are you monitoring compliance with firm policy on climate risk and are the firm's reviewers adequately trained on climate change issues to ensure effective hot / cold file reviews can take place?
These questions should help identify where improvements could be made, as well as ensuring that teams and firms have the evidence to demonstrate that climate risks are properly considered in their audit practice.