Sustainability Commitments and Financial Accounting
For those who follow, and actively pursue, SVI’s mission to change the way the world accounts for value, we live in interesting times. This blog summarises two important developments relating to the concept of ‘constructive obligations’, a nuanced element of financial accounting, within the context of sustainability commitments that companies are making.
Firstly, we respond to the recent decision made by the International Financial Reporting Standards (IFRS) Foundation on whether net zero commitments made by companies are constructive obligations and how they should be treated. Secondly, and building on this, the blog then sets out how a new legal opinion on true and fair, commissioned by SVI, can pave the way for more specific commitments that can impact on the financial statements.
The concept of ‘constructive obligations’ is central to these two developments and so we should start with an explainer:
For beginners, and in the simplest of terms, a constructive obligation is where a business has created an expectation that it will make a payment based on certain things that have been said or done. It is of course a lot more nuanced than that and for the purposes of this blog we will need to embrace the full technical definition as set out in International Accounting Standard on Provisions, Contingent Liabilities and Contingent Assets (IAS37):
“A constructive obligation is an obligation that derives from an entity’s actions where:
(a) by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and
(b) as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.”
Paragraph 10 of IAS37
In the context of sustainability, where companies are increasingly establishing practices, publishing policies and making statements, this has become a hot topic and an interesting area of exploration. When do the sustainability commitments made by companies meet the requirements for constructive obligations?
Should net zero commitments be treated as constructive obligations?
Since November 2023, the IFRS Interpretations Committee (IFRICs) have been responding to a request to clarify whether a company’s commitments to reduce emissions (in future years) creates a constructive obligation (under IAS37) and whether this should lead to a provision on the balance sheet and if so, should it be as an asset or future expense. Read more here.
Much of this enquiry has been led by the tenacity of Rethinking Capital. In response to this, IFRICs published a paper that specifically addressed how Climate-related Commitments should be treated with reference to IAS 37 Provisions, Contingent Liabilities and Contingent Assets. The paper explores how commitments to gradually reduce GHG emissions and subsequently offset emissions with carbon credits might meet the criteria for being a constructive obligation.
Ultimately, the paper concludes that there is no need to revise the current accounting standards.
Although the idea that net zero commitments should be recognised on the balance sheet might seem to be a good idea, this conclusion is not a surprise given that financial accounts relate to past events.
However IFRS do not rule out the possibility that a net zero commitment could meet the requirements for a constructive obligation highlighting the very real interplay between commitments and accounting standards. And it underlines the fact that, in reviewing whether the sustainability commitments have created a constructive obligation, management should; “… apply judgement to reach a conclusion at each reporting date considering all relevant facts and circumstances existing at that date. If the facts or circumstances change from one reporting date to the next, so too could the conclusion.”
What have SVI been doing in relation to sustainability commitments and financial accounting?
Commissioned by SVI, a new legal opinion was published in January 2024 that clarifies the legal requirement for company directors to only approve accounts that present a true and fair view. It is the first opinion to consider true and fair in the context of sustainability. You can read more about the opinion here.
In the opinion, the issue of constructive obligations is also explored and Para 41 (below) provides a similar position about net zero commitments as the one reached by IFRS.
Conscious of the difficulties in accounting for future commitments, and building on the last sentence in Para 41, SVI have been exploring how directors could deliberately choose to structure commitments in such a way as to create present year obligations which impact upon the accounts, and therefore require a provision to be made on the balance sheet.
An example of such a commitment would be:
“As directors we take responsibility for the consequences of our (current) carbon usage. We treat carbon as a cost of doing business and will make a payment based on the social cost of carbon”
We believe that commitments that are specific about taking responsibility for current carbon use, or other sustainability issues, are more likely to be a constructive obligation than the sorts of future commitments that are made by lots of companies at the moment.
Consider the above commitment with reference to the requirements for a constructive obligation;
- (a) by an established pattern of past practice, published policies or a sufficiently specific current statement, (the entity has) indicated to other parties that it will accept certain responsibilities;
- and (b) as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.
They are also more likely to be recognised as a provision on the balance sheet based on meeting the following three conditions (as referenced in Paragraph 14 of IAS 37):
a) the entity has a present obligation (legal or constructive) as a result of a past event;
b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and
c) a reliable estimate can be made of the amount of the obligation.’
Social Value International are working with a group of companies to put this into practice and more examples will be shared shortly. Please register here for more updates.
In conclusion, these two developments represent a reality that sustainability practices and financial accounting are connected. Company directors and auditors must now be alert to how their sustainability information including their commitments may affect their financial statements. As the stakes only get higher in relation to climate change, and sustainability more broadly becoming a material issue for investors, this only marks the start of more discussions on how the content of the financial accounts could evolve.
SVI want to accelerate the integration of sustainability information into financial statements. Only then will sustainability be part of mainstream decision making. We believe this can happen if company directors start making commitments that accept responsibility for their current impacts and dependencies on people and planet.
To find out more about the True and Fair Project register for updates here.