As ESG factors become a more critical part of corporations' everyday business, accounting firms may need compliance insight into how their clients are managing this
Over the past few years the audit sector has faced some well-documented challenges. A series of high-profile failures led to wide-ranging and systemic reforms, including the separation of accounting firms’ audit and consulting businesses, the introduction of a new regulator, and the prospect of joint audits.
Accounting firms are beginning to adapt to the new environment, but the sector is still enduring a period of transition. While deadlines for implementation do not come until 2025, instances of poor audit behavior continue to be seen in 2023.
In Australia, for example, the former head of international tax at PwC was banned for having made unauthorized disclosures to colleagues and clients about a government review committee on which he was serving. In the United Kingdom, PwC is being sued by former client Quindell for leaking confidential information during deal negotiations. In Germany, meanwhile, the audit regulator closed its investigation into EY’s handling of the Wirecard audit.
The transitional period in which the audit sector finds itself places tax & accounting firms in a more vulnerable position and raises the risks for organizations which engage with them, not least because accounting firms are increasingly becoming involved in advising organizations on the preparation and audit of their environmental, social and governance (ESG) data.
Regulatory focus on ESG has intensified over the past few years. At the international level, the Task Force on Climate-Related Financial Disclosures has provided final recommendations for consistent, comparable, reliable, clear, and efficient climate-related financial disclosures; and the International Sustainability Standards Board has consulted on exposure drafts of standards that deliver a comprehensive baseline for high-quality sustainability disclosure.
In the European Union, the Sustainable Finance Disclosure Regulation (SFDR) sets out a detailed disclosure regime that requires disclosures to be made at both the organizational and product level, meaning businesses need to have a detailed understanding of the composition of their products and services. In the U.K., new disclosure rules for companies with a U.K. premium listing are already in force, and the U.K.’s version of the SFDR is due to come into force this year.
While still in its early days, reports from the European Banking Authority and a joint report from the U.K.’s Financial Conduct Authority (FCA) and Financial Reporting Council (FRC) have revealed mixed levels of readiness for full disclosure. The European Central Bank reported that “banks do not yet sufficiently incorporate climate risk into their stress-testing frameworks and internal models, despite some progress made since 2020”, while the FCA and FRC reported that improvements still needed to be made in climate-related reporting.
Use of accounting firms
This web of regulations on ESG disclosure has led many organizations to realize that they lack the kind of detailed data needed to make the relevant reports which has prompted them to investigate ways in which such data could be extracted and reported. Given the need to find appropriate, available expertise on a tight deadline, it has seemed a natural route for many organizations to turn to their tax & accounting firms which already prepare their accounts for support and guidance. Accounting firms can undoubtedly help organizations with their preparations for ESG disclosures because they have up-to-the-minute knowledge of regulations and guidance.
Accounting firms must, however, be careful to avoid repeating past mistakes when preparing for ESG compliance. Audit reforms were prompted by number of concerns, including the need to address the inherent conflicts between undertaking an audit of a company’s accounts while also petitioning for potentially more lucrative consulting work. One concern over this apparent conflict of interest is that it might make auditors reluctant to challenge management assumptions with sufficient rigor.
The FRC’s quality reviews also uncovered more widespread failure on the part of auditors to challenge management adequately. There was also concern that the accounting rules themselves are too detailed, encouraging accounting firms to take a tick-box approach. To that end, the FRC issued a Statement of Intent on ESG to provide guidance for the accounting profession when dealing with ESG data. First issued in 2021, the Statement “identified underlying issues with the production, audit, and assurance, distribution, consumption, supervision, and regulation of ESG information.” The FRC has recently issued an update outlining the areas in ESG reporting where challenges still remain.
Compliance officers have an invaluable role to play when their organization is considering the appointment of an auditor to prepare or audit its ESG data. As a first step, they would be well-advised to review their organization’s regulatory risk registers to ensure that the engagement of a particular accounting firm will not expose the organization to risk. Such risk exposure could include: i) identifying conflicts of interest between the firm’s consulting function and any audit responsibilities; ii) outsourcing only at appropriate times to comply with crucial due diligence standards; iii) honoring all confidentiality agreements, especially with respect to newly gathered information; and iv) recording actions taken to maintain compliance and determining who has access to records.
Organizations are under considerable pressure to provide accurate, comprehensive, and timely data on the ESG impacts of their businesses, products, and services. Engaging help from their tax & accounting firm, which already prepares their accounts, might appear to be an obvious solution to the problem, but organizations must bear in mind the focus of the recent audit reforms, acknowledge that the nature of the relationship is changing, and implement controls accordingly.