Part 1 of 3

The Basics of Financial

and Nonfinancial Reporting

and Disclosures

On February 2, 2010, the U.S. Securities and Exchange Commission (SEC) published “Commission Guidance on Disclosures Related to Climate Change”[1] (“SEC Guidance”). Since then, there have been dozens of webinars, articles, and briefings on the SEC Guidance. Some have heralded the dawn of a new day of financial disclosure of climate change. Others have decried the fact that the SEC did not go far enough. What’s the truth? Probably neither – and for good reason.

This is the first of a three-part series on the SEC Guidance: what it is, what it isn’t, and what stakeholders should look for (and where) to get the information they want. The three parts are:

1. Basics of financial and nonfinancial reporting, and background on this SEC Guidance
2. SEC Guidance, with analysis of many passages
3. Suggestions for companies, investors, the environmental community, and other stakeholders

Understanding the basics (or reading a refresher) will help with the SEC Guidance. With these building blocks, some practical suggestions will make sense – or the reader can make other, more informed decisions.

The author cautions that I am not a Certified Public Accountant. Nor have I ever played one on TV. My educational credentials include an MBA. I worked six years at the largest public accounting firm in the world, and worked on over 100 procedures supporting financial audits – all led by CPAs.

Financial Reporting and Disclosures

Financial reporting is the presentation of financial data on a company’s position, operating performance, and funds flow for an accounting period. Familiar sources of financial reporting information include the annual report and SEC Form 10-K. Financial reporting includes a balance sheet of assets and liabilities at a specified point in time – say, at end of the fiscal year. U.S. Generally Accepted Accounting Principles[2] (GAAP) provide methods for calculating, and documenting the basis for, valuations of assets and liabilities. GAAP also addresses contingent liabilities – liabilities which may occur, or for which the valuation is not known. Within contingent liabilities, there has been a standard framework for contingent environmental liabilities since 1996. Financial statements also include statements of changes in financial positions, or income statements: income, cost of goods sold, expenses, gross and net profit. Income statements are for a specific time period, such as the year since the prior annual balance sheet. Financial reporting instruments provide data and information on an organization at a point in time. This data and information is from events that have already occurred. Sales have happened. The organization incurred expenses. The environmental liabilities included in the balance sheet reflect environmental contamination or legal obligations the company has already incurred.

Materiality

Financial reporting uses materiality as a key concept. Using a household example, imagine that you save the receipts for shirts, slacks, shoes, belts, dresses, skirts, socks, coats, etc. purchased by your household in a year. You could produce a statement at the end of the year for each type of item. It would probably be simpler to have one entry for “clothing” as an expense in your household budget. If you spent USD 40,000 on clothing so everyone in your family could attend the Academy Awards for one evening, that would be a separate line item, calling for some additional disclosure to your financial planner. It’s material (enjoy the pun).

Materiality differs from company to company. Table 1 provides sales and net income for three companies, and materiality thresholds based upon a definition. Note that the materiality thresholds differ dramatically for two companies with the same sales because of differences in profitability. Two companies with a 20-fold difference in sales have the same materiality threshold because of differences in profitability.

Table 1 – Illustration of Materiality Thresholds

	Company A	Company B	Company C
Annual Sales	USD 2 billion	USD 2 billion	USD 100 million
Net Profit	USD 350 million	USD 10 million	USD 10 million
Materiality threshold, IF DEFINED as the LESSER of 5% of sales OR 10% of net profit	USD 35 million	USD 1 million	USD 1 million

Financial disclosures are facts, details, and information relevant to a company, operation, or security that reasonable investors would want to know and that could influence their decisions related to their investment – and, hence, potentially the price of the stock or investment. A company’s loss of its largest customer, expected delays in the launch of a forthcoming product, a natural disaster that will curtail availability of a key raw material – any of these could have a substantial impact on the company, its earnings, and an investor’s decision to purchase, hold, or sell a stock. Financial disclosures can be retrospective – about things that have happened. Financial disclosures can also be pro-spective. Management communicates their thoughts on the state and direction of the company, disclosing information to provide greater transparency to investors.

Known or Reasonably Likely

Financial disclosures should address requirements, trends, or factors that are known or reasonably likely and that could have a material effect on the company. The intent is to provide transparency on the issues that matter, not to overwhelm the public with excessive disclosures on matters that are merely possible or will have only a nominal effect on the company. There is some subjectivity in this area, and disclosures can be made to meet the expectations of stakeholders.

For example, the United States recently announced significantly increased standards for fuel economy for cars and light-duty trucks. One would expect automakers to disclose this in public financial filings, especially if it is likely to have a material effect on their operations or on investments required to meet the new standard. What about an automaker that already meets the standard? In this case, the company may disclose the new standard because it is expected to increase their operations or profit. Consider the timing of when automakers would make disclosures. This requirement is a product of many years of proposals and discussions. If one delved into the history of automakers’ disclosures in financial statements, would you expect to see this mentioned at its first suggestion by an environmental group? At its first occurrence on U.S. Environmental Protection Agency’s (EPA) meeting agenda? At its first proposal? At preliminary adoption? Or only upon final publication as a requirement? There is subjectivity as to deciding what is “reasonably likely” in making disclosures in financial filings.

SEC Regulation S-K lists items and provides guidance for financial disclosures. Sections applicable to environmental matters include Item 101, which addresses the cost of compliance, legal proceedings, and risk factors, and Item 303, which addresses management discussion and analysis.

Nonfinancial Reporting and Disclosure

Companies report nonfinancial information, including information on programs, activities, performance, and goals for environmental and social / stakeholder matters. Companies report via company websites, through participation in industry groups, at conferences, in correspondence to customers, and through many other channels.

The Global Reporting Initiative (GRI) provides a standard framework for sustainability reporting, including greenhouse gas (GHG) emissions and dozens of other parameters related to an entity’s financial, environmental, and social / stakeholder performance. Some categories are required for all companies. Other categories are required for some industry sectors, and other categories are optional – but all are considered within a standard framework. The GRI framework does not set performance standards in any category; rather, the framework is designed to facilitate comparison of performance of companies.

The Climate Registry is a nonprofit collaboration among North American states, provinces, territories and Native Sovereign Nations that sets consistent and transparent standards to calculate, verify and publicly report GHG emissions. The Carbon Disclosure Project (CDP) is another nonprofit, focusing on carbon emissions reporting. The CDP manages a database of primary corporate climate change information and provides this information to investors and analysts such as Bloomberg. The CDP indicates they work for 475 investors with assets of USD 55 trillion. The CDP has expanded its focus to include the supply chain.[3]

Companies report on their environmental performance to regulatory authorities as required by law, regulation, permit, or plan. Environmental compliance information must be complete, accurate, and detailed. Companies report quantities of emissions, wastewater discharged, and waste generated and disposed of with accurate, precise data – often to the pound. All of this information is a matter of public record.

Environmental Community and the SEC

The environmental community has long expressed a desire for companies to disclose more information regarding how climate change, GHG regulations, and other business activities will affect their financial position (and what companies intend to do about it). They have looked to the SEC to require detailed disclosures.

As a result of investor complaints that they did not have sufficient information on which to base their investment decisions, the U.S. Government Accountability Office (GAO) reviewed the matter and published a report in 2004. The GAO report acknowledged that SEC filings did not include information these investors desired, but also indicated it was not within their purview to require it or to suggest that the SEC increase their requirements. The GAO report encouraged the SEC to work more closely with the EPA to ensure that financial reports and financial disclosures accurately reflected environmental requirements already in effect.

In September 2007, the New York Attorney General’s (AG) office sought information from five utilities on their analysis of how climate change would pose risks to the company. The AG brought action under the Martin Act, which requires full and complete disclosure of relevant matters to potential investors. The AG’s request was regarded by many as an opening salvo to require more transparency about risks and costs that companies would incur to address climate change. The AG announced a settlement with one utility in August 2008 and with another utility in October 2008.

Large institutional investors have submitted petitions to the SEC requesting the agency to require more disclosures related to climate change. The Interfaith Center on Corporate Responsibility (ICCR) has been a leader in the corporate social responsibility movement, driving action via shareholder proxy filings. The ICCR has approached dozens of companies for greater transparency, including via financial disclosures, around climate change since at least 2002.

SEC Guidance

It is against this backdrop that the SEC voted along party lines, 3 to 2, to release its “Commission Guidance on Disclosures Related to Climate Change”.

Part 2 of the series examines key portions of the SEC Guidance.

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Footnotes

[1] The Commission published the guidance on February 2; it appeared in the February 8, 2010 Federal Register.

[2] International Financial Reporting Standards (IFRS) are followed by most of the rest of the world. Although fundamental principles are the same, there are many differences. Rules, references, and principles cited in this article are from U.S. GAAP.

[3] The Carbon Disclosure Project has also directed some attention to water use and footprinting, believing this will be the next significant focus area for scant environmental resources including public awareness and sentiment for greater regulatory constraints.

About the Author

Douglas Hileman, P.E., CPEA, has over 34 years of experience in the environmental, safety and sustainability (ESS) fields. He worked for nine years in industry in environmental operations, corporate ESS program development, and due diligence. He has 25 years of experience in consulting, including six years as an in-house specialist at PricewaterhouseCoopers LLP. While at PwC, he supported financial audit teams for environmental liabilities, Sarbanes-Oxley compliance, and business processes, systems and controls. He has conducted ESS audits of conformance with consent decrees, sustainability data and claims, and many other elements of ESS. He is on the Board of the Auditing Roundtable. He is a Certified Professional Environmental Auditor, a Qualified Environmental Professional, and a member of the Institute of Internal Auditors. He is teaching “Financial Aspects of Sustainability” at UCLA Extension in Spring 2010. Information on his firm can be found at www.douglashileman.com.

Image: Growing Graph by Christian Ferrari, Italy.

References

Securities and Exchange Commission Guidance on Disclosure Related to Climate Change; effective February 8, 2010; http://www.sec.gov/rules/interp/2010/33-9106.pdf

AICPA Statement of Position 96-1; Environmental Remediation Liabilities; 1996

FAS (Financial Accounting Standard) 143, Accounting for Asset Retirement Obligations

FASB Interpretation Number 47 (FIN 47); Accounting for Conditional Asset Retirement Obligations

New York Attorney General’s actions against Xcel Energy and others; see http://www.oag.state.ny.us/media_center/2007/sep/xcel%20energy.pdf for subpoena dated September 14, 2007. Settlements with Xcel and other utilities also available on www.oag.state.ny.us website.

Environmental Disclosure: SEC Should Explore Ways to Improve Tracking and Transparency of Information; July 2004; GAO-04-808; http://www.gao.gov/new.items/d04808.pdf

The Climate Registry; www.theclimateregistry.org

Carbon Disclosure Project; www.cdproject.net

Global Reporting Initiative; www.globalreporting.org

Read the Rest of the Articles in this Series

Part 1 – The Basics of Financial and Nonfinancial Reporting and Disclosures

Part 2 – Detailed Analysis

Part 3 – Suggestions for Climate Change Disclosures