The U.S. Securities and Exchange Commission’s landmark climate change proposal thrusts the Wall Street regulator into a role it usually takes pains to avoid: setting accounting rules.

Almost 50 pages of the 500-plus page plan the agency issued Monday covers details of new financial statement disclosures big companies would have to make about climate change’s impact on financial statement metrics and how much they spend to combat risk.

The companies also would have to explain how they made the financial estimates and assumptions. If the rules are finalized, these footnotes would be part of companies’ audited financial statements—not the risk factors or management’s discussion and analysis (MD&A) sections, which are the SEC’s traditional financial reporting turf.

Federal securities laws authorize the SEC to set accounting rules but the agency rarely does so. Since the 1930s, the SEC has delegated the task to the private sector. In 1973, it farmed it out to the Financial Accounting Standards Board, the independent, private-sector body based in Norwalk, Conn.

“It has happened, but it’s not something that they do very often,” said Dennis Beresford, who was FASB chairman from 1997 to 2007. “They would prefer to have the FASB take the lead on almost every accounting-related issue.”

That’s by design. FASB—established in Connecticut to, at least in theory, steer clear of Washington politics and Wall Street money—writes the rules, and the SEC ensures companies follow them. FASB said it was monitoring the SEC proposal and declined to comment further.

The commission issues industry guides and staff accounting bulletins, and weighs in on how to interpret accounting rules through speeches, formal statements, and correspondence with individual companies, but only infrequently issues requirements for audited financial statement line items or disclosures.

One of the rare exceptions: in the 1970s, the SEC via ASR 147 required companies to provide more information in their footnotes about the off-balance-sheet risk of leasing real estate and heavy equipment, Beresford said.

High-Priority Plan

Rising temperatures and President Joe Biden’s push to combat climate change prompted the SEC to take action quickly, bypassing typically slow accounting rulemaking, said Robert Herz, who chaired FASB from 2002 to 2010.

“I think they thought this couldn’t wait; it’s a high priority to investors, and it’s a clear priority to the administration,” Herz said. “They want to get on with it.”

Under the plan, companies would have to highlight which parts of their financial statements are impacted by climate risk. If climate affects more than 1% of any line item—from inventories to revenue to long-term debt—companies would have to disclose the extent of the impact and describe it in their audited footnotes. They would also have to disclose what they spend to combat climate change.

“It’s remarkable how much they’ve integrated it into the financial statement. I wasn’t expecting it,” said Sandy Peters, head of financial reporting advocacy at the CFA Institute, which represents chartered financial analysts and advocates on investors’ behalf.

Marc Siegel, partner at Ernst & Young LLP and a member of FASB from 2008 to 2018, said he was also surprised by the breadth of the SEC’s disclosure proposals.

“It is certainly within the SEC’s mandate and jurisdiction to require disclosures within the financial statement,” Siegel said. “But during my time at FASB, the SEC had pretty much deferred all of that to FASB.”

The 1% threshold for disclosure also is quantitatively lower than what the market generally thinks of as material, a legal concept that governs what companies have to reveal as important to investors. The SEC in the proposal defended the threshold, saying a bright-line standard would provide consistency compared with a principles-based approach “and should reduce the risk of underreporting such information.”

The agency has used 1% as a threshold in other situations, such as rules around how a company presents details about excise taxes, the SEC said.

“They’ve put a line in the sand; if something is at least 1%, that’s material,” said Terry Warfield, accounting professor at the University of Wisconsin School of Business. “That’s a line relatively below what we’ve seen.”

The concept of materiality, however, also includes so-called qualitative factors. So if a comparatively small expense flips a line item from from positive to negative, for example, investors would consider that significant, Warfield said.

The Gap in GAAP

No part of U.S. GAAP—generally accepted accounting principles—spells out accounting requirements for issues related to climate change risk. FASB leaders have repeatedly said that writing rules about things like carbon footprints isn’t in its wheelhouse unless an issue affects a financial statement line item.

FASB reminded the market in March 2021 of numerous accounting requirements that could kick in when a company assesses climate risk, such as the financial impacts of pledges to go carbon-neutral or phase out energy-sucking machinery and equipment. Underpinning these requirements is the notion that they only come into play when they are material.

Many companies have pledged to reduce emissions, but most don’t expect to start accounting for the big costs to switch to greener technology or write off obsolete, gas-guzzling machinery until those costs become significant. When SEC reviewers peppered more than two dozen companies last year with questions about what they reveal about climate risk in their financial statements, all but one said the costs were not financially material yet.

Several of the companies—including Target Corp., Cisco Systems Inc., and Las Vegas Sands Corp.—described expenses that represented a small fraction of overall expenditures. They justified not disclosing them in their financial statements by saying they weren’t financially material. Cisco and Las Vegas Sands said their costs were about 1% of expenditures, and Target said the switching to more environmentally friendly business operations cost about 3% of capital expenditures.

The SEC is within its rights to set a strict threshold for the proposed disclosures, said former FASB Chair Beresford, an accounting professor at the University of Georgia Terry School of Business.

“People would be screaming even louder if FASB were taking the lead on some of these things,” he said.

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