Accounting for Going Green

Mary Mathews:

Thinking about this beforehand and including your finance team, your accountants, your advisors, while you're coming up with your ESG plans is going to be critical to making sure you're staying on side with your financial reporting matters.

Narrator:

Welcome to Accounting for the Future a BDO Canada podcast for financial leaders to navigate, change and achieve business growth. We'll uncover the challenges financial leaders may not have dealt with yesterday, but will definitely have to manage for the future.

Armand Capisciolto:

Hello and welcome to Accounting for the Future. I am your host, Armand Capisciolto, BDO Canada's National Accounting Standards Partner and Leader of Accounting Advisory Services. On today's episode, I'm joined by two BDO partners, Mary Mathews, a partner in our Accounting Advisory Group, and Braham Moondi who does both accounting advisory work and audits. I get the pleasure of working closely with both of them and talking about interesting accounting issues daily. Today is not going to be any different for us, other than we're recording it for you to listen to. Mary and Braham, welcome to Accounting for the Future.

Mary Mathews:

Thanks, Armand. Happy to be here.

Braham Moondi:

Thanks, Armand. Very happy to be here today and looking forward to this chat.

Armand Capisciolto:

Yeah. I think we're going to have some fun today. I think we have a really interesting issue to talk about. We talk about a weird accounting things daily, but I think this is ... I don't know, "weird" is the right word. It's interesting and it's current, it's topical. We're going to talk about accounting for going green, which is a really important topic right now, as countries and companies are making changes to achieve net zero. So, let's start the discussion on why is this an accounting issue. So, Mary, why the heck are accountants? Why do we care about this? Why are we talking about this?

Mary Mathews:

Well, moving to net zero is not something a company or a government can do in isolation. Right? So as part of that, we all have our part to play in this movement. And that includes us as accountants, right? And that's because our product, what we end up giving at the end of the day, our financial statements, our financial reports, they're going to be an important source of information for investors and companies and governments as they move forward in meeting these going green targets.

Armand Capisciolto:

Yeah. I think that's really important that the financial reports, things that we spend the majority of our day looking at, they're important source of information and whether that information is for making investment decisions or seeing where a company is along their path to net zero. And I think this really build upon that point. And I have to do a shameless plug here, that's what I'm doing. If you haven't already done so, please take a listen to our episode on sustainability and financial reporting. We discussed how the risks and opportunities related to climate and other sustainability-related matters could impact financial results today. So, Braham, what are you thinking about this? Is there anything else you want to highlight on this issue?

Braham Moondi:

For sure, Armand. First, I'll call it interestingly weird. So, let's mix both of those terms together. But just building onto Mary's point, I think it's also important to note that in addition to us accountants having to consider these general risks which come along with sustainability measures that companies might be taking, there are financial solutions that are being developed by governments all across the globe, that actually create market incentives for companies to reach their lower carbon targets or net-zero targets.

Armand Capisciolto:

So, Braham, are we starting to see some of these as you're putting these solutions? Are we seeing them in our client base?

Braham Moondi:

Yep. Let's do a deep dive and geek out. So, the most common ones in the market are cap and trade. There's virtual power purchase agreements that we like to call VPPAs, carbon offset credits. There's renewable energy credits or RECs and also sustainability linked bonds to name a few.

Armand Capisciolto:

Well, you brought up geeking out.

Braham Moondi:

Yeah.

Armand Capisciolto:

And as you know Braham, I love to geek out.

Braham Moondi:

Yup.

Armand Capisciolto:

And I think we could probably talk for a couple hours on each of these topics specifically and get into the accounting details, and we would have a lot of fun doing that. I don't know if our listeners would have a lot of fun listening to that. So, we're not going to do that today on all of them. But I do want to take a little bit of a dive into a few of them, so just so people can understand the issues and why these are somewhat difficult to deal with. So, Mary, let's start with sustainability linked bonds. What are we talking about with these things?

Mary Mathews:

Yeah. So, that's one of the common instruments we're seeing come out of this accounting for going green movement. Sustainability linked bonds are issued by companies and they're usually tied to some overall ESG target. One example I've seen is where the interest rate is going to be tied to reducing emissions. So, the bond terms will offer company a lower interest rate for meeting that ESG target, but the rates would increase if that ESG target is not achieved.

Armand Capisciolto:

Okay. So, they're paying 2% today. If they don't hit the target in a few years' time, they'll have to pay 3% or 4%. So, I assume the accounting's fairly simple. And I know it's not as I'm asking this question. It's just like a floating rate bond. Right, Mary?

Mary Mathews:

Well, Armand. Yeah, exactly. You said it. It's definitely not that simple. Right? It never is. And that's very true for financial instrument accounting. It's always complex. And part of the reason for that, is because the financial instrument standards were not written with these types of instruments in mind. And, in addition, the guidance for the holder of that instrument and the issuer of that instrument is not going to be the same in the accounting standard. So, there's going to be situations where the issuer might account for that instrument at amortized cost, and whoever the holder is might account for that instrument at fair value. And so, there's never a single answer, it's never quite clear. And it's always going to depend on the terms of the arrangement. And also, of course, the facts and circumstances of the holder and the issuer.

Armand Capisciolto:

It depends. Usually, it depends. Our favorite words, as people who look at these technical matters. And it's really interesting, because all three of us spend a lot of time looking at financial instruments, and financial instrument accounting is generally complex. You add another element to it being the sustainability-linked aspect to it. It seems like it's getting more complex. So, the good news, we have job security. But it's tough, right? Because I think one of the things that I often hear people talk about when we talk with sustainability linked, or financial instruments in general is, is it a typical lending arrangement, a basic lending arrangement? And typically, we wouldn't expect to have an ESG link to it, to a basic lending arrangement.

However, there are those that are saying, well, maybe we should. Maybe that's the direction that things are going to go, as banks try to reduce their finance emissions and other lenders reduce those emissions. So, we're going to have some fun with financial instruments, which we currently do. And it sounds like it's just going to get a little bit more fun.

Braham, switching gears now from financial instruments to maybe financial instruments ... I say maybe financial instruments, a little bit of foreshadowing. I know you work with a number of clients that have these virtual power purchase agreements and as you called them VPPAs earlier. We love as accountants to speak in acronyms. So, what the heck are these? What's a virtual power purchase agreement? And what are the issues?

Braham Moondi:

Yeah. No. For sure. So, a virtual power purchase arrangement or a VPPA is definitely the flavor of the season right now. So, they're very, very common in jurisdictions where you purchase energy from the electricity grid, which I like to call it, is non-denominational in nature. So, it could be both renewable and from non-renewable sources. So, what a VPPA is, it's essentially a side arrangement, that allows a buyer of any source of energy, but essentially renewable energy, to virtually purchase directly from renewable sources. So, these are typically long-term contracts, where the purchaser agrees to pay a fixed price for the energy over the term of that contract. But then, they are typically settled through net payments, which ... And I'm going to make it even more interesting, are equal to the difference between the fixed price of the contract, and the current spot price for the energy.

Now, to add another layer on top of it, the purchaser may also get a renewable energy credit. So, like I called them RECs, or in some jurisdictions in North America, these could be tax credits, as part of this arrangement that can result in direct cashflow savings for our future benefits. So, the attributes of these renewable energy credits, like I mentioned, are diverse across jurisdictions. Typically, in North America, I see them as being tax credits, but they could vary. And there are a number of complex issues, like you mentioned earlier, for both the purchaser and the seller to consider here. Again, it depends. It's based on the facts and circumstances of the issuer and the holder. But the typical questions we generally like to ask are, is this a lease? Is it a financial instrument? Is it a revenue contract, with an embedded derivative? The opportunities are endless here.

Armand Capisciolto:

Well, yeah. And again, I know again, our job is to talk about accounting, and people always think we have these answers. "Oh, I have a virtual power purchase agreement, how do I account for it?" And they think we just have the answer because ... But they're not all the same. Everyone has its own little idiosyncrasies and subtle changes in the agreement. They change the accounting. Right?

Braham Moondi:

Exactly. Exactly.

Armand Capisciolto:

Yeah. I know. It's an interesting one. And as you were describing them and you get into net payments and the difference between the fixed and the spot price, where I go, and again ... I feel like I ... Everybody's seen the movie The Sixth Sense, right? Sixth Sense?

Mary Mathews:

Yup.

I see dead people?

Braham Moondi:

Yup.

Armand Capisciolto:

I see financial instruments everywhere. That's my problem. That's my Sixth Sense. I see financial instruments. So, when you start talking about that, all of a sudden, I'm think, "Well, this really sounds like a swap that Braham's describing. Right? It's like an energy swap, a pay- fixed-receive-floating-energy swap. And it could be. And that could be that embedded derivative that you're talking about, or that financial instrument that you're talking about. But it could very well be a lease at the same time. Or a slight different fact pattern and we could be calling it a lease. So, these are really interesting, really common, especially, we're all located in Ontario. Very common in Ontario, because we, again, a jurisdiction that purchases from the grid.

But again, as companies want to purchase more renewable energy and make sure that's where all their energy's coming from, this is how you do it, because you don't know where it's coming from, the grid. It's the amalgamation of all the energy it's being generated in the province. So, I guess, when I think about this, and I hear the details of the contract matter. The other thing I'm hearing is, Mary, you mentioned this with financial instruments especially, that the standards don't necessarily deal with these issues specifically. And the fact that there isn't exact paragraphs on point that deal with these issues, that adds to the complexity a little bit. Right?

Mary Mathews:

Yeah. That's right. I guess, that "interestingly weird" comes up, right. It's a common theme for us. And that's because to get to the right accounting conclusion, you're usually going to have to play with a few standards at once and see how those standards actually interact. So, it's not easy even for us nerds that like to deal with this on the daily. And someone might think it's hard, but we kind of say the phrase, "Oh, how interesting," right, when something's quite difficult. So, even though we might get excited about it, we still need standard setting and that standardization, to give us nerds that guidance we need to get the accounting right.

I know it's not news to you guys. At the end of last year at COP 26, the International Financial Reporting Standards Foundation announced the formation of the International Sustainability Standards Board, what we're calling the ISSB. So, for us that like to follow what the standard setters are doing, that's exciting for us. And that's because this ISSB is aiming to bring about a much-needed, globally comparable, standard for reporting on ISG matters to the markets. And in addition to that, the IASB also took an agenda consultation recently and they received feedback that they should actually undertake projects related to climate-related risks and pollutant-pricing mechanisms.

Armand Capisciolto:

Yeah, and when you bring up ISSB the International Sustainability Standards Board. And yeah. It was announced that COP 26 and just recently, they've issued their first exposure drafts. So, they're hoping to have standards issued by the end of the year that's going to be discussing sustainability-related risks and opportunities and how the company is dealing with that, including climate. And so, that's very exciting and there's a lot of other things related to that happening. In addition to those standards being issued in Canada, our Canadian Securities Administrators, they've issued proposed guidance on climate-related disclosures. The SEC has done that. We're going to see ... Well, I think recently, the European Union has issued their rules on it. So, there's a lot going on from both a standard-setting standpoint and a securities regulations standpoint that's moving that disclosure of these risks forward, these opportunities forward, related to sustainability.

But I think what's really interesting is that the second part that you talked about, Mary, the fact that the IASB, the International Accounting Standards Board who sets the IFRS accounting standards is saying, "Well, we can't just leave it to these disclosures that are separate from the financial statements. We also have to think about how these changes impact financial reporting, and how this impacts the financial statements." So, the fact that both of those things are happening is really important for companies to remember. And I think it's really important too for listeners who are listening in, because I mentioned a bunch of securities regulation, and saying, "Well, I'm not subject to securities regulation. Why do I care about what this board is doing related to these new disclosures that I'm not going to have to comply with?". Well, the whole point of these disclosures is risks and opportunities. And risks and opportunities ultimately impact the company's bottom line. And if they impact the company's bottom line, they ultimately impact the financial statement.

So that link is really, really important. And I know, again, plug it again for our session on sustainability and financial reporting for people to watch it, but I can't stress that enough.

And then, a little bit kind of related to this, one of the things I've been thinking about as well, and I don't know if either of you have thought about this. Again, if I am a private company and I don't have to deal with all these securities regulations, but these risks impact me, am I thinking about putting disclosure in financial statements related to this? Should I be? Is there anything that mandates it, right now? Or have you thought of that at all?

Braham Moondi:

No. I'll take a shot at it first, Armand. And I think it's very interesting, because there are a lot of cashflow savings that are part of some of these initiatives, which private companies will take advantage of or should be taking advantage of. So, when you put that into context and look at the financial risks of those companies, of course, their users would want to know how those financial instruments, or however they describe those contracts, because like I said, it depends, and it's based on facts and circumstances. How do those interplay with each other? I believe that's an important disclosure item, regardless of it being private or publicly listed company.

Armand Capisciolto:

Yeah. It's really interesting, especially when we talk about the VPPAs or virtual power purchase agreements. In addition to securing renewable energy, which is a good thing, and what the company wants to do and why they're doing it, it's also de-risking their cashflows a little bit, because they've also entered into a long-term contract and they're fixing that price, right to get it. So, yeah. As you put it, there's definitely positives from a cashflow standpoint.

And then, I guess, the other piece of this, and I know something that gets talked about as well. We were talking about accounting for these virtual power purchase agreements. We're talking about accounting for a sustainable bond or sustainability-linked loans or bonds. And all of a sudden, I need information, right, I need information to determine, okay, am I actually hitting these targets that are in my sustainability-linked bond? If I'm tracking… if this virtual purchase power agreement is being accounted for as a lease, the accounting might not match the exact cashflows. Is there any other things that companies need to think about?

Braham Moondi:

Yeah. I'm going to put on my auditor hat now, for a second, and take off my accounting advisory hat. So, it's interesting, because as things start to develop in the market, you'll generally see accounting-standard setters following up with either new guidelines or new standards. And then, while that's happening, there's also the technology that's evolving. So, we've been talking about the complexity of accounting, but it's important to mention, I think, on this podcast that when you have complex accounting, you need proper internal controls and systems, to account for those transactions, to be able to measure what my cost savings are, to be able to track what my ESG initiatives were, and how am I tracking across them?

Especially because in these situations, neither the accounting will necessarily match the cashflows. Nor will the tracking of those key performance indicators. So, we often see companies dealing with these matters, unfortunately using spreadsheets and sometimes top-side journal entries, which is scary and is a recipe for errors. So, there is technology that is also coming into play here and just interpolating that with your current accounting systems and making sure everything is getting tracked appropriately is also very important for the stakeholders to note.

Armand Capisciolto:

Yeah. As auditors, we are definitely not fans of spreadsheets. We know they get used; we know all our clients use them. We're not saying don't talk to us if you use a spreadsheet. What we are saying, they are prone to error. You make a mistake in one formula and copy that formula down and you now have 100 mistakes. Right?

Braham Moondi:

Exactly.

Armand Capisciolto:

And so, the internal controls, the systems related to this new information that needs to be tracked, whether you're tracking it for sustainability-reporting purposes, or tracking it because it impacts the accounting for sustainability-linked bond or the accounting for a virtual power purchase agreement. I always pause when I say virtual power purchase agreement, because as accountants we have a lot of acronyms that have PPA in them. And sometimes it's a purchase price allocation, sometimes it's a prior period of adjust ... We love acronyms. We like using them and for more than one reason. So, I apologize to our users for my pause there, but that's just the simple fact of accounting that we love these things.

And I now lost complete track of where I was going, because I went on a little tangent on acronyms. But I think where I was going with this is that tracking is critical. And even when we think about some of the other ones that we didn't talk about, like cap and trade or offset credits, I think what's really important is, beyond the accounting, right? We like to talk about accounting, that's what we do on a daily basis. We like to talk about the accounting implications, but also the operational implications. If I don't have information to track, and yes, I can't abate all my GHG emissions, well maybe I'm going to use some carbon offset credits to deal with that. Well, again, before I invest in these carbon offset credits, wouldn't I want the data to know what I need to offset, to make the proper investment decision? And the systems, I think, are really critical in doing that.

So, a lot to talk about. We just scratched the surface, really, of these different products that are out there. I think a couple messages I just want to repeat before we end today is, one, there is not standard accounting for any of these things. I think that's critical. Right? So therefore, the accounting depends on the facts and circumstances and getting into the details of the contract. So maybe Mary, I'm going to ask you one last question before we end. When you deal with clients and you're dealing with accounting advisory, when do they ask you questions about how to account for this? Do they ask you after the contracts done? Do they ask you before the contracts done? When are they asking you this?

Mary Mathews:

Well, that's quite a question. My ideal world would be right before the dotted line is signed. But a lot of the time it might be after the fact. And that creates sometimes a bit of a headache for a lot of people, because the implications of these new types of contracts and new instruments that are being issued is that, you might not get the accounting you like or intended. And that could really change the face of your financial statements. Your balance sheet might go completely different, might affect your covenants. So, thinking about this beforehand and including your finance team, your accountants, your advisors, while you're coming up with your ESG plans is going to be critical to making sure you're staying on side with your financial reporting matters.

Armand Capisciolto:

Yes. I think that's a really important point. And, even though, I think accounting is critically important. I assume the two of you think accounting is critically important. I think we all believe accounting shouldn't drive business decisions. The business decisions, the business purpose, there needs to be the economics around it. But I do think it's important to know the accounting outcome, before you enter into a transaction, so you can think about things like, "Oh, wow! This seems like a great transaction, but I'm going to violate all my debt covenants." Well, that's a bad thing. You want to know that beforehand. Right?

And I think that's, for me, a key message when you're entering into these complex transactions, which are still pretty new and novel and the accounting's working out. Engaging your finance department, engaging advisors, talking to your auditors about what the accounting is going to look like before you execute the deal is highly recommended, so that you don't end up in that awkward situation where you entered into a really a good business deal, but had some horrible financial reporting implications.

Mary Mathews:

Completely true. It's just that knowledge is power, right. Knowing what you're getting into is really the important part, especially when it's just such a gray area for now.

Armand Capisciolto:

Mary and Braham, thank you so much. Myself and our audience appreciate your time, appreciate your expertise. I'd also like to thank our listeners for tuning in today. I'm Armand Capisciolto and this has been BDO's Accounting for the Future. Please let us know if you've found the topic interesting and useful and remember to subscribe if you liked it. And we'll see you next time.