Managing Fraud Risks in an Evolving ESG Environment
ENVIRONMENTAL | SOCIAL | GOVERNANCE
MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | FOREwORD2 MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | TAbLE OF CONTENTS
TABLE OF CONTENTS
Foreword.....................................................................................................................
Introduction to ESG..................................................................................................
Defining ESG fraud risk........................................................................................
Mitigating ESG fraud risk....................................................................................
Conclusion...............................................................................................................
About the ACFE.......................................................................................................
About Grant Thornton...........................................................................................
Appendix: Examples of ESG guidance and frameworks.................................
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3MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | FOREwORD
FOREWORD
Bradley Preber CHIEF EXECUTIVE OFFICER GRANT THORNTON LLP
Bruce Dorris PRESIDENT AND CHIEF EXECUTIVE OFFICER ASSOCIATION OF CERTIFIED FRAUD EXAMINERS
Environmental, social, and governance (ESG)
issues are some of the most important topics
discussed in the boardroom today. In an
increasingly interconnected world where
information flow is measured in nanoseconds
and trends go viral in a heartbeat, organizations
can quickly find themselves in the center of a
maelstrom. An executive posts personal views
regarding a controversial topic on social media,
evidence surfaces about unfair labor practices,
a supplier is discovered to have been polluting
the environment. In the age of cancel culture, the
possibility of these headlines strike fear into the
hearts of executives everywhere.
As consumers, employees, and investors are
paying more attention to these topics, ESG
issues have become a major consideration for
individual and institutional investors. The rise of
ESG-focused investing should, on its face, be a
movement defined by trust, good governance, and
accountability. After all, the movement to promote
corporate action on environmental, social, and
governance standards is aimed at making progress
on values and shared prosperity.
But, as with many new trends, the regulatory and
reporting frameworks related to ESG are struggling
to keep up with the pace of change. Without
consistent standards, the opportunity for fraud is
increased. At the same time, organizational leaders
feel pressured to make commitments and to report
positive progress toward ESG goals. For example,
40% of major companies have issued a public
commitment to reduce emissions. The pressure to
achieve those goals will rise as investors rely more
heavily on such ESG-related metrics, on par with
traditional financial reporting.
Anti-fraud practitioners have a critical role to
play in the future of ESG programs. They can
help organizations understand the internal and
external fraud risks presented by this paradigm.
They can also implement new internal controls to
prevent material misrepresentations and fraudulent
reporting of ESG metrics. In addition, they can help
protect the company against ESG-related external
frauds by unscrupulous suppliers.
Understanding how ESG programs impact your
organization and getting a clear look at new and
emerging fraud risks in this area are paramount.
Leveraging existing frameworks such as the
Fraud Risk Management Guide, published by the
Committee of Sponsoring Organizations of the
Treadway Commission (COSO) and the Association
of Certified Fraud Examiners (ACFE), can help
organizations better prepare to address those risks
in a structured and holistic manner.
Organizations that take a proactive approach to
mitigating their ESG-related fraud risk will have a
unique advantage in the marketplace. They will
be better protected and prepared to navigate
the ever-changing landscape to tackle complex
environmental, social, and governance issues
head-on.
MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | INTRODUCTION TO ESG4 MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | INTRODUCTION TO ESG
INTRODUCTION TO ESG
5MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | INTRODUCTION TO ESG
SRI
Inclusive
Responsibility
Impact
Care
Product quality & safety
Access & affordability
Diversity, equity, inclusion, & belonging (DEI&B)
Data security
Materials & sourcing
Customer privacy
Supply chain transparency
Labor standards
Human rights Employee relations
Community investmentEmployee benefitsSocioeconomic
progress
Health & safety
Working conditions Gender equality
Human capital management
Equity
Purpose
Leader
People-first
Green
Customer & product responsibility
Executive compensation
Responsible marketing
Business ethics
Board & executive oversight
Data privacy Internal controls
Anti-corruption
Regulatory compliance Corporate behavior
Critical incident risk management
Systemic risk management
Business model resilience
Board independence
Competitive behavior
Shareholder rights
Management of the legal & regulatory environment
Habitat preservation & enhancement
Sustainability Biodiversity
PollutionCarbon emissions
Water efficiency
Ecological impact Energy management
Waste management
Natural resource managementPackaging
Ecological impacts
GHG emissions
Climate change
Air quality
ESG BACKGROUND
Environmental, social, and governance (ESG) refers to nonfinancial factors that may influence how investors, donors, consumers, and workers choose to engage with an organization. ESG management and reporting focuses on tangible measures and intangible values of an organization. Those measures reflect standards of sustainability, ethical management, and quality of employment within an organization.
ENVIRONMENTAL
The “E” in ESG refers to the “environment.” Specifically, it reflects the goals and objectives an organization has established to protect and conserve the natural world. It considers things such as sustainability and carbon reduction efforts.
SOCIAL
The “S” refers to the “social” efforts an organization endorses to show that it values people and considers things such as diversity, equity, working conditions, and social justice.
GOVERNANCE
The “G” refers to organizational “governance” and specifically relates to an organization’s ethics. For example, governance includes aspects such as management behavior, transparency, and executive compensation.
ESG IN ACTION
FIG. 1 EXAMPLE ESG FACTORS
ENVIRONMENTAL
SOCIAL
GOVERNANCE
MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | INTRODUCTION TO ESG6 MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | INTRODUCTION TO ESG
Historically, investor and donor decision-
making relied heavily on a company’s financial
performance. However, ESG has increasingly
become an important consideration when deciding
to invest or donate. Likewise, consumers and
workers are increasingly looking to patronize and
work for companies that better align with their ESG
values.
While the popularity of ESG has risen sharply
over the last few years, it is not a new concept. A
2004 report first used the term ESG, referencing
“recommendations by the financial industry
to better integrate environmental, social, and
governance issues in analysis, asset management,
and securities brokerage.”1 That report laid the
groundwork for the popular interpretation of
ESG. That is, the way a company manages ESG
issues may reflect on its overall management
quality and correlate to the company’s reputation,
performance, and shareholder value.
An increasing focus on ESG should not come
as a surprise given the increasingly globalized,
interconnected, and competitive global market.
As individuals, many of us are adopting conscious
consumer buying habits, such as choosing a shoe
brand in part because the company donates shoes
to disadvantaged groups, or a grocery store that
donates portions of its proceeds to a food bank.
These examples offer a glimpse of some of the
nonfinancial ways that consumers may perceive
“value” in their business encounters.
Investors, donors, consumers, and workers make
choices based on the ethical decisions of the
businesses with which they engage. Companies
have taken notice and realize that strong cultural
awareness and positive ESG-related policies have
gone from a fringe specialty to a core necessity.
This focus is required to secure a strong brand and
market presence that influences decision-makers,
from investors and donors to consumers and
employees.
1 www.ifc.org/wps/wcm/connect/topics_ext_content/ifc_external_corporate_site/sustainability-at-ifc/publications/publications_report_whocareswins__wci__1319579355342 2 www.justcapital.com/news/more-corporate-climate-commitments-are-essential-to-limiting-the-effects-of-global-warming
According to Just Capital, over 40% of Russell 1000
companies have announced a commitment to reduce
emissions with a quarter of those companies disclosing
a Net Zero emissions commitment by 2050.2
7MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | INTRODUCTION TO ESG
3 www.bloomberg.com/professional/blog/esg-assets-may-hit-53-trillion-by-2025-a-third-of-global-aum 4 www.unfccc.int/climate-action/race-to-zero-campaign 5 www.un.org/en/climatechange/paris-agreement 6 www.cbp.gov/newsroom/stats/trade
Additionally, the increase in “sustainable investing”
has driven asset managers to expand their
portfolios of ESG-related assets. From 2018 to
2020, ESG assets under management grew from
$22.8 trillion to $35 trillion, with estimates that
they will make up a third ($53 trillion) of all assets
under management by 2025.3 The social and
economic consequences of not investing in ESG—or
appearing to not invest—are larger now than ever.
Due in part to media coverage of climate initiatives,
the environmental component of ESG receives
significant attention. Savvy, climate-conscious
investors are looking for organizations and
businesses that demonstrate climate-conscious
initiatives. Furthermore, internationally mobilizing
sustainability initiatives, such as the Race to
Zero Campaign4 and the Paris Agreement,5 have
accelerated the importance placed on climate
for both the producer and consumer of goods
and services. As such, organizations experience
severe pressure to adopt specific measures that
show they are conducting business in a way that
supports the environment.
Over the last few years, social- and governance-
related issues have also been in the public eye. For
instance, there is increased focus on forced or child
labor used in manufacturing production. In 2019,
the U.S. Customs and Border Protection detained
12 shipments that it believed to hold merchandise
linked to forced or child labor. Detainments
increased to more than 1,400 shipments in 2021
and are on pace to surpass 3,000 shipments
in 2022.6 This trend has increased pressure on
organizations to confirm the integrity of their
manufacturing production and supply chains.
MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | INTRODUCTION TO ESGMANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | INTRODUCTION TO ESG8
Pressure is mounting on the C-suite to prove
meaningful progress in setting and achieving ESG
goals. This pressure has resulted in the creation
of a business climate where the real risk is not adopting the principles of ESG. The development
and implementation of ESG-friendly programs can
be costly, both financially and logistically. Pressure
to adopt principles of ESG creates an environment
ripe for fraud, and fraud thrives wherever the
stakes are high.
INTERNAL ESG FRAUD
Internal ESG fraud is fraud committed by
management or employees. It often involves
intentional acts to deceive others by the reporting
of false or misleading ESG information; by omitting
material ESG facts; or by the improper disclosure
of ESG initiatives, programs, and metrics. Internal
ESG fraud may also involve corruption. Examples
of internal ESG fraud include the failure to disclose
the use of child or forced labor, harvesting
resources from illegal sites, or illicit trade and
trafficking.
Internal ESG fraud often occurs due to a lack of
supervisory oversight, poor accountability, and/or
a weak internal control environment. Additionally,
as organizations increasingly link more executive
compensation to ESG progress, certain ESG fraud
schemes may be unintentionally incentivized.
INTRODUCTION TO ESG FRAUD
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7 www.bloomberg.com/professional/blog/esg-assets-may-hit-53-trillion-by-2025-a-third-of-global-aum 8 Ibid. 9 www.usatoday.com/story/money/2018/05/11/millennials-socially-responsible-investing/580434002 10 www.goldmansachs.com/our-commitments/diversity-and-inclusion/board-diversity 11 www.npr.org/2021/09/10/1035901596/harvard-university-end-investment-fossil-fuel-industry-climate-change-activism; https://news.columbia.edu/news/university-announcement- fossil-fuel-investments; www.georgetown.edu/news/fossil-fuels-divestment-continues-georgetown-commitment-to-sustainability; www.rutgers.edu/news/rutgers-divest-fossil-fuels; www.universityofcalifornia.edu/press-room/ucs-investment-portfolios-fossil-free-clean-energy-investments-top-1-billion 12 listingcenter.nasdaq.com/assets/Board%20Diversity%20Disclosure%20Five%20Things.pdf
QUICK FACTS • Estimates place ESG-driven investment at greater than $35 trillion in assets under
management, and ESG-driven investments are on track to exceed $53 trillion by 2025.7
• Global sustainability investments now surpass $30 trillion, up 68% since 2014.8
• Nearly nine out of ten millennials report that they want their money to go to sustainable investments.9
• Goldman Sachs pledged to take public only those companies that have diverse boards.10
• Harvard’s endowment is divesting itself from fossil fuel companies, as are those for Columbia, Georgetown, Rutgers, and the University of California.11
• NASDAQ issued a rule requiring member companies to publicly disclose board-level diversity in a standardized method and explain if they do not have at least two diverse directors.12
EXTERNAL ESG FRAUD
External ESG fraud is fraud conducted by parties
outside an organization, such as vendors in
an organization’s supply chain, contractors,
customers, or other third parties. External ESG
fraud often involves an intentional act to deceive
an organization by omitting material facts or
disclosing false or misleading information relating
to ESG programs. As suppliers feel the pressure
to adopt ESG policies consistent with their key
customers, external fraud schemes may develop
relating to the reporting of intentionally false
and misleading representations about ESG
policies and adoption. Alternatively, unscrupulous
ESG-related vendors could take advantage of
an organization by supplying inaccurate ESG
information that results in the organization
fraudulently reporting ESG-related data.
One significant example of external ESG fraud
is the sale of fraudulent “green” investments to
supply desirable carbon emission credits to offset
greenhouse gasses. The sale of these fraudulent
investments represents fraud risk for companies
and their investors. Companies that buy these
credits may unknowingly misreport their carbon
position and suffer reputational and regulatory
consequences, while investors who buy stakes in
either the companies selling or buying fraudulent
credits may be subjecting themselves to
traditional Ponzi or other investment schemes that
exploit uninformed investors.
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THE FRAUD TRIANGLE AND ESG
The Fraud Triangle (Figure 2) is a framework
describing the conditions that allow fraud
to thrive. The three elements of the Fraud
Triangle—opportunity, incentive (pressure), and
rationalization—are all easily recognizable in the
ESG landscape.
OPPORTUNITY
Opportunity describes the environment that allows
fraud to occur. The opportunity for fraud to occur
increases when an organization lacks a control
environment to properly mitigate the inherent fraud
risk. In the ESG context, such a control environment
could include clear policies that establish ESG
metrics, as well as oversight of internal and
external actors to ensure compliance with these
policies.
With respect to ESG reporting today, benchmarks
are limited, and consistent guidance is lacking.
Many audiences—even sophisticated ones—
lack a full understanding of company-reported
metrics. These audiences also have a limited
ability to compare ESG claims across companies
and sectors, which is essential to find intentional
misstatements. Without the proper tools to
compare ESG claims, a real opportunity to
manipulate metrics exists and opens the door for
fraudulent ESG-related vendors and suppliers to
exploit immature programs.
FRAUD TRIANGLE
Opportunity
Incentive (Pressure) Rationalization
FIG. 2 FRAUD TRIANGLE
11MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | INTRODUCTION TO ESG
INCENTIVE (PRESSURE)
Pressure describes the perceived burden
potential fraud actors might experience that
would incentivize them to commit fraud. There
is enormous pressure on the C-suite to make—
and achieve—ESG promises. The pressure is
particularly intense when it comes to raising
capital. Increasingly, private equity, venture capital,
pension funds, and public entities are insisting
on reviewing a company’s ESG policies, goals,
and metrics. Even privately held companies must
raise capital—and when they do, investors are
increasingly asking these companies about their
supply chain oversight, environmental impacts,
executive compensation models, and other ESG-
related issues. Increasing investment focus on
ESG raises the stakes and increases the pressure
to commit fraud. This pressure could also result
in reduced scrutiny of suppliers or third parties,
as uncovering ESG fraud in the value chain would
negatively implicate the company.
RATIONALIZATION
Rationalization is a fraudulent actor’s ability to
convince themself that the circumstances justified
their illicit act. ESG represents many social virtues.
Therefore, bad actors may rationalize that making
progress on ESG promises is worthy of a reward,
not punishment. For example, if an organization
comes close—but still fails—to deliver on an
ESG promise, the organization may rationalize
a misstatement with the justification that “some
progress is better than none.” In other instances,
individuals may justify their actions because the
“ends justify the means.” If the choice is between
providing honest and transparent reporting of
poor ESG performance resulting in market losses
and layoffs, or cooking the ESG books to show
a positive result, it becomes clear how some
organizations might rationalize fraud.
MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | DEFINING ESG FRAUD RISK12 MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | DEFINING ESG FRAUD RISK
DEFINING ESG FRAUD RISK
13MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | DEFINING ESG FRAUD RISK
Grant Thornton developed an ESG fraud taxonomy
(Figure 3), inspired by the ACFE Occupational
Fraud and Abuse Classification System, also known
as the Fraud Tree.13 Traditional fraud taxonomies
typically look at categories of fraud that internal
and external actors perpetrate directly against an
organization, such as billing schemes, cyberattacks,
or fraudulent reporting. Grant Thornton’s ESG fraud
taxonomy considers fraud risks through an ESG
lens.
Examples of identified ESG fraud schemes
include inflating the value of carbon credits, using
modern slavery for production, making illegal
political donations, and paying bribes to forgo
specific regulation meant for the well-being of the
environment or people, among many others.
Some fraud schemes, such as modern slavery
violations, affect the perpetrator and the
organization receiving goods or services from the
perpetrator. ESG fraud and misconduct impacts can
occur anywhere in the supply chain.
ESG FRAUD TAXONOMY
13 www.acfe.com/-/media/files/acfe/pdfs/2022-rttn-fraud-tree.ashx
In addition to the three ACFE Fraud Tree categories— corruption, asset misappropriation, and financial statement
fraud—the ESG fraud taxonomy includes a fourth category called nonfinancial reporting fraud, which
introduces ESG-reporting-related fraud risks.
MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | DEFINING ESG FRAUD RISK14 MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | DEFINING ESG FRAUD RISK
FIG. 3 GRANT THORNTON’S ESG FRAUD TAXONOMY
ILLUSTRATIVE EXAMPLES
Conflicts of Interest Bribery Economic
Extortion Illegal
Gratuities
Concealed ESG-related Liabilities & Expenses
Improper Disclosures
Improper ESG- related Asset
Valuations
Overstated ESG-related Liabilities & Expenses
Bid-riggingSales schemes
Purchasing schemes
Invoice kickbacks
Carbon credit sales to
undisclosed related party
Permit officer demands
payment for logging permit
Grease payment to forgo safety inspection
Collusion for disaster relief procurement
ESG-related Inventory and Other Assets
Larceny Misuse
Theft of personal safety equipment
Personal use of donated goods
Inflated carbon credit value
Environmental cleanup
reserve used as cookie jar
No real estate assets are in
100-year flood plain
CORRUPTION ASSET MISAPPROPRIATION
NONFINANCIAL REPORTING FRAUD
FINANCIAL STATEMENT FRAUD
False Disclosure or RepresentationFalse Labeling or Advertising Failure to Disclose or ReportFalse/Disingenuous Certification or Pledges
Affirmative declarations or assertions
Failure to disclose or
report a fact
Failure to disclose or
report an event or action
Negative declarations or
assertions
Out of compliance
with certification or
pledge
Affirmative declarations or
assertions
Negative declarations or assertions
Affirmative declarations or assertions
Negative declarations or
assertions
Made with 100% recycled
materials
Fully complies with ______ certification
requirements
We are a founding
member of the ______ ESG
initiative
Board does not include a diverse
Director [not reported]
No plant accidents required
hospitalization during the prior
year
None of our products contain inputs resulting
from forced labor
Scope 2 Greenhouse
Gas Emissions declined by 10%
Dolphin-free tuna
On track for net zero greenhouse
gas emissions by 2035
ILLUSTRATIVE EXAMPLES
ILLUSTRATIVE EXAMPLES
15MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | DEFINING ESG FRAUD RISK
NONFINANCIAL REPORTING FRAUD
In addition to the three ACFE Fraud Tree
categories—corruption, asset misappropriation, and
financial statement fraud—the ESG fraud taxonomy
includes a fourth category called nonfinancial reporting fraud, which introduces ESG-reporting-
related fraud risks. This includes schemes in
which organizations intentionally omit, falsify, or
misrepresent material nonfinancial information to
deceive and attract investors, funding, loans, or
other benefits. Organizations can make material
falsehoods, misrepresentations, and omissions
for any ESG Key Performance Indicators (KPI)
or related operations. All organizations should
integrate ESG reporting metrics and disclosure
requirements across their operations, in the same
way that financial considerations drive enterprise
decisions. Much like financial considerations, these
metrics must have rigorous controls around the
disclosure and assessment process.
ESG FRAUD RISK ASSESSMENT
Organizations use the ACFE Fraud Tree to conduct
traditional fraud risk assessments. They can also
use the ESG fraud taxonomy to conduct an ESG
fraud risk assessment or to enhance a traditional
risk assessment by considering the entirety of an
organization’s operations, including third parties.
Third parties within the supply chain are a vital
piece of an ESG ecosystem, as organizational
leadership is accountable for its own business
practices and for those of its value chain. For this
reason, it is crucial to consider the ESG risks posed
by suppliers and customers, in addition to the risks
faced directly by the organization.
MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | DEFINING ESG FRAUD RISK16 MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | DEFINING ESG FRAUD RISK
During a fraud risk assessment, organizations
characterize fraud schemes to allow for an
enterprise-wide view. This categorization helps to
organize a comprehensive approach to assessing
fraud risks. To illustrate using an example from
the ESG fraud taxonomy, the following is the
categorization of a nonfinancial reporting fraud risk:
• Category: Nonfinancial Reporting Fraud
• Subcategory: False Disclosure or
Representation
• Sub-subcategory: Negative declarations or
assertions
• Scheme: Harvest mixing
Harvest mixing occurs when agriculture and
fishing entities mix valid goods with illicit goods
while declaring all goods valid. For example, a
fish supplier might disclose the fish as legally
caught when in fact only a small portion of the fish
were legally harvested, allowing the bad actors to
generate extra profit.
The ESG fraud taxonomy serves as a useful
foundation on which to build a tailored fraud
scheme library that is appropriate for a specific
industry or company. Organizations can then
leverage this information during a fraud risk
assessment to evaluate the controls in place to
mitigate the inherent fraud risk associated with
each scheme. In this example, we might evaluate
whether disclosures by suppliers are subject to
the proper controls to mitigate the likelihood of a
harvest mixing scheme.
Organizations should periodically evaluate ESG
fraud risks and corresponding internal controls that
mitigate those risks by conducting ESG fraud risk
assessments. ESG fraud risk assessments can be
conducted as stand-alone exercises or combined
with broader fraud risk assessments. Either way,
the assessments should consider both financial
and nonfinancial ESG fraud risks throughout the
entire supply chain.
Organizations should periodically evaluate ESG fraud risks and corresponding internal controls that mitigate those
risks by conducting ESG fraud risk assessments.
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FRAUD-ABUSE SPECTRUM
When discussing fraud and fraud risk related to
ESG activities, it is important to convey there is
a spectrum of wrongful or potentially fraudulent
behavior that may occur that threatens the integrity
of an organization’s financials, operations, and
reputation. The term fraud denotes a criminal act
to be proven in a court of law. For the purposes of
this guide, we use the term fraud risk to mean the
possibility that fraudulent activity could occur.
For example, inadvertent mismanagement and
negligence when vetting third-party vendors
or suppliers may lack malicious intent but still
negatively impact the organization’s ESG goals.
Especially in situations where the pressure to
deliver is high, executives may be tempted to avoid
asking too many questions about their supply
chain or adding rigor to their ESG metric reporting
process. This intentional avoidance—or willful
blindness—can have disastrous impact.
Perhaps less egregious, organizations might
engage in misleading behavior by putting
a positive spin on otherwise questionable
information. Organizations might be accused of
greenwashing—the marketing of environmentally
sustainable activity intended to attract ESG-
conscious investors and consumers with material
omissions or misrepresentation—by making their
environmental claims sound more beneficial than
they really are.
Likewise, when it comes to social initiatives, many
groups have been accused of virtue signaling—a
pejorative term for expressing a moral viewpoint
with the intent of communicating good character
by jumping on a social bandwagon, just for the
purposes of inflating their reputation even if their
position is disingenuous.
Abusive activities like these do not necessarily
rise to the level of fraud. Especially in times of
lacking or conflicting regulatory guidance, it is
important to understand that such activities fall
along a spectrum of behavior. As with any fraud
investigation, anti-fraud practitioners need to
be mindful of whether these misstatements or
omissions are material and if they were made with
intent.
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ENVIRONMENTAL
With the global spotlight on environmental impacts,
companies have more incentive than ever to
appear environmentally conscious. Environmental
risks, such as increased frequency and impact
of natural disasters, have a strong connection to
economic and financial instability. Environmental
risks can lead to operational and financial loss,
such as disruptions to production and changes in
asset value.
Over the last decade, environmental decline has
been a topic of major discussion from classrooms
to boardrooms to Congress and the United
Nations. In March 2022, the Commissioner of
the U.S. SEC issued a proposal to require public
companies to report climate risks and greenhouse
gas emissions.14 Consequently, organizations and
anti-fraud professionals alike must be aware of how
environmental fraud might occur.
The following are some example schemes of how
environmental-related fraud might occur:
• Harvest mixing: Mixing of valid and illicit goods
while declaring all goods are valid to generate
additional profit and nondisclosure gain
• Environmental standards manipulation: Falsifying or rigging environmental tests (e.g.,
emissions software) to falsely claim adherence to
standards
• Inflated carbon credit value: Inflating the value
of a carbon credit, contradicting a fair market
value analysis15
• Jurisdictional bribery: Bribing jurisdictional
authorities for a license or clearance to harvest
or transport protected wildlife and flora
ENVIRONMENTAL HARVEST MIXING AND THE FRAUD TRIANGLE
Opportunity: Regulators have difficulty monitoring the fishing behavior of a large and diverse set of actors spread across the globe, which makes it difficult to determine valid goods versus counterfeit goods.
Pressure: Stakeholders have expectations for the fishing companies to meet the seafood demand of consumers (markets, restaurant industry, etc.), creating increased pressure.
Rationalization: Companies may rationalize their behavior by observing their market—“All my competitors are doing it.”
14 www.sec.gov/news/statement/lee-climate-disclosure-20220321 15 www.ec.europa.eu/clima/eu-action/eu-emissions-trading-system-eu-ets_en. The EU developed a cap-and-trade system for the fair value of emission allowances (credits) in an effort to decrease total emissions.
19MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | DEFINING ESG FRAUD RISK
SOCIAL
Consumers, investors, and potential employees
are all looking at social factors. Thus, businesses
face increasing pressure to demonstrate socially
minded decision-making across the spectrum of
their operations. For example, human trafficking
and modern-day slavery have been a focal point in
the review and adoption of policies that promote
due diligence in sourcing. Likewise, companies are
increasingly expected to establish diversity, equity,
and inclusion (DE&I) initiatives to show they are
committed to a diverse and inclusive workplace.
With regard to modern-day slavery, although
international reporting and due diligence standards
have been mostly voluntary, companies will likely
begin to bear the legal weight of their supply
chain relationships in the future. Recently, the EU
proposed legislation for a social taxonomy.16
As social consciousness expectations rise,
companies must ensure they consider the fraud
risks inherent in these initiatives. The following are
some example schemes of how social-related fraud
might occur:
• Labor condition concealment: An organization’s
officers collude with supply chain actors
to conceal and misrepresent unsafe and
noncompliant labor conditions.
• Falsified DE&I metrics: An organization
knowingly misrepresents data on DE&I initiatives.
• Nonconforming social services: A vendor
contracts to provide socially conscious services
to support social-wellness programs but is not
capable of performing such services.
• Forced savings and deposit programs: A
supplier withholds a portion of a worker’s salary
and deposits it into a savings account to which
the worker does not have access until their term
of work is complete, creating an element of
servitude over fear of losing the withheld assets.
SOCIAL LABOR CONDITION CONCEALMENT AND THE FRAUD TRIANGLE
Opportunity: Limited standards in foreign territory and citizenship states create the opportunity for companies to exploit workers in retail manufacturing companies.
Pressure: The competitive market increases pressure across industries. Lower overhead costs can warrant lower product prices while increasing the bottom line.
Rationalization: Companies may use the rationalization of providing employment opportunities, which decreases the unemployment rate.
16 www.simmons-simmons.com/en/publications/cl09csqlp16110a47u4pcg3zb/eu-esg-developing-the-social-taxonomy
MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | DEFINING ESG FRAUD RISKMANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | DEFINING ESG FRAUD RISK20
GOVERNANCE
Corporate governance is a top priority for
consumers and investors, as it sets the tone and
expectations for how a company interacts with
stakeholders. An ethical corporate governance
structure provides reassurance to consumers,
employees, and investors that the organization has
a strong culture that aligns with its core values.
The following are some example schemes of how
governance-related fraud might occur:
• Misrepresentation/underreporting of suspicious activity: A company willfully
disregards suspicious transactions passing
through operations with clear indications of illicit
activity; a company violates policy and banking
regulations for greater cash flow.
• Clearing and forwarding extortion: A clearing
agent demands payment from an organization
for additional bond on top of an existing contract
to expedite the import of goods.
• Violation of independence: Audit committee
members violate conflict of interest standards
when engaging in decision-making or do not vet
conflict of interest relationships before engaging
in decision-making.
• Capital expenditure misclassification: An
organization misclassifies capital expenditures
as ESG-related for the purposes of company
reputation, or to meet executive compensation
incentives.
• Illegal tax shelters and underreporting: An
investment management firm unlawfully hides
assets and income in overseas tax shelters and
sanctioned jurisdictions to generate a higher
return and embezzle funds without disclosing to
the organization that is investing.
GOVERNANCE MISREPRESENTATION/UNDERREPORTING OF SUSPICIOUS ACTIVITY AND THE FRAUD TRIANGLE
Opportunity: Money transfer companies might have a reckless disregard for illicit transactions at a heavily trafficked transfer location.
Pressure: A pressure exists at money transfer locations, specifically those that are heavily trafficked, to provide or receive timely support to individuals in need. Money transfers also have cash flow needs they have to maintain.
Rationalization: Money transfer companies might justify ignoring potentially suspicious transactions by rationalizing they are providing opportunities to individuals in other countries who may need the support.
21MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | DEFINING ESG FRAUD RISK
IMPACT
Discussions of fraud most often focus on the
financial losses that result. ESG fraud certainly
carries financial risks. But the impact of ESG fraud
also carries additional compliance, reputational,
and other risks. When creating a program to
monitor and manage ESG fraud risk, it is important
to consider all the risk factors.
With the enormous pressure brought on by ESG
programs, executives might be tempted to avoid
inspecting their supply chain and internal programs
for fear of finding something undesirable. Whether
this qualifies as willful blindness, sticking their head
in the sand, or turning a blind eye, the problem is
unlikely to resolve itself. Unfortunately, in cases
where a reasonable person should have known
about these factors, the consequences can be
magnified.
FINANCIAL RISKS
ESG frauds may result in typical financial losses.
If, for example, a carbon-offset provider charges
for services not rendered, those dollars would be
considered a fraud loss. In an internal scheme, if an
intentional material misstatement is made during
ESG reporting and subsequently discovered, the
financial impacts to the organization could be
enormous.
As noted in the following discussions, there are
additional risk factors to consider. These risk
factors may combine to create a vicious cycle that
causes the financial loss to multiply.
REPUTATIONAL RISKS
Perhaps a larger risk for many organizations is
reputational risk. If a company is thought to have
intentionally misled or “looked the other way,” it
can suffer significant reputational consequences.
Investors lose confidence and call into question
the accuracy of all company reporting. Customers
boycott the brand. High-performing employees
abandon the company for an employer that
better aligns with their values. These reputational
consequences will soon translate into negative
financial impacts.
MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | MIT IGATING ESG FRAUD RISK22 MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | DEFINING ESG FRAUD RISK
COMPLIANCE RISKS
While regulatory frameworks relating to ESG are
still being formed, several types of ESG fraud
schemes covered in the ESG fraud taxonomy carry
their own compliance risks. For example, some
fraud schemes may involve bribery or extortion, the
discovery of which can expose the organization to
anti-bribery and anti-corruption (ABAC) compliance
violations. Such violations carry financial penalties
and may invite additional regulatory action and
requirements for costly remediation programs.
These findings also carry a negative connotation,
further exacerbating the reputational costs.
The combined effect of these risks shows that
it pays to be proactive. Organizations that
preemptively identify ESG fraud risk issues,
establish appropriate controls, and take swift
remedial action when necessary will fare much
better than those who take a more reactive stance.
Organizations that preemptively identify ESG fraud risk issues, establish appropriate controls, and take swift remedial action when necessary will fare much better than those
that take a more reactive stance.
23MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | MIT IGATING ESG FRAUD RISK
MIT IGAT ING ESG FRAUD RISK
MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | MIT IGATING ESG FRAUD RISKMANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | MIT IGATING ESG FRAUD RISK24
As stakeholders demand increased ESG
accountability, they must develop tailored
ESG frameworks with fraud risk management
components that withstand scrutiny. Incorporating
proper checks and balances to mitigate the risk of
ESG fraud and misconduct is vital.
Despite the lure of misstating ESG reporting, fraud
is not inevitable. The key is to install and maintain
guardrails; ask hard questions; and consistently
enhance reporting, controls, and approaches to
integrate ESG reporting into other reporting that
undergoes scrutiny. To do this, companies must
conduct ESG program activities and reporting with
oversight and accountability; ESG reporting should
adhere to the same rigor applied to financial
reporting.
Rigorous ESG guidance should consider policies,
procedures, data governance, and reporting
controls. Additionally, an ESG framework should
address the traditional management assertions of
accuracy, completeness, rights and obligations,
existence, and comparability, which are reflective
of the principles that auditors rely upon for the
assessment of financial audits.
• Accuracy: ESG reporting disclosures should have
the same rigor as financial statement reporting.
The data must be authentic and free from
misrepresentation.
• Completeness: Organizations should disclose
the full picture with thorough information
regardless of the weight. This includes reporting
all ESG information and disclosures.
• Rights and obligations: Organizations should
only disclose information that legally belongs
to the organization and is permitted for use.
This information includes obligations that
organizations will have to settle in the future.
• Existence and occurrence: Organizations should
only report ESG matters that have occurred
during the period(s) or that relate to conditions
that exist at the time of reporting.
• Comparability: Organizations should seek a
standardized reporting framework appropriate
for their industry to allow for comparability from
one reporting period to the next and across
organizations within their industry.
INCREASING ACCOUNTABIL ITY
Despite the power and lure of misstating ESG reporting, fraud is not inevitable. The key is to install and maintain
guardrails; ask hard questions; and consistently enhance reporting, controls, and approaches to integrate ESG
reporting into other reporting that undergoes scrutiny.
25MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | MIT IGATING ESG FRAUD RISK
MATERIAL ITY CONSIDERAT IONS
Materiality is a key part of protecting organizations
from ESG fraud risks. Something is considered
material if it would affect the judgment of
an informed stakeholder. For example, if an
organization’s executives know that one of their
most important products has a design flaw, that
knowledge is material information the executives
must disclose accurately, completely, and without
delay. The question of what constitutes material
information when it comes to ESG is still largely
unanswered; however, organizations can rely on
this question: Would this affect a stakeholder’s decision-making?
In the ESG and sustainability context, materiality
is separate and distinct from the understanding
of materiality under state and federal securities
laws and under Generally Accepted Accounting
Principles (GAAP). Items thought to be material
in ESG programs are not necessarily material for
securities law and GAAP purposes. Nonetheless,
in the absence of standardized frameworks and
definitions for ESG reporting, organizations should
apply a consistent process for deciding what is
material and what is not. When setting up an ESG
framework, considering the following types of
questions could prove beneficial in determining
materiality:
• Are my company’s ESG disclosures subject to the
same rigor as our financial disclosures?
• What are our management assertions about
ESG, and are controls in place to make faithful
assertions?
• Have we considered the risks posed by our
suppliers and vendors?
• Have we conducted adequate due diligence with
our suppliers and vendors to confirm that their
practices align with our ESG objectives?
• What is the plan to disclose and correct any ESG
reporting problems?
While such questions provide a helpful starting
point, organizations should refine the process for
establishing materiality in the coming years as the
ESG landscape evolves.
MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | MIT IGATING ESG FRAUD RISKMANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | MIT IGATING ESG FRAUD RISK26
RECOMMENDATIONS FOR MITIGATING ESG FRAUD RISK
It can be difficult for companies to structure
an ESG anti-fraud program when they are just
starting out, especially with the ESG landscape
evolving so rapidly. While there may be
challenges, traditional fraud risk management
guidance can help. In collaboration with the
ACFE, Grant Thornton published the Anti- Fraud Playbook17 to provide organizations with
actionable guidance on how to develop and
mature a fraud risk management program in
alignment with the five key fraud risk management
principles outlined in the COSO/ACFE Fraud Risk
Management Guide. This methodology provides
a strong foundation upon which organizations can
build a holistic fraud risk management program.
While ESG introduces new fraud risks and may
require new controls and reporting mechanisms,
a strong ESG fraud risk management program
should still align to these core principles.
With this approach in mind, the following are
recommendations for organizations to consider
when building an ESG-informed fraud risk
management program, aligned to these five
principles.
17 www.grantthornton.com/services/advisory-services/risk-compliance-and-controls/ACFE-global-fraudcon-and-playbook.aspx
FIG. 4 COSO/ACFE FRAUD RISK MANAGEMENT PRINCIPLES
FRAUD RISK GOVERNANCE: The organization establishes and communicates a
Fraud Risk Management program.
FRAUD RISK ASSESSMENT: The organization performs comprehensive fraud risk
assessments.
FRAUD CONTROL ACTIVITY: The organization selects, develops, and deploys
preventive and detective fraud control activities.
FRAUD INVESTIGATION AND CORRECTIVE ACTION: The organization establishes
a communication process to obtain information about potential fraud and deploys
a coordinated approach to investigation and corrective action.
FRAUD RISK MANAGEMENT MONITORING ACTIVITIES: The organization selects,
develops, and performs ongoing evaluations.
27MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | MIT IGATING ESG FRAUD RISK
FIG. 5 ESG FRAUD RISK MANAGEMENT RECOMMENDATIONS
COSO/ACFE Fraud Risk Management Principle ESG Fraud Risk Management Recommendations
Fraud risk governance
• Define ESG materiality thresholds.
• Identify and apply relevant ESG frameworks (see Appendix).
• Establish the “tone at the top” by communicating the importance of an ESG-related control and reporting program.
• Incorporate ESG-related risks into the organization’s risk appetite.
• Prepare internal ESG-related policies and procedures to measure employee and vendor actions against objectives.
• Define roles and responsibilities related to ESG programs and disclosures.
• Advance a culture of integrity, reinforcing the importance of accuracy and transparency.
Fraud risk assessment
• Conduct recurring, targeted ESG-focused fraud risk assessments or incorporate ESG components into the current fraud risk assessment methodology. This should include an ESG-focused supply chain risk assessment.
• Solicit feedback from key stakeholders using questionnaires and interviews.
• Leverage existing guidance including the ESG fraud taxonomy.
• Conduct interactive workshops with key stakeholders to review controls and specific areas of opportunity for risk mitigation.
• Tailor the ESG fraud taxonomy for organization-specific risks.
Fraud control activity
• Establish or ensure a strong supply chain control environment.
• Establish or ensure strong ESG disclosure reporting controls.
• Conduct supply chain mapping and integrate into third-party risk management programs.
• Leverage analytics and automation to enhance control systems for evolving ESG fraud risks.
Fraud investigation and corrective action
• Confirm whistleblower reporting and investigation capabilities are in place for ESG-related fraud schemes.
• Provide ESG-related anti-fraud training.
• Revisit anti-bribery and anti-corruption programs to ensure coverage of ESG-related fraud risks.
• Establish partnerships with collaborative organizations to support ESG- related fraud investigations.
Fraud risk management monitoring activities
• Establish Key Performance Indicators (KPIs) and Key Risk Indicators (KRIs) for the ESG fraud risk program.
• Build management reporting around ESG fraud risks.
• Establish ESG fraud risk board/commission-level reporting.
• Build advanced/predictive analytics to monitor the program.
MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | AbOUT ThE ACFEMANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | CONCLUSION28
For corporations, ESG factors have quickly become
as important as financial metrics. With this rapid
rise to prominence comes increased pressure and
wide opportunity for exploitation. Organizations
need to take stock of their ESG programs, update
their reporting standards, enhance their controls,
and establish capabilities to mitigate ESG-related
fraud risk.
The COSO/ACFE Fraud Risk Management Guide
provides a useful framework to ensure a holistic
approach to addressing these risks. Begin by
setting the right tone for your ESG anti-fraud
program by assessing new internal and external
risks. Use the findings from that assessment to
drive your prioritization of enhanced controls and
investigations procedures. And finally, establish
the right reporting metrics to monitor your program
over time.
Organizations that quickly adopt these
recommendations will be ahead of their peers,
resulting in an important advantage. As new risks
appear, they will be better prepared to address
these challenges.
Environmental, social, and governance fraud
issues will be faced by most organizations. While
these risks may be inevitable, fraud losses and
reputational damage are not. Anti-fraud and risk
management practitioners can help protect against
these new vulnerabilities, and they can establish a
strong foundation for navigating the complex ESG
environment for years to come.
CONCLUSION
29MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | AbOUT ThE ACFE
Founded in 1988 by Dr. Joseph T. Wells, CFE,
CPA, the ACFE is the world’s largest anti-fraud
organization and premier provider of anti-fraud
training and education. Together with more than
90,000 members in more than 180 countries, the
ACFE is reducing business fraud worldwide and
providing the training and resources needed to
fight fraud more effectively.
The positive effects of anti-fraud training are far-
reaching. Clearly, the best way to combat fraud is
to educate anyone engaged in fighting fraud on
how to effectively prevent, detect, and investigate
it. By educating, uniting, and supporting the global
anti-fraud community with the tools to fight fraud
more effectively, the ACFE is reducing business
fraud worldwide and inspiring public confidence in
the integrity and objectivity of the profession.
The ACFE offers its members the opportunity
for professional certification. The Certified
Fraud Examiner (CFE) credential is preferred by
businesses and government entities around the
world and indicates expertise in fraud prevention
and detection. CFEs are anti-fraud experts who
have demonstrated knowledge in four critical
areas: financial transactions and fraud schemes,
law, investigation, and fraud prevention and
deterrence.
Members of the ACFE include accountants, internal
auditors, fraud investigators, law enforcement
officers, lawyers, business leaders, risk/compliance
professionals, and educators, all of whom have
access to expert training, educational tools,
and resources. Whether their career is focused
exclusively on preventing and detecting fraudulent
activities or they just want to learn more about
fraud, the ACFE provides the essential tools and
resources necessary for anti-fraud professionals to
accomplish their objectives.
ABOUT THE ACFE
MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | APPENDIx30 MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | AbOUT GRANT ThORNTON
ABOUT GRANT THORNTON
Grant Thornton LLP (Grant Thornton) is the U.S.
member firm of Grant Thornton International
Ltd, one of the world’s leading organizations of
independent audit, tax, and advisory firms. Grant
Thornton, which operates more than 50 offices in
the United States and operates in more than 135
countries, works with a broad range of dynamic
publicly and privately held companies, government
agencies, and organizations.
Grant Thornton is a leader in fraud risk
management. Our fraud risk professionals are
progressive thinkers with a wealth of experience
developing robust anti-fraud programs across a
wide range of industries and across organizations
of varying missions and sizes. Our proven
fraud risk management solutions are based on
proprietary methodologies. We have developed
industry-leading benchmarking tools, maturity
models, and customizable, scalable fraud risk
assessment methodologies to address the evolving
risk landscape. Further, Grant Thornton was
instrumental in the development of the fraud risk
frameworks used both in government and in the
private sector. This insight into leading guidance
combined with our deep pool of expertise provide
insights that we bring to our clients to help them
combat fraud and focus mitigation efforts where
it matters most. With the scale to meet evolving
needs, Grant Thornton specializes in personalizing
solutions to help address today’s problems and
anticipate tomorrow’s challenges.
31MANAGING FRAUD RISKS IN AN EVOLVING ESG ENVIRONMENT | APPENDIx
ORGANIZATION URL
American Institute of Certified Public Accountants (AICPA) www.aicpa.org
CDP Worldwide www.cdp.net
European Commission (EC) www.ec.europa.eu
Financial Accounting Standards Board (FASB) www.fasb.org
Global Reporting Initiative (GRI) www.globalreporting.org
International Auditing and Assurance Standards Board (IAASB) www.iaasb.org
International Sustainability Standards Board (ISSB) www.ifrs.org/groups/international-
sustainability-standards-board
International Financial Reporting Standards (IFRS) Foundation www.ifrs.org
Value Reporting Foundation (VRF) www.valuereportingfoundation.org
Sustainability Accounting Standards Board (SASB) www.sasb.org
International Integrated Reporting Council (IIRC) www.integratedreporting.org
U.S. Securities and Exchange Commission (SEC) www.sec.gov
APPENDIX: EXAMPLES OF ESG GUIDANCE AND FRAMEWORKS
A variety of organizations have issued guidance or are developing frameworks for ESG programs and
disclosures. These frameworks and guidance are intended to promote continuity by advocating for
consistent, transparent, repeatable, and accurate ESG reporting.
Listed below are examples of organizations that have issued relevant guidance or published ESG reporting
guidelines as of the time of publication of this guide. This list is not intended to be comprehensive, and
changes are anticipated as the ESG landscape evolves. Check with these organizations directly to obtain
their most up-to-date guidance.
©️ 2022 Association of Certified Fraud Examiners, Inc. All rights reserved. “ACFE,” “CFE,” “Certified
Fraud Examiner,” “Association of Certified Fraud Examiners,” the ACFE seal, the ACFE logo and related
trademarks, names and logos are the property of the Association of Certified Fraud Examiners, Inc., and
are registered and/or used in the U.S. and countries around the world.
“Grant Thornton” refers to Grant Thornton LLP, the U.S. member firm of Grant Thornton International Ltd
(GTIL), and/or refers to the brand under which the independent network of GTIL member firms provide
services to their clients, as the context requires. GTIL and each of its member firms are not a worldwide
partnership and are not liable for one another’s acts or omissions. GTIL and each member firm of GTIL is a
separate legal entity. In the United States, visit Grant Thornton LLP at www.grantthornton.com.
Managing Fraud Risks in an Evolving ESG Environment
ENVIRONMENTAL | SOCIAL | GOVERNANCE
- Cover
- Table of Contents
- Foreword
- Introduction to ESG
- ESG Background
- Introduction to ESG Fraud
- The Fraud Triangle and ESG
- Defining ESG Fraud Risk
- ESG Fraud Taxonomy
- Environmental
- Social
- Governance
- Impact
- Mitigating ESG Fraud Risk
- Increasing Accountability
- Materiality Considerations
- Recommendations for Mitigating ESG Fraud Risk
- Conclusion
- About the ACFE
- About Grant Thornton
- Appendix
Educational Paper Purpose
1. Environmental, social, and governance (ESG) reporting is an area of growing focus for a wide range of interested parties including investors, credit rating agencies, lenders, preparers, regulators, and policy makers. ESG reporting includes a broad spectrum of quantitative and qualitative information. Interested parties seek to understand the effects of relevant ESG matters on an entity’s business strategy, cash flows, financial position, and financial performance. In other cases, parties seek that information from a public policy perspective or to influence corporate behavior.
2. Investors and other interested parties have raised questions about the intersection of ESG matters with financial accounting standards that are issued by the Financial Accounting Standards Board (FASB). While ESG matters cover a broad range of topics well beyond the topics covered by financial accounting standards, the FASB staff observes that many current accounting standards require an entity to consider changes in its business and operating environment when those changes have a material direct or indirect effect on the financial statements and notes thereto. That is often the case in areas of accounting that require management judgment and estimation.
3. The FASB staff developed this educational paper to provide investors and other interested parties with an overview of the intersection of ESG matters with financial accounting standards. This paper also provides examples of how an entity may consider the effects of material ESG matters when applying current accounting standards, similar to how an entity considers other changes in its business and operating environment that have a material direct or indirect effect on the financial statements. To better understand this topic, the FASB staff believes that it is important to understand the FASB’s role as the designated independent financial accounting standard setter for public companies, private companies, and not-for-profit entities. Therefore, this educational paper also discusses this topic.
4. This educational paper is organized as follows: (a) Overview of ESG Reporting (b) The FASB’s Role in Setting Financial Accounting Standards (c) Intersection of ESG Matters with Financial Accounting Standards.
5. This educational paper does not change or modify current generally accepted accounting principles
(GAAP) and is not intended to be a comprehensive assessment of the intersection of ESG matters with financial accounting standards. In addition, the examples included in this paper are illustrative and are not intended to convey additional requirements beyond those in current GAAP. Entities should refer to current GAAP and consider entity-specific facts and circumstances when preparing financial statements.
6. The views expressed in this educational paper are those of the FASB staff. Official positions of the FASB are reached only after extensive due process and deliberations.
FASB Staff Educational Paper
Intersection of Environmental, Social, and Governance Matters with Financial Accounting Standards
March 19, 2021
Intersection of ESG Matters with Financial Accounting Standards
2
Overview of ESG Reporting
7. ESG matters cover a broad range of topics well beyond the topics covered by financial accounting standards. There are several organizations that have established frameworks that an entity may leverage for voluntary or other reporting purposes. There are also several industry-based organizations that have established industry-specific recommendations for such reporting.
8. The following table includes examples of broad topics that interested parties commonly consider as ESG matters (not intended to be all-inclusive):1
Environmental
• Climate change
• Ecological impacts, such as pollution, deforestation, and loss of biodiversity
• Energy management, such as energy-efficient buildings and production processes
• Greenhouse gas emissions
• Litigation risk, for example, related to environmental contamination
• Policies and regulations
• Raw material sourcing
• Renewable energy
• Sustainable products and packaging
• Water and waste management
Social Governance
• Community relations
• Diversity, equity, and inclusion
• Employee health and safety
• Human capital development
• Labor management
• Privacy and data security
• Product quality and safety
• Supply-chain standards
• Antibribery and anticorruption
• Business ethics
• Corporate resiliency
• Diversity of leadership
• Executive compensation
• Lobbying and political contributions
• Ownership structure
• Tax transparency
The FASB’s Role in Setting Financial Accounting Standards
9. The U.S. Securities and Exchange Commission (SEC or Commission) has broad authority over
financial accounting principles and financial reporting for public companies2 and recognizes the FASB as the designated independent financial accounting standard setter for public companies. FASB standards are also recognized as the authoritative source of GAAP for private companies and not-for- profit entities by many organizations such as state Boards of Accountancy and the American Institute of Certified Public Accountants. While the FASB does not establish standards for ESG reporting, the application of many current accounting standards requires an entity to consider changes in its business and operating environment when those changes have a material direct or indirect effect on the financial statements and notes thereto.
10. As noted above, financial reporting requirements for public companies are established by the SEC. Those requirements include the financial statements prepared in accordance with GAAP as established by the FASB. Additionally, the SEC rules include disclosure requirements for information to be included in periodic filings, but outside the financial statements. This includes, for example, Management Discussion and Analysis and Risk Factors. SEC disclosure requirements for information that may need
1The categorization of topics as environmental, social, or governance is a matter of judgment and is presented solely to provide context
for the discussion in this paper. 2The U.S. Securities and Exchange Commission’s (SEC or Commission) broad authority over financial accounting principles and
financial reporting for public companies is derived from federal securities laws such as the Securities Act of 1933 and the Securities
Exchange Act of 1934.
Intersection of ESG Matters with Financial Accounting Standards
3
to be included outside the financial statements include Commission guidance on disclosures related to climate change.3
11. The FASB’s mission is “to establish and improve financial accounting and reporting standards to
provide useful information to investors and other users of financial reports and educate stakeholders on how to most effectively understand and implement those standards.” The FASB accomplishes its mission through a standard-setting process that is transparent and inclusive. The FASB’s Conceptual Framework4 states that “general purpose financial reports are not designed to show the value of a reporting entity; but they provide information to help existing and potential investors, lenders, and other creditors to estimate the value of the reporting entity.” General purpose financial reporting provides information about current conditions and trends that help investors in predicting a reporting entity’s future cash flows and results of operation. Financial accounting standards are not intended to drive behavior in any way, including benefitting one industry or business model over another or spurring businesses to take certain actions. Instead, financial accounting standards are intended to provide investors and related users with decision-useful, neutral information that faithfully represents an entity’s economic activity as a basis for investment and other capital allocation decisions.
12. General purpose financial reporting does not and cannot meet all the needs of existing and potential investors and related users. Users routinely consider information outside of general purpose financial reporting (for example, nonfinancial measures, qualitative evaluations of trends, earnings calls, press releases, and voluntary ESG reporting) as well as their own perspectives, which may include weighing factors that directly bear on their own personal values to make capital allocation and other decisions.
Intersection of ESG Matters with Financial Accounting Standards 13. When applying financial accounting standards, an entity may consider the effects of certain material
ESG matters, similar to how an entity considers other changes in its business and operating environment that have a material direct or indirect effect on the financial statements and notes thereto. Some industries may be more affected than others (for example, some industries may be more affected by certain environmental matters, such as changes in environmental regulations). The way in which an entity may consider the effects of ESG matters varies based on the accounting standard being applied and the nature and significance of the ESG matter. Some ESG matters may directly affect amounts reported and disclosed in the financial statements, for example, through the recognition and measurement of compensation expense. Other ESG matters may indirectly affect the financial statements; for example, an entity may suffer reputational damage from an environmental contamination that reduces sales. Other ESG matters may not have any material effect on the financial statements. In addition, an entity may consider certain ESG matters as an input to an accounting analysis; for example, a material decline in demand during the reporting period may be a consideration when estimating future cash flows used in a long-lived asset or goodwill impairment analysis. Lastly, risks and opportunities related to ESG matters may have an unfavorable, favorable, or neutral effect on financial statements.
14. The remainder of this educational paper provides examples of how an entity may consider the direct or indirect effects of material environmental matters when applying current GAAP. The examples below are intended to be illustrative and are not intended to convey additional requirements beyond those in current GAAP. While the examples focus on the intersection of environmental matters with financial accounting standards, the FASB staff observes that the effects of such matters on financial statements, if material, are considered in a similar manner as other changes in an entity’s business and operating environment (such as shifting consumer preferences and technological or regulatory changes). That is, how or when an entity considers the effects of environmental matters on financial statements is a facts- and-circumstances evaluation that, among other things, considers their significance. Lastly, the discussion below represents a summary of the respective accounting standards and is not intended to
3Commission Guidance Regarding Disclosure Related to Climate Change, Release No. 33-9106 (February 2, 2010) [75 FR 6290
(February 8, 2010)] 4FASB Concepts Statement No. 8, Conceptual Framework for Financial Reporting—Chapter 1, The Objective of General Purpose
Financial Reporting, paragraph OB7
Intersection of ESG Matters with Financial Accounting Standards
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be comprehensive. Entities should refer to current GAAP and consider entity-specific facts and circumstances when preparing financial statements.
GAAP Intersection of Environmental Matters with Financial Accounting Standards
Subtopic 205-40, Presentation of Financial Statements— Going Concern
The guidance requires management to evaluate, at each annual and interim reporting period, whether there is substantial doubt about an entity’s ability to continue as a going concern within one year after the date that the financial statements are issued.5 In performing that evaluation, management is required to consider all information that is known and reasonably knowable at the date that financial statements are issued. In its going concern evaluation, management may consider the effects of
environmental matters (for example, increased compliance costs related to
enacted emissions regulations), as well as other relevant factors that may be
material to an entity’s ability to meet its obligations as they become due within
one year after the date that the financial statements are issued. If substantial
doubt about the ability to continue as a going concern exists, management is
required to consider whether its plans alleviate that doubt. Management is
required to make certain disclosures if it concludes that substantial doubt exists
or that its plans alleviate substantial doubt that was raised. Such disclosures
should include information about those matters that were significant to the
going concern evaluation.
Topic 275, Risks and Uncertainties
The guidance requires an entity to provide qualitative disclosures about certain risks and uncertainties that could significantly affect the amounts reported in the financial statements in the near term.6 Disclosure requirements include information about the nature of an entity’s operations and current vulnerability arising from certain concentrations.7 An entity may determine that the effects of environmental matters are material to the entity in the near term and provide certain disclosures under that guidance. The guidance also requires disclosure of significant estimates that may be particularly sensitive to change. Disclosures are required if it is reasonably possible that assumptions that an entity makes about the future will result in a material change to the carrying amount of assets and liabilities in the near term. The entity may disclose, among other items, the nature of the uncertainty and an indication that it is at least reasonably possible that the estimate will change in the near term. The guidance encourages (does not require) disclosure of the factors that cause the estimate to be sensitive to change, as well as any risk- reduction techniques (for example, obtaining insurance) used by an entity. The FASB staff notes that disclosure requirements in Topic 275 may be similar to disclosures required under other Topics such as Topic 280, Segments, Topic 410, Asset Retirement and Environmental Obligations, and Topic 450, Contingencies.
Topic 330, Inventory
The guidance requires an entity to initially value its inventory at the cost to bring the inventory to its current condition and location. Such costs are generally determined using an acceptable cost-flow method such as first in, first out
5Substantial doubt about an entity’s ability to continue as a going concern exists when conditions and events, considered in the
aggregate, indicate that it is probable that the entity will be unable to meet its obligations as they become due within one year after
the date that the financial statements are issued (or within one year after the date that the financial statements are available to be
issued when applicable). The term probable is used consistently with its use in Topic 450, Contingencies. 6Near term is defined as a period of time not to exceed one year from the date of the financial statements in accordance with the Master Glossary of the FASB Accounting Standards Codification®. 7An entity should evaluate the criteria in paragraphs 275-10-50-8 and 275-10-50-16 to determine if disclosures related to certain
significant estimates and current vulnerability arising from certain concentrations are required.
Intersection of ESG Matters with Financial Accounting Standards
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GAAP Intersection of Environmental Matters with Financial Accounting Standards
(FIFO) or last in, first out (LIFO). Inventory measured using any method other than LIFO or the retail inventory method (RIM) is subsequently valued at the lower of cost and net realizable value (that is, the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation). Inventory measured using LIFO or RIM is subsequently valued at the lower of cost or market.8 When estimating net realizable value, management is required to consider all relevant facts and circumstances. Estimates of net realizable value could be materially affected by, for example, a regulatory change that renders inventories obsolete, a significant weather event that causes physical damage to inventories, a decrease in demand for an entity’s goods resulting from changes in consumer behavior or an increase in completion costs because of raw material sourcing constraints.
Subtopic 350-20, Intangibles— Goodwill and Other—Goodwill9 Subtopic 350-30, Intangibles— Goodwill and Other—General Intangibles Other Than Goodwill
Impairment of Goodwill and Indefinite-Lived Intangible Assets
The guidance states that goodwill and indefinite-lived intangible assets (for example, trade names) are not amortized10 but are instead tested for impairment at least annually or more frequently if impairment indicators exist.11 For goodwill, an impairment exists when the carrying amount of a reporting unit exceeds its fair value.12 For indefinite-lived intangible assets, a decrease in an asset’s fair value below its carrying amount results in an impairment charge. The direct or indirect effects of an environmental matter could give rise to an impairment indicator; for example, changes in hazardous waste management regulations that adversely affect an entity’s operations may be an impairment indicator. Environmental matters also may affect the measurement of an impairment loss when, for example, the matter materially affects the market participant assumptions used to calculate the fair value of the reporting unit (goodwill) or the fair value of the indefinite-lived intangible asset. An entity is required to disclose, among other items, the facts and circumstances that led to the recognition of an impairment loss and the method for determining fair value.
Finite-Lived Intangible Assets
The guidance requires an entity to amortize a finite-lived intangible asset (for example, client relationships or developed technologies) over its useful life, which is the period in which the intangible asset is expected to contribute directly or indirectly to cash flows of an entity. An entity is required to evaluate the remaining useful life at each reporting period and reflect any changes to the estimate in the financial statements prospectively. The effect of an environmental matter may be one of many factors that affect the estimated useful life of an intangible asset. For example, an entity may develop a more energy-efficient product to substitute a legacy product,
8Topic 330 defines the term market as the current replacement cost, subject to a ceiling (market shall not exceed net realizable value) and floor (market shall not be less than net realizable value reduced by an allowance for an approximately normal profit margin). 9The FASB currently has a project on its technical agenda related to the subsequent accounting for goodwill and identifiable intangible
assets and a project to address performing an interim triggering event evaluation for certain private companies and not-for-profit
entities. 10See paragraphs 350-20-35-62 through 35-63 for guidance on an accounting alternative for the subsequent measurement of goodwill
for certain private companies and not-for-profit entities. 11See paragraphs 350-20-35-3 and 350-30-35-18A for guidance that allows an entity to first perform a qualitative impairment
assessment to determine whether it is necessary to perform an annual quantitative test. 12Accounting Standards Update No. 2017-04, Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill
Impairment, eliminates the requirement to calculate the implied fair value of goodwill to measure an impairment charge.
Intersection of ESG Matters with Financial Accounting Standards
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GAAP Intersection of Environmental Matters with Financial Accounting Standards
resulting in a change in the estimated useful life of the client relationship intangible asset associated with the legacy product. Alternatively, an entity may acquire the rights to certain green technology that did not perform commercially as expected and, thus, would be subject to an impairment charge. A finite-lived intangible asset is evaluated for impairment in accordance with Topic 360.
Topic 360, Property, Plant, and Equipment
The guidance requires an entity to account for long-lived assets such as buildings, machinery, equipment, furniture, and fixtures, at their historical cost. An entity subsequently depreciates the cost of the asset, less any estimated salvage value, over the expected useful life of the asset. The availability of more energy-efficient equipment in the marketplace may result in a decrease in the estimated salvage value of less energy-efficient equipment and/or a decrease in its estimated useful life. The guidance also requires an entity to test a long-lived asset (or asset group) that is held and used for recoverability whenever an impairment indicator exists. Environmental matters could give rise to impairment indicators; for example, a material decline in market demand for products or a change in regulation that adversely affects an entity could indicate that a manufacturing plant may be impaired. When impairment indicators are present, an entity is required to evaluate whether the long-lived asset is recoverable (that is, if the undiscounted cash flow projections directly associated with the asset exceed the carrying amount of that asset).
Subtopic 410-20, Asset Retirement and Environmental Obligations— Asset Retirement Obligations Subtopic 410-30, Asset Retirement and Environmental Obligations— Environmental Obligations Subtopic 450-20, Contingencies— Loss Contingencies Subtopic 450-30, Contingencies— Gain Contingencies
Loss Contingencies and Related Topics
Loss Contingencies
Subtopic 450-20 provides a framework for determining when an accrual is required for a loss contingency13 (if the loss is probable and reasonably estimable). Examples of loss contingencies include liabilities for injury or damage caused by products sold and obligations related to product warranties. The guidance also states that general or unspecified business risks do not meet the conditions for accrual and that an entity is prohibited from accruing a loss contingency for those risks.
Environmental Obligations
The guidance requires an entity to consider relevant regulatory, legal, and contractual requirements when accounting for environmental obligations, for example, regulatory requirements to remediate land contamination or fines imposed by the government for failure to meet emissions targets. Entities are required to disclose the nature of the contingency and, in some cases, an indication that it is reasonably possible that the amount accrued could change in the near term. For unrecognized loss contingencies, entities are required to disclose an estimate of the possible loss or range of losses or a statement that such an estimate cannot be made. Asset Retirement Obligations
The guidance applies to contractual and other legal obligations associated with the retirement of long-lived assets that result from acquisition, construction,
13A contingency is defined in the Codification’s Master Glossary as “an existing condition, situation or set of circumstances involving
uncertainty as to possible gain…or loss…to an entity that will ultimately be resolved when one or more future events occur or fail to
occur.” Not all uncertainties inherent in accounting give rise to contingencies. The FASB staff observes that management judgment is
required to evaluate whether a condition, situation, or set of circumstances meets the definition of a contingency. Topic 450,
Contingencies, also includes specific transactional scope exclusions, for example, uncertainty in income taxes and accounting and
reporting by insurance entities.
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GAAP Intersection of Environmental Matters with Financial Accounting Standards
development, and/or normal operation of a long-lived asset. An asset retirement obligation (ARO) is a liability initially measured at fair value. An entity capitalizes the cost as part of the cost basis of the related long-lived asset and depreciates the asset over its useful life. Environmental matters may affect the recognition, measurement, and disclosure of an ARO in the financial statements, for example, those related to (a) a legal obligation to remove a toxic waste storage facility at the end of its useful life or (b) a regulatory requirement to decommission a nuclear power plant or an offshore drilling platform.
Gain Contingencies
Environmental matters may give rise to both risks and opportunities for an entity and, therefore, could result in decreases or increases to earnings and cash flows. Subtopic 450-30 states that gain contingencies usually should not be recognized in the financial statements until all contingencies are resolved and the amount is realized or realizable. For example, a gain contingency may result from a potential insurance recovery (that exceeds a recognized loss) related to damage sustained to a manufacturing facility during a significant weather event.
Topic 740, Income Taxes
Entities are required to recognize deferred tax assets for deductible temporary differences, operating loss carryforwards, and tax credit carryforwards to the extent that there is sufficient future taxable income to realize the tax benefit. A valuation allowance is recognized if, based on positive and negative evidence, it is more likely than not that some portion or all the deferred tax asset will not be realized. Environmental regulations could affect estimates of future taxable income. For example, estimates of future taxable income may be affected by projected increases in costs to comply with enacted environmental regulations.
Topic 820, Fair Value Measurement
Fair value measurements are used broadly in GAAP, for example, when accounting for assets acquired and liabilities assumed in a business combination, accounting for many financial instruments, measuring impairment of long-lived assets, goodwill, and other intangible assets, and performing a lease classification test. Fair value is a market-based measurement of the price to sell an asset or transfer a liability in an orderly transaction between market participants. Market participants’ assumptions related to, for example, potential legislation, or an asset’s highest and best use, may affect fair value measurements.
Various Industry Guidance in the 900 Topics
The effects of environmental matters, if material, may be an input to many
accounting measurements under various industry guidance.
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