Jan Bouwens (Professor of Accounting University of Amsterdam & Research fellow University of Cambridge)
Auditors issue a going concern opinion that typically does not extend beyond one year in advance. The idea of that opinion is to draw attention to pressing issues the management of the firm has to deal with and stakeholders have to bear in mind when dealing with the firm. An important question is whether the existing going concern statement is sufficient since companies must set climate objectives which effects by definition surface far out in the future but at the same time pertains to the very existence of the firm. Given that the companies’ existence is at stake, one should ask the question whether the going concern opinion should take issue with the attainability of long term objectives.
Each firm must set environmental objectives
With Morgan Stanley’s decision to embrace green goals, no one can argue that going green is being rejected by investors. With other financials Morgan Stanley has recognized that, controlling for all other risks, a portfolio of green-minded companies produces a better return than a portfolio that denies green. That is, in terms of cost of capital ignoring climate investments means that the firm exposes itself to a risk that will occur with a likelihood of 100 percent, this risk can be mitigated only if the firm is to invest in measures that reduce the effect of risk exposure (Coffee, 2021). This should lead each company to relate to green and if they don’t, they disappear, there is no escape. To illustrate my point: in the business of real estate it was recently demonstrated that markets do invoke the likelihood of houses to disappear in the future because of their climate risk exposure and that market do put a discount on the value of real estate to account for this risk (Giglio, 2021).
Analogically investors want to establish the extent to which the firms they (plan to) invest in are exposed to the risks of discontinuity in the future investors because of their climate risk exposure. Climate motivated regulation and legislation will impose on the firm as well, making earlier realization of climate objectives even more salient.
The question is whether firms will respond in time and whether they report on their achievements credibly?
People procrastinate
By their very nature, long-term goals require patience and trust from the user of information because the reader must want to wait for the goals to be achieved and rely on the capability of the company involved. In the first place, however, the user should be convinced that the long-term goals set should be preferred over shorter-term goals.
People tend to procrastinate necessary actions, and as Akerlof stated, even if this is at the expense of their own prosperity. His analysis can be irreverently summarized as follows, a smoker can quit smoking today, but can also decide to quit tomorrow. The costs of a postponement day are very low, while the yield today (quick fix) is very high. Every day that the smoker makes this trade-off, the decision is in favor of postponement, with the result that short-term solution always wins out over what is good in the longer term. We see the same phenomenon in retirement schedules. If you give people the freedom, a minority will choose to save for retirement.
Investor find it hard to value long term projects
Up until now the only hard test of long term objectives is in market prices of equity shares. We know, however, that these share prices are in the short run often affected by contemporaneous effects. For instance, when the demise of Enron dragged Andersen into its downfall, the market put a heavy discount on the prices of shares of firms audited by Arthur Andersen (Chaney and Philipich, 2002), this appeared to be a short term effect though (Nelson, Price and Rountree, 2008).
On the other hand shareholders seem to have hard time appreciating the long term effects of firm decisions. Private companies, stand a fair chance of not recovering their investments in Unicorn firms (The Economist, 2019) and once they went through an IPO almost half of the unicorns lose their status as unicorns (Gornall and Strebulaev, 2020).
In a recent paper Bhojraj et al. (2021) examine errors in earnings expectations implied by stock prices of firms. They compute lifetime earnings for domestic firms that started for the years 1975-2019 and compare such earnings to the stock price prevailing at the beginning of every year starting 1975. Of the 16,386 firms examined, 17% survived till 2019, 42% merged with other firms and the rest were delisted for other reasons. On average, only the best firms exceeded Treasury bill rate by more than 5 percent and the worst firms were valued at 60% of their initial market value. Taken together these findings suggest that investors have a hard time in valuing long term values while at the same time share prices are sensitive to news shocks that do not necessarily extend to all firms whose share price is affected.
Establishing milestones
To deal with the impediments investors have with valuing long term objectives and to mitigate procrastination, companies break down long-term ultimate objectives into interim goals or milestones, which encourage and motivate investors and employees to achieve long-term goals through stages. It goes without saying that climate goals typically qualify as long-term that it is obvious that companies stimulate and monitor their realization by setting sub-goals and managing them. In the climate transition, companies have to set (long-term) climate goals because their realization is a necessary condition for business continuity.
When evaluating interim goals, one should ask two questions: does the achievement of the interim goal indeed contribute to the achievement of the final goal and is the reported result correct?
Our knowledge of how interim goals achievement translate into future value is still at an early stage, let alone an objective evaluation of whether the realization does enhance the likelihood of survival of the firm. For this very reason it is important that future research starts to look into these questions.
Given the length of the lead time of achieving climate objectives it is important that auditors develop an evidence-based opinion whether the current firm activities are conducive to the long-term survival of the firm. This will require auditors to ascertain how intertemporal attainments are incentivized through targets and performance measures and to establish how and to what extent the achievements of milestones are indicative of attaining long-term objectives.
Summary
To summarize, now all firms are exposed to climate risks they have to direct their attention to long-term objectives if they are to survive. This will require firms to be convince to convince their stakeholders on the necessity of achieving these objectives and on the extent that their activities are conducive to that purpose. In order to convince stakeholders firms can use auditors to attest that their activities are conducive to achieving the long-term objectives and that they put in place working performance management systems that help the firm to achieve these objectives.
Literature
Akerlof, G. A. (1991). Procrastination and Obedience. The American Economic Review 81(2), Papers and Proceedings of the Hundred and Third Annual Meeting of the American Economic Association: 1-19.
Bhojraj, S., A. chani, and S. Rajgopal. (2021).Lifetime Earnings. Available at SSRN: https://ssrn.com/abstract=3951530.
Chaney, P.K. and K.L. Philipich. (2002). Shredded Reputation: The Costs of Audit Failure, Journal of Accounting Research 40(4): 1221-1245.
Coffee, J.C. (2021). The Future of disclosure, Columbia Business Review 2021(2): 602-650.
Giglio, S., M. Maggiori, K. Rao, J. Stroebel, A. Weber. (2021). Climate Change and Long-Run Discount Rates: Evidence from Real Estate, The Review of Financial Studies 34(8): 3527–3571, https://doi.org/10.1093/rfs/hhab032
Gornall, W. & I.A. Strebulaev. (2020). Squaring venture capital valuations with reality,” Journal of Financial Economics 135(1): 120-143.
Sustainability at Morgan Stanley. https://www.morganstanley.com/about-us/sustainability-at-morgan-stanley
Nelson, K.K., R. A. Price, and B.R. Rountree. (2008). The market reaction to Arthur Andersen’s role in the Enron scandal: Loss of reputation or confounding effects? Journal of Accounting and Economics 46: 279–293.
Nordhaus, W. D. (2013). The climate casino: Risk, uncertainty, and economics for a warming world. New Haven, CT: Yale University Press.
The Economist. (2019). Tech’s new stars have it all—except a path to high profits, issue 20 April 2019. https://www.economist.com/leaders/2019/04/17/techs-new-stars-have-it-all-except-a-path-to-high-profits
