Impact of ESG on financial reporting according to German GAAP (HGB) and IFRS

published on 20 February 2025 | reading time approx. 3 minutes

With the implementation of the Corporate Sustainability Reporting Directive (CSRD), ESG reporting will be a mandatory part of the audited management report in Germany (“Lagebericht”) in the future. However, ESG cannot be regarded as a separate, stand-alone section of corporate reporting. Rather, there is a variety of spillover effects, including on “traditional” financial reporting in accordance with German GAAP (HGB) and IFRS.

Introduction

A strong ESG profile is not just an end in itself or pure marketing tool for companies. Through various channels (e.g., regulatory framework, product innovations, changes in customer behavior) ESG issues also affect the (long-term) economic performance and thus the balance sheet. The possible effects are varied. Some selected effects that could be relevant for many companies are presented below.

Impairment of non-financial assets

Long-term non-financial assets primarily relate to intangible assets and property, plant and equipment. In both areas, the acquisition or production costs are usually depreciated over the expected useful life and, if necessary, impaired in accordance with both German GAAP (HGB) and IFRS. ESG-related factors can lead both to a reduction of the depreciation period and to the need to recognize impairments.

While the impairment test under German GAAP (HGB) is carried out at the level of the individual asset, under IFRS assets may have to be aggregated into cash-generating units (CGUs). On the one hand, this can lead to compensating effects, but on the other hand, it can also mean that goodwill not amortized according to IFRS and allocated to CGUs must be impaired as a result of ESG factors. In a present value analysis, the impact on the calculated adjustment values can arise both in the numerator due to changed cash flows (e.g., lower expected sales due to changed customer behavior or higher costs due to rising energy costs) and in the denominator due to increased cost of capital.

In addition to non-current assets, inventories may also need to be impaired to a lower amount. Once again, the aforementioned influences of changes in regulatory requirements or changes in consumer behavior, as well as potentially increased transportation costs, must be taken into account.

ESG-linked financial instruments

In the area of financial assets, the focus is particularly on ESG-linked instruments, the interest on which is linked to compliance with certain ESG indicators. If such loans are held as assets, the historical cost principle must be applied according to German GAAP (HGB). According to IFRS, for the initial recognition and the corresponding classification, it is necessary to assess on a case-by-case basis if the so-called SPPI criterion is met, according to which the cash flows from the financial instrument may solely consist of interest and principal payments. Only if this is the case and the business model consists of “holding”, the financial instrument is measured at amortized cost under IFRS. Otherwise, the financial instrument must be measured at fair value. When examining the SPPI criterion, it is necessary to assess whether or not the ESG ratio reflects the credit risk, an assessment that can only be made on a case-by-case basis considering the specific circumstances.

If ESG-linked loans are recognized as liabilities on the liability side of the balance sheet, it must be considered that under German GAAP (HGB) they are recognized at the settlement amount and interest is recognized as an expense (however, the highest value principle applies to variable repayment amounts). Under IFRS, however, the effective interest method is used, according to which the total expected cash flows, consisting of interest and principal payments, are discounted using the effective interest rate. Fluctuations in expected cash flows are only “compensated” by a changed effective interest rate if the effect results from a change in market interest rates. Therefore, it is again necessary to clarify if the ESG ratio reflects the credit risk and whether or not an adjustment is made to the interest rate not only for the credit risk, but also for the other components of the market interest rate. Any difference in book value resulting from the discounting of changed expected cash flows at the original effective interest rate must be recognized through profit or loss under IFRS.

For ESG-linked loans, it must further be clarified if the variable interest rate constitutes an embedded derivative that needs to be separated. However, this could possibly be denied under both German GAAP (HGB) and IFRS in many cases, but must also be assessed on a case-by-case basis.

Provisions

ESG-related issues also raise numerous questions regarding the recognition of provisions. On the one hand, there could be an increase in provisions for onerous contracts if long-term supply agreements become loss-bearing due to changes in legislation or customer behavior. If the unavoidable costs of fulfilling the contracts exceed the expected economic benefits, a provision must be recognized at the lower amount of the costs of fulfillment and any compensation payments for non-fulfillment.

Provisions can also arise from disposal, restoration, or similar obligations. Under German GAAP (HGB), such obligations must be accumulated as expenses on a pro-rata basis. Under IFRS, however, they must be recognized at the full amount of the estimated discounted costs and capitalized as part of the acquisition or production costs of the related asset. Changes in the measurement of the provision in subsequent periods or the initial recognition of a corresponding provision at a later point in time (apart from pure interest effects) must be treated as subsequent changes to acquisition or production costs.

Restructuring provisions can also become relevant in the context of ESG-related changes. German GAAP (HGB) itself does not contain any specific guidance for recognizing such provisions, although there are guidelines for social plans, at least under tax law. These must be recognized as provisions if they have either already been announced as of the balance sheet date or if the announcement is made during the preparation of the financial statements, but the resolution has already been passed as of the balance sheet date. In contrast, under IFRS, at least the main elements of the plan must have already been announced as of the balance sheet date, if implementation of the plan has not already begun. Additionally, for recognizing a provision IFRS requires a detailed formal restructuring plan, which includes, among others, the affected business areas and locations as well as the number of employees with severance claims. Only the necessary expenses directly related to the restructuring are to be included in the measurement of the provision, but not the costs of current or future business activities or future losses (with the exception of provisions for onerous contracts).

Finally, it should be noted that a variety of legislative procedures related to ESG topics is expected in the future. However, a provision due to planned legislation prior to the adoption of the law is not permitted under German GAAP (HGB), while under IFRS it is subject to the strict condition that the adoption of the law is virtually certain. In many cases, however, this is likely to be impossible to predict, meaning that IFRS also de facto rules out the recognition of provisions before the law is passed.

Conclusion

Due to the increasing relevance of ESG topics, companies must address their impacts not only in the context of non-financial reporting but also within the framework of “traditional” accounting. ESG-related issues can arise in various ways for different balance sheet items. Companies should, therefore, address both the economic and accounting implications of the dynamic developments in the area of ESG at an early stage.