Sustainability reporting: Getting clarity on materiality
At its simplest, materiality means information that is likely to influence the assessment process and decisions of stakeholders. The problem is that most people understand it differently. At university, I recall the loving reverence of lawyers as they revelled in the conceptual and philosophical underpinnings of materiality. This was in stark contrast to financial reporting lecturers who boiled materiality down to an asset or liability more than 5% of the total. In accounting, materiality was a legitimate justification for deviations from financial reporting standards, or having to grudgingly disclose additional information.
Materiality determines what a business should disclose to the rest of the world. Traditionally, something is considered material if it might affect the future value of the company. For the last 100 years materiality has been narrowly determined with reference to investors as something reasonably likely to affect the financial condition or operating performance of a company and therefore important to investors.
Financial materiality is used to tailor reporting standards for individual corporations, but also to justify the nondisclosure of different dimensions of sustainability, leading to serious problems with the relevance, consistency, comparability, and decision-usefulness of corporate reports. This is why redefining materiality for corporate reporting is such a hot topic. Recently, the World Economic Forum, in collaboration with Deloitte, EY, KPMG, and PwC, proposed a new era of corporate reporting based on dynamic materiality.
Evolving concepts of materiality
In theory, determining what is material requires imagining who might rely on information contained in corporate reports and predicting how they might use it. This is impossible to do with any level of certainty, which led to the development of standard processes to define what is material. These processes have evolved over time in response to legal conflicts, new risks, and changing social values as to missing, malevolent, or misleading corporate disclosures.
However, as our understanding of the drivers of corporate value has evolved in the context of global unsustainable development, the list of things that can impact financial condition has grown. This has been accompanied by a growth in extra-financial disclosures, which relate to issues that could have a significant impact in some way on a broad range of stakeholders. However, there is a gap in our processes of determining what issues are material in relation to extra-financial drivers of future financial valuations.
Reporting standards that adopt a stakeholder approach to accountability, such as the Global Reporting Initiative (GRI), typically use a form of external impact, rather than financial materiality. For example, under materiality in GRI Standards, organisations need to cover topics that reflect “significant economic, environmental, and social impacts or that substantively influence the assessments and decisions of stakeholders.”
GRI’s recent consultation is proposing a materiality assessment process that starts from the external social and environmental impact of corporate actions on others, rather than the financial value of a company. Meanwhile, the EU Non-Financial Reporting Directive contains a proposal for what it refers to as double materiality, which combines financial and external materialities. As a consequence, if an action affects a company’s financial value as well as a company’s significant external social and environmental impacts, then it is considered material and should be disclosed.
In the longer term, it is difficult to see how something that has a negative social or environmental impact would not lead to a negative impact on future company value. However, in the short term our markets still allow plenty of things that have a negative social or environmental impact to increase in company values. That’s why we have global problems like climate change and a shortage of natural resources. The question is how long will society, regulators, and customers allow this exploitation to continue?
Financial, external impact and double definitions of materiality share one characteristic: an ability to predict the future information needs of the users of corporate reports. This is further complicated by the question of how and where to disclose this information while taking into account the uncertainty of the timing and extent of any impacts.
The changing nature of business risks in our hyper-connected world means that it is incredibly difficult to predict what will become financially material over time. In the 1950s, who would have predicted the financial consequences of the health impacts of smoking? Similarly, in the 1980s who would have predicted the financial consequences to the oil, coal, and gas sector of scientific research that linked the burning of fossil fuels with climate change? Other than climate change and COVID-19, who knows the next drivers of financial risks to today’s leading companies? COVID-19, data privacy, plastic waste, biodiversity loss, or some unknown unknown? History tells us that the systemic financial risks come from where we are not looking and things not yet considered material.
Basing materiality assessment on knowledge of the past is therefore risky. A good place to start is to look at your business strategy, risk register, and the risks disclosed by your peers. Combine these with different sectoral or global scenarios to construct a plausible understanding of the impact your business might have on different stakeholders in a changing world. These impacts should help determine not only what is material to stakeholders but also what is material to the sustainability of your business model.
Innovators in this field are looking towards new approaches to identifying material risks and their leading indicators. For example, the World Benchmarking Alliance is using concepts of keystone companies combined with seven transformation scenarios linked to the UN Sustainable Development Goals and planetary boundaries. The scope and sophistication of the data provided by organisations like Datamaran is growing substantially. These databases are incorporating many more nonfinancial drivers of financial and operational performance, allowing users to undertake their own predictive modelling to get ahead of the curve.
There is a new digital potential for materiality assessment that is more dynamic, risk-based, and data-driven and that integrates evidence on external environmental, social, corporate governance, geopolitical, and technology trends. Building on developments in data science and digital technologies, users can take control by customising their own reports based on what is material to their decision protocols and aligned with their purpose.
Growth in responsible investment and sustainable business strategies is changing how decisions are evaluated and, as a consequence, how business performance is measured. The G17Eco open platform adapts the 17 UN Sustainable Development Goals to determine materiality and enhance corporate reporting while re-aligning business thinking and action. This type of initiative empowers all decision-makers and users of sustainability information to map, monitor, measure, and manage based on what they decide is decision-relevant to them.
Materiality matters. What is material and how it is assessed is undergoing a major transformation. Materiality concepts influence how all standards apply, including justifying exclusion or requiring additional disclosures. This is made more complicated by the exponential growth in data about companies swirling around the internet. It is difficult to keep up to date with the different consultations and what often appear to be esoteric or abstract discussions on the relative merits of double or external materiality. However, finance professionals need to be aware of these changes and their consequences and participate in the debate.
— Ian Thomson, ACMA, CGMA, is professor of accounting and sustainability and director of the Lloyds Banking Group Centre for Responsible Business at the University of Birmingham in the UK. To comment on this article or to suggest an idea for another article, contact Alexis See Tho, an FM magazine associate editor, at Alexis.SeeTho@aicpa-cima.com.