For years, ‘materiality’ was primarily an accounting or legal concept used to judge how wrong a number in a company’s financial statements must be for it to change an investor’s decision if the correct number was known instead.
Its principles and definition for financial reporting are well known and centred on what makes a difference to investors’ decision-making. But not being investors themselves, it can be hard for accountants to know what would in fact alter an investor’s decision. Accountants instead have to step into investors’ shoes and use their judgment about what matters.
It’s a new way of thinking and reporting for many companies
Applying materiality to sustainability reporting is even trickier. Investors themselves often don’t know how – or if – sustainability issues matter to their investment decisions. If they do matter, incorporating them into valuation models (such as discounted cashflow), including them in company engagements or using them in deciding how to vote at AGMs is challenging.
Still, sustainability report preparers need to think about what investors would want to know. Extending this to other stakeholders (such as the information employees and customers need) can be even more complicated.
Different approaches
Of course, new sustainability reporting requirements – such as the International Sustainability Standards Board’s (ISSB) standards or Europe’s Corporate Sustainability Reporting Directive (CSRD) – are forcing companies to quickly figure this out. Determining what’s material drives everything that comes next – from what topics are covered in the disclosures, to what information is disclosed about them, to aggregating or disaggregating information. It’s critical to get the materiality assessment right.
But what if investors haven’t seen the information yet to know whether it makes a difference to their decisions?
Those who’ve done a CSRD double-materiality assessment (DMA) will know its prescriptive requirements and guidance. That prescriptiveness is expected; it’s a new way of thinking and reporting for many companies, and the standard setters want to help.
The ISSB takes a top-down approach that is focused on business fundamentals (such as cashflows, access to finance and cost of capital). This is often referred to as ‘financial materiality’ because it focuses on the effect the environment and society can have on the company’s current or future financial performance. (Note that the ISSB’s standards don’t use that term but instead refer to identifying sustainability-related risks and opportunities.)
Don’t panic about the detailed rules. They are here to guide your thinking
Europe’s proposed changes to the DMA process would allow a top-down approach and will help align with the ISSB standards, at least for financial materiality. The DMA also includes a process for assessing ‘impact materiality’, which is about the effect, positive or negative, that a company has on the environment and society. Although the CSRD distinguishes ‘impact materiality’ from ‘financial materiality’, in the real world the line is blurry – impacts can turn into risks or opportunities over time, sometimes overnight.
Core principles
My approach to assessing materiality (and what to disclose) draws on my experience as a valuation professional and from drafting IFRS 13, Fair value measurement. Even without direct investor input, starting with basic valuation principles helps focus on what matters for the company: what it’s in business to do, what could hinder or enhance that over time and what actions it’s taking as a result.
This also helps keep an eye on the company’s impacts and which can have financial implications in the future.
If this information was known, would they invest in, buy from or sell to you?
Of course, investors will need reliable information about each of those points. As you assess materiality, here are some principles to keep in mind:
- Focus on what keeps – or should keep – the board up at night. A well-run business pays attention to what’s happening in the world around it and considers the strategic implications. That includes impacts just as much as risks and opportunities.
- Be sure to step back at the end of the process to see the full picture. After the materiality assessment, ask yourself if it truly reflects the reality of your business. If something seems surprisingly present or missing, you may need to revisit your thresholds and time horizons. This also helps set priorities.
- Distinguish the materiality of a topic from the materiality of the information about it. Many often conflate the materiality of an issue (a specific risk, opportunity or impact) with the materiality of the information about the issue (what gets disclosed). This can lead to disclosure of information that isn’t material because companies feel they should say something about a topic. If an issue is material, it doesn’t always mean that detailed disclosure about it is material as well. Conversely, an issue might not be material, but investors still want information about it. Climate change’s implications on a company’s financial statement amounts is an example.
- Don’t panic about the detailed rules. They are here to guide your thinking and reduce the chance of missing something important or making too much of something just because it seems like it should matter for you.
Identifying material topics determines what goes into your sustainability report, so it’s critical to get it right. The topics identified are shaped by the business model, value chain, industry and geography. Disclosure should reflect what investors (and other stakeholders) need, even if they don’t yet know they need it
Ask yourself: if this information was known – or unknown – how would it change someone’s view of the company? Would they invest in, work for, buy from or sell to it? That’s what matters.
