“Materiality is being redefined – through pressure on business from wider civil society, and through precedents established by company practice and, increasingly, regulation and litigation. But current experimentation in redefining materiality suffers from being ad hoc, often confused and confusing, and rarely credible. As a result, companies too often disclose information that is not used, incurring unnecessary costs without satisfying intended audiences.”
This was, according to Simon Zadek and Mira Merme, the state of materiality – 17 years ago. They published Redefining Materiality in 2003, before many of the currently omnipresent sustainability frameworks existed and, more interestingly, before any other paper addressed materiality in the non-financial domain. Yet, their critique still holds.
What have we achieved since in redefining materiality? More importantly, where should materiality go next?
2020 opened the new decade of action. The EU Commission is reviewing the Non Financial Reporting Directive (NFRD), and mandated the European Financial Reporting Advisory Group (EFRAG) to explore the possibility of creating European non-financial reporting standards.
Traditional financial reporting institutions such as the International Financial Reporting Standards (IFRS) Foundation, the International Federation of Accountants (IFAC), and IOSCO as well as jurisdictions from China, Japan and the USA are considering non-financial accounting.
In addition, the COVID-19 crisis highlights how swiftly and dramatically issues deemed non-financial can emerge quickly and become highly material – causing significant impacts on society and on business. An elaboration on the status quo of the requested redefinition of materiality is thus timely and needed.
Shareholders to stakeholders
Zadek and Merle saw in redefining materiality “the potential for developing a body of practice in corporate public reporting that is responsive to both investors and the wider stakeholder community.”
17 years later, that body of practice around materiality does indeed exist. Many sustainability frameworks and new non-financial reporting institutions contributed to redefining materiality by exploring the concept from different perspectives. Academic papers are increasingly investigating its theoretical implications.
As a result, materiality increasingly looks beyond the viewpoint of shareholders, embracing a broader range of stakeholders’ informational needs or, at least, enabling investors to act as a proxy of the wider society (as demonstrated by the increasing shareholder activism). Although still dominant, the principle of shareholder primacy in fiduciary duty is now being consistently challenged by solid and rigorous research.
Reflecting on the broadened intention of materiality, the subject is expanding to non-financial performance – both in terms of impacts of business activities on the environment and society, as well as impacts the latter has on the value of companies (nowadays commonly referred to the double materiality concept).
Finally, although the subject of the materiality test has not changed (the likelihood that the judgement of a reasonable person would have been changed), it can be argued that the profile of the “reasonable person” has significantly evolved. The volume of assets under management following the UN Principles for Responsible Investments and the fierce youth activism (from Greta Thunberg’s climate strikes to Extinction Rebellion’s acts) indicate the subject moving beyond investors.
As the minimum essential to make the redefinition of materiality effective, Zadek and Merle propose a number of conditions that “must be embedded within an appropriate corporate governance framework”. Those are:
- “An explicit process through which the [materiality] tests are applied, which ensures that the required information is identified, assessed and made available to the Board.”
- “A Board that collectively has the necessary competencies to be able to make sound decisions on the basis of the information provided.”
- “An external assurance of the entire process that is independent, delivered by providers with adequate competencies, and based on standards designed specifically to handle the range and complexity of non-financial as well as financial, and qualitative as well as quantitative, information”.
After 17 years, condition 1 is still not met. The body of practice described above around materiality is overcrowded with voluntary definitions and principles, but dramatically lacks consistency and guidance at the operational level. Resulting methodological fragmentation makes it impossible for companies to have a standard procedure of how materiality judgements can be rendered. Many companies therefore lack a consistent approach and wait for traditional financial reporting institutions to step up. The lack of the first condition naturally prevents conditions 2 and 3 to occur.
How can we overcome these practical challenges and close the gap between conceptual understanding and decision useful implementation?
Condition 1: An explicit process. Among practitioners, a materiality assessment is in many cases trivialized to administering a stakeholder survey, or conducting internal engagement activities such as workshops or roundtable discussions. While those elements are a necessary part of a materiality assessment, they are not sufficient alone. Different sources of information can be leveraged to gather more rich evidence of materiality, ease potential biases in the stakeholders’ perspective, triangulate insights, and provide different levels of data that can shed light on impacts and dependencies – as well as prove useful to different levels of management. Corporate filings, regulations, news, social media posts, academic papers, NGO activism are just some examples of the sources that should be analyzed when conducting a thorough materiality analysis.
Stakeholder engagement can then validate the results of the data-backed analyses by providing contextualization and tease out limitations, implications, and forward-looking insights. The recoupling of the evidence through systematic stakeholder dialogue is essential as it grounds the discussions in reality and bears the potential to align perceptions.
Condition 2: Materiality is a board responsibility. The materiality determination process must reside in the companies themselves. More importantly, the Board of Directors is best suited to lead materiality discussions in the light of its strategic intent. The current dominance of voluntary guidelines and frameworks however often implicitly primes a company’s determination process of material issues and leads to a limited level of corporate accountability. Attempts to establish and own a materiality assessment process grounded in data backed by stakeholder engagement need to be inclusive of different organizational bodies (e.g. risk committees) to gain relevance for the Board and actively claim its accountability.
Condition 3: Transparent and auditable materiality determinations. In the absence of standardized guidance only a transparent and systematic approach to data gathering, stakeholder inclusion and read out discussions will allow companies to audit their materiality assessment process. Assurance engagements can serve to ensure the design of a holistic and objective procedure as well as underline the need for Board accountability.
In 2003, Zadek and Merle saw the beginning of a trend in policy making. In 2020, the momentum supporting that trend accelerated vigorously. At the time, public policy institutions stepping in the field were limited and most of the work has been since carried out by partially ad-hoc and private bodies (such as the Global Reporting Initiative, the International Integrated Reporting Council, the Sustainability Accounting Standards Board).
Today mainstream and influential institutions (including the European Union, the International Financial Reporting Standards Foundation, the US Security and Exchange Commission, the World Economic Forum) are getting ready to take the lead. The European Union has been the first supranational institution to mandate environmental and social reporting with the Non-Financial Reporting Directive (NFRD), and is currently assessing whether to define its own reporting standard. On materiality specifically, the Non-Binding Guidelines published in July 2019 introduced the double materiality perspective:
- A company’s dependencies which can have a material impacts on the value of the company (where “value” is intended in broad sense, not just the financial measures reported in the financial statements);
- A company’s externalities which can have material adverse impacts on society and the planet
In the European Commission Guidelines introducing double materiality, the regulator clarifies that “these two risk perspectives already overlap in some cases and are increasingly likely to do so in the future. As markets and public policies evolve in response to climate change, the positive and/or negative impacts of a company on the climate will increasingly translate into business opportunities and/or risks that are financially material”.
The IFRS, after a long period of reservation regarding non-financial accounting, has recently broken its silence. In a speech delivered in November 2019, the International Accounting Standards Board (IASB) Chair indicated that the stream of sustainability standards looking at the financial materiality perspective is “particularly relevant for the update of the Management Commentary Practice Statement.”
“These standards”, he continued, “- with a clear financial materiality threshold – also fit well within the mission of the IFRS Foundation to provide financially relevant information to investors.” In November 2020, the IFRS Trustees finally launched a public consultation to determine whether there is a need for global sustainability standards; whether the IFRS Foundation should play a role; and what the scope of that role could be. Based on the Consultation Paper, the IFRS is focusing on potential standards based on a financial perspective of materiality.
Stateside, the U.S.SEC has not explicitly mandated environmental and social disclosures – preferring a principles-based approach based on financial materiality. Yet it acknowledges that some companies disclose “non-financial and financial metrics when describing the performance or the status of their business” in their regulatory filings. When such metrics are included in the filings, the Guidelines indicate that the MD&A is expected to include disclosures on “the reasons why the metric provides useful information to investors.” In other words, the US SEC expects a narrative that enables investors to see “through the eyes of management” why the disclosed non-financial metric is material.
Finally, also the influential World Economic Forum (WEF) stepped in the non-financial domain. A white paper, titled “Embracing the new age of materiality” focuses on how investors and corporations are developing the capability to anticipate future material issues. One of the key takeaways is the acknowledgement that what is financially immaterial today can become material tomorrow – suggesting that materiality is a dynamic “process of becoming”, rather than a “state of being”. Herewith introducing beyond the double materiality concept a new aspect of materiality.
While double materiality articulates two perspectives of materiality, stressing the impacts “on” and “of” a company (as described above), the dynamic materiality emphasizes the pathway an issue follows to become financially material, highlighting the triggers and catalysts that eventually determine financial impacts. In other words, the first concept focuses on a parallel dichotomy of materiality, while the second acknowledges that the materiality manifests dynamically over time.
Is it done then? Has materiality been successfully redefined? Although significant progress has been made conceptually, there are a number of practical challenges that are yet to be properly addressed.
In its own nature, materiality is an evolving, context-dependent, concept. Its redefinition should not come as a surprise. Rather than arguing on what materiality is and is not, this article is an invitation to practitioners, decision makers, and regulators to rethink materiality at a different level, i.e. addressing the practical challenges that were outlined already 17 years ago.
Clear and standardized processes, board accountability, and auditability are the building blocks for the practical implementation of an accounting principle that bears the potential to transform the role of business in society.
Donato Calace is the vice president of innovation and accounts at Datamaran. Denise Weger is senior manager strategic initiatives global health and corporate responsibility at Novartis.