September 2020 User View by Donato Calace, Vice President of Accounts and Innovation, Datamaran
IN 2003 Simon Zadek and Mira Merme published “Redefining Materiality Practice and public policy for effective corporate reporting”. It was pathbreaking in its argument that a broader definition of corporate accountability – one that embraces ESG matters – requires a new approach to materiality.
Today, four key ideas around materiality are essential to rethink the concept. These are especially relevant in a year where the COVID pandemic has demonstrated how swiftly and dramatically new issues can become highly material.
The first idea is that much work remains to be done at the operational level, despite a broad body of reporting practice that speaks to diverse stakeholders. Many institutions and standard setters have contributed to redefining materiality, academics investigate its theoretical implications, and in the market materiality assessments have become a diffused practice.
The body of practice is overcrowded with high-level definitions and principles, suffering from a lack of standardized operational guidance. Every company solves the materiality puzzle with ad hoc and inconsistent processes, failing to connect materiality to strategy and risk management, and ultimately to engage boards in making more informed decisions on emerging risks and opportunities.
Zadek and Merme suggested three conditions essential for redefining materiality: an “explicit process”, a “board that collectively has the necessary competence”, and “external assurance”. These conditions are still largely unmet.
Companies disclose information that is not decision-useful, as highlighted by the Alliance for Corporate Transparency and the European Commission in a fitness check of the Non-financial Reporting Directive (NFRD). This makes it more difficult for stakeholders to make informed decisions and hinders management’s capacity to demonstrate their focus on material issues.
Standard setters and policy makers have the opportunity to fix this, by providing standardized operational procedures that strike the right balance between a high-level principle-based approach and a strict rule-based approach. This is a recommendation Datamaran provided to the EU Commission during the NFRD consultation.
With its revision of the Universal Standards, the Global Reporting Initiative (GRI) is also introducing new disclosure requirements concerning the operational procedures of materiality determination. The GRI among others expects the reporting organization to “use a systematic, replicable, and documented approach to identify its material topics”.
The second idea is to reconcile the duality of materiality. For long, two opposing perspectives on materiality existed: one more stakeholder oriented, emphasizing the impacts an organization has on the environment and society, and the other more organization focused, centered on the impacts the environment and society have on the organization.
Reconciling these two approaches is not frictionless, although it is finally being addressed by timely guidance. Two new notions – double materiality and dynamic materiality – are indicating a promising way forward to overcome this conceptual dichotomy.
The EU Non-Binding Guidelines of July 2019 introduced the double materiality perspective, indicating that information is material when either:
- affecting the value of the company (where “value” is intended in broad sense, not just the financial measures reported in the financial statements);
- necessary for an understanding of the “external” impacts of the company – on society, the environment.
Double materiality doesn’t imply that there are two different definitions of materiality. Information can be material from one or both perspectives. Companies – boards in particular – are in charge of determining what is material.
From the letter Vice President Dombrovskis submitted to the European Financial Reporting Advisory Group (EFRAG) concerning the establishment of a Task Force to explore the possibility of developing European non-financial reporting standards, it is clear that the potential standards will pursue the double materiality perspective.
The World Economic Forum white paper “Embracing the new age of materiality” (2020) focuses on how investors and corporations are developing the capability to anticipate future material issues. A key takeaway 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” (as clearly explained in “Pathways to Materiality” by Serafeim and Rogers).
While double materiality articulates the impacts “on” and “of” a company, dynamic materiality emphasizes the pathway an issue follows to become financially material. The latter highlights the triggers and catalysts that eventually determine financial impacts. While the former focuses on a parallel dichotomy of materiality, the second acknowledges that the materiality evolves dynamically over time. Both notions emphasize that materiality can be seen from different angles, one non-financial and the other purely financial.
When the European Commission Guidelines introduces 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”. It can hence be inferred that the dynamic nature of materiality is implied in the concept of double materiality.
The third idea is to take materiality beyond reporting. As an accounting principle, materiality is inherently embedded in reporting. A redefinition of materiality requires its application beyond reporting, in particular in governance processes determining strategy and risk management.
As Zadek and Merme argued, materiality must be embedded within an appropriate corporate governance framework. The revision of the GRI Universal Standards supports this idea, demanding the involvement of the “highest governance body” in the materiality assessment processes. The GRI revision clarifies that the steps involved in identifying material topics include an “organization’s ongoing identification and assessment of impacts as part of its regular activities in order to manage its impacts”.
Taking materiality beyond reporting is an essential part of building transformative accounting, including reporting able to change behaviors. The challenge here lies in completing the quantum leap of rethinking materiality. A traditional materiality statement would indicate that “economic events are recognized based on their relative importance, and that for financial statements of year X materiality was determined on the basis of 5% of consolidated earnings”. Such a statement is mechanical, numerical, and backward looking. But a redefined materiality is strategic, both qualitative and quantitative, and forward looking.
The fourth idea is that this is not about ESG materiality. At stake is not a separate concept of “ESG” or “sustainability” materiality. Materiality should be seen as a single concept, and it is evolving – just as reporting and accounting is evolving. New policy developments are not forming a separate branch of reporting and accounting practices, but a new milestone in its overall history.
The author can be reached at donato@datamaran.com
Article partially based on Calace, D. (2019) Materiality: From Accounting to Sustainability and the SDGs. In: Leal Filho W., Azul A., Brandli L., Özuyar P., Wall T. (eds) Responsible Consumption and Production. Encyclopedia of the UN Sustainable Development Goals. Springer, Cham. https://doi.org/10.1007/978-3-319-71062-4_43-1, and Calace D. and Weger D. (forthcoming) Rethinking Materiality – 17 years later.
