December 2021 User Dr Kip Krumwiede, Former Director of Research at the Institute of Management Accountants (2014 – 2021), educator and business consultant
MATERIALITY as understood in sustainability accounting is essentially about key risks and key opportunities facing the organisation. But how can management accountants assess the level of significance of key risks and opportunities for their organization? And how can this be part of strategic planning, forecasting, and investment decision making? To add focus, let’s use climate change to help illustrate how materiality for a manufacturing company can be assessed and translated into business and financial decision-making.
While materiality is commonly applied with an inward-looking focus on financial reporting and cash flows, management accountants can use the concept to help address the outward-looking impact of the enterprise on the economy, society and environment. Traditionally, the focus in management accounting is on the relevance of information to a given business decision to be made. Materiality comes into play if information is potentially relevant to that decision. Management accountants today are expected to take a more proactive, strategic role in running the business as well as often take the lead in sustainability accounting and even risk assessment. A key challenge is measurement: how to measure potential risks and progress on sustainability goals?
When facing any measurement challenge, the management accountant should pose three questions:
- What is the purpose of the measurement?
- What is it exactly we are trying to measure?
- What does more (or less) of it look like?
Let’s say a company’s goal is to reduce the risk of cyberattacks. For question 1, the purpose may be the company is considering alternative IT security systems and reducing cyberattacks is an important consideration in the decision. The second question is usually the hardest to answer but is critical to good measurement. In this case, the answer should be specific, including the security systems being focused on, a list of events averted or reduced, and the types of costs averted with improved IT security. By answering the first two questions well, it is much easier to answer the third question. In this case, improved IT security can be measured by the reduction in the frequency and severity of a specific list of undesirable events and the related costs.
Scenario planning is often used to identify and prepare for potential future scenarios. Instead of trying to list all potential scenarios, scenario planning should focus on 1-3 critical issues or uncertainties. These might be the issues causing the biggest risks to the organization (e.g., cyber threat or customers not coming back) or a key driver of success (e.g., oil price on June 1, online traffic in May, or easing of COVID-19 restrictions).
Once these critical issues/uncertainties are identified, the management accountant can develop a scenario framework 2×2 matrix made up of two issues/uncertainties with at least two levels for each (e.g., high and low). The accountant then composes a narrative for each scenario as if it had already happened and address the implications for the business. He/she includes any early warning signals (i.e., leading indicators) suggesting which scenario(s) is (are) most likely. With that basis in mind, the scenarios are developed and modelled.
For example, Tesla’s success is driven by both advancing EV technology and building demand for EVs. Let’s say Tesla needs to build a forecast model is to estimate U.S. demand in 2022 to help decide the number of electric vehicles (EVs) to produce for the U.S. market in 2022. Two critical uncertainties affecting demand are gas prices and consumers’ environmental consciousness. Higher (lower) gas prices would mean higher (lower) demand for EV cars. Likewise, the higher consumers’ environmental consciousness the higher will be their demand for EV cars. Of course, there are an infinite number of factors that will affect demand for Tesla’s cars, but Tesla must identify which are the most critical (or material) to their success in their demand forecasting. Scenario planning can help by establishing 2-3 different scenario outcomes for each critical factor and then envision a 2×3 matrix with high and low outcomes for each critical uncertainty. The following matrix illustrates the estimated percentage impact on demand for each scenario:
Management accountants in a manufacturing firm can also use a balanced scorecard approach to help executives and investors focus more on the long-term and comprehend the greater significance (or materiality) of long-term value creation. An effective BSC creates a balance between nonfinancial operational measures and financial outcome measures. It includes measures from four different perspectives, starting with “learning and growth” and leading to “financial” objectives. For example, Tesla’s balanced scorecard might include the following linked measures related to the four perspectives (table below), starting with learning in the form of Research & Development for continual research on how to increase battery capacity.
Whatever perspectives are included, all the measures in a balanced scorecard should be based on strategic objectives and the implementation plan developed during the strategic planning phase. This would necessarily include both leading short-term measures linked to current action items and longer-term lagging measures of success. Time frames for capital expenditures will differ by company and industry (e.g., 12 months for chip maker versus 5 years for a big pharmaceutical company). Timeframes in financial planning and analysis (FP&A) in general tend to be shorter term in focus in the United States (12 months) than those in other nations (3-10 years), and this can have a negative impact on U.S. companies’ long-term competitive position. Materiality is also impacted. A U.S. company may be less likely to spend US$100K for more sustainable production processes than a company in Europe because it will impact this year’s bottom line. This is another reason for strong FP&A practices, which connect longer-term strategy and financial goals with shorter-term implementation plans.
In the U.S., management accountants tend to focus more on financial goals than industry, regulatory, and stakeholder goals. The latter goals are typically left to “Chief Compliance Officers” and “Chief Sustainability Officers.” However, with the increasing emphasis on non-financial goals and strategic roles being played by finance teams, proactive management accountants will research industry trends and market expectations to help guide their company’s performance metrics and data used in FP&A analysis. Management accountants at Tesla for example, may look for ways to track consumers’ environmental consciousness by using data on household photovoltaic (PV) solar panel installations as a leading indicator of demand for other cleaner technologies such as EVs. This data can easily be found on the U.S. Department of Energy’s website.
It may seem as though the concept of “materiality” is a foreign word to management accountants. But they essentially assess materiality for measurement purposes by focusing on what is most critical for the business, whether the goals relate to strategy, operations, sustainability, or financial outcomes.
The author can be reached at kip@krumwiedeconsulting.com
