Materiality Definition: The Ultimate Guide
Materiality in a nutshell
Materiality is a concept that defines why and how certain issues are important for a company or a business sector. A material issue can have a major impact on the financial, economic, reputational, and legal aspects of a company, as well as on the system of internal and external stakeholders of that company.
The materiality concept
The Materiality concept applies in a wide variety of contexts: accounting, reporting, business, financial, legal, risk and, more recently, Environmental, Social, and Governance (ESG) or sustainability or non-financial issues*.
The history of the concept dates back to 1867**, when the English Court introduced the term “material”, by referring to “relevant, not negligible fact” that emerged in the judgement of the false accounting case concerning the Central Railways of Venezuela. The English Common Law could indeed be considered as the cradle of the concept of materiality!
The concept of materiality has been brought into the public spotlight in the sustainability context by the Global Reporting Initiative (GRI) in their G3 Guidelines in 2006 – the cornerstone of the GRI Sustainability Reporting Framework.
It has quickly become essential for stakeholder engagement exercises and topic mapping while appearing as a keyword in consultant pitches. Sustainability professionals around the world clambered to understand the term and the process, outlined by standard setters like the GRI and the International Integrated Reporting Council (IIRC).
As a concept borrowed from the accounting and auditing domain, materiality represented the perfect idea to foster the integration of non-financial issues in the mainstream business thinking and decision making. It sounds professional, financially relevant, familiar to investors and auditors.
* For the purpose of this analysis the terms Environmental, Social, and Governance (ESG), Sustainability or Non-Financial are used interchangeably.
** Holmes, W. (1972). Materiality--Through the looking glass. Journal of Accountancy (pre-1986), 133(000002), 44.
The [many] materiality definitions
As mentioned initially, materiality is the concept that defines why and how certain issues are important for a company or a business sector. A material issue can have a major impact on the financial, economic, reputational, and legal aspects of a company, as well as on the system of internal and external stakeholders of that company.
However, there are a number of materiality definitions depending on the context of use. Although not exhaustive, the below definitions provide a perspective of materiality from key stakeholders – regulators, standards setting bodies, and investors.
Materiality definition by the Corporate Reporting Dialogue (CRD)
In the context of the sustainability or non-financial reporting, one of the statements of the common principles of materiality by the Corporate Reporting Dialogue (CRD) indicates that:
“Material information is that, which is reasonably capable of making a difference to the proper evaluation of the issue at hand.”
The CRD’s definition is significant as it represents a common definition reached by the eight principal standards and guidance setters for reporting organizations, including GRI, the IIRC, the Sustainable Accounting Standards Board (SASB), the Climate Disclosure Standards Board (CDSB), the Financial Accounting Standards Board (FASB), the Carbon Disclosure Project (CDP), the International Financial Reporting Standards (IFRS), and the International Organization for Standardization (ISO). It was set up to achieve a “greater coherence, consistency and comparability between corporate reporting frameworks, standards and related requirements.”
Materiality definitions from a regulatory perspective
The U.S. SEC
From a regulatory perspective there are a number of definitions of materiality or material information. As such, according to the United States Securities and Exchange Commission (SEC):
“A matter is "material" if there is a substantial likelihood that a reasonable person would consider it important.”
The recent remarks by U.S. Securities and Exchange Commission by William Hinman – Director of the Corporation Finance Division – on ESG disclosure are in a way advancing that the current accounting principles already cover non-financial factors. The SEC stance is then that the Commission won't prescribe issue specific disclosures – companies are in charge of assessing material risks.
"The flexibility of our principles-based disclosure requirements should result in disclosure that keeps pace with emerging issues, like Brexit or sustainability matters, without the need for the Commission to continuously add to or update the underlying disclosure rules as new issues arise."
"[..]if a company determines that its physical plants and facilities are exposed to extreme weather risks and it is making significant business decisions about relocation or insurance, then, when these matters are material, companies should provide disclosure."
The U.S. Supreme Court
The U.S. Supreme Court says information is material if there is:
“a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”*
* U.S. Supreme Court, 1976
Regulatory Timeline: Click to enlarge
The International Financial Reporting Standards (IFRS)
The standard setting body, such as the International Financial Reporting Standards (IFRS) Foundation defines materiality as the following:
“Information is material if omitting, misstating or obscuring it could reasonably be expected to influence the decisions that the primary users of general purpose financial statements make on the basis of those financial statements, which provide financial information about a specific reporting entity.”
The IFRS Foundation develops and promotes of the respective IFRS Standards through its standard setting body – the International Accounting Standards Board (IASB).
Another financial standard-setter the Financial Reporting Council (FRC) defines it in the context of auditing:
“Misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements.”
The ISO 26000
The International Organization of Standardization Guidance on Social Responsibility (ISO 26000) defines it:
“An organization should review all the core subjects to identify which issues are relevant. The identification of relevant issues should be followed by an assessment of the significance of the organization’s impacts. The significance of an impact should be considered with reference both to the stakeholders concerned and to the way in which the impact affects sustainable development.”
Materiality for investors
The World Federation of Exchanges (WFE)
Investor group – being well represented by the World Federation of Exchanges (WFE) ESG Guidance and Metrics – suggests:
- How the firm determines materiality and who was involved in determining which issues are material;
- Which issues the firm believes are material;
- How the company has decided that these are material (process, timeframe, relevant legal framework, etc); and
- How the identified issues are integrated into corporate strategy and what impact they could have on value creation.”
The other investor-led coalition that bridges the gap between the corporate and finance communities – the Task Force on Climate-Related Financial Disclosures says:
“[Referring to] materiality as a concept designed to guide the application of professional judgement for the purpose of determining acceptable levels of information disclosure in mainstream reports and thereby informing decision-making by the users of those reports.”
COSO and WBCSD
In the context of risk management, Enterprise Risk Management—Integrating with Strategy and Performance Framework by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and World Business Council on Sustainable Development (WBCSD) define material risk as:
“The possibility that events will occur and affect the achievement of strategy and business objectives.”
Importantly, both negative effects (for instance, a reduction in revenue targets or damage to reputation) and positive impacts or opportunities (including, an emerging market for new products or cost savings initiatives) are included.
Two major perspectives on materiality
Overall, these definitions provide two major perspectives – one is stakeholder oriented as it emphasizes the impacts an organization has on the environment and society. The other has a greater focus on an organization, as it is centered on the impacts the environment and society have on the organization.
The EU Non-financial Reporting Directive
Interestingly, the EU Commission released earlier in 2019 the Consultation Document on the Update of the Non-Binding Guidelines on the EU Non-Financial Reporting Directive (NFRD). It was the first policy to merge these perspectives in one.
The Document introduces a new definition of materiality – called “double materiality”. The first perspective concerns the potential or actual impacts of climate-related risk and opportunities on the “performance, development and position” of the company (indicated as “financial materiality”, with an investor type of audience). The latter refers to the “external impacts of the company’s activities” (labeled as “environmental and social materiality”, whose audience consists of consumers, civil society, employees, and investors too).
Read how the EU Non-Financial Reporting Directive is changing and what it means for business in this blog.
Update: Datamaran submission to the NFRD public consultation
On 10 June 2020, Datamaran responded to the European Commission on Non-Financial Reporting Directive, focusing on the application of the materiality principle.
Our response can be articulated on four main pillars:
- Materiality shouldn’t be considered exclusively as a reporting activity, but should be regarded as the foundation for a more complete strategic risk management process.
- Technology has a dramatic impact on resource efficiency while ensuring accuracy of analysis, quality and auditability of data, and comprehensiveness of insights.
- ESG rating agencies or investors should take into account a company’s materiality determination process, and not penalize lack of disclosure on non-material indicators.
- Data driven materiality, based on a robust standardized procedure, would allow to move beyond idea that companies’ accountability consists in along list of indicators to disclose on, and bring it back where it belongs - to the Board.
Whichever perspective is taken, the key takeaway from these different definitions is that materiality is flexible, time-variant, and context-driven. Consequently, the only defense against subjective and self-serving materiality is to ensure that the materiality assessment is accorded with a robust due process. As a result, the approach to the methodology of defining and assessing which non-financial issues are material becomes critical.
Click to enlarge
Frameworks or voluntary initiatives and regulations are asking for a robust process without describing it operationally and the standards to which companies are required to comply are increasing exponentially. In the last three years alone ESG-related regulations grew by more than 100 percent across the UK, US, and Canada, indicating that the ESG regulatory landscape is evolving fast. The transition of non-financial space from voluntary to mandatory amplifies the importance of the due process even more.
What does a robust materiality assessment look like?
Materiality assessment or analysis is a process in which a company identifies the environmental, social, governance and broader emerging issues, such as digitalization, innovation, geopolitical events that are most important given the operating context of a business.
Materiality analysis provides insights into future trends and business risks and opportunities that influences its ability to create value. It helps companies identify topics that their stakeholders expect them to focus on. The materiality assessment usually guides sustainability or integrated reports and it is an essential engagement tool internally. “It helps to review management approach on material topics and assess where we can improve” – suggests ING’s Sustainability Lead when discussing the bank’s Materiality Journey: Integrated Doing Accelerates Integrated Thinking.
ING Materiality Journey: Click to enlarge
There is no single and perfect way of undertaking a materiality assessment. However, there are suggestions on how to take materiality beyond reporting, leveraging its informational value to define strategy, identify and manage risks, as well as seize opportunities:
- Make better decisions about investment in sustainability (know what is material and where you can have the biggest impact or mitigate the biggest risk).
- Integrate non-financial issues into reporting to present a more complete picture to stakeholders.
- Enhance business strategy by using materiality assessment input to reflect new business risks and opportunities.
- Strengthen the foundation of sustainability work by embedding these issues across departments and supply chain.
- Enhance stakeholder engagement by presenting them with viewpoints on issues that illustrate long-term value.
- Stay ahead of continuously evolving stakeholder and regulatory compliance on these issues.
Read the seven tips to the perfect materiality analysis to get the detailed overview.
Materiality assessment: a shift in companies' approach
One of the key questions regarding the materiality assessment is how often companies should perform it, and the realistic time and resource demands associated with the maintenance of the process. More companies are choosing to run their materiality assessment than before. The recent Datamaran study shows that there has been an increase in the number of companies with a market capital above $ 20 billion doing the assessment, from just 69 companies reporting on materiality in 2011 to 329 in 2018.
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Notwithstanding due process, emerging issues can rapidly change what is material and put new ESG issues in the spotlight. The examples could be Greta Thunberg putting the climate change agenda to the heart of the corporate discourse or the #MeToo campaign fighting the sexual harassment at workplace. For this reason, companies are starting to identify and monitor material issues in a more dynamic and ongoing way – decoupling materiality analysis from the annual reporting exercise.
The risk of not completing a materiality assessment
An inadequate or uninformed materiality assessment approach exposes entities to financial, reputational, and legal risks among the others. The court of public opinion is often a good predictor of the real courtroom – especially considering the rise in mandatory disclosure requirements. The path from public outcry caused by greenwashing to legal accusations and sanctions for misrepresentation can be dramatically short.
EasyJet and Balfour Beatty were among four leading UK companies that have been reported to the Financial Reporting Council (FRC) over their failure to disclose climate change related risks in their annual reports to shareholders.
In the case of Nissan, it is clear that the company has failed to report critical corporate governance issues in its annual financial reports and SEC filings for the last three years. Had this been noted by shareholders and regulators, the lack of transparency should have given an advanced warning of a potential problem. Comparing Nissan to the other leading automotive companies showed that out of 40 companies covered, Nissan ranked 37th in 2016, 40th in 2017 and 35th in 2018 in terms of transparency. Nissan did not disclose any information on corruption and bribery, executive compensation or fair remuneration in any of the three years.
Datamaran Industry Heatmap 2018: Click to enlarge
Read on how Nissan’s lack of transparency could have highlighted the problem earlier – a detailed study of Nissan’s ESG disclosure compared to its peers.
Despite the difficulty of defining materiality and its practical application, it remains a key element in building integration between the non-financial or ESG or sustainability domain and the mainstream business management. With policymakers taking a tougher stance on ESG-related regulations, materiality will be front and center in defining corporate accountability.
From Reporting to Strategy: Best Practices in Corporate Materiality
Based on a series of in-depth interviews, this free ebook explores how the boldest industry leaders have brought materiality beyond reporting, leveraging on digital solutions to make their analysis dynamic, transparent, and decision-useful.
You will learn how to enhance the voice of stakeholders in your assessments, why continuous monitoring is critical to stay on top of emerging risks, how to use technology to implement a more credible and systematic method of conducting reasonable assurance of your ESG data, and the best practices to streamline your materiality process.
Get your free copy now!