1.        Introduction

How to respond to new definitions of materiality as applied to corporate performance and disclosure poses one of the biggest challenges facing boards and senior executives. Traditionally, materiality has been defined through the lens of financial reporting. Now, there’s a powerful and growing movement to apply a more expansive definition that includes disclosure of the risks and opportunities posed by sustainability issues such as climate change, human rights, and board accountability. In addition to the substantive issues affecting Environmental, Social and Governance (ESG) domains, other features of this new materiality framework include: longer time horizons in which to gauge impacts on corporate performance, greater uncertainty concerning outcomes, and the views of a wider group of stakeholders who impact, and are impacted by corporate behavior.

New materiality management calls for a different outlook on reporting and valuation—one that needs to be effectively managed and wired into a firm’s operating system. Over time, the materiality lens will have implications for multiple operating areas. They will range from; risk and compliance to strategy setting, corporate policy and governance, management practices including stakeholder engagement, and even human resource management.

Numerous external forces are converging to create increased awareness of ESG factors. These forces are challenging Chief Financial Officers (CFOs) to reconsider a traditional reporting model that may not effectively meet today’s information needs. CFOs are becoming more involved in sustainability, with a total of 83 percent of respondents stating that they are always involved or frequently involved in setting sustainability strategy (up from 65 percent in 2012) and 80 percent stating that they are always involved or frequently involved in executing sustainability strategy (up from 66 percent in 2012) at their organizations. [1]

Of the 250 largest companies in the world (G250 companies), 95 percent now issue separate sustainability reports. Moving forward, there likely will be greater alignment of traditional financial reporting and reporting on ESG topics. The International Initiative for Integrated Reporting (IIRC) is proposing integrating the disclosure of standard financial information with ESG information to provide a more complete view of the commercial, social and environmental context within which a company operates. Importantly, integrated reporting likely will require reporters to make valuation impacts of ESG information more explicit.

Right now, a disconnect often exists between what ESG information companies disclose to their stakeholders and the data that actually drives management and investment decisions.   Most agree that it is hard to know which information is business-critical for the long run.

For these reasons, focus is increasing in the sustainability world on the principle of materiality as the essential filter for determining which ESG information will be useful to key decision makers.

2.        Financial materiality: the big bang of the concept

In accounting practice, materiality is a central tool. It entails many financial aspects of disclosure, among them income tax allocation, treatment of renegotiation refunds, and risk issues (Bernstein, 1967). In the 1930s, the Securities and Exchange Commission (SEC) in the USA was concerned with the possibility that readers of financial statements would be swamped with unimportant information indiscriminately commingled with significant information (Bernstein, 1967). These public concerns about materiality originated with the legislation creating the Securities and Exchange Commission (SEC) in 1934. It continued with subsequent interpretations of its mandate to require disclosure of information for the protection of investors and the public interest. The SEC has continued to rule that qualitative, as well as quantitative, data can be considered material for disclosure purposes, even though financial disclosure has dominated.

Core to the definition of materiality is the notion that corporate information is material if its omission or misstatement would influence decisions made by general users of the information.

Definition of materiality and related guidance for financial reporting have evolved over the years, as new interpretations of materiality principles were adopted by standard setters, regulators, and international organizations. Their interest in materiality is much bigger than the environment because other non-financial areas have financial implications across the sustainability spectrum.

At the Exposure Draft ED/2015/8 IFRS Practice Statement: Application of Materiality to Financial Statements, the International Accounting Standards Board framed materiality as a process that provides a threshold or cut-off point that determines what will be included in a financial statement and what will be left out. It elaborates as follows:

1. “Materiality is a general concept that is widely used both in financial reporting and for other purposes. For example, it is common for legal agreements to refer to material information, usually within a specific context such as referring to ‘material changes to the terms of the offer’ which may or may not be financial in nature.
2. Information is material if omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature and magnitude, or both, of the items to which the information relates in the context of an individual entity’s financial report”

Materiality is a general and pervasive concept and is widely used in financial and non-financial reporting and for many other business purposes. For example, business contracts may include ‘material adverse change’ clauses, which may or may not be financial in nature. A material adverse change (also called a MAC) – also formulated as an Material adverse event or Material adverse effect (either, a MAE) – contingency is a legal provision often found in mergers and acquisitions contracts and venture financing agreements that enables the acquirer (or funder) to refuse to complete the acquisition or merger or financing with the party being acquired (often termed, the “target”) if the target suffers such a change.

In planning the audit of a corporation, an auditor will establish a materiality threshold for purposes of determining the scope of test procedures, which would be different from the materiality threshold the auditor will use for purposes of rendering the attest report on the fairness of the client’s financial statements taken as a whole. Materiality is frequently a legal concept as well because some countries, by either statute, case law or regulation, have established a definition of materiality they require to be applied in their jurisdiction. As an obvious consequence, it is not possible to establish a ‘one size fits all’ quantified definition of materiality.

Various definitions of materiality and related guidance for financial reporting evolved over the years, as new interpretations of principles of materiality were adopted by standard setters, regulators, and international organisations (Murninghan, 2013). It is clear that in accounting practice, materiality is measured as an expected change/loss in net income expressed in accepted monetary terms. Any material indicator can be quantified as a monetary value added up in the yearly balance. The question is how and to what extent sustainable issues can be measured, if at all, especially taking into account that their effect might be long-term rather than annually-based.

Many corporate leaders, including sustainability managers, are focused on materiality beyond the traditional and well-understood financial statement materiality concept. These leaders recognize that the traditional interpretation of financial statement materiality does not adequately capture non-financial business drivers. GRI guidance encourages companies to consider what is material to stakeholders, but the guidance does not provide enough information on what that could mean for a company. Is it a visit to the emergency room because a child has an asthma attack precipitated by air pollution? Is it five such visits in a week because the family lives next to a facility which emits particulate matter that causes chronic infection of the lungs? Is it a fire in a Bangladesh clothing factory? Is it rainforest destruction? If so, how many acres and in what timeframe?

For many companies, the problem is not a lack of ESG issues that are important to stakeholders, but when and why these issues might become financially material. This is particularly difficult for ESG issues because they are often related to externalities and are not properly priced in the marketplace. Thus, without a clear price signal, figuring out materiality is a more subjective, rather than objective, endeavor especially if you are only looking at it from a traditional financial statement standpoint. The costs of the externalities to others in the community, supply chain and the broader ecosystem are real and can be quantified via health economics and environmental economics. This is knowledge that needs to be more integrated into corporate decision-making on the trade-off between total (social and environmental) costs and benefits of every product and technology. Omitting this information means that it has zero value to the company.

That’s what AccountAbility set out to do in 1998 with the AA1000 Series of Standards, and what the Global Reporting Initiative (GRI) continued with issuance and periodic update of its Sustainability Reporting Guidelines. (The GRI’s most recent reporting guidelines were released last October, 2016).

https://www.globalreporting.org/information/news-and-press-center/Pages/First-Global-Sustainability-Reporting-Standards-Set-to-Transform-Business.aspx

More recently, several simultaneous global conversations about expanding and codifying materiality are underway. They push the boundary even further, and are evolving in different ways, depending on scale, scope, and geography. What they hold in common is a belief in new frameworks, timeframes, and metrics. Their focus: climate risk, political contributions, human rights, supply chain integrity, bribery and corruption, diversity, product quality and safety, and corporate governance.

Widening the focus of materiality is the means by which the basis of mainstream financial assurance and reporting can absorb, or be absorbed into, the sustainability agenda.

According to noted authors Robert G. Eccles, Michael P. Krzus, Jean Rogers, and George Serafeim, most definition and interpretations of materiality are “principles-based” and fairly general. (AccountAbility’s AA1000 Standards are principles-based.) In the U.S., materiality is rules-based.

General guidance for both approaches occur within clearly definition accounting standards—a Generally Accepted Accounting Principles (GAAP) in the U.S., the International Financial Reporting Standards (IFRS) everywhere else—promulgated by groups such as the Financial Accounting Standards Board (FASB) in the U.S. and the International Accounting Standards Board (IASB) throughout the rest of the world. The authors Eccles et al. (2012) argue for a way of definition materiality that accommodates both rules-based and principles-based approaches.

At a corporate level, the challenge is not only to stay abreast of these conversations, but also to apply a methodology that’s robust enough to definition those issues in anticipation of new disclosure requirements, and embed them into business models and long-term strategy.

Key questions become: How will you know which are the most important environmental, social, and governance issues that affect competitive performance, including.

3.        Sustainability reporting (major) standard-setters and definition of materiality

Over the last three years, the total number of instruments that require or encourage organizations to report information about their sustainability performance has grown rapidly and significantly worldwide.

As continued pressure to integrate ESG factors into business practice and disclosure matures, there is an equivalent push for greater focus and disclosure on their definition and impact. This means tying them to specific performance outcomes within the context of sustainability realities. The aim: to provide key stakeholders, including investors, with insight into the continuum of ESG factors and how they will shape institutional performance. Already, there are signs of a context-based approach springing up throughout the world.

If everything is material, it’s not material. Everything cannot be top priority. Everything cannot be most important. The complexity of sustainability, especially for large, global businesses, is vast. A list of potential material issues can run into hundreds of issues.

Key questions become: How will you know which are the most important ESG issues that affect competitive performance, including brand, reputation, and customer base? Who are you going to ask to answer this question, and how will you prioritize the answers? Once you’ve done that, how will you weave these sustainability risks and opportunities into your business strategy?

Early attempts to do this often involved creation of a “materiality matrix”, which featured issues considered important to both companies (on one axis) and stakeholders (on the other axis). While useful as a preliminary map, the effectiveness of materiality matrices is somewhat limited. That’s because they often don’t show the priorities of different groups, or the industrial benchmarks used by peers and investors to compare performance, or characteristics such as “innovation” that represent resilience and adaptability to changing times. They also don’t show key sustainability performance indicators within an industry, or provide for future disruptive events or changes in stakeholder priorities that may change the mix.

Just as AccountAbility did in 2006, a new approach to materiality needs to focus on what is important to the business. But it needs to do this with a wider focus, in order to capture:

A longer-term view of the issues that could affect the success of its strategy.

A wider view of the people whose actions influence performance and who therefore need sound information to guide their judgments.

A deeper view of the information necessary for sound decision making, including where necessary both financial and non-financial data, and forward as well as backward looking indications of performance.

New definitions and management of materiality will affect virtually every aspect of corporate operations, from the board room through the supply chain and extending through the product life cycle. At a minimum, CEOs, boards, and senior executives will need to familiarize themselves with recent developments and begin to sort through how they will link material sustainability issues to their financial reporting, stakeholder engagement and, increasingly, assess the impact of their sustainability performance (externalities) on a wider context. That’s a process of discernment and development, as mentioned earlier, that involves a wide variety of corporate personnel and stakeholders, across disciplines and departments.

More than that, CEOs, boards, and senior executives will need to understand the strategic importance of material sustainability issues, and make sure they are effectively managed. “Effective management” calls for a suite of new knowledge and skills, building on what already is there, and is necessary to reporting, stakeholder engagement, and determining sustainability impacts. This involves new partnerships with reputable policy institutes and analysts, so that the substantive issues of material importance—on climate, human rights, corporate governance, economic and political stability, employee health and safety, supply chain performance, and so on—are comprehended and continually updated.

Finally, CEOs, boards, and senior executives will need to adopt a new framework for excellence, one that puts dynamic, emergent learning at the center, rather than more static “knowledge transfer”—because new materiality management is about managing for the future, not just reiterating what has worked in the past.

It is about foresight, not hindsight. Approaching new materiality management this way creates a climate conducive to innovation and experimentation—and failure, because after all, who can fully predict what the future holds?—that, in turn, reignites an entrepreneurial spirit so vital to competitive advantage and continued business success. The bonus: it’s also vital to wider community well-being and prosperity, particularly for future generations.

Leading companies will seize the opportunity posed by new materiality management, and put processes into place to manage both financial and sustainability issues. Other groups in the corporate reporting ecosystem, of course, are also affected by these new definitions and applications of material sustainability priorities.

Accountants and auditors, management consultants, securities lawyers, investors, and advocacy groups will need to make adjustments in their goals and tactics.

For the moment in the next table there is a presentation of the definitions, scope and perspectives of materiality according to six relevant standard-setters in the field of sustainability reporting.

Table 1. Source: Corporate Reporting Dialogue. Statement of Common Principles of Materiality.

Available at: http://corporatereportingdialogue.com/wp-content/uploads/2016/03/Statement-of-Common-Principles-of-Materiality1.pdf

4.        The case of the seven biggest groups in Spain

I have chosen these companies as global ones and for this reason I expect that targeted to emerging forms of capitalism and especially more worried about how companies implement sustainability principles in their businesses.

The most immediate resource for this is the Financial Times Global 500 that ranks companies by market capitalization – the greater the stock market value of a company, the higher its ranking.

Below I paste the original ranking for the seven Spanish companies included (at the moment of writing this paper the last available ranking at the date of Marc, 31 2015).

[1] CFOs and Sustainability: Shaping their roles in an evolving environment. Deloitte Sustainability Global Enterprise Risk Services.

http://www2.deloitte.com/content/dam/Deloitte/global/Documents/Risk/dttl-risk-Deloitte-CFOs_and_Sustainability-2014.pdf

Table 4. Inditex Annual Report (2015)

Graphic 5. Telefonica’s Annual Report (2015