Does Materiality Matter?
Should the principle of materiality be applied more consistently to non-financial reporting?
Companies today are expected to report on a wide range of performance metrics and not just financial metrics. But in many cases, there are no clear guidelines or standards for what non-financial information to report – especially for topics such as environmental, social and governance (ESG) performance. In these emerging areas, companies often choose information to report based on what they believe stakeholders want, or by mimicking what others are doing. However, there is a growing push for more rigor in applying the principle of materiality to ESG reporting.
Although the idea of using materiality to frame ESG reporting is not new, it is generally not well understood and in many cases is not consistently or effectively applied. Does a more consistent, structured approach to determining materiality of ESG issues make sense? Or is it addressing a problem that doesn’t really exist?
Here’s the debate:
|As a public company, we must give stakeholders the information they need. Reporting is meant to provide investors and other stakeholders with information that is likely to affect their decisions and actions – and to fully disclose all material risks facing the business. The most direct way to determine what to report is by asking stakeholders what information they would like to see – and then analyzing their responses in a structured way that ties to business critical issues .||We already know what information to report. No one understands our business better than we do. Why waste time and money engaging with stakeholders and conducting formal analyses just to learn something we already know?|
|A structured approach to determining what to report is easier to defend. As with traditional materiality determination, qualitative information is a key input for determining what ESG information to disclose, but it can be a challenge to justify these choices. A consistent, structured approach based on stakeholder input and the principle of materiality can help protect our company and brand by demonstrating to investors, regulators and other stakeholders that we have our priorities straight, and that our reporting is unbiased and thorough.||When we’re told what to do, we’ll do it. Once regulators, accounting boards and other authorities establish clear reporting standards for non-financial areas such as ESG, we will diligently comply. But until that happens, we’ll just keep informally applying our own judgment or emulating what other companies are doing.|
|Materiality determination can save us time and money by reducing what needs to be reported. In an ideal world, all reporting requirements would be clearly defined. But in areas like ESG, that may not happen for a long time. By seeking input from our stakeholders – and then applying decision science methods to help establish priorities – we can focus our reporting on the metrics that are most likely to matter most today (both for our own internal decision making, and for the benefit of all stakeholders).||We don’t have the required data – and don’t want to invest in getting it. A more structured approach to ESG reporting based on materiality may lead to reporting requirements we aren’t prepared to handle. Instead of improving our systems and processes, let’s just keep reporting the data we already have.|
Eric Hespenheide, Partner, Global Leader, Business Risk, Deloitte & Touche LLP
Dinah A. Koehler,ScD, Research Leader, Sustainability and Climate Change, Deloitte Services LP
The consistent, structured use of materiality as a criterion for ESG reporting appears to be gaining momentum in the marketplace. The biggest barrier may be figuring out how to do it effectively and efficiently.
According to SEC Staff Accounting Bulletin 99, a matter is “material” if “there is a substantial likelihood that a reasonable person would consider it important.” Furthermore, the Financial Accounting Standards Board (FASB) notes that “the omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.”1
Since ESG materiality is rooted in stakeholder perceptions and priorities, it makes sense to ask stakeholders (both internal and external) what they care about and to consider a broader mix of information – both quantitative and qualitative. But that’s just the beginning. Running a business is not a popularity contest, and in most cases it’s impossible to please everyone. One of the main benefits of using a concept such as materiality in the context of ESG issues is that it helps narrow down the broad universe of ESG information to those items that help inform on the business’ ability to create and sustain value. In other words, it helps emphasize a business-centric view.
Decision science methods can help a company cut through complexity and determine what information is truly important to its business. In essence, the analysis revolves around two key questions:
- Is it likely the information will significantly influence stakeholder judgment, including shareholders?
- How much business value may be created or destroyed?
Consistently applying the principle of materiality to ESG reporting is an idea whose time has come. These days, business value is increasingly driven by intangibles such as resource efficiency, reputation, social responsibility, business model resilience, and capacity for innovation. Stakeholders can and do influence corporate performance on these issues. Companies that can deliver accurate and relevant reporting on these non-financial metrics are likely to enjoy a significant advantage in attracting and retaining customers, investors and talent – and may be better positioned to achieve their long-term performance objectives.
1See: http://www.sec.gov/interps/account/sab99.htm#foot3; See also: FASB, Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of Accounting Information (“Concepts Statement No. 2”), 132 (1980).
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