If you're a sustainability professional who got his or her start in environmental affairs, chemistry or toxicology, the word "materiality" probably wasn't part of your core curriculum. But the concept may be invaluable when it comes to prioritizing sustainability initiatives and communicating progress toward them — especially as awareness of these matters grows in the chief financial officer's office. With that in mind, we offer this brief accounting lesson.
What is materiality?
Practically speaking, materiality has its roots in corporate finance departments as part of generally accepted accounting principles. Here's the one-sentence definition most people throw around: "Information is material if its omission or misstatement could influence the economic decision of users taken on the basis of the financial statements."
Materiality is a guidepost for disclosure and reporting. An expense or write-off, therefore, would be considered material if the amount involved would affect how an investor or other stakeholder might value the company. A loss of $1,000 to a company with $10 million in revenue, for example, probably would be considered immaterial and unnecessary to disclose. But if the amount involved is larger — say, $100,000 or $1 million — good judgment suggests that it should be reported.
When you apply the concept of materiality beyond financials to environmental, social and governance factors, the rationale for disclosure takes on qualitative dimensions — many of which have no clear value. Often, the ESG factors are related external factors that may be a risk to revenue or income. The manner in which a beverage, food or semiconductor company reports on water conservation initiatives, for example, would differ dramatically from how these matters are considered by a financial services or construction firm.
Why is materiality increasingly relevant for sustainability reporting?
Discussions about materiality were thrust into the forefront of sustainability strategy and reporting dialogues with the release of the Global Reporting Initiative G4 framework in May 2013, which more explicitly names materiality as an integral part of sustainability reporting.
GRI's framework accounts for issues that have a "direct or indirect impact on an organization's ability to create, preserve or erode economic, environmental and social value for itself, its stakeholders and society at large." Yep, that definition covers plenty.
As already suggested, the concept of materiality is highly industry-specific. The 2013 GlobeScan/SustainAbility Issues Survey, which reflects the opinions of 881 sustainability executives from 91 countries, classifies the following as concerns that require both high levels of accountability and urgency: climate change, air pollution, access to energy, water pollution, bribery/corruption and biodiversity loss.
While most of the world's 250 largest companies disclose information about exposure to these factors, almost all of those disclosures currently are part of sustainability reports that live separately from traditional financial statements and annual reports. But those lines are beginning to blur, thanks to the push for integrated reporting.
"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," wrote two Deloitte experts on this matter, in an article for GreenBiz.
"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."
How does an organization assess materiality?
Figuring out which data is really important to external stakeholders — whether you're talking about employees, investors or the communities in which a company does business or operates facilities — is the high-level aim of materiality assessments.
This process involves convening meetings between sustainability teams, financial departments, line-of-business managers and other stakeholders. This will guide not only which factors demand attention but how that information should be presented, and to whom it should be disclosed.
"The best way to ensure engagement at all levels is to start with the C-suite and board of directors," Michael Muyot, president and founder of CRD Analytics, told GreenBiz in fall 2013. "If they don't agree to participate, that's a big red flag and almost a sure sign that project either will fail or be lackluster in its findings and recommendations."
What best practices are available to help with materiality assessments?
The sustainability reports of many high-profile companies are sprinkled liberally with mentions of where materiality assessments have been performed — from Anglo American (PDF) to EMC (PDF) to Marks & Spencer to Nestle to NextEra Energy to Sprint (PDF).
Accordingly, an increasing number of third-party consulting organizations are focused on assisting with facilitation. In addition, GRI, the International Integrated Reporting Council (PDF) and Sustainability Accounting Standards Board all offer specific guidelines regarding materiality that can provide a framework.
One common refrain is the suggestion to embed assessments into everyday decision-making at senior executive levels; the table stakes includes an annual review. Unfortunately, the approaches laid out by each organization is slightly different. IIRC's emphasis, as you might expect, takes the position that investors will take a longer-term view that inspires companies to take a more analytical look at the non-financial factors that create corporate value. SASB is "betting" that regulatory bodies will dictate the way material issues should be disclosed. And GRI leans heavily on the role of external stakeholders.
"For both SASB and IIRC, the level of materiality ascribed to an issue that is important to nonfinancial stakeholders is entirely contingent on how much it influences decisions and assessments made by the providers of financial capital. … By contrast, for the GRI, the opinions of stakeholders have value in their own right, regardless of investors," wrote BSR managing director Dunstan Allison Hope and advisor Guy Morgan in an August 2013 GreenBiz article, How to navigate the maze of materiality definitions.
Why haven't more companies embraced materiality within their sustainability programs?
That disconnect and fear of the unknown are the things that makes materiality such a difficult concept for many sustainability managers to grasp right now. Some companies might worry that disclosing certain information will result in the loss of competitive advantages, while others are reluctant to discuss matters that are not entirely within their control. Still others may struggle with quantifying the cost implications.
"What really matters is how companies adopt or change each approach and how credible the resulting reports are for their users," wrote Hope and Morgan. "If the past 20 years of corporate responsibility have taught us anything, it's that we're all better off when companies create approaches that work in the real world."
Top image of calipers measuring dollar plant by Sergey Nivens via Shutterstock.