Weighing the future cannot be a technical, bureaucratic exercise

by Carol Adams

Main points:

  • You can’t reduce materiality determining to a bureaucratic and technical process
  • How you measure something can bring unintended consequences
  • Some managers are able to weigh up complex issues with opposing impacts while others find it difficult

Involved in sustainability standards for many years, including the development of the AA1000 standard in the 1990s, my view has always been that we should learn from the concepts of financial accounting. Yet debates on financial versus sustainability reporting make a distinction between financial materiality and broader sustainability materiality. Are these very different, irreconcilable approaches to materiality? I believe the underlying logic is the same, even though the concept is quite different in sustainability reporting.

Photo by Who is Danny ShutterstockIn financial reporting the focus is still predominantly on the numbers, looking backwards within the boundaries of the reporting organization. When you look at sustainability impacts you look broader, at the supply chain and consider stakeholder views, how that impacts your reputation, and long-term implications for your ability to create value. It is a similar idea, assessing relevance in terms of level of significance, but the issues are different, the audience is different, and the purpose is also different.

The materiality procedure followed by financial accountants and auditors is narrower in focus. It is a technical solution that seeks to add objectivity. You define quantitative thresholds and the methodology gives a sense of objectivity. But in sustainability reporting it is not so technical and not an exact science. It is subjective and you have to apply principles.

In financial reporting the company management is ultimately responsible for the financial reporting process, and the Board needs to ensure there is an appropriate process. Financial auditors apply their tests and have to demonstrate to management and the Board that they’ve followed a due process.

In non-financial reporting management and the Board need to have a clear understanding of how they define value, the value they create and who they are creating value for. If you haven’t got that definition of value right, then your strategy and reporting won’t be aligned.

The assurance provider should examine whether the organization is working towards value creation as its leadership has defined it. Integrated Reporting forces the organization to think more long-term and work with a broader view of value. The starting point is to define value, the process of value creation and who value is created for. My research shows that integrated thinking and integrated reporting help to establish a broader understanding of value. Yet many integrated reporters still don’t clearly define what value is.

Recently in Australia, the ASX consultation on corporate governance principles considered incorporating the idea of the “social license to operate”. The social license today will be different from the social license in the future and in the final version they abandoned the idea. How would an assurance provider assess it when an organization is storing up problems for the future? Similarly, when considering “stranded assets”, financial reporting standards are hard to apply. IFRS does not like taking into consideration risks that are unknown or uncertain. It therefore discourages the devaluation of assets when there is uncertainty as regards future risks. This is storing up problems for the future.

The Corporate Reporting Dialogue acknowledges that there are different definitions and interpretations of materiality between the business, financial, legal and regulatory communities. Materiality will never be an exact science. It is also about principles and being ethical, including the desire to be accountable and make the best decisions for an organization.

Accounting developed very differently across the globe. In the UK there is the principle of substance over form, where you consider the substance of a transaction above the legal form of the transaction. The common Wall Street emphasis on decision-usefulness in terms of cash flow predictions is very narrow, versus usefulness in terms of long-term creation of value. Investors need to look beyond short-term cash flows. When we suffer from climate disasters, who cares about cash flows? Rules are easier to apply but meaningless in many cases. What is good in the long term is not determined by what ultimately can be translated into cash flows.

While financial and sustainability standard setters under the Corporate Reporting Dialogue have come up with a general, common definition of materiality, that broad definition can be applied differently in different situations. A certain level of consistency in applying materiality is necessary. But one size doesn’t fit all. The Corporate Reporting Dialogue’s Statement on Common Principles of Materiality states that an assessment of materiality is “primarily qualitative”. Quantitative materiality thresholds are said not to be “dispositive” by themselves. I absolutely agree. One factor in applying this with a management team is the type of thinkers you’re working with, their cognitive framing. Some managers are able to weigh up complex issues with opposing impacts in qualitative terms while others find that very difficult. Dealing with sustainable development risks and opportunities requires an ability to judge tradeoffs and assess connectivity holistically.

It is true that if something gets measured it gets managed. But depending on how you measure it, it might not get managed in the most appropriate way.  If you look at the performance evaluation criteria of executives, they often include non-quantifiable areas. Examples are people skills and adherence to an organization’s values. While they cannot be quantified, you can still form a view. We should not be obsessed in measuring in in quantitative terms. It is about changing the way business think.  You cannot reduce materiality determination to a bureaucratic and technical process. It requires judgement and needs to include senior managers and Board members able to deal with strategy with a long-term and holistic perspective.

This article was first posted on the Materiality Tracker website. With thanks to Cornis van der Lugt

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Comments

  1. Sarah-Jayne Dominic says:

    I am not sure that all members of the CRD have a common definition of materiality – more specifically the investor financial focus of some standard setters vs the impact on all stakeholders approach of others.

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