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Addressing the Challenge of Materiality - More than just Compliance
The concept of ‘materiality' is fundamental to corporate reporting practice. To be effective, an annual report should provide information that is of value – or ‘material' interest – to the intended users of the report. While there is clear guidance as to what materiality might mean for the purposes of annual financial and sustainability reports, there is considerably less experience to draw on when it comes to assessing materiality in the context of integrated reporting.
This article briefly reviews the understanding of materiality that should inform current reporting practice, and suggests an approach to materiality that is intended to meet the objectives that are driving the shift to integrated reporting.
Understanding the current approach to materiality
“Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful.” International Financial Reporting Standards (IFRS)
The IFRS definition provides a valuable starting point for understanding materiality. It's clear that assessing the materiality of particular information will require the organisation to identify the intended users of the report and to understand the types of decisions these users may be seeking to make based on the report. Clearly, annual reports cannot satisfy all of the needs of all of the potential users all of the time, hence the requirement for some judgement regarding the likely nature of the priority user group and their particular information needs.
For the purposes of financial reports, the reported information is intended to facilitate informed economic decisions about the organisation. There is a clear expectation as to what this information should cover, including typically such issues as financial position, performance and cash flows. In the context of financial information, materiality is generally used in the sense of the magnitude of an omission or misstatement of accounting data that misleads users. It is usually measured in monetary terms, and is judged both by the relative amount and the nature of the item concerned.
In terms of sustainability reports, materiality is more difficult to assess requiring greater judgement across a potentially vast array of sustainability issues. The IFRS equivalent for sustainability reporting is the Sustainability Reporting Guidelines of the Global Reporting Initiative (GRI). Now in their third generation, the GRI Guidelines suggest that the material issues that should be reported are those that “reflect the organisation's significant economic, environmental and social impacts, or that would substantively influence the assessment and decisions of stakeholders” (emphasis added).
Further guidance on assessing the potential significance of a reported impact is provided in the recently released international standard on social responsibility, ISO 26000. In its guidance on determining the significance of social responsibility issues (clause 7.3.2.2), the standard states that “issues that are generally considered to be significant are non-compliance with the law, inconsistency with international norms of behaviour, potential violations of human rights, practices that could endanger life or health, and practices that could seriously affect the environment”. This is a high bar and one that would suggest that most current sustainability reports probably fail the materiality test.
Concerns with current reporting practice
“A lot of what's in sustainability reports I consider unnecessary. I'm in favour of them in principle, but unfortunately I feel that companies are sticking stuff in these reports for the purposes of (a) ticking a box and (b) putting in information despite knowing that it doesn't have a great deal of bearing. So companies can say ‘Yes, we've done a very thorough job', but in actual fact, the stuff they stick in the reports is of no particular importance to anyone. So that's why I'm not reading them any more. I've never read any of them that I regard as particularly changing any perception that I've had before.”
South African financial analyst (personal communication)
In designing an effective materiality process aimed at identifying the material issues to include in an integrated report, it is useful to consider the rationale that has been driving the move – locally and internationally – to integrated reporting.
Informing this shift is the belief that current reporting practice is not delivering. Professor Mervyn King articulates this clearly in the foreword to the South African Discussion Paper on integrated reporting issued in January 2011, where he maintains that many stakeholders “question the relevance and reliability of annual financial reports as a basis for making decisions about an organisation”. He states further that “reports based largely on financial information do not provide sufficient insight to enable stakeholders to form a comprehensive picture of the organisation's performance and of its ability to create and sustain value, especially in the context of growing environmental, social and economic challenges”.
Sustainability reports are similarly seen to suffer weaknesses. They often seem disconnected from the organisation's financial reports, they typically provide a backward-looking review of performance, and they very rarely make the link between sustainability issues and the organisation's core strategy. And as the quote from the South African analyst implies, sustainability reports are often guilty of ‘carpet-bombing', covering too many non-material issues in the hope of meeting the needs of all its stakeholders and, in the process, often failing to meet the needs of any of them.
In short, current reporting practice fails because most reports fail the test of materiality. Reports may be getting longer yet critical disclosure gaps remain: most reports are not providing the information that is needed to enable stakeholders to make an informed assessment of the total economic value of the organisation, particularly given the rapidly changing societal context.
Materiality and integrated reporting
“The development of Integrated Reporting is designed to enhance and consolidate existing reporting practices... to move towards a reporting framework that provides the information needed to assess organizational value in the 21st century.”
(IIRC Discussion Paper)
The September 2011 Discussion Paper of the International Integrated Reporting Committee (IIRC) defines integrated reporting as the process that “brings together the material information about an organisation's strategy, governance, performance and prospects in a way that reflects the commercial, social and environmental context within which it operates. It provides a clear and concise representation of how an organisation demonstrates stewardship and how it creates value, now and in the future.”
The South African Discussion Paper suggests that the underlying objective of an integrated report is to allow users of the report to determine whether the organisation's governing structure has applied its collective mind in identifying the environmental, social, economic and financial issues that impact on the organisation, and to assess the extent to which these issues have been incorporated into the organisation's strategy.
So what does all this mean for materiality? As noted earlier, information is material if it is of such importance and relevance that it could substantively influence the assessments and decisions of the organisation and its stakeholders. Based on the above understanding of integrated reporting, it is suggested that the targeted users of an integrated report are those individuals or organisations (from whichever stakeholder category) that wish to assess the organisation's capacity to create value now and in the future. While the long-term investor may be seen as a good proxy, he is clearly not the only stakeholder that has an interest in assessing the organisation's continuing ability to create value.
To enable stakeholders to make this assessment will require the organisation to disclose its impacts on the financial, economic, social and environmental systems that have a bearing on its ability to create value, as well as to reflect on the organisation's capacity to respond effectively to the changing societal context. The report should demonstrate how the organisation's key decision-makers have been engaged in identifying the most material issues, and it should disclose how (if at all) its strategy provides for the changing societal context.
Our experience in advising companies on their reporting and strategy processes has led us to believe that in seeking to identify its material issues, an organisation's governing structure should ideally be engaged in a process that considers the following questions:
- What are the links between the organisation's value drivers and social, natural and economic systems?
- How does the organisation position itself in the context of current societal trends? For example, is the organisation seeking mainly to reduce costs and manage risks, or is it striving to differentiate and brand itself explicitly on its approach to societal challenges?
- What organisational competencies – employee skills, operating systems, strategic partnerships, company culture and so on – are needed to deliver on its stated strategic commitment and to ensure that the company remains competitive in the context of a rapidly changing business environment?
- What are the key strategic focus areas and associated performance indicators to deliver this?
Through this active internal reflection, we believe the integrated reporting process will not only produce a report that is material and fit for purpose, but ideally will also assist in addressing what respected business strategy guru, Michael Porter, has called the “out-dated approach to value creation” that pervades much of business, characterised by its obsession with short-term financial performance that ignores the broader societal influences that determine longer-term success.
Fulfilling the potential of integrated reporting
In his foreword to the IRC Discussion Paper, Professor King suggests that “if done properly, organisations that produce an integrated report for the first time will take a new look at themselves and their business models… and will be encouraged to explore new and potentially innovative opportunities in their products, services, processes and markets.” He maintains further that integrated reporting “has the ability to improve strategic decision-making, improve performance and enhance reputation among stakeholders”.
For this exciting potential to be fully realised it is critical that the integrated reporting process does not simply become a compliance-driven exercise that is administered in comparative isolation by the company secretary or investor relations department. Instead, it will require the active engagement of the organisation's governing structure, included in particular as part of the materiality process. asa
Jonathon Hanks BA (Hons), LLM, MsC, is Managing Director at Incite Sustainability, and a member of both the Working Group of the South African Integrated Reporting Committee and the Advisory Group to the International Integrated Reporting Committee.
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Article Comments
So it seems the intergrated reporting is very much concerned with the non financials because it seems that is the part which an ordinary person can easily understand. Is it that the financial reporting are more technical? Then if that is the case there should be auditors who should check those ticks and make sure that before they are submited out in reports there should be true and fair.
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