Organizations have to disclose their financial information periodically to meet regulatory compliance and stakeholder requirements. But what information needs to be disclosed is determined by its materiality or relevance for the users of the financial statement.
According to SEC’s guidelines, both qualitative and quantitative aspects need to be considered for materiality assessment. The Financial Accounting Standards Board (FASB) emphasizes that materiality cannot be reduced to a numerical calculation.
The point being emphasized is that materiality is a relative notion that relies on the circumstances of the financial reporting entity as well as the intended users of the financial statements.
And that brings us to the second part of our discussion; double materiality.
It has been firmly established that external factors such as environment and climate impact the financial performance of a company. Therefore, such information can be deemed material that should be disclosed to the stakeholders for complete transparency and fair flow of information across the capital chain.
Double materiality discussion takes it a step ahead and proposes that in addition to external factors impacting the financial performance of a company, a company’s operations also impact the climate, environment, and other factors classified under the sustainability or ESG umbrella.
Definition of Materiality
We gave an overview of materiality and double materiality in our introductory section, however, to gain a better understanding of double materiality it is advisable to revisit how materiality is defined in accounting terms and understand how it is determined and why is it important for businesses.
Materiality as a concept can well drift into the realms of philosophy and fit there as perfectly as it does in the world of accountancy, as some may argue. And a lot has to do with how materiality is viewed and how differently it is applied much like philosophy.
Moving out of the labyrinths of philosophy to the relatively straight streets of accounting one will discover materiality is defined as a company’s financial statements prepared by accepted accounting standards and must include a complete record of all items that are likely to have an impact on investors’ decision-making. If the omission or misstatement of information in a company’s financial statements impacts the users of those statements, affecting their decisions, it becomes material.
Federal Accounting Standards Advisory Board defines material from the lens of omissions and misstatements of information and their impact on the users and deems this as a tried-and-true definition also endorsed by the Securities and Exchange Commission (SEC), Public Company Accounting Oversight Board (PCAOB) and American Institute of CPAs (AICPA).
FASB however offers no guidance to define materiality and nor explains how materiality should be applied in a set of given facts and circumstances.
And there is a reason for it.
Ascertaining materiality involves a degree of judgment and subjectivity, and there are no hard and fast rules or guidelines for identifying what is and is not material.
It brings us to the discussion about how to assess what is material and what is not.
How Is Materiality Determined?
While accounting principles and professional guidance can help, determining materiality ultimately depends on the facts and circumstances of each instance. When determining materiality, the size and nature of the item, the impact on the financial statements, the intended consumers of the financial statements, and the context of the disclosure are evaluated.
IFRS defines, “Materiality as 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.
IFRS explains that when evaluating materiality, it is important to consider how users might be influenced in making economic decisions based on financial statements, taking into account what could be deemed as reasonable expectations.
Materiality filters financial information and ensures that it effectively and thoroughly summarizes an entity’s internal accounting records. This includes presenting information clearly and succinctly that assists users in comprehending financial statements.
Excessive disclosure of irrelevant information or the hiding of material information can make financial statements more difficult for users to understand.
To establish whether the information presented is valuable to the primary consumers a few strategies can be adopted and some of these methods are:
- Determining the usefulness of any information by gathering opinions and expectations of the users through discussions or by accessing publicly available information.
- Management can also assess the utility of financial data by imagining themselves as external users who lack access to internal knowledge about important risks or value drivers. It will help analyze the decisions and information they would want if they were in the same circumstances as external consumers.
- Another way of assessing materiality is by observing market responses to specific transactions or disclosures made by the company, as well as responses from external parties like analysts to requests for information.
- Analyzing the types of information provided by other entities operating in the same industry is another way to determine materiality. However, caution must be applied entities in the same industry may have similarities, as the same information will be material for all of them
Importance of Materiality in Financial Reporting
Materiality is a critical notion in financial reporting that assists businesses in determining what information should be included in their financial statements. Materiality refers to the importance of an item or piece of information in affecting the economic decisions of financial statement users. It is critical to examine an item’s materiality to ensure that financial statements are not misleading and offer stakeholders relevant and reliable information.
Overview of Double Materiality
Double materiality was proposed formally by the EC in Guidelines on Non-financial Reporting: Supplement on Reporting Climate-related Information published in June 2019.
It guided the organization that their management report should contain details essential to comprehend the effects they have on sustainability-related matters, as well as information necessary to comprehend how sustainability matters influence their growth, achievements, and status.
And the concept of double materiality (impact materiality and financial materiality) was introduced. The upcoming ESRS will assess the sustainability information reported based on which materiality criteria it meets.
A broad definition of double materiality derived from EFRAG”s guidelines is that the double materiality assessment serves as a criterion to evaluate whether a sustainability topic or information must be included in a sustainability report. A sustainability matter is considered “material” when it meets the criteria outlined for either impact materiality, financial materiality, or both.
It also makes sense to understand the stakeholders of double materiality.
EFRAG recognizes two sorts of stakeholders:
Affected Stakeholders- Those who are impacted by the firm and those who utilize sustainability statements but do not identify within a company’s ecosystem.
User stakeholders- They are various entities that have a stake or interest in the sustainability reporting of a company. It includes public authorities, business partners of the company, equity investors (such as asset managers), lenders (such as credit institutions and insurance undertakings), civil society organizations, trade unions, and social partners.
Stakeholders who are impacted by the company contribute to impact materiality, whereas users contribute to financial materiality.
Employees, top management, and equity investors, on the other hand, may contribute to both aspects.
Difference Between Double Materiality and Traditional Materiality
As we discussed in the previous section, financial materiality refers to the significance of financial information to a company’s financial statements. It primarily concerns itself with whether an omission or misstatement of financial information may have an influence on investor decisions or the overall truth of financial statements. Financial materiality only considers the financial consequences for the company and its stakeholders.
Double materiality, on the other hand, is a concept that analyses both the internal and external repercussions of a company’s activities. It acknowledges that a company’s sustainability performance can influence its business operations and financial performance, and vice versa. Thus, double materiality analyses both the financial repercussions on the corporation and its stakeholders, as well as the social and environmental impacts on society as a whole.
Importance of Double-Materiality for Business
Double materiality is important for businesses because it acknowledges that a company’s financial performance is inextricably linked to its social and environmental implications.
Businesses can acquire a more thorough picture of their sustainability performance and the associated risks and opportunities by evaluating both the internal and external implications of their activities.
The double materiality approach helps businesses transparently communicate with the stakeholders to build trust.
Management can also assess the utility of financial data by imagining themselves as external users who lack access to the entity’s internal knowledge about important risks or value drivers. In doing so, they might analyze the decisions and information they would want if they were in the same circumstances as external consumers.
Double materiality helps businesses to:
- Identify areas where they can create long-term value for their stakeholders
- Uncover chances to decrease costs, improve brand reputation, and attract new consumers or investors that value sustainability
- Incorporate sustainability considerations into strategic decision-making processes, to strengthen their resilience to sustainability-related risks and regulatory changes
In the next section, we explore the significance of double materiality in detail.
Significance of Double Materiality
The concept of double materiality recognizes that a company’s sustainability performance can have an impact on both its financial performance and the social and environmental impacts of its activities on society as a whole. As a result, it goes beyond financial reporting, which focuses solely on the financial effects of a company’s operations on its financial statements.
Importance of Considering Environmental and Social Impacts on Business Decisions
Companies can find chances to produce long-term value for their stakeholders by analyzing both the internal and external implications of their activities.
The growing sustainability-related risks have strengthened the demand for transparency and disclosure on non-financial aspects of a business’s operations and impacts.
Integrating sustainability considerations into their strategic decision-making processes allows businesses to better respond to emerging sustainability risks and regulatory changes and identify opportunities to create long-term value for their stakeholders.
Role of Double Materiality in Corporate Sustainability and Responsibility
The notion of double materiality recognizes the interaction between a company’s financial performance and its social and environmental repercussions. Therefore, companies cannot ignore both the internal and external implications of their activities when making decisions about their business operations and plans.
Businesses are part of society and don’t operate in vacuums and have a responsibility toward that community. Double materiality allows companies to demonstrate their commitment to responsible corporate citizenship and contribute to sustainable development by examining the social and environmental implications of their actions.
Steps taken to mitigate negative impacts while enhancing good benefits improve their reputation and brand value among stakeholders.
It also gives stakeholders a thorough picture of their sustainability performance and demonstrates their commitment to sustainability by evaluating both the financial and non-financial implications of their actions.
So how can organizations approach double materiality?
Implementation of Double Materiality
How companies can incorporate double materiality into their decision-making processes
The consequences of an organization on the economy, environment, or society are critical, as are the influences of society and the environment on the organization. It is critical to analyze both features separately while also acknowledging their interdependence.
A few considerations while approaching double materiality include:
- Understand the implications for the value chain and the stakeholders involved.
- Involving stakeholders to generate a comprehensive list of sustainability topics.
- Ascertaining the most important topics
- Incorporation of the findings into both reporting and strategy.
Initiating a detailed and in-depth inquiry into impact materiality and financial materiality by meticulously crafted questions can be insightful for organizations.
Challenges and limitations in implementing double materiality
For successful assessment, a few challenges to look out for include:
- Identifying the right stakeholders
- Engaging with the C-suite and senior leadership
- Ascertaining the right level of granularity
- Defining appropriate timeline
- Adequately assessing long-term risk in absence of substantial data
- Integrating results into reporting and the decision-making process
Regulatory Landscape of Double Materiality
The European Union (EU) has been at the forefront of double materiality regulatory actions. The EU issued a non-binding advice document on non-financial reporting in 2018, encouraging businesses to evaluate both the internal and external repercussions of their actions.
The guidance emphasizes the importance of double materiality in identifying sustainability-related risks and opportunities, and it advises businesses to report on their social and environmental impacts in a way that is relevant to their business model.
In 2019, the EU introduced a proposal for a Corporate Sustainability Reporting Directive (CSRD), making it mandatory for all significant enterprises in the EU that are already subject to the NFRD to report on their sustainability performance. Within this approach, organizations are expected to incorporate not just affect materiality perspectives (from the inside out), but also financial materiality perspectives (from the inside in) in their annual report. CSRD came into force on 5 January 2023 and the companies subject to the CSRD will have to report according to European Sustainability Reporting Standards (ESRS). EFRAG recently released the first set of draft ESRS.
Additionally, the GRI Standards are the only global sustainability reporting framework that comprehensively captures the outward impact of organizations on people and the planet, with a focus on their impacts.
The changing regulatory environment and increasing demand from the stakeholders for a transparent and complete picture of an organization’s financial and non-financial health have made double materiality important and relevant.
Businesses should consider adopting double materiality assessment in their strategies and decision-making process to comply with the updated regulation or simply gain the fast-mover advantage in jurisdictions where it has not been made mandatory yet.
As ESG and sustainability reporting movement gains momentum double materiality will get more widely adopted by businesses to assess their impact materiality in addition to financial materiality.