An introduction to financial materiality: a guide for corporates

Guest writer: Toby Fox

Materiality is a GAAP (generally accepted accounting principles) principle. For a materiality factor or sustainability to translate into financial performance, it must have a positive or negative impact on either the amount of cash flow generated by the company, or the revenue growth of the company. 

Financial materiality is growing in importance as thousands of publicly listed companies around the world are now measuring, managing and reporting on ESG issues (Ioannis loannou, 2011).This is a recent phenomenon with most companies having initiated their ESG strategies within the last decade. 

This phenomenon is partly a result of companies themselves paying an increased interest into these internal factors. But also, due to increasing pressure for the disclosure of company sustainability factors by stakeholders, nongovernmental NGO’s, activists and civil society groups. 

Lastly, increasingly investment funds are considering financially material factors such as environmental, social and governance (‘ESG’) issues as part of the investment process to determine a default investment strategy. It believes that financially material considerations are implicitly factored into the expected risk and return profile of the asset classes that members are investing in (David Freidburg). Most institutional investors now report that the primary reason why they use ESG data is because these issues are or will become financially material (Amel-Zadeh and Serafeim, 2018).Therefore, it’s within the companies’ interest to disclose relevant ESG factors, as they are likely to receive higher levels of investment.

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Financial materiality by industry

Financial materiality differs greatly between industry because not every ESG factor will be material to all business and sectors, with (Robert G Eccles, 2012) stating materiality and reporting standards must be developed on a sector‐by‐sector basis, and that failure to do so will result in inconsistent and even misleading disclosures (RobertG Eccles, 2012). Therefore, ultimately, it's essential for companies to identify, manage and disclose the ESG factors that are material to them, taking legal requirements into account. However, what is financially material will change overtime and is changing with rapidly increasing speed. 

Another challenge with identifying materiality factors is knowing which of the many ESG dimensions are most material for a company in terms of creating value for shareholders, stakeholders and investors over the long term. Several studies have found that an industry-specific approach to materiality yields economically significant results against the SASB industry specific standards (SASB, 2018).

How does the Sustainability Accounting Standard Boards (SASB) define financial materiality?

 SASB identifies financial material factors as factors that are reasonably likely to impact the financial conditions or operating performance of a company and therefore are most important to investors.

 The SASB Materiality Map is a widely used tool that identifies sustainability issues that are likely to affect the financial condition or operating performance of companies within an industry. 

 Here is an example of how SASB breaks down key issues in the Extractives & Mineral Processing industry. 

Source:https://materiality.sasb.org/

How a business can understand their financial materiality factors

Businesses often find identifying their financial materiality factors challenging, due to the expansive reservoir of ESG data. Some businesses choose to simply follow the requirements found in the international financing reporting standards(IFRS) (Hans Hoogervorst, 2017).This results in financial statements that comply with the accounting requirements but do not communicate information effectively to investors. This is because what is material to a company can be different to what is material to an investor. 

 SASB has also developed its own Sustainable Industry Classification Systems (SICS) which comprises 11 sectors which subdivided into 77 industries. For each industry, standards have been established for the ESG issues most likely to be material to investors. The standards for each industry are determined from a total list of 26 ESG General Issue Categories classified in the dimensions of Environment, Social Capital, Human Capital, Business Model and Innovation, and Leadership and Governance, this is shown below. However, this can also be a problematic classification as SASB’s industry categorisation may not account for all key issues based on the company’s specific business model. You can look up what industry your company is classified into here. 

Figure 1: Universe of Sustainability Issues (SASB).

Communicating key issues via a materiality matrix

It is increasingly popular for companies to communicate which issues are most important to them via a Materiality Matrix. For a materiality matrix companies map their Influence of Stakeholders from Lower to Higher on the ‘y’axis and the Impact on the company on the x axis. 

 Below is an example of how Ford inc does this matrix: