How financial accounting determines materiality and what this means for sustainability
The Materiality Files Blog 2: ‘Every Pencil Matters!’, Co authored By Jeremy Nicholls & Ben Carpenter
In the first blog of the ‘materiality-files’ series, we illustrated how a financial materiality lens would fail to prevent human rights abuses and how SVI are advocating for a ‘wellbeing materiality’ approach.
In this blog we get a bit more technical to explore how the concept of materiality is actually applied in financial accounting and in doing so we reveal how sustainability accounting and impact management have (generally) not followed the same logic or approach. We conclude by illustrating what it might look like if sustainability accounting was more analogous to financial accounting.
Materiality in financial accounting
Speak to a financial accountant and they will probably explain that materiality refers to the risk that information is missing from the financial statements (or irrelevant information has been included) that would affect the decisions of the primary users of those financial statements. They may go further to say that information should be relevant and should be faithfully represented. This means the first issue is to define what information will be in the scope and the second will be the risk that the information is subsequently materially misstated.
Information in scope
The Conceptual Framework for Financial Reporting, which provides guidance on applying accounting standards, is primarily a framework for determining relevant information that can be faithfully represented. At the risk of over-simplification this is information that informs decisions by primary users with an interest in expected financial returns. This information is defined as those economic phenomena that meet the definition of asset, liability, income or expenditure or equity and that meet a required level of certainty.
There is a risk here that information that should be included is missing – and the information is incomplete. Or that information has been included that shouldn’t be. Or that information that has been included has not been faithfully represented. If any of these occur those primary users may now make different decisions. This is the risk of material misstatement. The misstatement matters because it may influence decisions.
It’s worth referring to the paragraph in the Conceptual Framework that addresses materiality, para 2.11.
Information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions that the primary users of general purpose financial reports (see paragraph 1.5) make on the basis of those reports, which provide financial information about a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude, or both, of the items to which the information relates in the context of an individual entity’s financial report. Consequently, the Board cannot specify a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation.
An accounting system should be designed to minimise the risk that relevant information is missing and it is the function of the auditor to design an audit program that reduces audit risk, the risk that the audit does not identify missing information, to an acceptable level. Auditors have a whole standard on this; ISA 315 on Identifying and Assessing Risks of Material Misstatement.
So to manage the risk of material misstatement we need to know the user, the decision, the purpose behind the decision to determine relevant information and then the level of uncertainty the user is willing to accept that information is missing (or included that shouldn’t be) or not faithfully represented. This has to be generalised for the maximum number of users. In general purpose financial reporting (i.e. standard financial accounts) the primary users are “current or potential investors, providers of loan finances or suppliers, who cannot get the information from other means, making decision to provide economic resources to an entity in the expectation of financial returns”[1].
Let's imagine that a company buys a single pencil and see how this is captured in financial accounting:
Is it in scope?
This purchase is an economic phenomenon and meets the definition of an expenditure. The pencil exists, it works (otherwise you would send it back) and we know how much it costs. It is in scope and it meets the required level of certainty. So, yes, we account for it.
Is there a risk of misstatement?
If the purchase of this one pencil was not included, it would be a misstatement but not a material one because it would not affect the decision of an intended user of financial accounts – i.e. it would not change a decision to provide resources to an entity in the interest of expected financial returns.
Even if the expenditure on all the pencils were missing (because of a mistake in accounting or because of fraud) it would not be material. Quite possibly, if expenditure on all stationary were excluded it would still not be material.
Nonetheless, all these things are accounted for because they are in scope. And then aggregated – pencils are aggregated into stationary, stationary into office supplies, office supplies into operating costs. All possible because there is a common unit of measurement.
Whether or not something is material – i.e. if it were missing it would affect decisions – is assessed at a high level of aggregation – e.g. for expenses like the pencil in relation to the overall profit or loss, for assets like a photocopier, in relation to the balance sheet. So if the expenditure on office supplies totalled less than a certain percentage of the total of the profit or loss, it might not be considered material if it were omitted. A threshold is needed to do this, and this is set by the auditors. Guidance from KPMG suggests this is between 3% and 10%.
So, if the total expenditure on stationary exceeded the threshold percentage – which it might if the company was an arts school – then this would be material information if it were not included. It could mean investing in the art school rather than elsewhere because the expectation of financial returns is higher than it should have been had the information been included.
Let’s compare this with how materiality is assessed in sustainability accounting and reporting.
Generally, sustainability accounting and reporting does not follow the same logic and the same process. In sustainability, there is no attempt to account for every single sustainability phenomenon (the equivalent of the single pencil as an economic phenomena). Scope is not defined first. Instead, the starting point for determining whether information is relevant, the scope of the account, is to consider whether it is material and to do this at some level of aggregation (topic, subtopic or perhaps aspect of wellbeing), considering whether if the aggregated information were missing it might influence users. And if the information is considered, at this stage, to be not material, the information is not included in the account. This is completely the reverse to financial accounting. But this presents a Catch-22 situation. We are second guessing what information that we think might be useful. The equivalent of those pencils may very well not be included in a sustainability account.
This approach may have arisen from reading of para 2.11 above as if this was guidance for determining relevant information. But if this was the interpretation being used by accountants, information about pencils would not be collected.
If sustainability phenomena are the equivalent level of analysis as economic phenomena then sustainability phenomena would be impacts to wellbeing. By failing to include them, we risk excluding impacts on wellbeing from scope and then making decisions that could then reduce wellbeing and so undermine sustainability. To follow the logic in financial accounting we should account for all impacts to wellbeing that meet a required definition. This could, for example, be aspects of wellbeing using the OECD approach[2] but would also need to address thresholds and allocations in determining whether changes were positive or negative.
Better sustainability accounting
In the first blog of this series, we spoke about the reported human rights abuses that have taken place on a Del Monte pineapple farm. Let’s imagine that Del Monte managers and investors considered impacts on wellbeing to be relevant and within scope. This would mean that efforts would be made to capture all impacts (large and small) and decisions would be made with the interest of optimising impacts on wellbeing. This would be the starting point, though only the starting point, for an accounting system designed to prevent human rights abuses and to create a more sustainable world.
Of course, it is not possible to account for all these changes in the same way as finance because there is no paper trail of transactions. The impacts would need to be modelled and estimated, which does increase uncertainty. The key question then is whether this uncertainty meets the requirement for the information to be useful. Whether information could be faithfully represented. Then if there were a common unit [3] (and leaving aside the question of how to do this well), the impacts could then be aggregated and decisions about whether their exclusion would be material would be made just like we did when we aggregated the pencils to ‘stationary’ and ‘operating costs’. An estimate of changes in people’s health including small changes would still be accounted for.
The risk of material misstatement is then whether the scale of omitting these impacts, when aggregated, would affect decisions. This needs an understanding of the level of risk that primary users are willing to take. If our purpose is optimising wellbeing and our primary users (recognising that others may act as their agents) are those with an interest in increases in wellbeing, then these users will want to have information on a more complete understanding of impacts on wellbeing. Even if there is more risk that this is less accurate.
Current practice in sustainability reporting tries to anticipate the sustainability phenomena that are thought to be material before information is collected and aggregated. The problem with this approach is that a) the decision about what ‘we’ think might be material is rarely informed by people who experience impacts on wellbeing, and b) information is being excluded and we have an incomplete account against which to assess material misstatement. This incomplete account will affect decisions being made.
In our third blog in this series, we will outline the case for ‘wellbeing materiality’ and how it is actually the logical approach for determining what information matters. Our recent Top Tips webinar with Jeremy Nicholls on 5th September took a deep dive into this subject and examined how accounts of wellbeing would result in different decisions being made. Watch a recording of the webinar.
About the Materiality Files
SVI are producing a series of blogs and a webinar on the subject of materiality. Why? The existential threats of climate change and social inequality are real for us all. In an attempt to reverse these negative trends and create a more sustainable world there needs to be a transformation in the way capitalism works and that means a change in the way decisions are made. Central to this transformation is changing the purpose behind investment decisions and then the information that matters to inform decisions with that purpose will also change. The concept of materiality is central to this.
Footnotes
[1] Para 1.3 in Conceptual Framework Financial Reporting, https://www.ifrs.org/issued-standards/list-of-standards/conceptual-framework/
[2] https://www.oecd.org/wise/measuring-well-being-and-progress.htm
[3] Most sustainability reporting does not use a common unit and therefore prevents aggregation and comparison of the relative importance of impacts. But impacts on wellbeing can be accounted for with a common unit. One way of doing this is by using money as a proxy. This approach provides transparency over the inevitable trade offs in decisions and ensures that those experiencing the impacts inform those trade offs. Where the approach recognises thresholds, it will also flag up trade offs which should not be made and where alternative options are required. It is worth noting that even within financial forecasting, proxies are often used to represent different options and help support decision making.