Redefining materiality: The key to unlocking sustainable value generation

The definition of materiality is very different in financial accounting compared to sustainability accounting. There are strong arguments for considering all of a company's well-being impacts as relevant and determining what is most material instead of using materiality as a filter for what information to collect.

Look at any sustainability report and see a "materiality matrix". The labels on the axes vary, but one dimension is materiality from the business perspective, and the other is materiality from the stakeholder perspective.

What companies then say about this matrix and even the definitions of materiality in disclosure standards and guidance varies greatly. The International Sustainability Standards Board (IISB) published the S1 Standard, which will be widely adopted, including in the Caribbean, this year: "Entities are required to disclose material information about the sustainability-related risks and opportunities that could reasonably be expected to affect the entities prospects. The materiality of information is judged in relation to whether omitting, misstating or obscuring that information could reasonably be expected to influence decisions of primary users of general-purpose financial reports." These primary users of the S1 standard are investors, creditors, or decision rights holders, and their expectations are presumed to be financial.

Until recently, the concepts were described, but the actual guidance for arriving at what is material, in real, practical terms, was missing. As a result, colleagues tell me that many consultants just make it up – you start with a long list of possible topics, you consult stakeholders about information on what matters would influence their decision-making, you review the financial relevance of these matters to the company, and you generate a combined list of matters, based on your consultations you derive a joint ranking in high, medium, low from two perspectives, you group the topics into themes, and present it all in the materiality matrix.

Well-being materiality for sustainable development

Financial accounting has long adhered to a strict and different interpretation of materiality. In financial accounts the focus is on the risk that missing or irrelevant information in financial statements could mislead primary users. As sustainability accounting and reporting is maturing and the urgency and risk of business to contribute to a sustainable future and to avoid profiting from creating harm, a new perspective emerges. The "well-being materiality" approach. This approach, as introduced by experts Jeremy Nicholls and Ben Carpenter, could revolutionise how businesses and their stakeholders assess a company's impact on sustainability.

Traditional view of materiality in financial accounting

In financial accounting, materiality is a safeguard against the omission or misrepresentation of significant information, not a filter. As Nicholls and Carpenter point out, this concept is traditionally applied with comprehensive focus, where even the most minor economic phenomena, and they use the example of the purchase of a single pencil, are considered within scope if they meet specific criteria of relevance and certainty.

In the financial domain, the Conceptual Framework for Financial Reporting says that all information that meets the definition of asset, liability, income, or expenditure meets a level of certainty is to be included – they are all relevant. There are no other size, significance, etc filters – everything is used. Materiality is not a filter. Materiality relates to the risk that things that matter are missed out by mistake, accident or fraud. Auditors, in turn, have a whole standard (ISA 315) on how to design an audit programme that reduces the risk that the audit does not identify missing information to an acceptable level.

Shift to sustainability accounting

Contrasting sharply with this approach is the practice of common sustainability accounting. Here, the method considers whether the absence of aggregated information on a particular topic, subtopic, or aspect of well-being could influence the primary users of the information – in the case of the ISSB presumed to be investors, creditors, or shareholders interested only in financial results. This approach, while more convenient because you may well end up measuring less, runs the risk of limiting the assessment and valuation of the company's actual impact.

The common perception is that the first step in sustainability accounting is to decide what is material instead of actually determining what all the impacts of the company are as well as their value (as perceived by those who experience them), and this can lead to prematurely excluding information because it was deemed non-material at the outset.

Having more and better information on all of its actual impacts allows companies to make better decisions, resulting in increases in the net value they generate.

Embracing well-being materiality

The concept of well-being materiality proposed by Nicholls and Carpenter offers a transformative approach. It suggests that businesses should account for all impacts on well-being that meet a defined threshold, similar to how financial phenomena are treated. This approach ensures a more comprehensive understanding of a company's sustainability impacts, including those that might seem insignificant in isolation but are material when aggregated.

Implications for sustainable value generation

Adopting a well-being materiality approach could significantly alter how businesses assess their sustainability impact. It encourages a more inclusive and thorough evaluation of how business activities affect environmental and social well-being. This method acknowledges that all changes, large and small, can have substantial effects on sustainability. For an organisation to optimise its sustainable value generation, just like the optimisation of financial results alone, it needs to know what effects different courses of action can have and how to increase these and limit any adverse effects. This is why it is essential to determine what is material after you have accounted for all effects.

Challenges and opportunities

It would be almost unthinkable for companies to operate in the financial domain as most are coming to think it is good practice in the sustainability domain. Implementing the well-being materiality approach is not without challenges. Unlike financial transactions, sustainability impacts often lack a clear paper trail and require modelling and estimation, introducing a degree of uncertainty. However, this approach aligns with the growing global emphasis on sustainable development and corporate responsibility, offering businesses a framework to make more informed, holistic decisions that consider the broader impact on society and the environment.

The Caribbean context

In regions like the Caribbean, where environmental and social challenges are particularly acute, the adoption of well-being materiality could be pivotal. This is true not only for the private sector but also the public sector – not least because of its disproportionally large size. Companies and public entities that adopt the more comprehensive and rigorous well-being materiality approach are better placed to generate more sustainable value and contribute effectively to sustainable development.

Dr Axel Kravatzky is the managing partner of TT-based Syntegra-360 Ltd, vice-chair of ISO/TC309 Governance of Organizations and president of EUROCHAMTT. He enables companies to flourish, helping them increase the sustainable value they generate through integrated governance, certified management systems, and transformational leadership.