Materiality: Driving integrated thinking

4 May, 2018

The discussion of materiality has been a foundation of both financial reporting and more recent frameworks for sustainability and integrated reporting.

Recognizing the unique nature of each enterprise, a discussion of materiality serves to identify which aspects of the operational environment internally and externally should be reported on, as being key to transparency and understanding.

In November 2015, the IIRC in conjunction with the International Federation of Accountants (IFAC) issued a publication “Materiality in <IR>: Guidance for the preparation of Integrated Reports” which provides suggestions and approaches for preparers of integrated reports who are trying to determine what should be included. While this is a helpful document organizations are still facing challenges as they develop their materiality determination process in integrated reports.

First, materiality as a concept has been well honed and developed to support financial reporting and thus much of the strength and depth builds on this background and not on non-financial aspects. Second, materiality in reporting can be different from materiality in strategy; most organizations drive reporting from strategy where strategy formulation is the point at which the criticality of key influencers and resources of enterprise activity – i.e. the business model are determined.

Reviewing the statements of materiality in existing reports using the integrated reporting model seem to raise the question as to whether a shift to integrated thinking is occurring? As an example, the 2016 report of Sun International identifies the approach to materiality, but then places the responsibility with the financial team – i.e. a somewhat traditional approach?

If integrated thinking is being demonstrated then not only should the discussion and decision making on materiality be cross-functional and reflect consideration of ALL capitals, its results should clearly reflect a broad base of attributes relative to strategically important elements within and across the capitals.

For many organizations there is a close connection between performance as measured by financial capital outcomes and the effectiveness with which the financial capital consumed is being utilized. The integrated reporting model clearly provides for communicating such a relationship as being key to understanding business effectiveness, yet there is almost never any discussion in materiality of two of the most critical aspects.

First – the major consumer of financial capital is in fact payments for human capital, and through human capital an organization builds and sustains intellectual capital and relationship capital. More importantly human capital drives innovation, creativity, responsiveness and many other attributes of competitive advantage; yet there is often little or no discussion on the importance of leadership development, employee engagement, morale, productivity, innovation and other aspects that can demonstrate the risk that both management and investors face in utilizing human capital. In fact, many organizations still report metrics such as hours of training which provides little real strategic insight.

Secondly most organizations rely on revenues derived from customers as a key source of financial capital inflow; while many organizations discuss areas such as the regulatory environment in their materiality review there are few that identify and discuss the strength and stability of the relationships that are behind their incoming cash flows and any risk associated with client relationships. Thus the two largest sources of financial capital that are strategically dependent on non-financial “asset” performance are often not discussed in the depth that would allow investors to determine whether management and / or the board is building and protecting the value of the intangibles behind the financial performance or whether non-financial assets are being depleted in order to deliver the level of financial outcomes being seen.

If integrated reporting is to be an effective change agent in shifting capitalism and corporate thinking towards a balanced approach where all capitals are critical to sustainability and enterprise survival, then a key starting point must be the discussion around materiality and the six capitals. While many organizations indicate that their investors are consulted about materiality for integrated reporting, one has to realize that in many situations investors don’t know what questions to ask! In addition, it is the board and management who must have the clearest picture of how the six capitals are employed and drive value creation and sustainability? If organizations are looking to integrated reporting to help tell a better and more holistic picture of how their business model works to create value, then they – not the investors must take the lead in determining what is important. A great example of the failure of this transition is contained in statements by Paul Polman, the CEO of Unilever who suggest in a recent Financial Times article that “… Unilever has been forced to compromise on strategy and that this has had detrimental consequences for long term, sustainable value creation.” This is not the result of integrated thinking!