A growing significance
Today, embedding sustainability within the business fabric has become an essential component of a successful business. Simply put, investors, customers, suppliers and others expect companies to focus on the long term and not make today’s solutions the problems of tomorrow. In order for a business to demonstrate its success, it needs to provide its stakeholders with more than the traditional financial statements to assess corporate performance. Indeed, it could even be argued that the primary focus of company reporting should be on its sustainability in the broader sense, with its financial performance forming one part of that, along with its performance in managing environmental, social and governance matters.
Although progress has been made on the type and volume of ESG disclosures companies make, there is little consensus on how to measure corporate performance beyond using financial metrics like share price returns and profit. How to determine what’s material to the business beyond using financial thresholds and how to determine which stakeholders matter most to the business beyond its shareholders remains unclear. This is set to change.
In 2022, the International Financial Reporting Standards (IFRS) foundation, as the largest accounting standard setter, formed a new board for sustainability reporting known as the International Sustainability Standards Board (ISSB), and issued recent proposals on sustainability and climate disclosures. In parallel, the European Commission, through the European Financial Reporting Advisory Group (EFRAG), is developing their own rules for sustainability disclosures in support of the proposed Corporate Sustainability Reporting Directive (CSRD). Once finalised, these developments will help make the move away from voluntary disclosures, towards more consistent and comparable disclosures.
That said, there are two critical barriers to achieving the pivotal global alignment because of differing opinions on what should be reported and to whom: materiality and impact.
Materiality
Assessing materiality is not always easy in a financial reporting context, but over the years we’ve developed approaches and rules of thumb to make its application practical and more coherent.
However, defining materiality in a sustainability context can indeed be tricky. This is a critical aspect of sustainability reporting because it determines what gets reported. Here, EFRAG has proposed a double materiality approach based on both financial materiality (meaning that an activity has a financial effect that influences future cash flows) and impact materiality (meaning that an activity has an impact on people or the environment).
Impact
Given that a company’s impact on people and the planet can have financial implications on the business, this information is critical for investors. While not all impacts have estimable cash flow outcomes and therefore might not be material from a financial or traditional enterprise value perspective, this doesn’t automatically make the information or issue unimportant. The barrier here is that impact is often assessed qualitatively and is, in some cases, in the eye of the beholder. A negative impact to one stakeholder group can be beneficial to another and vice versa.
Next steps
What is clear is that we are at a critical point in the evolution of corporate reporting; and the proposals set out by the ISSB and EFRAG offer optimistic insight into what is to come. They target the continuous effort needed to work towards establishing a system that is understandable, comprehensive, and relevant, providing the information needed for investors and other stakeholders to make aligned decisions to overcome some of the most pressing challenges the world is facing. We all have a part to play in this, and we can’t let this moment pass us by. We finally have the impetus, the technology, and a fragile consensus to help codify the means and method of disclosure – but this will only work if everyone gets involved and supports global alignment.
