The Definition of Materiality
The concept of materiality is a fundamental principle of financial reporting in the U.S. Generally, the concept of materiality recognizes that some matters, either individually or in the aggregate, are important to the fair presentation of an entity’s financial condition and performance. The federal securities laws contain several provisions concerning the materiality of misstatements and omissions in SEC reports. These provisions, combined with judicial review, form the basis for our understanding of the materiality of non-financial information. Regulations promulgated under the federal securities laws that mention materiality include the following rules: Rule 12b-2, Rule 12b-20, Rule 10b-5, Rule 210.1-02 (Regulation S-X), Rule 210.4-01(a) (Regulation S-X), Rule 210.4-02 (Regulation S-X).
Material information has been defined by the U.S. Supreme Court as presenting a substantial likelihood that the disclosure of the omitted fact would have been viewed by the “reasonable investor” as having significantly altered the “total mix” of information made available. (TSC Indus., Inc. v. Northway, Inc. 426 U.S. 438 (1976)).
Basic Inc. v. Levinson, 485 U.S. 224 (1988) is another seminal U.S. Supreme Court case on materiality. Three important principles were established: 1) Contingent or speculative events are not immaterial simply because they are contingent or speculative; 2) The materiality of contingent or speculative events depends on the significance the reasonable investor would place on the information; and 3) The significance of contingent or speculative events to investors depends on both the likelihood of occurrence and the magnitude of potential impact.
SEC Staff Accounting Bulletin No. 99 (SAB 99) expresses the SEC’s opinion that exclusive reliance on quantitative benchmarks to assess materiality in preparing financial statements and performing audits is inappropriate. Financial rules of thumb, by definition, will not pick up non-financial issues. Therefore, SASB is developing a new series of tests that can pick up the materiality of non-financial information in order to prioritize environmental, social, and governance issues on behalf of the reasonable investor.
At SASB, evaluating the materiality of sustainability issues involves looking beyond conventional measures of assets and liabilities to those embedded in aspects of social and environmental performance and stakeholder relationships, which may hold the key to future business success or failure. As Regulation S-X states (17 C.F.R.2101.1-02 (o)), this is information…” about which an average prudent investor ought reasonably to be informed.”
The application of non-financial materiality tests to obtain a broader view of materiality is not only of interest to those concerned with the contribution of business to sustainable development. It is also important to those with their sights set firmly on the financial performance of their investments. Disclosure of material issues is important to investors, companies, regulators, and the public:
- The SEC already requires disclosure of material issues in the Form 10-K, 20-F and other filings in use by investors.
- Institutional investors have a fiduciary duty that requires them to consider material issues.
- Companies have limited resources, and must therefore focus on disclosing and managing relevant issues.
- The potential for negative social and environmental impacts of operations can present material costs to society.
Because the concept of materiality is so central to disclosure and investment performance, and because the universe of sustainability issues is so vast, SASB is the definitive voice regarding the relative materiality of industry-specific sustainability issues. This effectively bridges the gap between financial and sustainability reporting. For integrated reporting to become a reality, an integrated view of materiality across financial and non-financial information is imperative.
SASB is evaluating the materiality of information at the industry-level, because this represents the sweet spot between relevance and comparability. SASB focuses on intractable, systemic issues that are applicable to most, if not all, companies within the industry, and that are of interest to most investors. It is important to note that SASB does not alleviate the CFO and CEO from their accountability for disclosure of material information in the Form 10-K, as per Sarbanes-Oxley (Section 302, “Corporate Responsibility for Financial Reports,” requires the CEO and CFO of publicly traded companies to certify the appropriateness of their financial statements and disclosures and to certify that they fairly present, in all material respects, the operations and financial condition of the company.) SASB provides evidence-based prioritization of material issues and standards for disclosure to ensure that decision-useful information is provided to investors and that peer- to- peer comparison is possible for these key issues. This articulation of sustainability issues and trends facing the industry, and how to best disclose them, supports the CFO and CEO in their fulfillment of Item 303 of Regulation S-K, which is intended to give investors a “look at the company through the eyes of management.” Among other things, Item 303 requires registrants to disclose known trends, events, or uncertainties that have affected, will affect, or that are reasonably likely to affect the registrant’s liquidity, capital resources, or results of operations.
A Key Partnership
SASB is partnering with the Initiative for Responsible Investment (IRI) at the Hauser Center for Nonprofit Organizations at Harvard University to further explore and define a rigorous, replicable, auditable method for determining the materiality of sustainability issues at an industry level for use in SASB’s standards setting process.
The Initiative for Responsible Investment (IRI), founded in 2005, provides institutional support for catalytic activities in support of responsible investment broadly construed. To this end, it convenes institutional investors and interested parties for discussions related to responsible investment, publishes research and white papers on various aspects of responsible investment, and provides support services for institutional investors pursuing responsible investment goals.
The IRI is playing a crucial role in the establishment and implementation of the initial framework for defining and establishing industry specific sustainable materiality. The IRI is collaborating with SASB to establish a theoretical and practical framework for the definition of sustainability materiality and its relationship to financial materiality. The IRI will also ensure consistent application of the framework in determining materiality across disparate industries.
The IRI’s work for SASB will build on its two publications: