ESG/sustainability professionals are well versed in the concepts of financial materiality (embedded in traditional financial reporting)and double materiality (embedded in relatively new sustainability disclosure frameworks and EU directives). But as the call grows for third party assurance of ESG reports, companies must understand how auditors/assurance providers apply “materiality” in their engagements. This excellent article from Becker.com discusses the term in the context of auditing financial statements – which differs in important ways from the two more familiar definitions:
“The current definition in generally accepted auditing standards Section 320 defines material misstatements as: ‘Misstatements, including omissions, are considered to be material if there is a substantial likelihood that, individually or in the aggregate, they would influence the judgment made by a reasonable user based on the financial statements’. The financial statement auditor’s determination of materiality is a matter of professional judgment and is affected by the auditor’s perception of the financial information needs of users of the financial statements. Judgments about materiality must be made considering the following:
- Surrounding circumstances affected by the size or nature of a misstatement, or a combination of both.
- Both qualitative and quantitative considerations.
- Consideration of the common financial information needs of users as a group. (Note: The possible effect of misstatements on specific individual users, whose needs may vary widely, is not considered.)
For purposes of determining materiality, the auditor may assume that reasonable users have the following characteristics:
- Have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information in the financial statements with reasonable diligence.
- Understand that financial statements are prepared, presented, and audited to levels of materiality.
- Recognize the uncertainties inherent in the measurement of amounts based on the use of estimates, judgment, and the consideration of future events.
- Make reasonable judgments based on the information in the financial statements.
The concept of materiality is applied by the auditor when both planning and performing the audit, and in evaluating the effect of identified misstatements on the audit and uncorrected misstatements, if any, on the financial statements.”
It may be argued that ESG/sustainability disclosures and associated assurance differ from those applicable to financial statements and GAAP (in the US). Perhaps, but those differences are becoming blurred as sustainability disclosure and assurance standards increasingly build off financial standards.
ESG leaders, staff and advisors: If you are contemplating obtaining third party assurance for sustainability/ESG disclosures, discuss with your auditor how they will determine and apply materiality in their engagement. That is vital in preparing for the audit and understanding the assurance report, its limitations and intended audience. In that light, I once again renew my call for companies to consider a “Statement of Significant Audiences and Materiality” as proposed in 2015 by Robert Eccles and Tim Youmans. Such a formal evaluation and statement about the company’s assessment of users of ESG/sustainability information could be quite useful to assurance providers and to companies who may take issue with situations where providers interpret the basis of materiality.
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