The Evolution of Materiality in Business

Relevant, reliable and high-quality information is the basis for sound decision-making. Too much information leads to information overload or decision paralysis. A large amount of information does not mean improved decision-making processes, which is why its relevance must be ensured. And that is precisely what materiality is for.

Materiality is a filter through which information passes, separating the essential from the non-essential, the useful from the useless, and the relevant from the irrelevant. This principle has been applied in accounting for decades. Materiality parameters are derived from the decision-making needs of the target group that consumes the information.

There are a number of approaches to assessing the materiality of information, the most important of which are financial, impact and dual or double.

Financial materiality

According to generally accepted accounting principles (GAAP), materiality is a principle that determines whether discrepancies in financial reporting, such as omissions or misstatements, would influence the decisions of a reasonable user. The primary focus is on the company's own activities and historical financial data such as revenues, costs and assets. The materiality threshold is often set as a percentage of a selected item (e.g. 5% of pre-tax profit), with the specific basis and percentage depending on the nature of the company and its significance to users of the financial statements. However, this rule is not absolute, and professional judgement must always be applied.

Financial materiality, which primarily reflects the needs of investors, creditors and capital market participants, has not been able to fully meet the increasing demand for information. World-renowned investors such as Warren Buffet and Bill Miller made no secret of their investment strategy, which ignored these retrospective short-term metrics of annual returns and assets and focused on the company's ability to generate profits in the long term.

Impact materiality

In addition to the targeted product, every activity has unintended side effects. For example, a side effect of dyeing a product is the risk to workers' health through the inhalation of volatile substances. Efforts to capture the external impacts of an organisation on the economy, society and the environment led to the creation of impact materiality. In 2006, the GRI published its first guidelines regarding this concept. Unlike financial materiality, it is no longer decisive how information affects the prosperity of an organisation. The complexity continues to grow, as organisations must take into account information about the value chain in addition to information about their own activities.

A key innovation of the concept was that the informed groups should not only include persons with a financial interest, but also groups that are directly or indirectly affected by the business – consumers, employees, communities affected by the activities, and civil society organisations. Impact materiality even covers the information needs of those who do not have the opportunity or tools to defend their interests directly, such as future generations, nature, or excluded or disadvantaged groups of people.

In practice, the application of such materiality is complicated. Different groups have different and sometimes conflicting interests. It can be assumed that the organisation providing the information will apply materiality to satisfy the information needs of those entities that have a significant impact on the organisation's prosperity, primarily entities providing financing and key business partners. Such prioritisation may jeopardise the information needs of other groups.

Double materiality

As we know it, double materiality was first mentioned in the Commission's communication on non-financial reporting guidelines in 2019. One of the ideas behind double materiality is changing the dogma that sustainability is unrelated to finance. What was historically known as non-financial reporting has become sustainability reporting. This is a clear signal that sustainability aspects cannot be understood solely as non-financial, but that they have an inseparable financial character and impact on the prosperity of the organisation.

The CSRD introduces a new central concept of a double filter – double materiality. If information passes through the impact filter and is significant for society or the environment, it becomes material. If the information passes through the financial filter and is therefore relevant to groups with financial interests in the company, it becomes material. This materiality will continue to apply despite the ongoing simplification under Omnibus I. Financial materiality here is different and more complex than the original materiality of the same name in financial reporting. The assessment focuses on forward-looking risks and opportunities, such as potential financial scenarios, rather than relying on historical data. Though it is difficult to accurately express the potential environmental, social, and other external impacts on an organisation’s prosperity and stability in monetary terms. Finally, as with impact materiality, an organisation must include not only its own activities but also its business partners.

The concept of materiality is expanding within the framework of double materiality and becoming more comprehensive, but at the same time less transparent and confusing for users.