The demand from users for environmental, social, and governance (ESG) information has continued to grow, but standards remain under development and reporting is not yet mandated for most U.S. entities. Although ESG represents real opportunities for CPAs to provide valuable services, there remains a paucity of guidance on the presentation and attestation of ESG reports. Determining materiality is a key question in ESG reporting and the attestation of that information. The authors look at the current, existing materiality guidance for ESG reporting and how it compares to traditional financial reporting.
“Materiality, like beauty, is in the eyes of the beholder.”
—Ernest L. Hicks, Journal of Accountancy (June 1962)
“I know [materiality] when I see it!”
—Potter Stewart (former U.S. Supreme Court Justice)
A broadening array of stakeholders—beyond investors and creditors—are increasingly demanding that financial statements and sustainability reports disclose environmental, social, and governance (ESG) matters and other sustainability issues. These disclosures include environmental impact (e.g., climate change), resource efficiency (water and energy), social concerns (workplace diversity), product safety, corporate conduct, and other nonfinancial information.
This demand for increased ESG reporting comes primarily from 1) shifting social expectations for companies to take greater responsibility and 2) investment and business professionals recognizing that ESG issues materially affect a company’s value. State Street, Vanguard, BlackRock, and other investment advisory firms have urged entities to provide sustainability reports, disclosures or other evidence of their commitment to ESG. Investors, creditors, suppliers, customers, local communities, and other stakeholders also often pressure companies to provide ESG disclosures.
After discussing the extent of ESG reporting, this article will examine existing materiality guidance for ESG engagements, how ESG materiality differs from financial statement materiality, and how professionals apply materiality in ESG examinations.
Extent of ESG Reporting
Many companies voluntarily provide ESG information, despite the current lack of consensus on what they should provide. However, the new International Sustainability Standards Board (ISSB) standards discussed below provide some non-authoritative guidance on what U.S. GAAP financial reports should provide. Currently the SEC does not require firms to issue separate sustainability reports. These optional reports may contain an attestation report from a CPA, or a report from a consulting, or engineering firm.
State of 2021 ESG Reporting and Assurance
As Exhibit 1 shows, the current situation provides opportunities for CPAs to expand their practices, but it requires CPAs to meet their professional responsibilities in doing so. CPAs may provide consulting services, helping companies provide ESG information. Also, they might provide assurance on an entity’s ESG reports, often requiring environmental engineers and other specialists to join the engagement team. CPAs who audit a firm’s financial statements may provide assurance on ESG information, because both the financial statement audit and an examination or review of ESG information are considered assurance services. Due to independence concerns, however, CPAs should not provide both consulting and assurance services on the same ESG information.
CPAs face increased competition from consultants and other non-CPAs in the ESG space; see “How Firms are Seizing the ESG Opportunity” by Andrew Kenney (Journal of Accountancy, October 2022) for a discussion of practice opportunities and needs. [Also, see “ESG: The Latest in Sustainability Reporting—Panel Discussion from the Baruch College Financial Reporting Conference” (CPA Journal, August 2022)—which provide good background information on ESG.] An overlooked aspect of most discussions of ESG issues, however, is materiality.
Standards for ESG Reporting
Various standards setters have provided or proposed presentation standards or attestation standards for ESG reporting. Presentation standards (akin to financial reporting standards) are designed for the companies preparing the ESG disclosure, while attestation standards (akin to auditing standards) are designed for the professionals attesting to the ESG disclosures. The following standards setting bodies have issued standards for ESG presentation:
- ▪ In 2022, the International Financial Reporting Standards (IFRS) Foundation formed the ISSB. The ISSB recently issued its first two sustainability standards that directly affect entities that follow IFRS. Local standards setters must still approve these standards, which is expected to happen soon. These standards also provide non-authoritative guidance for U.S. and other entities that do not follow IFRS. IFRS S1, General Requirements for Disclosure of Sustainability-related Financial Information and IFRS S2, Climate-related Disclosures both are effective for years beginning on or after January 1, 2024 (earlier application is permitted). IFRS S1 has set a global baseline for reporting requirements and disclosures of sustainability-related risks and opportunities. IFRS S2 has reporting requirements specific to climate-related disclosures, in concert with the IFRS S1 reporting framework. The ISSB’s initial standards have been built upon the earlier sets of standards described below.
- ▪ The Sustainability Accounting Standards Board (SASB) Foundation is a nonprofit organization based in San Francisco and founded in 2012; SASB began publishing industry-specific sustainability accounting standards in 2018.
- ▪ The Global Reporting Initiative (GRI) is an independent international organization founded in 1997, headquartered in the Netherlands. GRI’s sustainability reporting standards provide widely adopted guidance for entities’ reporting practices.
- ▪ The Financial Stability Board (FSB) was established in 2009 by members of the G20 major economies. It monitors and recommends improvements in the global financial system. In turn, the FSB established the Task Force on Climate-related Financial Disclosures (TCFD). The TCFD recommends the types of information that companies should disclose to investors, lenders, and insurance underwriters to help assess and price risks related to climate change.
- ▪ In 2015, The United Nations developed 17 Sustainability Goals (SDG) that represent interlinked objectives to help sustain global peace and prosperity. These goals include good health and well-being; clean water and sanitation; and affordable and clean energy.
- ▪ FASB and the SEC have proposed ESG presentation standards for companies subject to their jurisdiction (discussed further below).
The AICPA, PCAOB, and International Auditing and Assurance Standards Board (IAASB) have issued attestation standards (including materiality) to help CPAs provide reasonable assurance (an examination) or limited assurance (a review) on ESG information.
Materiality Definition and Guidance
Determining and using materiality are important for ESG presentation and attestation standards. Materiality is not a new concept. The ISSB, SEC, AICPA, FASB, PCAOB, and other regulators/standards setters have long relied upon the concept. In the 1930s, the SEC first defined materiality as information that should be furnished to average, prudent investors for decision making (SEC Instruction Book, 1935). In the 1976 U.S. Supreme Court decision in TSC Industries v. Northway, Justice Marshall stated that a “fact is material” if there is “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.” Although this idea relates specifically to “reasonable” investors, materiality guidance refers to a reasonable user as the basis to determine whether an item is material. In any case, materiality is a matter of professional judgment rather than a formula.
Preparers and auditors consider materiality from both a quantitative and qualitative perspective. An item is quantitatively material when it exceeds an amount a reasonable user would consider important; it is qualitatively material if a reasonable user would consider it important, regardless of the amount.
Materiality guidance has two major uses. The first use considers when an event or item is large or important enough that the user should know about it. Preparers develop internal controls to record, measure, and disclose these items. Much of the current consideration deals with this disclosure-oriented materiality. The second use involves how large a misstatement that would influence a user’s decision about the entity should be corrected. This correction-oriented materiality is most associated with attestation engagements.
In this respect, AT-C 205.A21 explains materiality within the context of misstatements. According to this standard, misstatements, including omissions, are material if there is a substantial likelihood that, individually or in the aggregate, they would influence a user’s judgment. A CPA’s consideration of materiality is a matter of professional judgment and is affected by their perception of the common information needs of intended users as a group.
In addition, because CPAs should recognize that immaterial misstatements for ESG elements could later become material, they should encourage the correction of all misstated ESG elements except those that are de minimis.
IFRS S1 contains the following definition of materiality: 17. An entity shall disclose material information about the sustainability-related risks and opportunities that could reasonably be expected to affect the entity’s prospects. 18. In the context of sustainability-related financial disclosures, information is material if omitting, misstating, or obscuring that information could reasonably be expected to influence decisions that primary users of general purpose financial reports make on the basis of those reports, which include financial statements and sustainability-related financial disclosures and which provide information about a specific reporting entity.
(para. 17, 18)
Regarding sustainability, IFRS S1 requires entities to disclose their governance process and controls, strategy, risks and their management, metrics, and targets as part of their issued financial reports. Thus, if the sustainability disclosure is outside of the financial statements, an auditor should treat these disclosures as “other information” and perform the procedures required by AU-C 720. If the disclosure is within the notes to the financial statement, the auditor would perform the same type of procedures as for any note information.
The ISSB has previously proposed that, for ESG information, auditors use a materiality threshold that is double the materiality for the financial statements as a whole. This implies that users do not need more exact ESG information to make their decisions. A problem with this approach is that the ESG information might be measured in units of measurement other than financial currency. For example, financial statement materiality might be $5 million, whereas the ESG reporting might disclose that the entity had carbon emissions of 40 tons. How can one double this materiality? Rather than include this double materiality, or any other numerical guidance, the IFRS S1 interpretive guidance says the following:
Materiality judgments are specific to an entity. Consequently, this standard does not specify any thresholds for materiality or predetermine what would be material in a particular situation.
Therefore, materiality remains a matter of professional judgment for preparers and auditors.
The SEC and other regulators might consider the standards developed by various organizations (including those standards setters mentioned above) in developing their own materiality standards and guidance on ESG.
On June 17, 2022, the SEC proposed (Release Nos. 33-11042; 34-94478: “The Enhancement and Standardization of Climate-Related Disclosures for Investors,” https://bit.ly/3XYYjp6) that registrants disclose climate-related risks that will likely materially impact their financial statements over the short, medium, and long term. Climate-related risks include actual or potential negative effects of physical and transition risks. Physical risks include such acute events as hurricanes. Transition risks involve regulatory, technological, and market changes that mitigate climate risks, such as escalating insurance costs. Registrants would need to disclose the nature of acute, chronic, physical, and transition risks and their plans to mitigate or adapt to such risks. Registrants would also describe the actual and potential impacts of each risk over time on their strategy, business model, and outlook.
The SEC proposal controversially uses a bright-line test to require classifying financial statement disclosure items into one of three metrics: 1) financial impact metrics, 2) expenditure metrics, and 3) financial estimates and assumptions. The SEC proposal would also have companies disclose climate-related risks in these three disclosure categories if the impact exceeds 1% of the financial statement line item. This is a much narrower materiality than typically used for financial statements; the SEC did not provide a basis for this 1% proposal. Note that this discussion generally concerns what is material enough to disclose—not how large of a misstatement should be corrected.
Although several entities issue ESG standards, U.S. CPAs should focus on the SEC’s standards and guidance. Those practicing outside the United States should focus on the ISSB’s standards and guidance.
Nature of ESG Information and its Effect on Materiality
ESG information differs greatly from financial statement information in these ways:
- ▪ It is unclear who will use the information or how it will be used, as well as what is important to users and how materiality affects users’ decisions; because ESG is relatively new, many users have not considered what is material enough to influence their decisions.
- ▪ Much ESG information is not quantitative.
- ▪ Misstatements in one piece of information are usually unrelated to misstatements in other information (unlike financial statements where the debit/credit system causes misstatements in one account to be related to misstatements in another account).
- ▪ Different standards, systems, and controls often exist for each type of ESG element. Some of these systems might not have adequate controls.
This affects an attestation engagement in several ways:
- ▪ Although much is known about financial statement users and their needs, very little is known about ESG users. Therefore, a CPA might ask the engaging party who uses the ESG report and how they make decisions based upon it. The engaging party might need to ask some users for this information.
- ▪ There might be different users for different ESG disclosures; thus, a different materiality threshold might be needed for each ESG disclosure.
- ▪ The engaging party might request assurance only on some ESG disclosures (e.g., because the engaging party believes some ESG disclosures are less important to users than others); engagement letters, representation letters, and reports should clarify which ESG matters a CPA is reporting on. For ESG information where no assurance is provided, a CPA should follow the standards for other information.
- ▪ There are different standards for preparing ESG information. The engagement letter should document which standards apply to the ESG information.
- ▪ Materiality for ESG purposes might be in units other than units of currency (e.g., tons of carbon released into the atmosphere).
- ▪ Because users usually consider each ESG element separately, CPAs should not aggregate or offset misstatements in one element with misstatements in other elements.
- ▪ Materiality is always a matter of professional judgment, not a formula; thus, standards do not indicate required percentages but require professional judgment based on assessment of user needs.
- ▪ CPAs should separately assess inherent risk, control risk, and risk of material misstatement for each ESG element, given each ESG element’s separate materiality.
Differences in Determining Materiality
Exhibit 2 illustrates how CPAs determine and use materiality for financial statement audits versus ESG examinations.
Meeting User Needs
Because ESG is a very broad concept, narrowing its focus presents a significant challenge for regulators and the CPA profession. ESG is an area where CPAs can meet user needs by providing consulting or assurance services. CPAs need to keep on top of changing standards and guidance, including materiality guidance. Yet the basic concept that materiality is determined by professional judgment based on user needs is unlikely to change.