Updating the purpose of financial reporting
The Materiality Files Blog 3: ‘Dismantling financial materiality and transforming capitalism’, co-authored by Ben Carpenter and Jeremy Nicholls
In the first blog of the Materiality Files series, we illustrated how financial materiality is failing to prevent human rights abuses and how SVI are advocating for an approach to materiality based on wellbeing. In the second blog we outlined how most sustainability accounting does not follow the same logic as financial accounting when it comes to the relationship between relevance and materiality – although it could and, we think, should!
In this third blog we continue to examine the logic of materiality in financial accounting to dismantle the term and whole concept of ‘financial materiality’. We delve into the Conceptual Framework for Financial Reporting and illustrate how a small but necessary evolution to the purpose of financial reporting is the real key to transforming capitalism and creating a more sustainable world.
Firstly, a quick reminder of what financial materiality is:
In the context of financial reporting, financial materiality is information that is material to the decisions made by primary users, of which more later. In the context of sustainability, financially material information has become an accepted term for information on “those ESG issues that affect the company's ability to generate future cashflows, in other words, its enterprise value.”[1]
The overriding focus here is on profit and managing risks to financial return. This emphasis on profit is hardly surprising considering the capitalist global economy that exists today. We all know the phrase: “money makes the world go round” – but capital markets and financial flows only happen because of our international accounting standards. So let’s examine these accounting standards.
The Conceptual Framework for Financial Reporting (CFFR)
The best place to look is a wonderful document (published by the IFRS in 2010 and 2018) called the Conceptual Framework for Financial Reporting (CFFR). This document articulates the basis, foundations, and ideas that underpin our international accounting standards and therefore the wheels of our global economy.
We think that, to understand why our global economy works the way it does, we need to get down in the weeds of accounting. Even if you are not an accountant, it will be worth reading the 800 words in the screen shots below that set out the objectives of general purpose financial reporting [2].
Why is this so important?
1. Who are the primary users of financial reports?
According to paragraph 1.2 the information (in financial reports) is useful to: “existing and potential investors, lenders and other creditors”. Who falls within this description exactly? Well, you the reader – you probably have a pension or are thinking about starting one – so that makes you an existing or potential investor. And if it is a state pension, your government is a lender (since tax due is generally paid a year after the period to which is relates) and so is also a primary user, acting on your behalf.
So, we are all primary users of financial reports!!
Let’s dig further because in paragraph 1.8 it expands on the idea of primary users by saying:
“Individual primary users have different, and possibly conflicting, information needs and desires. The Board, in developing Standards, will seek to provide the information set that will meet the needs of the maximum number of primary users. However, focusing on common information needs does not prevent the reporting entity from including additional information that is most useful to a particular subset of primary users.”
This bit is really interesting – honestly! It recognises that there are many different ‘individual primary users’ of financial reports with many different information needs – but the International Accounting Standards Board will seek to provide the information set that will meet the needs of the maximum number of primary users. Which leads us to our next question …
2. What is the information set that will meet the needs of the maximum number of primary users?
Let’s assume that all primary users (remember that’s all of us) want information about financial returns. Yes, of course we do – so the content of paragraphs 1.2-1.4 are not wrong! But … is there any other information that is needed by primary users? Let’s try this experiment:
In our experience of asking this question (to as many people as we can), our guess is that you voted somewhere between option 2 and 4. (We are running this as a live poll to see what information set would meet the needs of the maximum number of readers – please vote!). In 2019, a Social Value UK survey found that only 15% of the population wanted their investments to maximise financial returns with no interest in the social or environmental impact of the investment[3].
If this is what we all want from our investments then it follows that the information that meets our needs includes information about the social and environmental return (or consequences of) from our investments. Even for an investor who states they are only interested in financial returns, it is problematic to ignore social or environmental returns because they won’t know when those investments are going to have consequences for their own lives. A good example of this is climate change. Having ignored the environmental returns of our investments for decades we are all now feeling the impacts of climate change.
So, it is fair to assume that information on social or environmental returns falls within the needs of the maximum number of primary users (of financial reports).
[Note: We have used the phrase social and environmental returns to be consistent with the language of financial returns. A better way to look at this is to see financial returns as an aspect of social returns, and together social and environmental returns can be thought of as changes to our individual and collective wellbeing.]
What is alarming is that the current information set being provided in financial reports is appropriate only for those who choose option 1. The Conceptual Framework for Financial Reporting makes no explicit reference to social or environmental consequences of an entity – it is solely about financial returns. But really? Who are these people that would vote for option 1? Who are the people that have no interest in social or environmental consequences of their investments? They would have to be people that do not care about the future of our planet and for the human rights and dignity of others. Maybe some people do hold these views – but surely this is not the majority!
The financial or double materiality debate shouldn’t be about whether social and environmental consequences become material to financial returns. That is a red herring. Financial materiality should not be the basis for annual accounts. Social and environmental information should not be an add-on in another set of disclosures; it should be integrated into those annual accounts, and follow the same logic for creating useful information. The 2019 Social Value UK survey also found that 76% of respondents thought that social and environmental information should be made available in a company's accounts, and 40% thought it should be mandatory for companies to include financial, social and environmental value when determining the overall profitability of a company.
So, how do we change this?
Over the last 50 years global capitalism has undoubtedly led to significant developments in living standards for many but this has not happened for everyone. For example, consider that 24% of the world’s population live in fragile contexts, characterized by impoverished conditions and dire circumstances; 9.2% of the global population live on less than $2.15 per day; and the richest 1% own almost 46% of the world's wealth.
As we sit here almost a quarter of the way through the 21st century it is clear to us all that the future of the planet and our shared prosperity remains in the balance. The existential threats of climate change and rising social inequalities are visible, real and harming us all. Governments, business leaders and investors are all stuck in various attempts to create a more sustainable and equal world. We believe one of the most effective solutions lies hidden under our very noses.
The solution is beautiful in its simplicity: we update the Conceptual Framework for Financial Reporting. Let’s imagine that we evolved the objective of general purpose financial reporting to actually reflect and meet the needs of the maximum number of users – this could be done by simply adding references to sustainable development and the wellbeing of people and planet as relevant (and we mean relevant rather than material) information to users of financial reports.
We do not even need to change the definition of primary users (i.e. “existing and potential investors, lenders and other creditors”). This is adequate – it captures that we are all potential users of financial reports.
The change required relates to the purpose behind the decisions that users are expected to make. It would be entirely reasonable and appropriate to make the following change to this sentence in paragraph 1.3 :
1.3 The decisions described in paragraph 1.2 depend on the returns that existing and potential investors, lenders and other creditors expect, for example, health and social connections as well as financial returns such as dividends, principal and interest payments or market price increases. Investors’, lenders’ and other creditors’ expectations about returns depend on their assessment of the amount, timing and uncertainty of (the prospects for) changes to wellbeing (including future net cash inflows to the entity) and on their assessment of management’s stewardship of the resources on which the entity depends (including its economic resources). Existing and potential investors, lenders and other creditors need information to help them make those assessments.
Paragraph 1.4 would also need adapting – perhaps in the following way:
To make the assessments described in paragraph 1.3, existing and potential investors, lenders and other creditors need information about:
(a) the economic resources of the entity, claims against the entity including social and environmental returns (wellbeing) and changes in those resources and claims; and,
(b) how efficiently and effectively the entity’s management and governing board have discharged their responsibilities to use the resources on which the entity depends (including its economic resources).
[For more detailed analysis on how non-financial information can be integrated into financial statements see this paper published by Capitals Coalition in 2021: Disclosing impacts on natural, social and human capital in financial statements , and the Conceptual Framework for Sustainability Reporting.]
These proposed changes are just an example of how we could re-define the purpose of financial reporting. By focussing on the purpose and the decisions made by users (of financial reports) the debate about financial materiality (and all the other silly terms – single, double, triple, dynamic, etc) would disappear. Information is either material to a user – for a decision with our new purpose – or it is not. (See blog 2 and our webinar).
The change to the purpose of financial reporting does not even need to be too radical (assuming that enhancing wellbeing for all is not controversial). Financial returns remain a part of that, and many of the structures would remain, albeit with an updated purpose and an updated statement of their public interest, and yet it would transform capitalism and help us create a sustainable and equitable world. We must acknowledge that a narrow purpose that focuses on financial returns alone is outdated. More appropriate is a focus on enhancing wellbeing that includes financial returns. This would change how we calculate profit. The ability to make profits with unaccounted for costs to the wellbeing of people or planet would be significantly reduced.
Is accounting for wellbeing possible? In blog 2 we showed that it is not without its difficulties but yes – it is entirely possible. Wellbeing or life satisfaction is a well-defined concept globally. The OECD has a framework and is developing multinational data sets. Social Value practitioners have been developing practices for accounting for wellbeing since 2007. The UNDP (and soon ISO) have standards for decision making that contributes positively to sustainable development.
If we have the political will to embed ‘wellbeing’ into the purpose of financial reporting, and if it is enshrined in legislation, the innovation and practice within the accounting profession will quickly make significant strides. Humanity has shown how we can harness technology and data to do amazing things. Why not collect data on wellbeing that can improve our decision making and accountability?
We all need to live in a sustainable world where wellbeing of people and planet is enhanced alongside financial returns. It makes sense for everyone, and we have the power to hard wire this purpose into financial reporting which is the basis for so much of our decision making.
Don’t forget to vote in our opinion poll about the returns you seek from your investment!
About the Materiality Files
SVI have produced a series of blogs and a webinar on the subject of materiality. Why? The existential threats of climate change and social inequality are real for us all. In an attempt to reverse these negative trends and create a more sustainable world there needs to be a transformation in the way capitalism works and that means a change in the way decisions are made. Central to this transformation is changing the purpose behind investment decisions and then the information that matters to inform decisions with that purpose will also change. The concept of materiality is central to this.
Blog One “Financial materiality and human rights, pineapples and profits” illustrates the futility of relying on market forces to fix the problems that have been caused by profit maximisation.
Blog Two “How financial accounting determines materiality and what this means for sustainability” outlines how most sustainability accounting does not follow the same logic as financial accounting when it comes to the relationship between relevance and materiality – although it could and, we think, should!
Webinar : Top Tips on Principle Four. Our webinar showed that neither the timeframes or value (from the perspective of the entity) of social and environmental impacts are adequate in preventing human rights abuses or the degradation of our natural environment.
[1] https://www2.deloitte.com/hu/en/blog/esg-explained/2021/esg-explained-5-materiality-matters.html
[2] https://www.ifrs.org/content/dam/ifrs/publications/pdf-standards/english/2021/issued/part-a/conceptual-framework-for-financial-reporting.pdf