Materiality in practice: applying a materiality mindset
Published: 12 October 2023
3 minute read
Introduction
Boards and management have a duty to provide material information about the company in the annual report and accounts (ARA). In light of this, the FRC Lab researched how companies can use materiality for better, not more reporting. When companies report, they need to comply with all of their legal and regulatory obligations. However, this report is intended to help them report clearly and in a compelling way on those issues that the board and management deem to be of greatest importance to stakeholders.
Applying a materiality mindset
Boards and management determine the financial, narrative and other information to be reported. This process involves a materiality assessment. Most forms of corporate reporting are subject to a materiality assessment, albeit some disclosures are always deemed material by law, regulation or relevant accounting standards.
Standards and guidance, such as IFRS, FRS 102 and the Guidance on the Strategic Report all discuss how materiality applies to reporting. Auditing standards provide a separate specific purpose for materiality.
For preparers, deciding what information is material can be difficult; what may be material to one group of users, may not be to another. It is subjective and requires boards and management to use judgement.
Applying a materiality mindset can be powerful for corporate reporting. By thoroughly reviewing, ranking, and removing any information that is not relevant, management strengthen the value of their reporting. Identifying what matters can be a useful input not only for strategic planning, but also for identifying and refining controls and processes.
Drawing on the lessons learned from our project participants, we have compiled a toolkit to help companies apply a materiality mindset to reporting:
- Think about investor needs and decision-making
- Take a holistic approach to materiality
- Embed a materiality mindset
We see these as elements of a cycle of continuous improvement. While these tips are primarily focused on a reporting perspective, they will be of value to wider strategic and risk management processes as well.
Think about investor needs and decision-making
Investor"What I think should or shouldn’t be in the annual report and accounts? It’s no secret sauce – it’s the important information"
The exact definition of materiality varies subtly depending on the reporting framework. However, in general, information is typically understood to be material when omitting, misstating, or obscuring it could be reasonably expected to influence the decisions of primary users of financial reporting.
For UK ARAs, the primary users are commonly understood to be existing and potential investors, lenders and other creditors. For the sake of simplicity, we use ‘investors’ throughout this document as shorthand for all types of primary users involved in the project.
Understanding how investors use information to make decisions will help boards and management when making materiality assessments. The FRC spoke to investors to understand what core information investors look for and how they use it for decision-making. We have distilled these views into a practical tool to help companies understand investor decision-making.
Take a holistic approach to materiality
Investor"Sometimes it feels like companies are taking a tick box approach to materiality"
Companies and their advisers told us materiality is typically considered through three separate lenses:
- Quantitative financial thresholds – typically assessed as a set threshold for correcting errors and including disclosures about significant transactions;
- Qualitative financial aspects – generally an informal understanding of ‘what’s important’ to the company that frames narrative reporting; and
- Sustainability-related information – a focused review on sustainability-related issues, typically collecting multiple stakeholder viewpoints and mapping these on a matrix.
While each of these lenses overlap and interrelate, most companies looked at them separately. This differs from how investors evaluate information for decision-making. Investors want to understand the business model and strategy in a holistic and connected way. Boards and management can benefit from aligning their materiality assessments more with investor needs. We spoke to companies and advisers to understand how better to connect materiality. Learn more about how to take a holistic approach to materiality.
Embed a materiality mindset
Non-executive director“Materiality is not just a mechanical thing that you add up for misstatements."
Thinking about investor needs and decision-making, as well as taking a holistic approach to materiality provides a firm reporting foundation. We spoke with companies and advisors about what they found helpful when reporting. To aid companies, we’ve collated their tips for how to embed a materiality mindset.
Methodology
Participants join Lab projects by responding to a public call or being approached by the FRC. An iterative approach is taken, with additional participants sought during the project, though it is not intended that the participants represent a statistical sample. The Lab also regularly reviews other sources of information, for example but not limited to, relevant research reports, podcasts and news media.
References made to views of ‘companies’ and ‘investors’ refer to the individuals from companies and organisations that participated in this project. Views do not necessarily represent those of the participants’ companies or organisations.
Views were received from a range of investors, companies, and organisations through 50 in-depth interviews, as well as six roundtable discussions.
Not all topics discussed will be relevant for all companies and all circumstances, but each provides a potential approach to considering and applying materiality that may be helpful when reporting.
We would like to thank all those who gave their valuable time to this project.
This is part one of a four-part series Applying a materiality mindset.