Expanding the Concept of Materiality to Environmental, Social, and Governance: Audit Issues and Implications

Materiality is a fundamental concept used in and by various professions. Certainly, it is a well-established concept in both the accounting and legal professions (Sommer 1975), but it is used in other professions as well, such as in actuarial science (Actuarial Standards Board 2013). Former U.S. Securities and Exchange Commission’s (SEC) Commissioner A. A. Sommer, Jr., stated:

With the expansion of environmental, social, and governance (ESG) reporting outside of the United States, and the proposed inclusion of ESG disclosures in U.S. issuers’ public reports (Securities and Exchange Commission (SEC) 2022), a debate has emerged as to whether the concept of materiality should be focused on an issuer’s financial value and investors (financial materiality) or be a broader concept also focusing on an issuer’s impacts on the environment, society, and stakeholders beyond direct investors (environmental and social materiality). This expanded definition is known as double materiality (European Union 2019).

In this paper, we discuss how the definition of materiality has evolved and continues to evolve in response to current and proposed ESG disclosure requirements. We also discuss related issues and implications for auditors.

Prior to the passage by Congress of the United States securities laws, the accounting and auditing professional standards, to the extent they existed at all, did not provide a standard with respect to materiality. Nearly nine decades ago, the SEC articulated that when management made judgments regarding materiality in financial disclosures, the determination was to be from the perspective of an average prudent investor, not from the perspective of management and auditors.¹ Specifically, SEC Rule 405 defined materiality as:

Over the decades, academics and others have expressed differing views from Congress, the courts, and regulators about the definition of materiality. For example, Patterson (1967) argued that a more explicit and rigorous definition of materiality would provide more uniformity in financial statement presentation; and Rose, Beaver, Becker, and Sorter (1970) advocated for an empirical measure of materiality.² Unsurprisingly, the issue of materiality with respect to public financial disclosures made pursuant to the securities laws soon proceeded to the U.S. courts.

Among others, in SEC v. TX Gulf Sulphur Co. (1968, 401 F.2D 833), the Second Circuit Court of Appeals made clear that a material fact “is information which is likely to affect the market price of any of the company’s securities or is likely to be considered important by reasonable investors, including speculative investors, in determining whether to trade in such securities” (Karmel 1978, 2). The court went on to state that with respect to a prospective transaction (merger), whether a fact is material “will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event.”

In Affiliated Ute Citizens v. US (1972, 406 U.S. 128), a case involving a failure to disclose, the Supreme Court held a material fact was one in which “a reasonable investor might have considered them important in the making of his decisions.” In Escott v. BarChris (S.D.N.Y 1976, 283 F. Supp. 643, 68–681), the court held that matters to which a reasonably prudent investor be informed are those matters that “an investor needs to know before he can make an intelligent, informed decision whether or not to buy the security.”

In TSC Industries v. Northway, Inc. (U.S. Supreme Court 1976, 426 U.S. 438), the Supreme Court opined, “an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote” and “it does not require proof of a substantial likelihood that disclosure of the omitted fact would have caused the reasonable investor to change his vote.”

In Basic, Inc. v. Levinson (U.S. Supreme Court 1988, 485 U.S. 224), the Supreme Court affirmed its earlier definition of materiality in TSC Industries and added, to fulfill the materiality requirement, “there must be 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.” The Supreme Court also held materiality must be determined on a case-by-case basis and rejected the arguments of academics and practitioners for a bright-line, quantitative standard.

Since the turn of the century, interest in ESG has grown exponentially. The number of electric vehicles being purchased, solar panels installed on homes, and media coverage of abnormal climate events such as uncontrollable wildfires and droughts all highlight the tremendous interest in environmental issues. Calls for action to address climate change have resonated around the globe. The United Nations Paris Agreement of 2015 and Climate Change Conference of the Parties of 2021 reflect a growing belief in the urgency of climate change. Individuals, activists, and politicians have discussed increasing disclosures of companies’ ESG impacts on various stakeholder groups, not just investors. Other countries are ahead of the United States in mandating ESG disclosures. For example, the European Union (EU), in its Nonfinancial Reporting Directive, notes:

As might be expected, the issue of materiality in terms of ESG disclosures and assurance has become the subject of much debate. Tager (2021) described, “The concept of double materiality…is not just climate-related impacts on the company, but also impacts of a company on the climate—or any other dimension of sustainability, for that matter.” The double materiality standard was adopted by the EU in its Nonfinancial Reporting Directive (European Union 2019), and the Global Reporting Initiative (GRI) and World Economic Forum have advocated for a definition and standard of materiality based on double materiality (Katz and McIntosh 2021).

In contrast, the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TFCD) adopted a materiality standard consistent with how a company prepares its financial filings.³ In its Consultation Paper on Sustainability Reporting, the International Financial Reporting Standards Foundation (IFRSF) started a process to establish a Sustainability Standards Board (SSB) and recommended that the SSB adopt a materiality standard consistent with the International Accounting Standards Board (IASB) approach rather than a double materiality standard (International Financial Reporting Standards Foundation (IFRSF) 2020). More importantly, the U.S. Congress, courts, and SEC have not adopted a double materiality standard, a prerequisite for the use of that standard in the United States.

In response to requests of activists, investors, and politicians, in 2022, the SEC issued its proposed rule, The Enhancement and Standardization of Climate-Related Disclosures for Investors (Proposal, SEC 2022, 35, 65, 80–81). The Proposal is modeled after the TFCD disclosure requirements. If adopted, the Proposal “would require a registrant to disclose whether any climate-related risk is reasonably likely to have a material impact on a registrant, including its business or consolidated financial statements, which may manifest over the short-, medium-, and long term.”

The Proposal states materiality would be defined as consistent with the Supreme Court opinions and SEC definitions. That is, based on financial materiality. Materiality would consider: (1) both quantitative and qualitative factors, (2) be largely fact specific, and (3) for future events, would require “an assessment of both the probability of the event occurring and its potential magnitude or significance to the registrant.” The Proposal goes on to state:

However, the Proposal diverges from a materiality determination based strictly upon that of a reasonable investor when it comes to disclosures of the impact on financial statement line item elements. (Previous SEC rules have also adopted such an approach.) Instead, a “bright line” test is used for three categories of financial statement metrics. The categories are (1) financial impact metrics, (2) expenditure metrics, and (3) financial estimates and assumptions. The Proposal would require disclosure in the audited financial statements of the disaggregated financial statement impact metrics of severe weather events, other natural conditions, transaction activities, and climate-related risks unless the aggregated impact of these matters is less than 1 percent of the total financial statement line item for the relevant fiscal year. Disclosure is also required of expenditure metrics of these same items (each of the amount of expenditure expensed and capitalized) using the same 1 percent threshold as for the financial impact metrics. Table 1 highlights differences in the approach to materiality of the TFCD, the Proposal, and the EU.

The SEC received over 10,000 comment letters in response to the Proposal.⁴ Comments both supported and opposed the bright-line disclosure threshold. Example comments are provided in Table 2.

The Proposal requires limited assurance on greenhouse gas (GHG) disclosures initially and then transitions to reasonable (high level of) assurance on GHG disclosures. The Proposal does not require assurance to be provided by a CPA.⁵ If asked to perform GHG (or other ESG) attestation for an issuer, CPAs must determine, among other things, whether they have the appropriate skills and independence to conduct the engagement, which attestation standards should be followed, the criteria for determining whether all required disclosures are included, whether the client’s applicable internal controls should be considered and evaluated, and how to apply materiality.

In light of the competition for ESG assurance engagements from non-CPA providers, there may not be a sufficient pool of competent, trained, and experienced individuals to fill the expected demand for ESG assurance. Many academic institutions have yet to include ESG topics, nonfinancial assurance, and double materiality in their curricula. Therefore, it is probable accounting firms will need to develop and provide training to meet the expected demand for ESG assurance.

Independence is a hallmark of assurance services. The American Institute of Certified Public Accountant's (AICPA) Code of Conduct requires that CPAs maintain an independent mindset when conducting assurance services. Consulting with issuers on ESG matters will create an independence issue when providing ESG assurance, and such services violate the stated principles of the SEC. CPAs should closely evaluate their independence prior to agreeing to conduct an ESG assurance engagement.

Although limited assurance in the context of financial statements is substantially less than obtaining reasonable assurance, limited assurance requires a basic level of knowledge commensurate with that obtained in an audit.⁶ As of yet, there is no guidance for assurance specific to GHG disclosures (or other ESG matters) from either the SEC or the Public Company Accounting Oversight Board (PCAOB). However, CPAs can look to the AICPA's Statement on Standards for Attestation Engagements (SSAE) No. 18 and the AICPA’s authoritative guide, Attestation Engagements on Sustainability Information Guide (including greenhouse gas emissions) for guidance. The PCAOB may issue guidance to address this gap. New guidance will have to be understood and implemented by assurance providers.

It is possible issuers will engage specialists, particularly to help accumulate and quantify environmental exposures like GHG emissions. Auditors of public companies must follow the PCAOB’s auditing standards when using or relying on the work of specialists, and these standards have recently changed (Public Company Accounting Oversight Board (PCAOB) 2022).

There are several disclosure frameworks for ESG disclosures. Among these are frameworks of the TFCD, GRI, and Sustainability Accounting Standards Board (SASB). Although the Proposal does not specify the criteria against which assurance providers should determine the adequacy of an issuer’s ESG disclosures, the Proposal reports the TFCD’s framework is “widely endorsed by U.S. companies and regulators and standard-setters around the world” (SEC 2022, 37).

There are numerous ESG metrics companies could track and report. Bloomberg’s ESG dataset is organized into more than 2,000 fields of company data that span from air quality measures to board structure.⁷ Without mandated guidance, it is likely issuers’ disclosures will lack comparability. The results of a recent survey indicated financial analysts prefer that a single standard be established prior to requiring ESG assurance (CFA Institute 2021). Before then, assurance providers will have to be somewhat versed in all the major frameworks.

When performing an audit of an issuer’s financial statements, the auditor is required to evaluate internal control over financial reporting. The Proposal does not require an attestation report on the effectiveness of controls over GHG emissions disclosures. However, to the extent that ESG disclosures are included in the financial statements, the auditor must consider the likelihood an issuer’s controls are not sufficient to reduce the likelihood and risks that ESG disclosures are materially misstated. The most popular framework for evaluating the adequacy of internal controls is COSO 2013, which, for the most part, does not consider controls needed to minimize the likelihood of inadequate ESG disclosures. Consideration of internal controls over the production of ESG disclosures is likely to require extra effort and consideration by issuer-auditors.

The Proposal utilizes the U.S. historical notion of materiality. For certain financial statement disclosures, it also includes a “bright-line” standard. Overall, financial materiality with a focus on the perspective of a reasonable investor is retained. Materiality does not assume deliberations by those outside the realm of the company and its investors. As prescribed by Congress and the U.S. Supreme Court, it is based on the substantial likelihood the information would be material to an investor.⁸ For the time being, double materiality will not apply to issuers’ ESG disclosures. However, it is likely that individuals, activists, and politicians will continue to advocate for a more outward-looking perspective on ESG, and it is possible that materiality will move from a securities law model to one more centered on public interest. Auditors should continue to follow the debate of double materiality.