Bridging the gap: Financial vs. sustainability reporting materiality

Introduction: What is the gap?

Climate change is one of the most critical challenges humanity faces today. Over the last few years, businesses have been reporting more and more information on climate-related risks in the ‘front half’ (narrative section) of their annual reports, often on a voluntary basis. As the effects of climate change become more severe and noticeable, climate risk has emerged as a material risk in the sustainability reporting of numerous entities. However, there’s an apparent disparity when users look at the consistency of information throughout the annual report: while the front half often highlights material climate risks, the financial statements frequently contain little to no information about these risks. Users are asking why – and challenging whether this can even be right. This article aims to bridge that gap and explain why differences exist between sustainability and financial reporting – and also why emerging mandatory sustainability reporting regimes might help close the gap in the future.

Why is there such a gap?

Materiality is the key concept that determines what information should be included in an entity’s reporting. This concept is fundamental to any form of corporate reporting, including sustainability reporting (whether under voluntary or mandatory frameworks) and financial reporting. Although the definition of materiality can differ among various reporting frameworks, there is often alignment in practice. Information is generally considered material if omitting, misstating or obscuring it might influence decisions made by users, such as investors. However, despite this alignment, applying a similar materiality concept can lead to different outcomes in sustainability reporting and financial reporting due to their differing objectives.

Let’s consider a business located in an area at high risk for wildfires. As wildfires are becoming more extreme and more frequent due to climate change, a significant increase of property insurance premiums is expected over the long term. From a sustainability reporting perspective, the expected increase of property premiums is material information for users as they are focused on future effects resulting from climate risks. From a financial reporting perspective, the focus being on current effects, premiums incurred in the financial year have remained stable and have not yet materially affected the financials. Even though both types of reporting think about what's important (or ‘material’), they focus on different things.

The differing needs of users in sustainability and financial reporting drive different materiality judgements, as each type of reporting serves different objectives. But what are these different objectives? Let’s now revisit the objectives of sustainability and financial reporting to better grasp the expectation gap.

Sustainability reporting fulfills multiple purposes, and its use largely depends on the priorities and needs of the stakeholder. From an investor’s perspective, the primary objective of sustainability reporting is to provide them with useful sustainability-related information, enabling them to make better-informed investment decisions. In most emerging sustainability reporting regimes, reported information is not limited to risks and opportunities that have already affected an entity but also those which could crystallise in the future. This means that sustainability reporting is more forward-looking, addressing both current and possible future risks and opportunities over the short-, medium-, and long-term, and of course this means it covers broader time horizons. Financial reporting, on the other hand, typically provides a snapshot of the entity’s financial performance and position during the year that’s just ended based on events which have taken place during that financial year. While its objective is to provide useful financial information to investors, it is inherently backward looking and focused on the reporting period which has just finished. Although some aspects of financial reporting rely on forward-looking elements, such as impairments and fair value measurements, these are typically related to the assessment of an entity’s existing assets and liabilities. In contrast, as we’ve noted above, sustainability reporting often needs to take account of future events or planned actions which haven’t yet impacted (or may never impact) existing assets and liabilities. Consequently, the different objectives of sustainability and financial reporting can lead to different materiality judgments in each type of reporting.

To illustrate this, let's consider a simplified example of an energy-intensive manufacturing business facing climate transition risks. Management has assessed that transitioning to greener technology over the long term (beyond 5 years) will have a material financial effect, requiring significant investments in new technologies. These anticipated financial effects are considered material for sustainability reporting, reflecting the organisation’s commitment to managing its climate-related risks. So, there’s lots of narrative in the ‘front half’ about how the entity is planning for the transition and the required investments. From a financial reporting perspective, the future capital expenses are not yet recognised on the balance sheet as they represent a future commitment to purchase assets, not a liability that exists at the balance sheet date. However, climate transition risk is considered when testing assets for impairment. The cash flow impact of the need to replace technology is factored into the impairment valuation model but does not result in an impairment loss. Consequently, climate risk is not considered material in the financial statements, leading to limited or no disclosure.

This example demonstrates that a material climate risk in sustainability reporting may not always be considered material in financial reporting.

How to bridge that gap?

Disclosing identified material climate risks is important, but providing an explanation of how these risks are expected to affect an entity’s business, strategy, and financial planning offers even more valuable insights to users. This allows users to better grasp the connection between these risks and their effects on entities. Typically, such detailed disclosures are voluntary under today’s ‘non-mandatory’ sustainability reporting regimes. The Taskforce on Climate-related Financial Disclosures (TCFD), a framework that has become broadly applied by multinationals in recent years and even mandated in some jurisdictions, has issued recommendations to describe the impact of climate-related risks and opportunities on an entity’s business, strategy, and financial planning. To further enhance understanding, it would be highly beneficial to explain, in the front half of the report, why a material climate-related risk or opportunity does, or does not, result in a material financial effect in the current reporting period. This additional information would be useful for investors to better understand why sometimes limited information about climate risks is disclosed in the financial statements, thereby helping to close the expectation gap.

In July 2024, the International Accounting Standards Board (IASB) also issued an exposure draft on ‘Climate-related and Other Uncertainties in the Financial Statements’ to address similar concerns. The proposed examples aim to enhance the transparency of information in financial statements and strengthen the connection between financial statements and sustainability disclosures provided outside the financial statements.

The ‘new’ mandatory sustainability reporting frameworks, such as the International Sustainability Standards Board (ISSB) and the Corporate Sustainability Reporting Directive (CSRD), will undeniably help enhance sustainability disclosures and ultimately ease the connectivity gap with the financial statements that we’ve explored above. By mandating further disclosures, such as those on current and anticipated financial effects or on planned actions to address climate-related risks, the new frameworks will provide users with much more detailed and complete information on the effect of climate risks on an entity’s business. Transitioning to the new mandatory reporting frameworks is undoubtedly a challenge for entities. However, if these gaps get closed, it will ultimately benefit all stakeholders by providing investors with the comprehensive information they need.