Material Weakness Definition

What is material weakness?

A material weakness occurs when one or more of the internal controls— the activities, rules and processes designed to prevent material misstatements in the financial statements and improve the efficiency of operations — are ineffective. If a deficiency in internal control is a material weakness, it could result in a material misstatement of a company’s balance sheet. financial state. This would render the company’s financial statement data unreliable and ineffective in assessing the company’s financial health and determining a reasonable price for the company’s stock.

When an audit is performed and a material weakness in the company’s internal controls is detected, the auditors report the material weakness to the audit committee. Every publicly traded company in the United States must have a qualified audit committee. The audit committee, which is part of the board of directors, requires the management of the company to take action to correct the controls and rectify the material weakness.

Key points to remember

  • A material weakness exists when one or more internal controls fail.
  • When identified, a firm’s audit committee must take action to remedy the weakness.
  • An unresolved material weakness can lead to a material misstatement – incorrect information in a financial statement that may change the decisions of its users.
  • US companies must follow generally accepted accounting principles (GAAP) when preparing financial statements.
  • A material deficiency is one or more deficiencies in a company’s financial information and is less serious than a material weakness.

Understanding Material Weakness

A material weakness, when pointed out by an auditor, merely suggests that a misstatement might be occurring. If a material weakness is not detected and resolved, a material misstatement could potentially occur in a company’s financial statements. An error in the company’s financial statements can have a tangible effect on the Evaluation.

In the United States, companies must follow the Securities Exchange Committee (SEC) adopted generally accepted accounting principles (GAAP) when preparing financial statements. Most US companies subscribe to the 5% materiality rule, which states that erroneous values ​​5% above the basics (eg, gross profit, net income, etc.) are material.

Material weakness vs significant impairment

Sometimes material weakness and significant deficiency are used interchangeably. They both identify shortcomings, but one carries more weight than the other. A material deficiency, that is, one or more weaknesses in a company’s financial reporting, deserves attention, but is less likely to have an impact on the financial statements than material weaknesses.

GAAP does not protect against or provide guidance on material weaknesses.

Example of material weakness

For example, an overstated revenue of $100 million would be a material misstatement for a business generating sales of $500 million per year. Incorrect company valuations, due to material weaknesses, can affect the company’s share price. Because of their potential to harm the integrity of the public, material weaknesses in a company’s internal controls should be identified early.

In October 2018, Costco Wholesale (COST) reported a material weakness in its internal control. According to a press release, “The weakness relates to general information technology controls in the areas of user access and program change management on certain information technology systems that support company’s financial reporting process. In simpler terms, unauthorized persons may have gained access to the company’s financial information systems.

The company also said it did not identify any inaccuracies in the financial reports and that corrective efforts began immediately. Shortly after their public announcement, their stock price fell about 4%.

In 2019, Costco completed its remediation efforts, concluding that its internal controls over financial reporting were tested and operating effectively as of September 2019.

What is the impact of material weakness?

Material weaknesses can damage a company’s reputation and, therefore, its value. A company’s stock price may fall because some investors view the company as a risky investment. Depending on the outcome of the weakness, the company may spend significant sums to cover additional legal fees and external audit costs. Additionally, employees, especially management, can be scrutinized and disciplined for their lack of oversight.

Which is worse: major deficiency or material weakness?

A material weakness, which is more serious than a material deficiency, is a deficiency in internal control or a set of deficiencies that create a material misstatement in a company’s financial statements. According to the SEC, a material deficiency is a deficiency that adversely affects “the company’s ability to record, process, summarize, and report financial information to the external auditor and audit committee, with the intended result that those parties may more effectively perform their respective responsibilities with respect to the company’s financial reporting. »

What are the indicators of material weaknesses?

There are several indicators of material weaknesses in internal controls. Some of the most notable include evidence of fraud by senior management, the identification of a financial misstatement in the company’s financial statements missed by the company’s internal controls but detected by an auditor, and mishandling of reporting. external and internal financials of a company.

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