What Is Material Weakness?
A material weakness is when one or more of a company's internal controls—activities, rules, and processes designed to prevent significant financial statement irregularities and improve operation efficiency—is ineffective. If a deficiency in internal control is a material weakness, it could result in a material misstatement in a company's financial statements. This would make the company's financial statement data unreliable and ineffective for assessing the company's financial health and determining a reasonable company stock price.
When an audit is conducted 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 US must have a qualified audit committee. The audit committee, a part of the board of directors, requires that the company's management take steps to fix the controls and rectify the material weakness.
Key Takeaways
- A material weakness exists when one or more internal controls fail.
- When identified, a firm's audit committee must take steps to remedy the weakness.
- An unresolved material weakness can result in a material misstatement - incorrect information in a financial statement that can alter the decisions of its users.
- US companies must follow Generally Accepted Accounting Principles (GAAP) when preparing financial statements.
- A significant deficiency is one or more deficiencies in a company's financial reporting and is less severe than a material weakness.
Understanding Material Weakness
A material weakness, when reported by an auditor, simply suggests that a misstatement could occur. If a material weakness remains undetected and unresolved, a material misstatement could eventually occur in a company's financial statements. An error in the company's financial statements may have a tangible effect on a company's valuation.
In the US, companies must follow the Securities Exchange Committee (SEC) adopted Generally Accepted Accounting Principles (GAAP) when preparing financial statements. Most US firms subscribe to the 5% materiality rule, which states that misstated values 5% above bases (e.g., gross profit, net income, etc.) is material.
Material Weakness vs. Significant Deficiency
Sometimes, material weakness and significant deficiency are used interchangeably. They both identify deficiencies, but one carries more weight than the other. A significant deficiency, which is one or more weaknesses in a company's financial reporting, warrants attention but is less likely to have an impact on the financial statements as with material weaknesses.
GAAP does not safeguard against or provide guidance on what are material weaknesses.
Example of a Material Weakness
For example, a $100 million overstatement in revenue would be a material misstatement for a company generating sales of $500 million annually. Incorrect company valuations, as a result of the material weaknesses, may affect the company's stock price. Due to their potential to hinder the integrity of the public, material weaknesses in a company's internal controls must be identified promptly.
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 over certain information technology systems that support the Company's financial reporting processes." In simpler terms, unauthorized persons may have gained access to the company's financial reporting systems.
The company also reported that they did not identify any misstatements in the financial reports and that remediation efforts began immediately. Soon after their public announcement, their stock price fell by approximately 4%.
In 2019, Costco completed their remediation efforts, concluding that its internal controls over financial reporting was tested and operating effectively as of September 2019.
What is the impact of a material weakness?
Material weaknesses can adversely affect a company's reputation and, subsequently, its value. A company's stock price may drop as some investors deem the company as a risky investment. Depending on the result of the weakness, the company may expend large sums to cover legal and additional external auditing fees. Also, employees, particularly management, may be heavily scrutinized and subject to disciplinary actions for their lack of oversight.
What is worse: significant deficiency or material weakness?
A material weakness, which is more severe than a significant deficiency, is an internal control deficiency or collection of deficiencies that create a material misstatement in a company's financial statements. A significant deficiency, according to the SEC, is one that negatively affects the "company's ability to record, process, summarize and report financial information, to the external auditor and the audit committee, with the intended result that these parties can more effectively carry out their respective responsibilities with regard to the company’s financial reporting."
What are 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 leaders, the identification of a financial misstatement in the company's financial statement missed by the company's internal controls but caught by an auditor, and poor management of a company's external and internal financial reporting.