Material Weakness

Material weakness is a single issue or a combination of two or more internal control issues. It can lead to operational inefficiency and financial statement irregularities, which can result in a material misstatement. Whenever a lapse of this nature is identified, material weakness remediation must be carried out to eliminate the inconsistencies.

Since the financial statements would have inconsistencies, they would be deemed unreliable. Therefore, they cannot be used to determine the company's financial health or compute the appropriate stock price. Every time such a weakness is found, it is reported to the audit committee. The audit committee ensures that management takes immediate steps to rectify the flaws.

A material weakness in internal controls refers to a significant deficiency in a company's financial reporting processes that could lead to misstatements of the financial statements. This term is used within the context of audits and financial reviews to describe flaws in a company's internal control system that could potentially allow errors or fraud to go undetected.

Internal controls are the mechanisms, procedures, and policies a company uses to ensure the accuracy and reliability of its financial reporting. When these controls are functioning optimally, they detect and ward off errors or irregularities. However, an audit material weakness indicates a substantial risk that the financial statements could be inaccurate or misstated. This weakness can arise due to various issues, like ineffective oversight by management, inadequate accounting systems, or poor communication of financial data.

A material weakness is a serious concern for a business. It can undermine investor confidence and may lead to scrutiny from regulatory authorities. Companies identified with such issues are often required to take corrective actions, such as revising their internal control procedures or improving staff training.

While the identification of a material weakness does not guarantee financial misstatements, it does highlight a critical area of risk that must be addressed to ensure the integrity of financial reporting. All listed companies in the United States are required to have an audit committee that ensures the management takes corrective actions.

The most common causes for companies having these weaknesses are:

• Inadequate Accounting Staff: One of the most common causes of these issues for companies is the need for sufficient accounting staff to ensure quality checks and proper documentation regarding accounting standards and regulatory requirements. 
• Inadequate Review: These reports are generally reviewed by an external auditor. However, reviewing the financial reports without knowing the company's happenings could lead to errors remaining undetected because the auditor needs more context for the report. 
• Technological Update: Incorporating new technology is always intended to simplify tasks and improve efficiency. However, it always comes with a significant level of risk. There is a chance of data being lost or leaked.
• New Accounting Standard Adaptation: When a company transitions from one type of accounting standard to another, it takes on multiple risks of lapses in internal control. Post-implementation checks are needed to ensure the correctness of reports. Otherwise, they must ensure that material weakness disclosure is provided during the audit.

Now that the theoretical aspects of audit material weakness are out of the way, it is time to address the concept's practical applicability through the examples below.

Example #1

LMN Corporation had a 10-member accounting team. Each report was checked twice to ensure accuracy. However, the company implemented new Enterprise Resource Planning (ERP) software.

Some senior staff needed help grasping the ebbs and flows of the new technological implementation. Moreover, the accounting team needed to be given a particular orientation, resulting in multiple misinterpreted reports. The issue was reported to the audit committee, which instructed the management to get external help and sort the issue before the next filing date with the SEC (Securities and Exchange Commission). 

Example #2

ProPetro, an oilfield services company, was under investigation by the United States Securities and Exchange Commission in 2019 when the company’s board of directors found material weakness in terms of financial control within the company and an undisclosed transaction with a former chief accountant.

However, after thorough assessment and scrutiny, the company said that no misstatements were found in its financial statements.

The impact can be significant if the company does not carry out material weakness remediation. The consequences can include:

• The company’s reputation and its value can be significantly affected.
• As a result, the stock price might experience a downturn as investors might perceive the company as a risky investment. 
• The company might have to spend a massive amount towards rectification in the form of legal and auditing fees.
• Top management and other employees may face disciplinary action owing to the lack of oversight.

The most common ways to detect these weaknesses are:

• Internal Audits: Regular internal audits can identify weaknesses in internal controls before they escalate. Internal auditors review processes, systems, and compliance with established procedures.
• Audit Evaluations: External auditors play a crucial role in detecting material weaknesses during a company's financial statement audit. They gauge the potency of internal controls and identify any significant deficiencies.
• Management Review: Management is responsible for continuously monitoring and evaluating internal controls. Reviewing financial reporting processes helps identify potential weaknesses.
• Error Trends: Repeated errors or discrepancies in financial records can indicate a significant weakness. Patterns of mistakes suggest that existing controls are not adequate.
• Whistleblower Reports: Reports from employees or third parties about irregularities in financial processes can point out such weaknesses and further investigation can be ordered post material weakness disclosure.

1. A few of the most effective ways to ensure that audit material weakness can be avoided are:

• Risk Assessment: A thorough risk assessment must be in place to identify potential roadblocks based on the company's objectives. These findings can help place checks at different levels and protect the company from finding flaws in internal control. 
• External Audits: A fresh perspective from an outsider can give the company complete insights. They can also provide an honest report without any prejudices or biases. These reports can not only point out existing flaws but also help find best practices to avoid such inconsistencies in the future. 
• Regular Checks: Checks placed at different levels of the organization can ensure that all aspects of reporting are flawless. This provides an additional level of security before an external audit can confirm the authenticity of the reports. 
• Whistleblower Protection: Provide a safe passage for employees or outsiders to point out unethical practices within the company or even rewards. As a result, they shall be motivated to report such practices.

The differences between material weakness disclosure and significant deficiency are:

Material Weakness

• It is a lapse in the internal control of a company. This leads to misstatements of financial statements.
• Misstatements lead to financial statements being unreliable, which indicates severe internal control problems.
• It may lead to scrutiny from regulatory authorities and investors losing confidence in the company.
• Weaknesses are reported by auditors in their financial statements audit reports. Management then takes corrective actions.

Significant Deficiency

• It is a lesser-impact deficiency within a company's internal control. It can still lead to misstatements or errors, but not necessarily at a material level.
• The lower intensity does not mean that the people involved would not garner attention and scrutiny. They would still be held accountable.
• It shows where internal control needs improvement. Even though it does not cause substantial financial errors, it is still a factor to improve.
• The auditor reports these errors to the board of directors or management. However, they are not always publicly disclosed unless regulatory authorities instruct them to do so.