What is a Material Weakness?

As per PCAOB Auditing Standard No. 2201 material weakness is defined as a significant deficiency or combination of deficiencies in Internal Control over Financial Reporting. It indicates that existing controls are inadequate to prevent or detect and correct material misstatements in financial reporting on a timely basis.

During the evaluation of control deficiency, specifically in the case of material weakness, auditors assess materiality based on the potential size of misstatement that could result from the deficiency and the likelihood of misstatement occurring and not being prevented or detected.

Auditors must report any material weakness identified during an audit to the company’s audit committee and publicly in the audit opinion for external stakeholders. This communication is crucial as it informs the designated authorities about the significant issue that could affect the integrity of financial statements. Management must recognize the material weakness and either design new internal controls or correct existing ones to eliminate identified deficiencies quickly. This rectification process is critical in restoring confidence in financial reporting and assuring stakeholders that the company is taking the issue seriously.

Unlike other less severe deficiencies, it is mandatory to report material weaknesses even if a misstatement has not yet occurred or has been flagged in the audit. This ensures that potential risk to financial reporting is identified and must be addressed to prevent inaccurate financial statements.

Material Weakness vs Significant Deficiency

The difference between a material weakness and a significant deficiency lies in the severity of the control failure and its potential impact on financial reporting.

Both terms are defined in auditing standards such as SAS 115 (for private entities) and AS 2201 (for public entities), and both require management communication and those charged with governance. Only material weaknesses must be disclosed externally.

Example of a Material Weakness (Mattel Case Study)

Mattel, a leading global toy manufacturer, disclosed a material weakness in its ICFR related to IT systems, which delayed its annual reports in 2023. Previously, they also faced issues regarding overestimated revenue valuation. With the disclosure of a material weakness, delaying financial reports led to increased market scrutiny and shook investors’ confidence, negatively impacting stock prices.

Impact of Material Weaknesses

Financial Reporting Risks

A material weakness in internal controls significantly increases the risk of misstatements in a company’s financial statements. If left unaddressed, a material weakness can compromise the accuracy and reliability of economic data, leading to misinformed assessments of the company’s financial health.

The SEC requires US publicly traded companies to follow GAAP for transparent and consistent financial reporting. As a benchmark, the 5% Materiality Rule is a standard guideline for assessing misstatements, implying that misstatements exceeding 5% are generally deemed material and require correction and disclosure.

Reputational Damage and Value Decline  

Disclosure of a material weakness in investors’ minds signals poor governance and control, ineffective management, and can increase skepticism regarding the reliability of financial statements. These factors damage the company’s reputation, reduce market confidence, and often result in declining stock prices.

Financial and Legal Consequences  

Addressing material weaknesses requires extra effort to remediate the issues by undertaking additional audits, hiring consultants, and managing legal liabilities. These activities can burden the company with unexpected expenses, and if investors or regulatory bodies initiate legal action, this can cause significant adverse impacts to the company’s financials.

Scrutiny and Disciplinary Actions  

Regulators may increase their oversight or trigger investigations if there is a history of control failures. Internal management, designated officers, or committees often come under scrutiny for quick remediation and the implementation of strict procedures to safeguard against future failures. Depending upon the severity of the material weakness, disciplinary actions or a management change may also be triggered.

Indicators of Material Weaknesses

Certain events and findings can indicate that internal controls have material weaknesses that are being abused or causing financial misstatements, and a material weakness audit can further reveal the nature of these abuses.

Evidence of fraud by senior leaders

Fraud involving senior management strongly indicates a material weakness in internal controls. Senior management often can override controls, and without oversight or procedures, the monitoring actions of top management can be misused to allow for fraudulent activities.

Identifying a financial misstatement missed by internal controls but caught by an auditor.  

Misstatements in financial reporting caught by external auditors indicate that internal controls have design flaws or operational problems, causing material misstatements. If auditors were the primary source for seeing the misstatement, and not an internal controls team, it would highlight a significant issue in the company’s ability to ensure the reliability and accuracy of financial reporting.

Poor management of external and internal financial reporting.

Inaccurate, delayed, or inconsistent financial reporting frequently indicates the presence of material weakness due to ineffective and poor financial management. Unqualified accounting and finance staff, inadequate processes, ineffective technology, and insufficient review or oversight could cause it.

What Is Auditing Standard No. 2201?

Auditing Standard No. 2201 (AS 2201), issued by the Public Company Accounting Oversight Board (PCAOB), guides auditors conducting an integrated audit of internal control over financial reporting (ICFR) along with an audit of financial statements. AS 2201 replaced AS5 when the PCAOB reorganized its auditing standards in 2015. While the content of AS5 remains largely intact, it was renumbered and restructured for clarity.

AS 2201’s full name is “An Audit of Internal Control Over Financial Reporting That Is Integrated with an Audit of Financial Statements”.

AS 2201 establishes the framework for evaluating and reporting on the effectiveness of the company’s ICFR, enhancing stakeholder confidence in the reliability of financial information and compliance with regulatory requirements.

Read More

Importance of Internal Control Audits for Compliance

What Is the Purpose of PCAOB Auditing Standard No. 2201?

AS 2201 focuses on the importance of effective internal controls for reliable financial reporting.

AS 2201 establishes requirements for auditors when they perform an integrated audit of a company’s Internal Control Over Financial Reporting (ICFR) and Financial Statements.

AS 2201 key objectives include:

1. Enhance audit efficiency by aligning the evaluation of financial data with the systems that generate it.
2. Provide a structured approach for assessing the effectiveness of a company’s ICFR. This includes identifying significant risks, testing control activities, and deciding whether controls function effectively to prevent or detect material misstatements.
3. Focus on areas of highest risk to prioritize auditing efforts. This will result in more effective audits and reduced unnecessary compliance burdens for companies.
4. Enhance transparency of financial reporting for investors, regulators, and other stakeholders.
5. Support regulatory compliance with Section 404 of the Sarbanes-Oxley Act (SOX). This section states that public companies assess and report on the effectiveness of their internal controls and that external auditors provide an attestation.

Well-designed and efficiently working internal controls enhance the quality of audits and provide confidence to stakeholders that financial statements are trustworthy and reflect the company’s realistic financial position.

PCAOB Auditing Standard No. 2201 and AICPA SAS 115 (formerly SAS 112)

Statement of Auditing Standards (SAS) 115 guides auditors in evaluating and communicating internal control deficiencies identified during financial statement audits. It was issued by the American Institute of Certified Public Accountants (AICPA) in 2008 and supersedes SAS 112.

SAS 115 (Statement on Auditing Standards No. 115) and AS 2201 (PCAOB Auditing Standard No. 2201) are closely related auditing standards. They share a conceptual framework, terminology, and objectives, but differ in scope and application context.

SAS 115 was designed to align with PCAOB AS 2201’s predecessor, Auditing Standard No. 5 (AS5). This ensures consistency between audits of nonpublic (SAS 115) and public entities (AS 2201), even though the regulatory environments differ.

Key Definitions (Appendix A of AS 2201)

AS 2201 includes Appendix A, which defines key terms for understanding and applying the standard.

AS 2201.A2 – Control Objective

A control objective is a specific goal or target that evaluates the effectiveness of the internal controls for which they are designed. The control objective provides reasonable assurance that a mechanism is in place to prevent misstatements or errors and that they are detected and corrected on time if they occur.

It is linked to the relevant financial statement’s assertions, i.e., whether the asset exists, transactions related to the assets are accurate, and information is up to date with proper presentation and disclosure.

AS 2201.A3 – Deficiency in Internal Control over Financial Reporting (ICFR)

A deficiency in ICFR occurs when the control’s design or operation does not allow management or employees to detect or prevent material misstatements in financial statements. Either the control is not designed correctly or does not work as intended, which may result in an inaccurate financial report.

Types of Deficiencies

Deficiency in Design existswhen a necessary control is missing or poorly designed. Even if it’s working as intended, it cannot prevent or detect misstatements.

Internal control design flaws include:

• a missing approval process,
• inadequate segregation of duties,
• unclear procedures,
• ambiguous or missing review policies.

Deficiency in Operation occurs when an appropriately designed control does not work as intended. It can be due to inadequate knowledge or training, or personnel lacking the authority or competence to conduct the control effectively.

AS 2201.A4 – Financial Statements and Related Disclosures  

Financial statements and related disclosures commonly refer to the official financial documents companies prepare. These documents provide a structured view of their financial position and performance using generally accepted accounting principles (GAAP).

They include balance sheets, income statements, equity and cash flow changes, and relevant notes.

These financial statements and reports should exclude management discussions and analysis (MD&A), earnings forecasts, or plans irrelevant to GAAP’s general practices.

AS 2201.A5 – Internal Control Over Financial Reporting (ICFR)  

Internal Control Over Financial Reporting (ICFR) is a process designed and monitored by the company’s senior leadership, i.e., the chief executive and chief financial officers, confirming the reliability of financial reporting and financial statements under GAAP.

Key Components of ICFR

1. ICFR emphasizes maintaining a comprehensive and precise record of financial transactions and asset dispositions, ensuring a clear and auditable trail of financial activities that supports the accuracy and completeness of financial statements.
2. Proper controls are designed to record transactions in compliance with GAAP, authorized by designated management. These controls create transparency and reduce the risk of fraudulent activities, promoting confidence in financial reporting.
3. ICFR includes controls that prevent and detect unauthorized acquisitions or dispositions that could impact the financial statements and act as safeguards for the company’s assets.

Notes on ICFR

• Assessments made by external auditors of the ICFR are separate and distinct from operational effectiveness audits that analyze and ensure the accuracy and reliability of the company’s internal controls for public disclosure. ICFR is the system of controls that is entirely the responsibility of the company’s management, while operational effectiveness audits and public disclosure are often tied to SOX 404 requirements.
• Even well-designed and implemented ICFR systems can have different issues and limitations, such as human error, collusion to override controls, and management’s ability to override established processes. It’s important to have regular monitoring and revision processes to improve these control mechanisms.
• ICFR can significantly reduce the risk of material misstatements in financial reports, but cannot eliminate the risk. The goal is to provide reasonable, not absolute, assurance regarding the accuracy of financial reports.

AS 2201.A6 – Management’s Assessment

Management’s Assessment is a formal evaluation of the annual report regarding the effectiveness of the company’s ICFR. It is required under the SEC regulations, specifically item 308 (a) (3) Regulations S-B and S-K. This assessment provides insight for stakeholders from the management perspective into whether ICFR is designed and operating effectively, and ensuring reliable financial reporting according to GAAP.

AS 2201.A7 – Material Weakness

Material weakness, by definition, is a situation present in ICFR where a single or combination of deficiencies exists such that there is a reasonable possibility that a material misstatement in the company’s financial statements cannot be prevented or detected on time. The existence of a material weakness is a significant concern for management, auditors, and investors.

According to the Financial Accounting Standards Board Statement No. 5, Accounting for Contingencies (“FAS 5”), “reasonable possibility” means there’s more than a slight chance but less than a high likelihood that something could happen, like a material misstatement. It has not happened yet, but it could.

When a material weakness is identified, it must be disclosed in both management assessment and audit reports, as it impacts ICFR’s overall effectiveness.

Material weakness examples include:

• segregation of duties,
• failure to reconcile accounts,
• lack of oversight from management,
• weak IT controls.

AS 2201.A8 – Preventive vs. Detective Controls  

• Preventive controls are designed to prevent errors and fraudulent activities from happening. These controls function as safeguards to minimize the likelihood of misstatements, such as segregation of duties, proper authorization procedures, and access restrictions to financial systems.
• Detective controls are reactive measures designed to identify errors or fraudulent activities that have already occurred. These controls focus on monitoring and analysis mechanisms such as reconciliation, audits, and exception reporting.

Effective ICFR is a balanced combination of both approaches. Preventive controls help minimize the risk, while detective controls function as a safety net to identify any issues that may have slipped through the preventive measures.

AS 2201.A9 – Relevant Assertion  

A relevant assertion is a financial statement assertion with a reasonable possibility of containing a material misstatement of the financial statements. A financial statement assertion relates to items such as account balances, classification of transactions, and disclosures.

Common categories of assertions are :

• Existence or occurrences: all assets, liabilities, and equity interests exist and are recorded in transactions.
• Completeness: All accounts and transactions that should be presented in the financial statements are included. Valuation, i.e., assets, liabilities, equities, and expenses, is included in financial statements, and any adjustments are also recorded if there are any.
• Rights and obligations: The entity holds the rights to assets; obligations are liabilities that the entity owes, if any.
• Presentation and disclosure: Financial statements components are correctly classified and disclosed.

Relevant assertions are determined based on inherent risk, which reflects the risk of material misstatement, assuming that no internal controls are in place or may not be effective. This helps audit efforts focus on areas with a high risk of material misstatement.

AS 2201.A10 – Significant Account or Disclosure  

A significant account or disclosure is reasonably likely to contain a misstatement, individually or aggregated with others, that could materially affect the financial statement.

Determining if an account is significant depends on inherent risk, meaning the likelihood of a material misstatement due to the account’s nature or the company’s environment, before considering internal controls. Auditors assess accounts or disclosures using criteria such as the size and composition of accounts, the complexity of transactions or estimates, the nature of accounts (e.g., cash, inventories), the history of previous misstatements in specific areas, and whether associated parties are identified as high risk.

AS 2201.A11 – Significant Deficiency  

A significant deficiency is less severe than a material weakness in internal control over financial reporting (ICFR). However, it requires attention from responsible parties to prevent it from escalating and generating a misstatement. Significant deficiencies include:

• insufficient review processes,
• lack of segregation of duties,
• inadequate documentation,
• inadequate training,
• competency gaps.

Conclusion

We have discussed in detail the importance of how deficiencies in internal control over financial reporting can result in misstatements, which can result in significant deficiencies or material weaknesses. Where a considerable deficiency signals an issue in internal controls that requires management attention, a material weakness indicates a severe deficiency in financial reporting that has a reasonable possibility of causing a financial misstatement.

Material weaknesses can be a vast, ongoing cost to an organization. Luckily, they can be consistently avoided with a comprehensive control framework based on continuous monitoring.

Pathlock is the leader in continuous control monitoring, covering all IT General Controls, Internal Controls over Financial Reporting, and other required controls for SOX Compliance. With connections to the leading enterprise systems, Pathlock can connect directly to SAP, Oracle, Workday Financials, and NetSuite to monitor your real-time financial controls.

With Pathlock, you can continuously monitor compliance and operational effectiveness, highlighting potential and executed risks early, enabling the business to execute remediations in time for an audit. Additionally, you can enforce compliance with preventive controls that keep behavior in line with what is required. When audit season rolls around, Pathlock can automatically generate a report outlining all the controls, compliance with those requirements, and any potential violations remediated. For organizations seeking tools to address regulatory requirements, enabling compliance through proactive governance processes is at the forefront of Pathlock’s mission and solution offerings.

FAQs