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 澳洲幸运5官方开奖结果体彩网:financial statements. This would make the company's financial s𝔍tatement 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.

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 澳洲幸运5官方开奖结果体彩网:valuation.

In the US, companies must follow the Securities Exchange Committee (SEC) adopted Gen🍃erally 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.

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 2023, toymaker Mattel reported a material weakness in its information technology controls, causing it to delay publication of the 2023 annual report. In a filing to the SEC, the company stated that these deficiencies "have not resulted in any material misstatements or omissions" and pledged to complete a correct filing by March 15, 2024, well after the normal deadline for a company of Mattel's size.

Despite these assurances, Mattel's stock fell around 3% in extended trading after the announcement, and continued to decline for several months. In the annual report filed on March 15, Mattel clarified that the company "did not design and maintain effective user access and provisioning review controls" in its IT systems.

The Bottom Line`

In auditing, a material weakness is a deficiency in a company's internal controls that could lead to misstatements in the company's financial disclosures. Material weaknesses often result in large sell-offs, as they lead investors to question the company's ability to accurately report its financial condition.