Material Weakness can harm organizational reputation and financial performance. In this article we look at current trends in material weaknesses, what’s at stake and what organizations can do to reduce the chances of misstatements.
Misstatements in company financials may seem mundane until they hit front page news with ripple effects that can impact stock prices, senior leadership teams and shareholder confidence.
Recently, companies like Credit Suisse, BNY Mellon, Mattel, Marcum and others were called out for misstatements in their financial reporting. While the reasons vary across organizations, research into material weaknesses and their most common causes can show us what most often leads to financial misstatements.
What is a material weakness?
A material weakness, as defined by the Securities and Exchange Commission (SEC), is a deficiency, or a combination of deficiencies in Internal Control over Financial Reporting (ICFR) such that there is a reasonable possibility that a material misstatement of the registrant’s annual or interim financial statements will not be prevented or detected on a timely basis.1
Said more succinctly, it’s an admission by an organization that the internal controls around their financial reporting may not prevent a misstatement.
Companies with material weaknesses are required to report them in their public SEC filings – an action which can result in additional costs, risks and reputational damage. If companies fail to address these material weaknesses, they can result in misstatements and the delivery of incorrect information to company stakeholders.
Current state of material weaknesses
A 2023 report from PwC found a resurgence of material weaknesses in public company disclosures.
Specific findings include:
• The number of material weaknesses disclosed in a company’s 10-K jumped 73% from 2021 to 2022
• Material weakness numbers increased 25% in the first quarter of 2023 relative to Q1 2022
• 55% of material weaknesses reported related to either the financial close process, personnel inadequacies/segregation of duties or IT general controls
What’s behind material weaknesses
There are likely some common themes behind these trends.
Lack of skilled accounting
“The widening shortage of accountants has begun showing up in financial statements,” reports the Wall Street Journal. A KPMG Report found that the percentage of material weaknesses attributed to ‘lack of accounting resources/expertise’ has steadily increased from 34% in 2021 to 48% in 2022 and 55% in 2023.2
This shortage shows few signs of improvement with U.S. accounting graduates with either a Bachelors or Masters in Accounting falling 7.4% between 2021 and 2022 – the largest drop since the mid-90s.3
Additionally, the data suggests that a high turnover of resources increases the likelihood of material weaknesses. Whether related to restructuring efforts or resignations, insufficient change management and a lack of knowledge transfer can lead to an increase in errors.
Increase in IPOs and SPACs in recent years
While IPOs and SPACs have slowed down in the last year or two, in 2021 IPOs (including SPACs) enjoyed a
record year with 2,340 new issues raising $428.9B. That’s following a 462% jump in proceeds raised by SPACs between 2019 to 2020. These companies typically have fewer resources and a leaner operating model, which can result in weaknesses related to inadequate personnel, oversight and level of reviews.
PwC’s research found that “Forty-three percent of all US IPOs since 2017 disclosed at least one material weakness before going public and most de-SPAC companies are likely at greater risk for fraud within just two years of going public due to material weaknesses and internal control deficiencies in a number of key areas.”4
Failing to test remediation measures
The KPMG report cited above also found that, of the 768 companies that filed a report with a material weakness between 2019- 2023, 226 companies or almost 30% disclosed them in multiple years.
Andrew Imdieke, an assistant professor of accountancy at Notre Dame’s Mendoza College of Business has done research on why and when a company’s remediate strategies will likely be successful or fail. He explains, “I became very skeptical about the extent to which other companies were really fixing these problems,” said Imdieke. “There were these cases where a company would report a material weakness in inventory and then say they fixed it, but then a year later, you’d see a restatement related to the same exact problem.”
In his research he found that companies that are disclosing that they’ve solved the problem in less than a year are significantly more likely to be in the failure category later. “They need to take the time to let these remediation processes operate and test the effectiveness of their strategy,” observes Imdieke.5
Inadequate financial controls
In some instances, material weaknesses stem from poor or lacking controls around disclosures themselves and from inadequate financial controls around the close and reporting processes.
KPMG found that from 2022 to 2023, material weaknesses stemming from the timeliness, accuracy and completeness of disclosure controls increased from 21% to 43%.
Additionally, KPMG found the top two process-related areas responsible for material weaknesses in 2023 were identified as:
• Financial Close/Reporting (57%): Defined as failure to design and maintain formal accounting policies, procedures and controls over significant accounts and disclosures to achieve complete, accurate and timely financial accounting, reporting and disclosures, including accounting for complex features associated with warrants, segregation of duties and adequate controls related to the preparation and review of journal entries.
• Systems (33%): Where information technology general controls (ITGCs) related to the Company’s information technology (IT) systems were ineffective. Therefore, the automated process-level controls and manual controls dependent upon the accuracy and completeness of information derived from those IT systems were also ineffective because they could have been adversely impacted.
This could point to the increased Finance IT complexity in organizations today and their struggle to consolidate, standardize and report efficiently.
What’s at stake?
Companies disclosing material weaknesses in internal controls can face repercussions, including reputational damage and market backlash due to diminished investor confidence. Share prices can dip and the organization may trigger regulatory scrutiny from bodies such as the Securities and Exchange Commission (SEC).
Additionally, credit rating agencies may downgrade the company’s creditworthiness. Therefore, swift and effective action is necessary to restore trust, ensure regulatory compliance, and safeguard the company’s financial stability and stakeholder relationships.
What can companies do about it?
While there are several potential reasons for material weaknesses, a company can often improve their controls, data and systems environment to address pressing issues.
1. Implement strong internal controls: Establish robust internal controls that include segregation of duties, proper authorization processes and regular monitoring of transactions. This ensures that errors or irregularities are detected and corrected promptly.
2. Establish a culture of accountability: Ensure leadership communicates that it’s safe and encouraged to come forward with broken processes or identified issues when they are noticed.
3. Eliminate as many manual and spreadsheet-based processes as possible: The less data is moved around and duplicated the better. By automating core finance processes, removing data lifting and shifting and implementing a trusted data foundation companies lessen the risk associated with manual processes.
4. Create clear policies and procedures: Document clear and comprehensive accounting policies and procedures. Ensure that employees understand their roles and responsibilities in the accounting and reporting processes.
5. Streamline processes: Invest in software and automation tools that streamline accounting and finance processes and provide transparency in the application of accounting rules and provide source to post visibility into the transactions that support journal lines and balances.
6. Monitor and test: Continuously monitor and test internal controls to identify any weaknesses or deficiencies. Implement regular reviews of control activities and perform testing to ensure effectiveness and compliance with established procedures.
The prevalence of material weaknesses in organizational internal controls presents significant risks to both reputation and financial performance. Recent trends indicate a resurgence in the disclosure of such weaknesses, with root causes ranging from a shortage of skilled accounting professionals to deficiencies in financial controls and inadequate remediation strategies.
To mitigate these risks, companies must prioritize the implementation of robust internal controls, foster a culture of accountability, and establish clear policies and procedures. In some cases, a finance data and accounting platform like Aptitude Fynapse can help finance teams increase productivity and lower costs through the automation of data and accounting processes.
By taking decisive action to strengthen their controls, organizations can safeguard their reputation, ensure regulatory compliance, and maintain the trust of stakeholders in an increasingly complex financial landscape.
Previously published in CFO Futures: An Autonomous Finance Magazine (Spring 2024)
2 https://kpmg.com/kpmg-us/content/dam/kpmg/pdf/2024/trends-in-material-weaknesses.pdf
3 https://www.wsj.com/articles/accounting-graduates-drop-by-highest-percentage-in-years-5720cd0f
5 https://mendoza.nd.edu/news/time-is-on-managements-side-study-shows/
