What Are Examples of a Material Weakness?

A material weakness is a deficiency, or a combination of deficiencies, within a company’s internal control over financial reporting (ICFR). The Public Company Accounting Oversight Board (PCAOB) defines it as a situation with a reasonable possibility that a significant error in financial statements will not be prevented or detected in a timely manner. This indicates that the safeguards in place are inadequate, even if no error has yet occurred.

ICFR is the set of processes designed to ensure reliable financial reporting, covering everything from transaction approvals to data security. When a weakness is identified as “material,” it signals a breakdown in this system that could mislead investors and other stakeholders.

Common Examples in Financial Reporting Processes

A common source of material weaknesses is the period-end financial closing process. This occurs when a company lacks a structured approach, such as not requiring a formal review of last-minute journal entries. For instance, a controller might post significant adjustments to revenue or expense accounts without a secondary review from the Chief Financial Officer. This absence of oversight creates an opportunity for errors or misstatements to go undetected.

The discovery of numerous audit adjustments after year-end is often an indicator that the closing process is flawed.

The failure to properly reconcile key accounts is another common example. Account reconciliations ensure that amounts in the general ledger match supporting documents like bank statements. A material weakness exists when these reconciliations are not performed on time, are not reviewed, or when discrepancies are not resolved. For example, failing to reconcile a primary cash account for months could allow a cash shortage or bank error to go unnoticed.

For accounts receivable, this failure could mean the company is overstating its assets by not writing off uncollectible balances. In the case of intercompany accounts between a parent and its subsidiaries, a lack of reconciliation can lead to incorrect consolidated financial statements.

Complex spreadsheets used for accounting estimates are another area of concern. Many companies rely on them for calculations like revenue recognition or valuing financial instruments. A material weakness can arise from inadequate controls over these spreadsheets, known as end-user computing (EUC) controls. For example, a spreadsheet for calculating a warranty liability might lack access restrictions or version control, allowing anyone to alter formulas or inputs.

If a formula error is introduced into an unprotected spreadsheet, it could cause a liability to be materially understated, overstating the company’s net income. The weakness stems from the lack of controls like password protection, logic testing, and independent review of inputs and formulas.

Examples Related to Information Technology

Material weaknesses are often tied to Information Technology General Controls (ITGCs). A common IT-related weakness is poor access controls in financial systems, where employees have access privileges exceeding their job requirements. This undermines the segregation of duties. For instance, a single accountant who can create a vendor, enter an invoice, and approve the payment creates a risk of fraud or error.

This lack of segregation of duties is a material weakness because one individual can perpetrate and conceal fraud or error. When system access rights are not properly restricted and reviewed, the company loses a safeguard against unauthorized or incorrect transactions.

Another IT area is change management for financial applications. A material weakness can exist when no formal controls govern changes to software that processes financial data. For example, a developer might modify code in the company’s enterprise resource planning (ERP) system and move it to the live environment without independent testing or approval.

An untested or unauthorized code change could introduce systemic errors, altering how discounts are applied or revenue is recognized. This could lead to a material misstatement affecting every transaction processed by the flawed logic. A robust change management process with documented testing, review, and approval is necessary to ensure financial systems remain reliable.

Ineffective controls over system-generated reports used in financial reporting can also be a source of risk. Many financial analyses rely on reports produced from IT systems. A material weakness can be identified if the company relies on a report without validating its underlying logic and data sources. For example, an accounts receivable aging report might be used to estimate the allowance for doubtful accounts.

If no one in the accounting department has tested the report to ensure it correctly categorizes invoices and uses accurate data, there is a risk it is wrong. This deficiency is a material weakness because a flawed report could lead management to make a materially incorrect accounting estimate.

Control Environment and Personnel Examples

The control environment and personnel can also be a source of material weaknesses. An example is the lack of sufficiently qualified accounting personnel. This issue arises when a company’s business is complex, but its staff lacks the technical knowledge of U.S. Generally Accepted Accounting Principles (GAAP). For instance, a company might engage in complex transactions like derivative hedging or business acquisitions without staff who understand the specific accounting rules.

This gap in expertise means complex transactions could be materially misstated. The weakness is not a single failed process but a foundational lack of competency. Without the right personnel, the company cannot correctly apply GAAP, making material errors more likely.

Management override of internal controls is another example. This occurs when senior leadership intentionally disregards or directs a subordinate to bypass established procedures. An instance would be a CEO instructing a manager to backdate a sales agreement to improperly recognize revenue in an earlier period to meet an earnings forecast.

Management override undermines the integrity of the entire control system and the ethical tone at the top. It shows that even well-designed controls are ineffective if leadership is willing to ignore them. The existence of such an override indicates a flaw in the control environment that could lead to a fraudulent material misstatement.

Ineffective oversight by the audit committee of the board of directors can also be a material weakness. The audit committee oversees the company’s financial reporting process, internal controls, and external auditors. A weakness exists if the committee lacks independence from management or if its members lack the financial expertise to challenge management’s decisions.

For example, if the audit committee passively accepts management’s explanations for aggressive accounting policies without asking probing questions, it fails its oversight duty. This failure creates a risk that management’s judgments will go unchecked, potentially leading to a material misstatement and weakening the entire governance structure.

Identifying and Communicating a Material Weakness

A material weakness can be identified by a company’s management or its external auditors. Under the Sarbanes-Oxley Act (SOX), management must assess the effectiveness of its ICFR annually. Separately, external auditors may identify a weakness during their integrated audit of the financial statements and ICFR. Auditors test key controls, and if tests reveal a flaw, they must evaluate if it represents a material weakness.

Once a material weakness is identified, specific communication protocols are required. The auditor must communicate the finding in writing to the company’s management and its audit committee before the audit report is issued. This ensures those charged with governance are aware of the control failure. Management is also required to report any identified material weakness to the audit committee.

For public companies, a material weakness has direct disclosure consequences. Management must disclose any material weaknesses existing at year-end in their annual report, typically in Item 9A of Form 10-K. The disclosure must describe the weakness and management’s plan for remediation. Concurrently, the auditor will issue an adverse opinion on the effectiveness of the company’s ICFR, stating the controls are not effective.