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, what could result is a material misstatement in a company's financial statements. This would make the company's financial statement 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 valuation.

In the US, companies must follow the Securities Exchange Committee (SEC) adopted Generally 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.

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.

GAAP does not safeguard against or provide guidance on what are 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 marketplace, it is important that material weaknesses in a company's internal controls be identified and fixed in a timely manner.

In October 2018, Costco Wholesale (COST) reported a material weakness in its internal control. According to a press release, "The weakness relates to general information technology controls in the areas of user access and program change-management over certain information technology systems that support the Company's financial reporting processes." In simpler terms, unauthorized persons may have gained access to the company's financial reporting systems.

Key Takeaways

  • A material weakness exists when one or more internal controls fail.
  • When identified, a firm's audit committee must take steps to remedy the weakness.
  • An unresolved material weakness can result in a material misstatement - incorrect information in a financial statement that can alter the decisions of its users.

The company also reported that they did not identify any misstatements in the financial reports and that remediation efforts began immediately. Because remediation will continue throughout 2019, the full effects of this internal control break may not be fully realized until fixed. Soon after their public announcement, their stock price fell by approximately 4%.