In today’s complex financial and regulatory landscape, internal controls not only need to be properly designed, but also operating consistently as designed to be considered effective. A material weakness is a significant flaw in internal control over financial reporting, creating a reasonable possibility of a material misstatement in the financial statements — one that auditors, regulators, and management can’t overlook.
Successfully remediating a material weakness requires a structured approach that includes developing a clear plan aligned with the external auditors, closely monitoring progress, and conducting internal assessments to validate effectiveness. If left unaddressed, material weaknesses can erode investor confidence, expose organizations to increased compliance scrutiny, impact insurance rates and even lead to financial restatements.
Learn what constitutes a material weakness, why it matters, and how to remediate it effectively to increase financial integrity and operational resilience with the following insights.
What’s a material weakness?
As defined in Rule 1-02 of Regulation S-X, a material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting 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.
For SEC registrants, material weaknesses are required to be disclosed publicly in the Form 10K and 10Q for investors, and the world, to see. In some cases, the disclosure of a material weakness can occur even before companies are listed or subject to Section 404 of the Sarbanes-Oxley Act of 2002 (SOX 404).
What’s the impact of a material weakness on organizations and investors?
When a material weakness is reported, the consequences can be far-reaching, including:
Loss of Investor Confidence. Investors rely on accurate financial statements to make informed decisions. A material weakness signals the risk of potential inaccuracies in financial reporting, leading to diminished trust and distraction.
Regulatory bodies such as the SEC or PCAOB may increase oversight, requiring additional reporting or remediation efforts.
Stock Price Volatility. Disclosures of material weaknesses often lead to negative market reactions, resulting in stock price fluctuations.
Increased Audit Costs. External auditors may need to conduct additional testing, increasing internal and external audit fees. Recurring material weaknesses can result in an additional material weakness being identified by the external auditor over tone at the top.
Operational Disruptions. Addressing and remediating a material weakness often requires significant management attention and resource allocation, which can disrupt day-to-day operations, impact insurance rates, and create questions by vendors and customers.
How to remediate a material weakness effectively
The ability to remediate a material weakness quickly and effectively can keep financial integrity and operational efficiencies on track. Successfully remediate material weaknesses with the following steps.
Develop a remediation plan
Start remediation efforts early
Prompt action is critical as newly implemented or redesigned controls require time to mature before they can be evaluated for effectiveness. If significant effort is required to update or implement new controls, starting early allows enough time to implement and perform the controls.
New or redesigned controls require appropriate seasoning, including:
Time to train control owners and perform the control(s) according to the designated frequency.
Time for testing the design and the operating effectiveness across multiple instances.
Below is an example of common minimum sample sizes based on internal control frequency.
Leverage the remediation plan in SEC filings and disclose material changes in controls
The plan to remediate material weaknesses should align with the remediation plan in your Form 10K and 10Q. These disclosures have already been reviewed by many parties, including external auditors, and serve as a solid framework for a detailed remediation plan.
Material changes in controls are required to be disclosed on a quarterly and annual basis as the remediation plan is implemented.
Tips for material weakness disclosures
Developing a clearly worded material weakness in your filings will help during remediation. Broadly worded material weaknesses, such as ineffective control environment or lack of staffing resources, are difficult to remediate.
Material weaknesses that describe the root cause in more narrow terms around the specific control failure — for example, accounting for lower of cost or net realizable value — are easier to target remediation actions than broad process descriptions, like inventory process.
Engage a cross-functional team
A cross-functional team, including accounting, finance, internal audit, information technology, and operations, is essential to effectively remediate a material weakness, as each department provides unique expertise and perspectives that contribute to a comprehensive understanding of the issue. Including information technology would be crucial to remediating a system control deficiency and including SEC reporting or a technical accounting expert would be crucial to remediating a GAAP deficiency.
Collaboration among these functions ensures that all aspects of the weakness are addressed, from financial reporting to IT controls and operational processes. By working together, the team can develop and implement robust solutions that not only rectify the current weakness but also strengthen the overall control environment.
Internal audit can provide crucial help in designing needed changes to remediate material weaknesses and incorporate these in the organization’s SOX 404 compliance program.
Ensure alignment with external auditors
A collaborative approach with external auditors can streamline the remediation process and uncover the underlying root cause of the issues and proposed resolution.
Agree on the Root Cause. Material weaknesses can arise from gaps in the internal control environment or as a direct result of errors in the financial statements. It’s important that both management and the external auditor are aligned on the root cause of the material weakness, so that the solutions properly address and remediate deficiencies.
Share Detailed Remediation Plan with External Auditors. The external auditor is responsible for evaluating and concluding on the remediation efforts performed by management. Once the remediation plan is developed, it should be shared with the external auditor for their input and consideration; they can’t advise on what the solution should be, however they can provide insights on the planned approach and share their firm remediation requirements.
Monitor the plan execution
Consistent oversight is crucial to ensuring timely remediation and should include:
Scheduled Check-Ins. Regular updates help track progress and identify potential roadblocks, keeping the remediation plan on course.
Responsiveness to Changes or Delays. Address changes or delays promptly. Delays can hinder the length of time that new controls have to mature and can potentially restrict the ability to produce enough samples to satisfy an external auditor’s remediation requirements. This is particularly important for system implementations or changes needed to remediate material weaknesses.
Conduct internal assessments
Before engaging external auditors for walkthroughs and testing, perform internal assessments to verify the control operates as designed and achieves the desired control objectives.
Internal assessments should:
Test Control Execution. Test new automated controls prior to system go-live to verify they operate as designed prior to launching. Test new manual controls as soon as changes are implemented to confirm the execution appropriately satisfies each of the control attributes.
Review Documentation. Confirm that control documentation includes and properly evidences the execution of each of the control attributes, including documentation of completeness and accuracy of key reports and spreadsheets used in the performance of the control.
Address Deficiencies Proactively. Conduct an internal assessment before the external auditor to identify and resolve any issues, increasing confidence that the external auditor’s evaluation will go smoothly. This can identify gaps or errors in execution that can be addressed in advance of a formal assessment by the external auditor.
