As emerging-growth companies seek investor confidence, it’s critical to build an effective internal control environment. Being newly established, there’s a high likelihood control deficiencies will occur.
When control deficiencies accumulate to a level where the risk of financial misstatement is likely, management and/or external auditors may determine a material weakness.
What Is a Material Weakness?
As defined by the Public Company Accounting Oversight Board (PCAOB), “A material weakness (MW) 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 company’s annual or interim financial statements will not be prevented or detected on a timely basis.”
When issued, organizations are required to disclose the details of the material weakness, possibly impacting the organization’s reputation and bottom line.
So what causes material weaknesses and how can they be remediated effectively?
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Common Causes of Material Weaknesses
Specific to emerging-growth companies, material weaknesses are commonly caused by:
- Inadequate segregation of duties, often found in smaller finance organizations with limited personnel, creating conflicts in roles and duties.
- Inconsistent information technology general controls (ITGC) within the control environment as well as personnel with the knowledge and expertise to implement and manage the controls, putting at risk the accuracy and reliability of systems and data.
- Lack of oversight and monitoring of key business processes, including inadequate review/approval of transactions or reconciliation, allowing erroneous or fraudulent activities to go undetected.
- Insufficient evidence documentation relating to control and review procedures, leading to the inability to validate the occurrence of key business procedures.
- Insufficient or uneven training for business and IT control owners, creating an environment where controls may be designed effectively but do not operate as consistently as intended.
- Inadequate consideration of complex or non-recurring transactions or significant events such as mergers, acquisitions, or other complex transactions that may occur outside the normal course of business can increase the possibility of misstatement if not appropriately accounted for.
Material Weakness Remediation Tactics
When a material weakness is identified, management must initiate a collective remediation effort, including key stakeholders, control owners, internal audit, finance, and IT. In some circumstances, where management lacks appropriate bandwidth to oversee remediation, a third party can assist in the remediation efforts.
The keys to working toward an effective conclusion include:
- Understanding root cause: Management must understand the root cause of the issue(s) identified. If the root cause is not adequately identified, the issue(s) may not be fully addressed, leaving the organization at risk of not completely remediating the material weakness.
- Developing a remediation plan: Management should document a plan or “roadmap” to address the root cause and any other downstream effects. The remediation plan should address all aspects of the material weakness, including specific steps to be taken, a timeframe, and roles and responsibilities for those involved.
- Alignment with external auditor expectations: It’s critical to align expectations with the external auditor. Aligning expectations early in the process allows for effective remediation by minimizing risks associated with miscommunication and ambiguity.
- Project management/oversight: Delegation and understanding of ownership during control execution and remediation of the material weakness is vital. All persons identified in the remediation roadmap, and any other relevant stakeholders, are responsible for owning the material weakness remediation effort and will be held accountable.
- Updating SOX controls and documentation: Management must consider applicable changes to the control environment and update documentation accordingly. Updates to flowcharts/narratives, risk and control matrices, or policies should be indicative of the changes.
- Reinforcement of SOX training: Continuous reinforcement of SOX training is important for any organization, especially when facing a material weakness. Stakeholder awareness of potential downstream impacts on the business can drive sustained operating effectiveness in the execution of SOX controls.
As emerging-growth companies establish their internal control environment, deficiencies can and will occur. Understanding the process and building a plan to overcome a material weakness being issued is critical to removing it from disclosures and reinforcing investor confidence.
For expert support understanding, anticipating, and responding to material weaknesses, contact CrossCountry Consulting.