What is Material Weakness? How to Assess Material Weaknesses of Internal Control of a Company?

Companies employ internal controls to protect against any unwanted risks. In some cases, these may also help companies improve their operating efficiency. Either way, these controls are crucial for companies in the long run. The primary purpose of internal controls of a company is to prevent or detect and correct, any irregularities within a company’s operations.

In some cases, however, internal controls may fail to do so. These are when deficiencies exist in a company’s internal control systems. These deficiencies may have varying impacts. In some cases, they will have minimal effects. However, they may also cause significant issues within a company. For that, auditors will need to determine whether any deficiencies may cause material weaknesses.

What is a Material Weakness?

A material weakness is when the internal controls within a company are ineffective. There are two reasons why it may occur. Firstly, internal controls may not exist in areas where auditors expect them to exist. In this case, the absence of internal control causes these weaknesses. In other cases, internal controls may exist but still fail to work as expected. In this case, the deficiency may also give rise to material weaknesses.

They have a direct impact on a company’s operations. Most importantly, however, these also affect its financial statements. They can result in material misstatements in a company’s financial statements. Therefore, these can cause significant issues within the financial reporting process.

Since these weaknesses impact financial data, these are also crucial for auditors. When auditors deem a deficiency to be a material weakness, they need to communicate it with the audit committee at the client. Similarly, auditors need to evaluate the impact the weakness may have had on the company’s financial statements. It is one of the reasons why material weaknesses are crucial for auditors.

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What does Material Weakness mean?

It doesn’t necessarily question a client’s financial statements. Instead, it suggests that a misstatement may have occurred or may occur in the future. In case auditors fail to detect such weaknesses, it could eventually affect the company’s financial statements. Even then, the influence of such weaknesses may not be material.

A material misstatement does not, however, mean a significant deficiency exists. These are both terms that relate to internal control deficiencies. Therefore, most people use them interchangeably. However, both have different meanings. It is crucial to understand the difference between material weaknesses and significant deficiencies to understand material weaknesses further.

What is the difference between Material Weakness and Significant Deficiency?

A significant deficiency is a deficiency or a combination of deficiencies that need attention. Usually, these deficiencies are less severe compared to material weaknesses. Therefore, significant deficiencies are unlikely to impact a company’s financial statements. However, these still need attention as they can turn into material weaknesses in the future.

A material weakness, on the other hand, is more severe. As mentioned, these can impact a company’s financial statements and can cause issues with financial reporting. For auditors, these weaknesses are more crucial due to the obvious implications. However, that does not imply that significant deficiencies are ignorable.

How to Assess Material Weaknesses of Internal Control of a Company?

Auditors must use their professional judgment to determine whether an identified deficiency is a material weakness. For that, they will need to consider various factors. Some of these are as below.

  • The presence of compensating controls that mitigate the risk of a potential misstatement. In these cases, the compensating controls must be operating effectively for them to be reliable.
  • The potential impact of the misstatement that the deficiency may cause. The higher this impact is, the more likely it is the deficiency will be a material weakness.
  • The risk factors involved. These risk factors may include the nature of the account, losses caused, the relationship of the control to other controls, etc.
  • Whether the deficiency may prevent an official from concluding that the transaction conforms with the relevant reporting standards.
  • Whether specific indicators of these weaknesses exist, these may include identification of fraud, ineffective oversight of the company’s financial reporting, etc.
  • Whether there is a reasonable possibility that the controls will fail to prevent any material misstatements from occurring, several factors may cause this, such as inappropriate segregation of duties, ineffective risk assessments, etc.
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Unlike significant deficiencies, material weaknesses may need immediate care. Therefore, auditors need to report them to the management as soon as they identify them. They are a critical area for both internal and external auditors. Once identified, both auditors must discuss these weaknesses with the company’s management.

Conclusion

Internal control deficiencies may exist in any company. These deficiencies can also be a material weakness sometimes. They are deficiencies that can lead to material misstatements in a company’s financial statements. Several factors can cause a deficiency to be a material weakness. Auditors must use their professional judgment to determine whether they may exist.

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