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Confront Material Weakness in Your Internal Controls Over Financial Reporting

Despite the turmoil and unpredictability of the early 2020s, trust in economic resilience continues to trend upward. In a recent iteration of PwC’s annual global CEO survey, 77% of respondents stated that they expect global economic growth to improve in the years to come, with over half exhibiting a high level of confidence to grow their own companies’ revenues.

Opportunity for Growth, Potential for Material Weakness

With executive leaders focused on a growth mindset, CFOs should be prepared to scale their business effectively. This includes punching up essential processes like internal controls over financial reporting, since increased volume brings a greater risk of material weakness.

While growth is practically always a good thing, it comes with new challenges for the Office of Finance. For example, are you dealing with an increase in transactions or adding an additional data source from a new vendor? How much time is this adding to your month-end close process? You may reach a point at which you’re considering adding headcount to take on the increased workload, or seeking alternative solutions like a BPO. Whether you’re a restaurant looking to open new locations or a supply chain provider expanding your product line, there are several new potential sources of risk to your reported numbers.

Reasons To Disclose A Material Weakness

While disclosing a material weakness has historically been viewed negatively, market trends and demands are changing.

We’ve previously discussed the benefits that SOX compliance brings to CFOs; now let’s take a closer look at internal controls over financial reporting specifically.

As a refresher, the SEC defines a material weakness (MW) as “a deficiency, or combination of deficiencies, in internal controls over financial reporting (ICFR) 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.” Simply put, this is any gap in a company’s finance processes that can cause uncertainty or inaccuracy in the reported numbers.

Historically a MW in a company’s ICFR has come with possible negative consequences, like loss of confidence from stakeholders or bad press. However, recent years have seen more and more companies disclosing these vulnerabilities. In fact, research by PwC shows that since 2016 an average of 43% of companies going public have disclosed at least one material weakness beforehand. This raises the question: if a MW reflects poorly on a business, why disclose it?

1. Due Diligence

First and foremost, the growing number of businesses disclosing any MW is a clear indicator that market expectations exist for companies to have a strong understanding of their internal controls, especially before beginning the initial public offering (IPO) process. Since public companies must adhere to government regulations and compliance, identifying gaps is the first step toward mending them.

2. Transparency

Despite best efforts, there is no such thing as an opportunity completely without chance. Savvy investors know this: after all, the phrase is ‘risk mitigation,’ not ‘risk elimination.’ Businesses that identify a MW give potential investors full visibility of the risks they’d be taking on. This provides them with the information needed to make fully informed decisions. When confronted responsibly, providing transparency can actually increase investor confidence.

3. Take Action

Most importantly, identifying a material weakness also gives businesses the opportunity to solve it. That same PwC study found that 98% of companies that disclosed a MW also included remediation plans to address them, often by implementing more than one solution. By improving their ICFR, companies can mitigate risk, increase stakeholder confidence, and drive their overall value upward.

Most Common Forms of Material Weakness – And How to Remediate Them

Confronting a material weakness also gives the opportunity to remediate it.

Any business can benefit from having a strong framework for internal controls, even if they’re not planning on going public anytime soon. In general, companies identify fewer issues with internal controls over financial reporting if they operate under public company rules—such as GAAP or SOX compliance—for 6 to 12 months before their IPO. This leads to fewer filing disclosures, and brings the added benefit of displaying a commitment to protecting value for stakeholders.

PwC reports that, of the issues identified, businesses most commonly disclose a MW caused by:

  • Understaffed accounting teams
  • A lack of visibility into financial reporting
  • Finance procedures that aren’t standardized

To remediate these MWs, companies are:

  1. establishing or revising their standardized processes and/or
  2. hiring additional personnel.

Hiring can be an effective approach, but onboarding new staff could become an expensive and cumbersome process, especially if a finance team doesn’t have a standardized process in place. Rather, companies seeking to improve their ICFR would be better served by adopting or expanding automation of the financial close process.

Financial close automation can bring many benefits to the Office of Finance, including a shortened financial close process, increased visibility and trust in financial statements, fewer bottlenecks, improved team morale, and more time for value-adding tasks.

Each of these benefits provided by automation can lead to fewer instances of material weakness in a company’s internal controls over financial reporting. Companies seeking to scale their business to even greater heights can set themselves up for success with these steps.

If your business is ready to scale without fail, check out our related eBook.

Scale Without Fail

Ensure the integrity of your financial close as you grow your business.

Download the eBook

Written by: Nathan Stabenfeldt