Strategies for Remediation: Tackling Material Weaknesses in Financial Reporting

As part of an analysis performed by Marcum LLP, more than 800 companies’ 2023 financial filings were reviewed to identify and stratify their reported material weaknesses. These companies included long-standing public companies, newly public companies (S1 and S4), and foreign private issuers. The results were discussed in a lively webinar hosted by Marcum on July 20, 2024. Here are the key takeaways from the virtual event.

Here are some basics you need to know to understand the findings of Marcum’s analysis. First, what is a material weakness? A material weakness refers to a significant deficiency, or combination of deficiencies, in internal control over financial reporting that could result in a material misstatement in the financial statements. Essentially, it’s a flaw or issue in the company’s internal controls that could lead to inaccuracies or errors in its financial reporting. Companies must disclose material weaknesses in their annual reports filed with the Securities and Exchange Commission (SEC) and are expected to take corrective action to address them.

Material weaknesses often reflect deeper issues in business processes, potentially leading to operational inefficiencies. Addressing and rectifying the identified weaknesses can be costly and resource-intensive. Additionally, material weaknesses may lead to more extensive audit procedures, resulting in higher audit fees.

The analysis revealed over 1,500 reported material weaknesses. The data showed that approximately 6% of 10-K filers, 28% of S-1/S-4 filers, and 19% of foreign private issuers reported four or more material weaknesses. Most companies in our data reported at least one material weakness. As we expected, due to having the most filings of the three categories, the 10-K filer category had the largest number of material weaknesses (by count). However, the majority of those companies reported one (1) material weakness, whereas companies in the other two categories generally reported two (2) or more.

The top 5 industries with material weaknesses, as a percentage of all reported material weaknesses, were Financial Services (17%), Technology (14%), Healthcare (11%), Pharmaceuticals (5%) and Energy (5%). Financial services leading the way came as no real surprise as the industry is subject to a high level of regulation and scrutiny. For some of the other sectors, often it is a case of them establishing their internal control function – formalizing processes, policies, and procedures. As another example, the healthcare sector sometimes suffers from a lot of older technology that they have been unable to upgrade. With the focus on patient care, internal controls and processes often do not get the necessary attention.

The report also provided a snapshot of the common types of material weakness themes, with these rising to the top in most cases:

• Resource constraint
• Segregation of duties issues
• Accounting for complex/non-routine transactions

These challenges are not unique to any one industry or type of filer. Resource challenges continue to impact how things get done at organizations. Dealing with material weaknesses requires management’s attention, support, and financial commitment by the company. Coordination with your internal and external audit resources is crucial to navigating root-cause identification remediation to avoid continued reporting of material weaknesses and potential impacts on operations.

Leading practices when remediating material weaknesses include:

1. Understand the Root Cause

• Root Cause Analysis: Perform a thorough analysis to identify the underlying causes of the material weaknesses. This can include process failures, lack of training, insufficient resources, or inadequate oversight.

2. Develop a Remediation Plan

• Action Plan: Create a detailed remediation plan that outlines the steps needed to address the deficiencies, including timelines and responsible parties.
• Prioritization: Prioritize the remediation efforts based on the severity and impact of the weaknesses.

3. Strengthen Internal Controls

• Control Design: Redesign and implement more robust internal controls to prevent and detect material misstatements.
• Automation: Where possible, automate controls to reduce the risk of human error and increase efficiency.

4. Enhance Training and Communication

• Training Programs: Provide comprehensive training to employees on the new or updated internal controls and processes.
• Communication: Maintain clear and open communication with all stakeholders, including employees, management, and the Board of Directors.

5. Engage External Experts

• Consultants: Consider engaging external consultants or experts who can provide an independent assessment and recommendations for remediation.
• Collaboration: Work closely with external auditors to ensure remediation efforts align with their expectations.

6. Document and Report Remediation Efforts

• Documentation: Maintain thorough documentation of all remediation efforts, including the actions taken, timelines, and outcomes.
• Reporting: Provide regular updates to the Board of Directors, audit committee, and external auditors on the progress of remediation efforts.

7. Foster a Culture of Compliance

• Tone at the Top: Ensure senior management and the Board of Directors set a strong tone, emphasizing the importance of internal controls and compliance.

Marcum’s comprehensive review of 2023 financial filings reveals a significant prevalence of material weaknesses. The analysis highlights the sectors most affected, such as financial services and technology, and uncovers common themes like resource constraints and the issue of segregation of duties. Addressing these weaknesses is critical for regulatory compliance and ensuring operational efficiency and accuracy in financial reporting. Companies are advised to prioritize remediation efforts through root cause analysis, robust internal control redesign, and enhanced training programs. The findings underscore the importance of ongoing commitment from management, clear communication, and, when necessary, engagement with external experts to foster a culture of compliance and mitigate future risks.