A material weakness is a significant error or irregularity found in a company’s financial information or internal controls. Internal controls are the rules and guidelines instituted by companies to protect their accounting information from a material weakness. If material weaknesses are found in a company’s accounting process, the entire process may be deemed ineffective at properly recording and reporting financial information. Material weaknesses found in a company’s internal control process may indicate ineffective internal controls or that accounting management has failed to accurately protect financial information from errors and irregularities.
Generally accepted accounting principles (GAAP) are the highest authority on accounting principles the United States (U.S.). While companies must follow these principles when recording and reporting financial information, GAAP does not provide specific information on what is considered a material weakness. If an error or irregularity is found in a specific general ledger account or a monetary amount is improperly recorded into a company’s accounting ledger, the common accounting industry standard is the 5 percent rule. The 5 percent rule states that a material weakness must exceed 5 percent of the dollar amount in the general ledger account or the improperly entered amount into the company’s general accounting ledger. This 5 percent rule allows companies to make minor de minimis errors, or insignificant errors, that do not materially affect financial information.
Internal control weaknesses are often seen as more significant errors in an accounting operation. Incorrectly recording numbers in a general ledger can occur through simple data entry error by an accountant. Internal control weaknesses indicate accounting controls developed by company management have not been able to protect financial information from been compromised. A material weakness related to internal controls may allow fraud or embezzlement to occur by company employees. Publicly held companies must be extremely careful with internal control weaknesses since managers must sign a statement indicating that a managerial review of internal controls has not discovered a material weakness in the company’s accounting operation.
External financial audits are a common tool used to detect the possibility of a material weakness existing in a company. These audits test the company’s financial information and internal controls to ensure that all company rules are being followed when recording and reporting financial information. Auditors will also test the company’s financial information against GAAP and other external accounting guidelines. If a material weakness exists, auditors will note the weakness in their final report and discuss the issue with company management. This meeting can help companies correct material weaknesses and ensure that no future financial statements or information contain errors from the error.