May 16, 2023

Material Weaknesses Trending Up

This report from PwC addresses a recent resurgence in material weaknesses with the number disclosed in 10-Ks increasing by 73% from 2021 to 2022 and 25% from the first quarter of 2022 to the first quarter of 2023. Here are some other statistics from the report:

– 62% of material weaknesses in 2022 are driven from smaller companies with revenue ranging from $100M – $500M. Contrary to this, there has been an improvement in the volume of material weaknesses for larger companies with revenue > $5B as material weaknesses have dropped 59% since 2020.

– 55% of material weaknesses reported relate to the following key areas:

  1. Financial close process, which includes a range of issues related to the timely gathering of data for use in the close process. It can also include issues with accounting policies and procedures that prevent timely, accurate or complete information from being reported.
  2. Personnel inadequacies and SOD issues, which relates to deficiencies in the number, training, qualifications, and conduct of resources. It also captures when issues associated with segregation of duties are raised.
  3. IT general controls, spanning the suite of controls across the IT domains (access to programs and data, computer operations, system change management, and system implementation). Deficiencies in IT general controls can be more pervasive in nature, and have a downstream impact on the reliability of business process controls or data.

The report attributes these trends to the following factors and suggests some key steps for remediation and prevention:

– Increase in IPOs and SPACs in recent years. Although IPOs and SPACs have recently slowed down, the effects of poor controls in transactions completed before 2022 can linger. These companies typically have fewer resources and a leaner operating model, which can result in weaknesses related to inadequate personnel, oversight and level of reviews. Forty-three percent of all US IPOs since 2017 disclosed at least one material weakness before going public. In addition to this, PwC’s research reveals that most de-SPAC companies are likely at greater risk for fraud within just two years of going public due to material weaknesses and internal control deficiencies in a number of key areas.

– Increase in digitization and technology investments. Companies often overlook risk mitigation measures and controls intended to address digital transformation initiatives such as cloud migration, greater automation, and increasing reliance on machine learning.

– Increase in turnover of resources. Whether related to restructuring efforts or resignations, there is often insufficient change management, transition, and transfer of knowledge to new control owners as turnover occurs.

Meredith Ervine