Material Weakness

A material weakness is when one or more of a company's internal controls, which are put in place to prevent significant financial statement irregularities, is considered to be ineffective. If a deficiency in an internal control is thought to be of a material weakness, this means that it could lead to a material misstatement in a company's financial statements. This would make the company's financial statement data unreliable and an ineffective tool for assessing the company's financial health and determining a reasonable company stock price.

When an audit is conducted, and a material weakness in the company's internal controls is detected, the auditors will report the material weakness to the audit committee. Every publicly traded company in the U.S. is required to have a qualified audit committee. The audit committee is a part of the board of directors and will require that the company's management take steps to fix the controls and rectify the material weakness.

A material weakness, when reported by an auditor, simply suggests that a misstatement could occur. If a material weakness remains undetected and unresolved, a material misstatement could eventually occur in a company's financial statements. An error in the company's financial statements may have a tangible effect on a company's valuation.

For example, a $100 million overstatement in revenue would be a material misstatement for a company generating sales of $500 million annually. Incorrect company valuations as a result of the material weaknesses may affect the company's stock price. Due to their potential to hinder the integrity of the public marketplace, it is important that material weaknesses in a company's internal controls be identified and fixed in a timely manner.