Material Weakness

DEFINITION

Under PCAOB Auditing Standard 2201, a material weakness exists when there is a reasonable possibility that a material misstatement of the financial statements would not be prevented or detected on a timely basis. Companies must disclose material weaknesses in Item 9A of the 10-K and explain their remediation plan. Once disclosed, the company is required to update on remediation progress in subsequent filings.

WHY IT MATTERS FOR RETAIL INVESTORS

Material weakness disclosures historically correlate with restatements and stock-price drops. The remediation plan and timeline tell you how seriously management is taking it. Watch for repeat-year material weaknesses (signals management cannot fix the problem), and material weaknesses combined with NT 10-K (signals likely restatement). A single, well-explained, quickly-remediated material weakness is a recoverable event; a chronic one is structural.

RELATED TERMS

• Internal Controls over Financial Reporting
• Sarbanes-Oxley (SOX)
• Financial Restatement
• NT 10-K