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  • Writer's pictureDaniel Goelzer

Material Weaknesses are Increasing and the Accountant Shortage May Be to Blame

PwC reports a “resurgence” of public company material weakness disclosures. In The resurgence of the material weakness, PwC warns that, when material weaknesses are reported, “shareholders’ confidence in the integrity of the financials and the control environment can be shaken, and reputations of company executives and governing boards (e.g. the Audit Committee) can be harmed by a loss of trust. For these reasons, prompt resolution and remediation of an identified material weakness is typically expected.”

In a July 11 article, the Wall Street Journal also discussed material weakness disclosures, but from a different angle. In Maurer, The Accountant Shortage is Showing Up in Financial Statements, the Journal noted that an increasing number of companies are reporting material weaknesses resulting from an inability to attract and retain enough qualified personnel to perform internal control responsibilities. The Journal states: “The disclosures come as fewer people are pursuing degrees in accounting and entering the field, resulting in more positions open and for longer periods of time. What’s more, academics say, the shortage will likely be compounded as more accountants retire without a robust pipeline of replacements.”

Using information from data provider Ideagen Audit Analytics (AA), PwC reports that material weaknesses disclosed in public company annual reports on Form 10-K rose 73 percent from 2021 to 2022. Further, in the first quarter of 2023, material weaknesses increased 25 percent compared to the same period in 2022. Under the Sarbanes-Oxley Act of 2002 (SOX), public companies are required to assess the effectiveness of their internal control over financial reporting (ICFR) and disclose any material weaknesses; in addition, larger public companies are required to obtain an opinion from their auditor on ICFR effectiveness. A material weakness, which indicates that ICFR is not effective, is defined as “a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis.”

PwC attributes the increase in material weaknesses to three factors:

  • Increase in IPOs and SPACs. PwC states that 41 percent of U.S. initial public offerings since 2017 disclosed at least one material weakness before going public. “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.”

  • 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.”

Based on AA data, PwC also finds that three areas were the basis for more than half of all reported material weaknesses: Consistent with the Wall Street Journal article noted above, personnel inadequacies (such as number, training, qualifications of personnel, and inadequate segregation of duties) topped the list, accounting for 20.3 percent of material weaknesses. Financial close process (19.8 percent) and IT general controls (e.g., access to programs and data, computer operations, system change management, and system implementation – 15.1 percent) were the second and third most frequent explanations. In terms of company size, 62 percent of 2022 material weaknesses were reported by companies with revenue between $100 million and $500 million.

PwC’s paper concludes with six suggestions for remediating and avoiding material weaknesses:

  • Compile your remediation plan - what gets measured gets done.

  • Plan your resourcing strategy - give precedence above other competing priorities.

  • Start early - remediation doesn’t happen overnight.

  • Communicate often - all parties need to be involved.

  • Think about the long-haul - build a sustainable solution.

  • Consider the warning signs - get ahead of potential issues.

Comment: PwC’s report, and the Wall Street Journal’s article, seem to mirror the conclusions in AA’s most recent report on material weakness disclosure. See Ineffective ICFR is More Common; Staff Shortages May be the Cause, August 2022 Update. That report found that, in fiscal 2021, the percentage of companies that reported ineffective ICFR increased across all company sizes and was at the highest level since SOX ICFR reporting began in 2004. Further, lack of qualified accounting personnel was the most frequently cited control issue in adverse ICFR assessments. These trends appear to be continuing, if not accelerating.

The federal securities laws require all public companies to establish and maintain a system of internal accounting control to provide reasonable assurance that (among other things) transactions are recorded as necessary to permit preparation of GAAP financial statements. Audit committees may want to reflect on whether personnel vacancies or turnover could be affecting their company’s controls and what steps should be taken to address these issues.

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