Definition of Material Weakness Key to SEC-PCAOB Internal Control Regime

The definition of material weakness is a central feature of the reforms because management’s assessment of the company’s internal controls is based on whether any material weaknesses exist. Similarly, the objective of an audit of internal control is to obtain reasonable assurance as to whether material weaknesses exist. The term’s importance is evident from the rule that management is not permitted to conclude that the company’s internal controls are effective if there are one or more unremediated material weaknesses.

The SEC staff has said that it will apply the PCAOB’s definition of material weakness when applying Commission rules. Previously, Auditing Standard No. 2 defined material weakness as a significant deficiency, or combination of significant deficiencies, resulting in more than a remote likelihood that a material misstatement of the financial statements will not be prevented or detected. Acting on complaints that this definition was confusing and made it difficult to assess the severity of deficiencies, the Board revised the definition in Auditing Standard No. 5.

In AS5, the Board defines a material weakness as a control deficiency, or combination of control deficiencies, such that there is a reasonable possibility that a material misstatement of the company's financial statements will not be prevented or detected on a timely basis. The Board replaced the standard ``more than a remote likelihood’’ with `` reasonable possibility’’ based on its belief that companies and auditors were evaluating the likelihood of a misstatement at a much lower threshold than the Board intended. The new standard should, in the Board’s view, result in the identification of the most important material weaknesses. This is also the definition of material weakness used in the SEC’s management guidance.