Proposed Definition of Material Weakness Is Crucial to Lowering Internal Control Costs

The revised definition of material weakness proposed by the PCAOB and endorsed by the SEC’s proposed guidance is flawed and unhelpful, warned the ABA committees on federal securities regulation and accounting. In a letter to the SEC, the committees said that the terminology employed in the proposed formulation of the term material weakness is sufficiently ambiguous so as to continue to result in the overly conservative applications that the proposals seek to remedy.

The definition of material weakness is a central feature of the proposed 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 material weaknesses. It is also instructive that the Paulson Committee on Capital Markets Regulation believes that the SEC’s revised guidance on materiality is the most important issue affecting the cost of sec. 404(b) implementation and must be considerably strengthened if Sarbanes-Oxley costs are to be significantly decreased.

The SEC staff has said that it will apply the PCAOB’s definition of material weakness when applying Commission rules. Currently, Auditing Standard No. 2 defines 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 proposed Auditing Standard No. 5.

The Board proposes to define 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. 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.

While agreeing that the current “more than remote likelihood” is too low a probability standard, the ABA committees said that inserting reasonable possibility would not change the probability standard. Accountants have interpreted the terms remote, reasonably possible and probable, as used in FASB Standard No. 5, Accounting for Contingencies, as levels of probability that are contiguous, noted the committee.

The auditors interpret it as, once an event is more probable than remote, it is reasonably possible. This interpretation of reasonably possible leads to events being reasonably possible at a probability level of substantially less than 50%. In fact, said the ABA, some accountants take the position that reasonable possibility is triggered at a probability level of as low as 25%. The bar groups believe that such a level of probability is too low for this purpose. Further, the market does not perceive material weakness disclosures as meaningful because they sweep in items that are not important to an investor’s evaluation of the effectiveness of the internal controls or the reliability of the financial statements.