Audit Analytics has released a white paper, Predicting Material Weakness, which discusses how certain company events and disclosures—such as late filings, auditor changes, or CEO / CFO departures—can be used to predict the probability that the company will also have a finding of material weakness.
Using the model described in the paper, we found that 23 of the top 25 companies with the highest probability of reporting a material weakness went on to actually report a material weakness in the following year.
So what is a material weakness? A company whose internal controls are judged to be ineffective is said to have a material weakness. Material weakness may be disclosed in quarterly or annual reports complying with Sarbanes-Oxley (SOX) 302 and 404 reporting requirements. Companies found to have a material weakness are at higher risk for material errors, fraud, and financial restatements.
Material weakness findings peaked in 2014 among all filers, and then decreased slightly for the last two years. So far 1,391 companies have reported a material weakness this year.
To make the predictions, we estimated a regression model on Audit Analytics Accounting Quality + Risk Matrix (“AQRM“) data, which tracks warning signs reported across our databases. These warning signs are classified according to three levels of severity: notable, significant, and critical (most severe).
Our results show that the AQRM flags have considerable power in predicting material weakness. Sorting companies into “low” and “elevated” risk groups based on their predicted probabilities, we found that companies in the elevated risk group were 11 to 13 times more likely to report a material weakness than companies in the low risk group.
The AQRM flags associated with the largest increase in the probability of a finding of material weakness in the same year include:
- A critical change in auditor (company changed auditors and reported issues in dispute with its former auditor in the calendar year) increases the probability of a material weakness by 12.74%
- A critical financial restatement (company reported a reissuance restatement or filed two or more financial restatements in the calendar year) increases the probability by 19.61%
- A significant vote against auditor ratification (company received a vote against auditor ratification for significant reasons in the calendar year) increases the probability by 24.02%
In addition to having internal control and disclosure control issues, the AQRM flags associated with increased probability of a finding of material weakness in the following year include:
- A critical change in CFO (any issues cited as reasons for the change or it is the second (or more) CFO change in the past two years) increases the probability by 3.65%
- A notable late filing (non-timely reports filed within four weeks of the deadline that do not cite Tier 1 or Tier 2 issues) increases the probability of a finding of material weakness in the following year by 4.93%
- A significant late filing (company cites only Tier 2 issues in the filing or if it is the second non-timely filing within the year) increases the probability by 6.29%.
Predicting material weakness probabilities can be used to analyze current client’s risk, for business development, or to assess prospective clients. Data is available for purchase as part of Audit Analytics’ Exploratory Research. Our analysts engage in this research to help better understand current market conditions, and track the latest disclosure trends and regulations as they impact financial reporting.
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