Public reporting companies that have material weaknesses in their internal control over financial reporting (“ICFR”) are required under Rule 308 of the Securities Exchange Act of 1934, as amended, to report such material weaknesses in their quarterly and annual reports along with proposed remedial measures. A material weakness is defined as a deficiency, or a combination of deficiencies, such that there is a reasonable possibility that a material misstatement of an issuer’s financial statements will not be prevented or detected on a timely basis.
On January 29, 2019, the Securities and Exchange Commission (“SEC”) settled charges with the following four public companies for alleged deficiencies in maintaining ICFR: Grupo Simec S.A.B. de C.V., CytoDyn, Inc., Lifeway Foods, Inc. and Digital Turbine, Inc. The SEC noted that these entities failed to maintain ICFR for seven to ten consecutive annual reporting periods and as a result are compelled to pay fines ranging from $35,000 to $200,000. The SEC indicated “… the four companies disclosed material weaknesses in ICFR involving certain high-risk areas of their financial statement presentation…and took months, or years, to remediate their material weaknesses after being contacted by the SEC staff.” Melissa Hodgman, an Associate Director in the Commission’s Enforcement Division said that the Commission is committed to holding public reporting companies accountable for failure to timely remediate material weaknesses in ICFR. Ms. Hodgman further stated, “Companies cannot hide behind disclosures as a way to meet their ICFR obligations. Disclosure of material weaknesses is not enough without meaningful remediation.”
ICFR is designed by, or under the supervision of, an issuer’s principal executive and principal financial officer, or persons performing similar functions, to provide reasonable assurance that the issuer’s financial statements are reliable and prepared in accordance with GAAP. (see Auditing Standard No. 5). ICFR describes the procedures used by public reporting companies to enhance the reliability of their financial statements by reducing the risk of material errors or misstatements.
Some recurring material weaknesses which have been identified by issuers over time and across industry sectors include: inadequate segregation of duties, inadequate procedures for reviewing and recording of transactions as well as the reporting of such transactions, and lack of sufficient accounting and financial reporting personnel able to implement formal accounting policies with an appropriate level of accounting knowledge. Issuers have remediated such material weaknesses by, among other things, engaging third-party service providers to assist with financial reporting, hiring staff with appropriate accounting and financial reporting knowledge and conducting training related to key accounting policies, internal controls and SEC compliance.
Any public issuers that have reported material weaknesses in their ICFR for more than one or two consecutive reporting periods either without offering a plan to address those weaknesses or offering a plan but failing to take corrective actions are at risk, and should discuss their remediation plans with experienced securities counsel to avoid potential exposure to liability.