Financial Reporting Problems at Molex, Inc.(a)

Case Solution: Financial Reporting Problems at Moles, Inc.(A)

Group 9

CHEN Sirui 17210690047

YANG Zihan 17210690074

ZHANG Tianjiao 17210690077

Q1. What was the financial reporting problem that arose at Molex?

Solution:

For several years, profits on inventory sales between Molex subsidiaries, which had not been sold to an external by period end, had not been excluded in computing the consolidated firm’s earnings and inventory. It led to an $8 million pre-tax or $5.8 million after-tax inventory valuation error. Consequently, earnings, inventory and retained earnings were most likely overstated.

Though Molex’s management officers including the chief financial officer and chief executive officer noticed the inventory error, they decided it to be immaterial and not to disclose to Deloitte & Touche, the external auditors, before signing the Sep 10, 2004 representation letter.

Moreover, Molex management recognized this accounting error without disclosure. It violated accounting standards.

Q2. Why were the auditors so concerned by management’s failure to disclose what appeared to be a small amount in the management representation letter?

Solution:

Firstly, let’s figure out why managers considered the inventory error immaterial.

This accounting error amounted to $8 million before tax and $5.8 million after tax. As reported in unaudited consolidated income statement, net revenue was approximately $640 and net income was approximately $56 million. Total pre-tax inventory error accounted to 1.25% of net revenue, which was around the general level, 1%.

However, it made sense that the auditors were so concerned about this seemingly unimportant error. Reasons are as listed as following.

First, it was about the whole audit industry. Because of scandals caused by audit companies and their clients, SEC strengthened supervision and came up with new rules to regulate the audit industry. In this case, Deloitte & Touche was faced with more regulation than ever, therefore tended to be more conservative.

Second, it was riskier for related-party transactions and principles required auditors to pay more attention to them. This inventory accounting error arose from transactions between the parent company and its subsidiaries and thus should be checked more carefully.

Third, management’s failure to disclose this error seemed a deliberate manipulation. Given bad performance of Molex stock price from Jan 1 to Nov 15, 2004, management had strong motivation to improve the financial report by cutting or deferring expenses. Therefore, net income would be increased. This kind of manipulation might raise report’s outside users’ expectation of Molex stock and led them to make decisions otherwise impossible. For example, investors might raise expectation of Molex therefore its stock price.

Also, though 8 million was a small amount, when combined with other separately small errors, the amount might be large enough to influence the whole financial report. Management should disclose as much questionable issues to external auditors as possible so that they could decide whether these issues were material enough to influence the final financial report greatly.

Last but not least, considering management’s failure to disclose this accounting error, it was impossible for auditors to believe objectivity and authenticity of information provided by Molex. Since CEO and CFO had great influence on financial records, they might lie on other issues as well. Auditors should be conservative about that.

Q3. What determines whether a financial reporting issue is material?

Solution:

Materiality is a concept or convention within auditing and accounting relating to the significance of an amount, transaction, or discrepancy. The objective of an audit of financial statements is to enable the auditor to express an opinion whether the financial statements are prepared, in all material respects. Information is said to be material if omitting it or misstating it could influence decisions that users make on the basis of an entity's financial statements.

The concept of materiality is applied by the auditor both in planning and performing the audit, and in evaluating the effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the financial statements and in forming the opinion in the auditor’s report.

The assessment of what is material – where to draw the line between a transaction that is big enough to matter or small enough to be immaterial – depends upon factors such as the size of the organization's revenues and expenses, and is ultimately a matter of professional judgment. The IASB has refrained from giving quantitative guidance for the mathematical calculation of materiality. While ISA 320, paragraph A3, does provide for the use of benchmarks to calculate materiality, it does not suggest a particular benchmark or formula. Several common rules to quantify materiality have been developed by academia. These include single-rule methods about materiality setting: 5% of pre-tax income; 0.5% of total assets or 0.5% of total revenue.

According to the income statement of Molex, 5% of pre-tax income was $3,828,300; 0.5% of total revenue was $3,201,150. Thus the materiality level was around $3,000,000. However, even if the amount of the financial reporting issue was below this amount, if the issue was very important to the users and would affect their decisions, the issue should be material regardless of the amount.

What’s more, a relationship exists between audit risk and materiality. This relationship is inverse. The higher the audit risk of the company itself, the lower the materiality will be set. Since the management of Molex had strong motivation to improve the financial report by cutting or deferring expenses, it was riskier than ordinary company. Thus, the materiality level could be adjusted downward.