Molex Accounting Case Analysis

Financial Reporting Problems at Molex, Inc.

Group 2

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

When computing consolidated financial report, Molex failed to prepare elimination entry about intercompany profit transaction. Since Molex subsidiaries had not sold these inventories to external customers, the sales, COGS and inventories that had not achieved in the respect of group company should been eliminated.

The elimination entry for year (ignore tax):

(1) Intercompany profit transaction in year ended June 30, 2004:

Dr:  Sales  3.0million

      Cr:  Inventory  3.0million*ratio of margin

             Cost of good sales  3.0million*(1-ratio of margin)

(2) Intercompany profit transaction in previous years:

Dr:  Retained earnings  5.0million*ratio of margin

      Cr:  Inventory  5.0million*ratio of margin    

The impact of the elimination entry to some accounts and financial ratios (assume ratio of margin is 35%):

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2. Why were the auditors so concerned by management’s failure to disclose what appeared to be a small amount in the management representation letter？What was the financial reporting problem that arose at Molex?

(1) Audit industry was suffering from the corporate accounting scandals these years. Arthur Anderson was convicted of obstruction of justice for shredding documents related to its Enron audit and was forced to surrender its licenses. Besides, several of Deloitte & Touche’s largest clients were also hit with fraud and accounting problems. The SEC regulations were tightened and new regulations were adopted such as the Sarbannes Oxley Act of 2003.  The auditors were under more pressure and under stricter supervision so they would be sensitive to any potential fraud.

(2) Even though it was a small amount, it would still affect the shareholders. The management’s option to claim that the error was immaterial was aimed to  increase the share price and avoid the risks that a fraud may cause. Since King was vice chairman of the board and owned 0.2% of voting common stock and 201,293 stock options, he had the intention to hide the material issue so that the share price would increase.

When computing consolidated financial report, Molex failed to prepare elimination entry about intercompany profit transaction. Since Molex subsidiaries had not sold these inventories to external customers, the sales, COGS and inventories that had not achieved in the respect of group company should been eliminated.

(3) On July 21, 2004, both King and Bullock were aware of the problem and concluded the amounts involved were not material. On Sep 10, 2004, King and Bullock signed the management representation letter for the annual financial statements and 10-K on August 20, 2004 with no mention of the inventory error. The CEO and CFO didn’t discuss the error with Deloitte & Touche until Oct 15.  They signed the letter which guaranteed that they had disclosed all the financial records and related data and there were no material transactions in the records etc., but actually they didn’t disclose the error of inventory and breached the letter. Deloitte & Touche thought it was a fraud and the auditors ware concerned about the significance of the omission to the Audit Committee and the trust between the auditors and the CEO and CFO.

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

In FASB, material is defined as“the magnitude of an omission or misstatement in the financial statements that makes it probable that a reasonable person relying on those statements would have been influenced by the information or made a different judgment if the correct information had been known”.

(1) Absolute number of misstatement

Auditors will usually select a planning materiality in auditing. If the absolute number of misstatement is higher than the selected materiality, then this misstatement will usually be considered to be material. If not, the auditors should consider other elements.

The materiality should be chosen based on benchmark (usually some elements of financial statement) multiplying by selected percent based on experience.  The choice of selected percent should consider the scale of company, the characteristic of industry and the scope of financial statement users.

The following are common used benchmarks in deciding materiality:

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(2) Accounting fraud

If one financial reporting issue is considered to be the sign of accounting fraud, the materiality should be set lower. Since it reflect the honesty and reliance of senior executives and increase the risk of internal control.