From: Man Fun Daniel Yeung, Seung Kim, Young Jae Lee, Max Kirsch Date: Oct. 18, 2010
Re: Financial Reporting Problems at Molex, Inc.
This report discusses Molex, Inc.’s conflicts with its auditor, Deloitte and Touche, over a reporting issue in 2004. The report explains the details of the firm’s issue while also addressing the intentions behind Molex’s decisions, Deloitte’s concerns, and the resolutions for the conflict. MOLEX’S PROBLEMS
In mid-July 2004, Molex’s corporate finance group identified an on-going accounting issue within the firm: for several years, Molex had mistakenly recognized “profits on inventory sales between Molex subsidiaries (but which had not been sold to an external customer by period-end)” in its earnings and inventory accounts. In other words, Molex recorded extra profits and inventories from internal inventory sales without reversing the accounts at the period-end (Exhibit 1). As a result, several accounts including retained earnings, net income, and inventory were inflated. The total amount of error accumulated to a before tax amount of $8 million ($5.8 million after tax) with $3 million before tax ($2.2 million after tax) of the error directly related to the fiscal year that ended on June 30, 2004. Dianna Bullock (CFO) and Joe King (CEO) discussed the issue during an executive meeting in July of 2004 and decided to ignore the problem because they perceived it as immateriality. In the same month, the managers signed its representation letter for its 10-K reports without notifying Deloitte of the reporting issue. The management team did not disclose the matter with Deloitte until October 2004 prior to the first quarterly report. Deloitte was unsatisfied with the firm’s dishonest behavior. After Molex failed to provide explanations for the accounting errors to the public, Deloitte demanded Molex to remove both Bullock and King from the executive team. CORRECTIONS TO THE ACCOUNTING ISSUE
If the firm corrects the accounting issue in its financial statements for the fiscal year that ended on June 30, 2004, Molex should make adjustments both on the income statement and the balance sheet. On the income statement, the firm should reduce the gross profit by the $3.0 million amount relevant to the period. Because Molex mistakenly inflated its earnings with profit from sale of inventory between its subsidiaries, the firm should also reduce its tax expense. Molex needs to adjust down its tax expense by the difference between the before tax and after tax adjustment amount ($0.8 million). The reduced tax expense represents tax rebates for the firm. Furthermore, the net income account should also be deducted by the after tax profit amount of $2.2 million; this adjustment corrects the overstated earnings value. On the balance sheet, Molex should adjust the relevant accounts by the full $8.0 million amounts rather than just the $3.0 million adjustment relevant to the year. The income statement represents the company’s performance over the fiscal year while the balance sheet reflects the firm’s condition at the point of year-end. Thus, Molex’s should adjust its inventory account by deducting the $8.0 million because this is the difference between inventory accounts for the selling subsidiary and the buying subsidiary (Exhibit 1). The firm should also decrease the retained earnings account by $5.8 million because net income is a component of year-end retained earnings. Finally, the firm should decrease its tax payable account by $2.2 million. For both the retained earnings and tax payable adjustments, the changes represent accumulated overstatements throughout the error years.
MOLEX MANAGERMENT’S DECISION
Many factors influenced Molex’s management team and caused the firm to hide the accounting issue from the auditors. Firstly, managers were under constant pressures to meet the market and analyst expectations. According to the...