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This note was prepared by Professor Paul Healy for the sole purpose of aiding classroom instructors in the use o
f
Financial Reporting Problems at Molex, Inc., HBS No. 105-082. It provides analysis and questions that are
intended to present alternative approaches to deepening students comprehension of business issues and energizin
g
classroom discussion. HBS cases are developed solely as the basis for class discussion. Cases are not intended to
serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.
5-106-018
REV: DECEMBER 16, 2005
Financial Reporting Problems at Molex, Inc.
Teaching Note
Overview
In mid-July 2004, Molex Inc.s corporate finance group identified a problem with inventory that
had affected results for several years. Profits on inventory sales between Molex subsidiaries (but
which had not been sold to an external customer by year-end) had not been excluded in
computing the consolidated firms earnings and inventory. Consequently, earnings, inventory
and retained earnings were overstated. In their September management representation letter to
383
1. Why do Molex have to hire an external auditor?
2. What was the financial reporting problem at Molex? How would the correction of the
problem be recorded in Molexs financial statements?
3. What factors do you think influenced managements decision not to raise the issue with the
auditors?
4. Why were Molexs auditors so concerned about the reporting problem at Molex? If you
were a member of the board, would you agree with their concerns?
5. As a member of Molexs board, what would you do to respond to the auditors request that
the CFO (and possibly the CEO) be replaced?
Question 1 Why do Molex have to hire an external auditor?
For students with limited prior experience, the case provides a good opportunity to discuss the
role of the external auditor. I usually start by asking students why Molex hires an auditor. Many
students will respond that Molex has to hire an external auditor because under the Securities and
Exchange Act. I then push them to think about why the Act makes this a requirement. For
As indicated in the management representation letter, the firms managers, who have the best
information about the firms operations and performance, are responsible for providing
investors with information on performance. The primary information source is the financial
statements, which are prepared in accordance with Generally Accepted Accounting Principles
(GAAP). However, since financial statement preparation involves considerable judgment and
384
Question 2 What was the financial reporting problem at Molex? How would
the correction of the problem be recorded in Molexs financial
statements?
The financial reporting problem at Molex arose because the company had not eliminated profits
from inter-company sales between its subsidiaries which had not been sold to an external customer
by year-end. As a result, consolidated inventory and earnings were overstated by $8 million and
$5.8 million respectively. Most students are unlikely to be aware of the complications of
consolidated financial statements, so a simple illustration may help clarify the issue.
Table A Example of Consolidation Reporting Problem
Subsidiary A (Seller) Subsidiary B (Purchaser) Consolidated without adjustment
INCOME STATEMENT
EFFECT
Revenues $48
Cost of sales 40
Operating profit 8
BALANCE SHEET EFFECT
Cash 48
Inventory (40)
INCOME STATEMENT
EFFECT
Revenues 0
Cost of sales 0
Operating profit 0
BALANCE SHEET EFFECT
Cash (48)
Inventory 48
INCOME STATEMENT EFFECT
Revenues $48
Cost of sales 40
Operating profit 8
Tax expense (25%) 2
Net income $6
BALANCE SHEET EFFECT
Cash 0
Inventory 8
The consolidated financial statements, shown in Table A, present a misleading record of the
consolidated companies income statement and balance sheet. Group earnings are overstated by
$6 million, the after-tax effect of the intra-company sale. The consolidated inventory is
385
Ending Balance Sheet Adjustments:
Inventory Decrease by $8.0 million
Taxes payable Decrease by $2.2 million
Retained earnings Decrease by $5.8 million
Income Statement Adjustments:
Question 3 What factors do you think influenced managements decision not
to raise the issue with the auditors?
(a) Error viewed as immaterial. In the management representation letter, management assures
the auditors that it is not aware of any material transactions that have not been properly
recorded in the accounting records. Management argued that it viewed the error as
immaterial. This leads to discussion of what is material. Should materiality be viewed in
terms of the income statement? If so, does the accounting problem have a material effect on
earnings or on a particular line item in the statement? Should the income statement impact
Table B Impact of Molexs Financial Reporting Problem on the June 30, 2004
Annual Results and on the September 30 Quarterly Results
Percentage Effect on Percentage Effect on
June 30, 2004 June 30, 2004
Financial Statement Item Annual Results Quarterly Results
$8m Adj $3m Adj. $8m Adj $3m Adj.
Income Statement
Gross profit + 1.0% + 0.4% + 4.8% +1.8%
Income from operations + 19.7% +7.4%
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
386
Source: Molex June 30, 2004 annual report and June 30, 2004 quarterly report.
A second way of looking at materiality is to ask whether it would have affected investors
perception of the firms performance and the stock valuation. Students will note that if the
There is one further fact that seems to suggest that in the end the auditors themselves did not
consider the matter material. When the $8 million charge was finally recorded for the
September 30, 2004 quarter, it was not separately disclosed either in the management
discussion or in the income statement. If the auditors had considered it to be material,
wouldnt they have required some form of disclosure?
At this point, I ask students to vote whether they consider the amount material or not.
(b) Management Inexperience. Joe King has an operations/quality background and has no
(c) Family-Owned Firm. Many students point out that the firm is family-owned (62%). This is
(d) Environment Unfavorable for Reporting Accounting Problems. Several factors made it a
challenging environment for reporting accounting problems. First, the market was skeptical
of accounting restatements given the accounting scandals of Enron, Worldcom, etc. Second,
2002-2003 had been difficult years for Molex, with both sales and profits down (profits
Question 4 Why were the auditors so concerned about the reporting problem
at Molex? If you were a member of the board, do you agree with
their concerns?
The auditors clearly consider the omission by management to be very serious. I ask the students
whether they agree. In the management representation letter, management assures the auditors
that it is not aware of any material transactions that have not been properly recorded in the
accounting records. Management argued that the reporting problems which were not disclosed
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
387
In addition, the revelation probably exacerbated other auditor concerns. The audit committee
had no financial expert, and their financial experience was weak. Many board members were on
multiple boards, raising questions about whether they were devoting too little time to the Molex
board. The high level of family ownership may raise questions about whether the company is
being run for all stockholders, or primarily for family members. There was a new and
inexperienced CFO.
These concerns would have been communicated to Deloitte & Touches head office, where top
partners would have been keenly alert for problems following the accounting scandals at some
To put a little more heat on students, I note that Dianne Bullock, the CFO, did not notify the
audit committee of the problem either. Would they be as concerned about the omission if they
were a member of the audit committee? Some will argue that the issue has become blown out of
proportion and that it is unreasonable to fire Bullock simply because of poor judgment over
such a minor issue. They will struggle to understand why the auditors are pushing for this
outcomewhat else do they know? Others will note that if you lose your trust in the CFO you
have a real problem, since both the board and the auditors rely on that trust. Bullock was hired
within the last six months. Would you hire her now if you knew this information?
Question 5 As a member of Molexs board, what would you do to respond to
the auditors request that the CFO (and possibly the CEO) be
replaced?
No matter what the students opinion on the culpability of Bullock and King in the accounting
problem, the board has a problem. If it refuses to fire Bullock, the auditors will probably quit.
What impact will this event have on the firm? First, the auditors will file an 8-K with the
Securities Exchange Commission to disclose the reason for quitting. How will this be
interpreted by investors will it affect the firms stock, particularly given the high level of short
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
388
NASDAQ SmallCap Market. Finally, given this public disclosure, who will now want to audit
the companys financial statements? What requirements will another large audit firm place on
Molexs board before signing on to become the auditor?
Conclusion
The case provides some insights into the inner workings of the financial reporting process and
the external audit. It shows the how important it is that the external auditors, the audit
committee, and management trust each other. In this case, that trust appeared to be broken, at
least between the auditors and top management, with material consequences for all parties
involved. I wrap up the case by telling the class what subsequently happened.
Subsequent Events
Exhibit 1 Events for Molex Following the Accounting Problem
Date Event Stock Reaction
November 10, 2004 Molex reassigned CFO, Diane Bullock, to
position of vice president and treasurer, and
announced it would delay filing quarterly
earnings report because of an auditor dispute.
Robert Mahoney, former CFO was appointed
acting CFO.
2.4%
November 13, 2004 Deloitte & Touche resigned after Molex refused
to dismiss Joseph King and Diane Bullock.
Deloitte demanded that King and Bullock be
prevented from serving as officers while it
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
389
March 23, 2005 Following its filing of the 10-Q for the December
31, 2004 quarter, Nasdaq reinstated Molexs
Exhibit 2 Molex Sales, Net Income and Stock Performance after Accounting
Problem
Nasdaq Composite
Sales Net Income Stock Price Versus Index Versus
($000) ($000) June 30, 2004 Price June 30, 2004 Index
4th quarter (6/30/2004) $631,817 $57,201 0% 0%
