Financial Reporting Problems at Molex, Inc.(a)

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Q4. What is the relation between management, the board, the audit committee, and the external auditors in financial reporting?

Solution:

To summarize, management is in charge of preparing financial reports while members of the board are important users of reports. Because of agency problem between management and the board, the board has to ensure objectivity and authenticity of public reports. As a result, the board assigns independent audit committee and hires external auditors to check financial reports.

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Figure 1: Relation between Four Entities

More specifically, we will discuss their relationship one by one.

Management and board: agency problem

Since the board is seldom involved in daily operation of the company, members of the board see how well the company is going on by reading financial reports. Management may have motivation to cheat in reports for their own interest, which harms authenticity of reports.

Board and audit committee: The board assigns audit committee to supervise

To guarantee authenticity, the board usually assigns an audit committee to supervise activities of management in financial reporting. In other words, the audit committee is responsible to the board.

Management and audit committee: be supervised

The management’s activities are supervised by the audit committee internally. As a part of the company itself, the audit committee should check financial information and assess its quality routinely.

Board and external auditors: be hired to check independently

The board hires external auditors to check financial reports of the company. External auditors help the board to guarantee high-quality financial reports. Meanwhile, the board may help the auditors’ work when necessary.

Management and external auditors: provide necessary materials and be checked

The management should provide necessary financial materials for the external auditors and ensure the quality of information provided through letters like management representation letter. In a word, management should try the best to cooperate with auditors’ work.

Audit committee and external auditors: cooperate

The audit committee and external auditors should cooperate when check financial reports. They should hold meetings to share information and assessment which help them to work better. The external auditors can refer to some of the audit committee’s results when audit.

Q5. What should the board do in this situation?

Solution:

The board of Molex should dismiss Deloitte & Touche and hire a new auditor. Meanwhile, we should disclose the financial problem to the new auditor and recognize the entire error amount in the first quarter and disclose it. Reasons are as following.

First, the CEO took an important part in Molex. He had worked in Molex for 29 years since 1975 from a quality control manager to the CEO. He played a key role in both domestic and international markets. If we dismissed him as auditors required, it would bring great influence on both the company’s daily operation and stock price.

Second, the CFO didn’t make severe mistakes. Considering her relatively brief history with Molex, she had nothing to do with previous financial problem before she joined Molex. Also, she took appropriate reactions for the financial problem subsequently. The company had already removed her as a CFO. It was unnecessary to take further action against her.

Third, in an attempt to resolve the dispute, the audit committee held an inquiry with the help of independent legal and accounting advisor, showing that the management had not deliberately withheld information from the auditors. In this case, managers weren’t totally wrong though they failed to disclose these.

Forth, Deloitte took the idea that they cannot rely on the CEO’s and CFO’s representation. There was no fault on Deloitte because it was just doing its job. Unluckily, there was little we could do except switching to another qualified auditor. And if we disclosed the financial problem to the new auditor we hired, there would be no credit problem, which would help us to cooperate better.

Lastly, the board should make the management promise to record the entire error amount in the first quarter. Even though this action would lower the revenue and net income of the first quarter, which might affect the stock price eventually, it was necessary. Because recognizing the additional amounts in subsequent quarters was not appropriate according to accounting standards and might mislead investors. So the company should correct it and then disclose it.