Analyze this case using a strategic perspective. In your answer cover the following:

a. Look at this case from the standpoint of the auditors and from your own (Maria Garcias) standpoint.

b. Knowing what you know now, which strategic principles would you say were ignored or misunderstood by the auditors and yourself?

BANK OF BUSINESS SOLUTIONS Wednesday, April 13, 2005, 9:48 a.m.:

Congratulations are in order! You remember that I told you last year that we would be submitting your opinion about MicroDex financial statements to a bank to get some financing to our planned addition of a production facility. Dont you? Well, the Bank of Business Solutions just notified me that the loan committee approved our three million-dollar loan after analyzing this years audited financial statements. The committee was really impressed that while everyone else in our industry operated at a loss or just broke even, we showed a substantial profit this period, crowed Kevin Clark, CFO of MicroDex, in a telephone call to Daniel Riley, an auditing manager at Peter Nelson, LLP. Daniel headed the audit team that issued an unqualified opinion on MicroDex financial statements for each of the last four years.

Thats great! Daniel responded. The loan means that youll be able to complete that new circuit board production facility that you told me about, doesnt it? That circuit board is the product your budget shows is going to increase sales revenue and cash flow next year. Its a good thing you were able to generate a profit and get the loan. Without the new product, things looked pretty bleak.

MicroDex designs and manufacturers circuit boards for low-tech applications, such as those used in major household appliances. Sales in the appliance circuit board industry had declined or been flat in the past 18 months because of peoples reluctance to buy new appliances in a poor economy. MicroDexs new circuit board was for washers and dryers that compete with Maytags Neptune series. MicroDexs customer (a major competitor of Maytag) was launching a new washer/dryer with characteristics similar to the Neptune series, but they expected the price to be about 25% below that charged by Maytag. MicroDex had developed a circuit board to meet the engineering specifications of the new product, but could only land the business if they had new production facilities.

Sylvia Lopez, an auditing staff member assigned to one of Daniels jobs, overheard the conversation between Daniel and Kevin on the speakerphone while sitting in Daniels office.

Daniel, I didnt know that the company operated at a profit this year! exclaimed Sylvia. During my field work, I analyzed the monthly income statements through November, and they showed that the company operated at a loss almost every month! How did they report a substantial profit at year end?

Daniel replied, Several years ago they made an investment in the stock of a closely held company that they thought might be a good strategic alliance. Unfortunately, that opportunity didnt work out. Until December 2004, MicroDex had been holding the investment and hadnt been receiving any dividends. The CFO of MicroDex actively searched for a company to buy the stock, and in December 2004, located a strategic buyer who took it off their hands at a substantial gain! Daniel continued. Since MicroDex frequently buys and sells stock investments, the gain is a part of their income from continuing operations.

Oh, thats clever! Sylvia responded. But if it were such a large transaction, why didnt they just use the cash flow from the stock sale to finance the new manufacturing facility?

Well, Daniel explained, the company that MicroDex sold the stock to, Greenco, is having their own cash flow problems right now. They couldnt afford to give MicroDex cash, so MicroDex accepted a non-interest bearing note due in 5 years. Although MicroDex wont see the cash for five years, since the title to the stock has passed to the new owners, it can record the gain on the sale.

Sylvia pondered this information for a few minutes, and then queried, Why a non-interest bearing note? Most companies with a credit rating like Greenco are paying about 15% on loans for transactions like this one.

BANK OF BUSINESS SOLUTIONS Wednesday, April 13, 2005, 9:48 a.m.:

Congratulations are in order! You remember that I told you last year that we would be submitting your opinion about MicroDex financial statements to a bank to get some financing to our planned addition of a production facility. Dont you? Well, the Bank of Business Solutions just notified me that the loan committee approved our three million-dollar loan after analyzing this years audited financial statements. The committee was really impressed that while everyone else in our industry operated at a loss or just broke even, we showed a substantial profit this period, crowed Kevin Clark, CFO of MicroDex, in a telephone call to Daniel Riley, an auditing manager at Peter Nelson, LLP. Daniel headed the audit team that issued an unqualified opinion on MicroDex financial statements for each of the last four years.

Thats great! Daniel responded. The loan means that youll be able to complete that new circuit board production facility that you told me about, doesnt it? That circuit board is the product your budget shows is going to increase sales revenue and cash flow next year. Its a good thing you were able to generate a profit and get the loan. Without the new product, things looked pretty bleak.

MicroDex designs and manufacturers circuit boards for low-tech applications, such as those used in major household appliances. Sales in the appliance circuit board industry had declined or been flat in the past 18 months because of peoples reluctance to buy new appliances in a poor economy. MicroDexs new circuit board was for washers and dryers that compete with Maytags Neptune series. MicroDexs customer (a major competitor of Maytag) was launching a new washer/dryer with characteristics similar to the Neptune series, but they expected the price to be about 25% below that charged by Maytag. MicroDex had developed a circuit board to meet the engineering specifications of the new product, but could only land the business if they had new production facilities.

Sylvia Lopez, an auditing staff member assigned to one of Daniels jobs, overheard the conversation between Daniel and Kevin on the speakerphone while sitting in Daniels office.

Daniel, I didnt know that the company operated at a profit this year! exclaimed Sylvia. During my field work, I analyzed the monthly income statements through November, and they showed that the company operated at a loss almost every month! How did they report a substantial profit at year end?

Daniel replied, Several years ago they made an investment in the stock of a closely held company that they thought might be a good strategic alliance. Unfortunately, that opportunity didnt work out. Until December 2004, MicroDex had been holding the investment and hadnt been receiving any dividends. The CFO of MicroDex actively searched for a company to buy the stock, and in December 2004, located a strategic buyer who took it off their hands at a substantial gain! Daniel continued. Since MicroDex frequently buys and sells stock investments, the gain is a part of their income from continuing operations.

Oh, thats clever! Sylvia responded. But if it were such a large transaction, why didnt they just use the cash flow from the stock sale to finance the new manufacturing facility?

Well, Daniel explained, the company that MicroDex sold the stock to, Greenco, is having their own cash flow problems right now. They couldnt afford to give MicroDex cash, so MicroDex accepted a non-interest bearing note due in 5 years. Although MicroDex wont see the cash for five years, since the title to the stock has passed to the new owners, it can record the gain on the sale.

Sylvia pondered this information for a few minutes, and then queried, Why a non-interest bearing note? Most companies with a credit rating like Greenco are paying about 15% on loans for transactions like this one.

MicroDex didnt have any loans against the investment, so they arent incurring any interest cost on the stock or the new note. They figured that there isnt any need to hurt Greencos cash flow when MicroDex doesnt have any interest cost on the investment, Daniel responded.

Daniel, you sure know a lot about this transaction, teased Sylvia. Youd think that you had found the buyer and negotiated the deal.

Well, I am pretty excited, Daniel responded. I worked with the CFO on the transaction, reviewing the entry in the general journal and its reporting in MicroDexs income statement. I may not have arranged the deal, but I was instrumental in getting out the audited statements just in time. As you know, MicroDex really needed some serious cash infusion as soon as possible from some lender to complete a production facility for that new circuit board.

Since I missed all the excitement while I was working on a different client, why dont you share the details of the transaction? demanded Sylvia.

Well, MicroDex was carrying the investment at $5,100,000 and sold it to Greenco for $8,000,000. So they booked a $2,900,000 gain on the transaction, Daniel confidentially replied.

Sylvia looked troubled and finally confided to Daniel, Im enrolled in a CPA review course and last week we studied long term receivables and payables. I learned that generally accepted accounting principles (GAAP) require notes receivable due in more than one year to be carried at their present value. Wouldnt that affect the profit you reported? Daniel looked at Sylvia like she was trying to put him on the spot and icily replied, I explained that MicroDex didnt incur any interest on this investment before the sale, so present value calculations arent necessary! And, yes, the income statement we audited is consistent with GAAP.

Net Income Common Shares Outstanding

$2,880 3,000

MicroDex Income Statements For the four years ended December 31, 2004 (in 000s except per share amounts)

Net Revenues and Gains Expenses and Losses Cost of Sales Operating Expenses Other 4,570 Taxes 1,690

2004

2003

$26,300

12,150 3,075 3,966 2,671

$4,438 3,000

2002

$25,100

9,845 2,890 3,146 3,318

$5,901 3,000

2001

$20,900

9,200 2,300 2,214 2,515

$4,671 3,000

$27,500

15,200 3,160

Memo

To: Maria Garcia, Loan Delinquency Department, Bank of Business Solutions. From: Jonathan Fox, Senior Lending Officer, Bank of Business Solutions Date: January 17, 2008

Re: Default on MicroDexs loan

______________________________________________ __________________________ 

As I mentioned to you earlier today, I am forwarding to you the MicroDexs file. It is now in default on the three million dollar loan we extended on April 12, 2005. The total amount currently outstanding is $2,390,000. We were just informed yesterday that MicroDex has commenced bankruptcy protection under Chapter 7 of the Bankruptcy Code. As such, the prospects of full recovery are minimal.

In addition to the loan documents, I am attaching copies of all the financial statements that we obtained from MicroDex as part of the loan application, including the one for year 2004, which we received from MicroDexs CFO on February 2, 2005.

In looking back at the financial statements that we had in our file, I was stunned by MicroDexs dramatic and sudden collapse. When we approved the loan, the loan committee gave a lot of weight not only to the financial statements from 2004, but also to the ones from the prior three years; we were keenly impressed by the firms pattern of income stability during those four calendar years.

I am also attaching a copy of an article I had placed in my file a number of years back. Ever since reading the article, I have had a lingering suspicion that the story in the article is about MicroDex.

GREEN TIMES

December 15, 2005

Glen Oak, Green. In a surprise move yesterday, twelve staff accountants at Peter Nelson, LLP left the firm and joined a competitor, Pillsbury & Skadden. In an interview with one of the twelve former auditors, it was learned that the departure followed alleged auditing irregularities practiced by senior partners at Peter Nelson, LLP. I have been really disillusioned with the level of scrutiny the senior managers and partners have been employing with regard to a number of audit engagements. In one case that I have worked on while I was an intern, my former manager signed off on an unqualified audit opinion where the client, a designer and manufacturer of home appliance circuit boards, had substantially

overstated income and assets in contravention with General Accepted Accounting Principles. It is really too bad. I am really looking forward to joining this new firm. I believe it has a lot of potential, said one of the twelve departing accountants who wished to remain