MagnaChip's Cheap Practices

MagnaChip Semiconductor Corp (“MagnaChip”) is a Delaware Corporation based in Luxembourg. Its primary business is focused on manufacturing and selling semiconductor products through distributors operating mainly in South Korea. Following its IPO in 2011, MagnaChip has been engaging in several inappropriate accounting practices in relation to revenue recognition and expense reporting.

MagnaChip demonstrates a perfect example of fraudulent activities that are not only happening on the company-level but are also ingrained in the culture throughout the company involving many employees. High pressure from the senior executives often leads to employees resorting in a variety of ways to meet aggressive revenue objectives set by the management.

Pull-in Sales

One of the fraudulent practices is referred to as “pull-in” sales (or channel stuffing), which is a deceptive business practice by sending the retailers and customers more products earlier than needed to boost revenue numbers. This is usually done using an undisclosed side agreement offering incentives or concessions to distributors or retailers. While this “pull-in” sales practice does not comply with the requirements of GAAP, many employees in MagnaChip utilize it as a means to meet sales targets. Not to mention, the participation of Margaret Hye-Ryoung Sakai (“Sakai”) as the CFO of MagnaChip in approving and failing to correct certain improper pull-in sales.

Sun Ip Go

Other than “pull-in” sales, MagnaChip also engaged in a fraudulent revenue recognition practice called “Sun Ip Go” (or advance warehousing). Since its IPO, MagnaChip has been improperly recognizing revenue on unfinished goods earlier than it should be and recorded them as completed or even shipped to customers.

D-Project

Another way that MagnaChip misrepresented its financials is by engaging in a series of transactions known as “D-Project” to make the Aged Uncollectible Accounts Receivable as received when it is obviously not. The “Sun Ip Go” and “D-Project” along with “Pull-In” sales falsely improved MagnaChip business performance for many years.

Besides revenue cycle fraud, MagnaChip also falsified its financial statements by delaying the recording of expenses totaling up to $18 million. Rather than complying with the GAAP procedures to record the full amount of contingent liability in the current period, MagnaChip recognized the expenses over time.

MagnaChip also increased gross margin by inappropriately delaying taking some inventories off of the books when they became obsolete. Under US GAAP, companies are required to record the scrap inventories as expenses as soon as the inventories have passed their age, in which MagnaChip failed to perform. This practice improperly inflated the gross margin number in the company’s books.

All of these schemes left some trails in the company’s financial statements that ended up being the auditors’ lead to further investigation. When the fraud was discovered in 2015, MagnaChip was penalized to pay $3 million and was suffering a drastic stock decline due to the loss of investors’ trust.

The Internal Control Deficiencies at MagnaChip

The company’s control environment was one of the most influential catalysts in the making of this fraud. The immense pressure imposed by the management incentivizes employees to meet aggressive financial objectives, which sometimes leads to some suspicious activities.

This high pressure to boost sales number was also supplemented by the lack of monitoring and disclosure from the management to the Audit Committee. The “secretive” nature of the MagnaChip management and the omission of certain required disclosures limited the Audit Committee’s ability to oversee the financial reporting process.

The Stock Price After Restatement

Following the discovery of the fraud by the regulators in 2015, MagnaChip immediately suffered a drastic stock decline. From its highest point in February 2015 (approx. $15.10), the price continued to fall to around $5.23 in March 2015. Although the price has gained a little pace since the drop, the stock price has never recovered to where it was before.

The Role Of External Auditors In Discovering Fraud

MagnaChip’s external auditors have the responsibility to maintain independence towards the company’s financial reports. The auditors need to have professional skepticism in countering the potential fraud committed by management.

Fortunately, in the case of MagnaChip, the auditors have performed professional skepticism quite decently. Ensuing the increasing accounts receivable balances in 2013, the external auditors along with the Audit Committee have been discussing concerns regarding the company’s internal control and reporting. Due to this concern, they issued an internal investigation which then led to the discovery of many other fraudulent practices in the financials.

Takeaway

The case of MagnaChip teaches the auditors to be mindful of the many ways that a company can commit fraud. Not only in the revenue cycle, but MagnaChip also participated in the whole acquisition and payment cycle fraud. From the practice of channel stuffing, Sun Ip Go, D-Project to the delaying of the recording of expenses, MagnaChip got its hands dirty in varieties of techniques.

The auditors need to be able to perform appropriate and sufficient risk assessment procedures to be able to detect these kinds of fraudulent activities. In this case, fortunately, the auditors do their job properly. They successfully implemented professional skepticism in their audit process which led to further investigation, discovering a lot of deceitful activities along the way.