Question

Case 1-1 You are the new chief financial officer for Redlands Manufacturing, Inc. The firm that you have just joined has recently paid substantial penalties to settle claims related to fraudulent financial reporting practices. The Board of Directors has also created an Office of Ethics and Compliance in response to the scandals. Francis Bacon, the chief of the newly created ethics office, recently dropped by your office for some insights about accounting and fraudulent financial reporting. The chief ethicist stated that he has a background in philosophy, but he lacks understanding of the accounting discipline. He identifies the tactics that the company employed when it essentially cooked its books. Bacon stated that Redlands employed some devious practices that were obviously unethical, but that he lacked the accounting vocabulary to articulate their financial statement consequences. He essentially wanted to understand why specific practices violated accounting standards, and sought your help with this matter. Bacon began by stating, “I have identified five types of arrangements that Redlands engaged in over the period in question. Each type of activity has a clever sounding name. Here is my list:” Channel Stuffing. Redlands shipped manufactured goods to certain retailers, in certain instances regardless of whether or not the retailers ordered the products. Our firm recognized revenues upon shipment of these non-ordered items, which usually took place towards the end of the year. We informally agreed to take back the merchandise if the retailer could not sell it. It was kind of a wink and a nod deal. Redlands did not recognize an allowance for the merchandise that its retailers could return. Vendor Dinging. Our firm told many of its suppliers that they were shipped a disproportionately large number of raw materials that did not conform to contracted specifications. Consequently, Redlands unilaterally decreased its cash payments to those vendors. Most of the suppliers did not dispute our claims and merely reduced our obligation to them. Of course, many of those materials were of acceptable quality and we used them in manufacturing our products. Capitalizing Revenue Expenditures. Redlands placed numerous recurring business costs on its balance sheet as long-term assets, rather than charging the full cost of the item as an expense in the current reporting period. Our firm then recognized only a portion of those questionable assets’ cost as a current expense, which we called depreciation. These costs, such as salaries expense, had no future benefit beyond the current reporting period. Special Purpose Entities (SPEs). Redlands Manufacturing shielded debt (liabilities) from its balance sheet with these types of arrangements. Our firm contracted with ostensibly independent companies in business ventures that were debt financed. The other companies, not Redlands, reported the debt on their balance sheets. Our SPE partners, however, consisted of businesses established by Redlands executives. Bacon told you that he was preparing to make his initial address to the Board of Directors concerning staff training which should insure that the firm does not engage in the above practices, or any other ones like them. He wants you to explain to him how such unethical practices violate accounting conventions, and how they inflated the financial appearance of the firm. Required: Write a memorandum to Francis Bacon explaining how each practice violates generally accepted accounting principles, and how each type of transaction might affect reported income, financial position, and cash flows.

Answer 1

Situation -1.

Mistake:

Sales without order and Revenue Recognition.

GAAP Violation:

Revenue should be recognized only when the following condition is satisfied.

• The revenue is earned whether entity has substantially accomplished what it must do to be entitled to receive the benefit represented by the revenue.

So the company can only treat as a sales as revenue if the sale is done as per the order. Here there is no such official order made from the part of retailers so as per GAAP the company does does not have the right without an order from the customer hence the current transfer of goods cant be treated as sales and cant recognize revenue based on such transfer.

Effect on income statement:

Amount revenue will get increased which will result in an increase of the total profit.

Effect on financial position:

Closing stock will get reduced and debtors will increase

(Assumes the sales was credit sales)

Effect on Cash Flow:

As stock decrease there will be a cash inflow first which will be set off by a cash outflow due to increase of debtors.

Situation 2.

Mistake:

GAAP Violation:

As per GAAP the revenue expenses should be recognized as per the primary document. Here they dose not considered that principle which is a violation of GAAP

Effect on income statement:

Purchase expense reduced so income will get increased

Effect on financial position: Value of closing stock will be less than what in the primary document. Creditors will also be less than what is in the primary document.

Effect on Cash Flow:

Cash outflow will be less when compared to the primary document.

Situation 3.

Mistake:

Recognizing revenue expense as capital expenditure.

GAAP Violation.

Every recurring expense are revenue expense and every nonrecurring expense are a capital expense as per GAAP. Here they recognized Recurring expenses as a capital expense and violate the GAAP principle

Effect on income statement:

As Revenue expense is not recognized it will cause an increase of the revenue profit more than what it is.

Effect on financial position:

Long-term liability will get increasingly more than what it is

Effect on Cash flow:

No final effect because the cash outflow will be on time whatever be the nature.

Situation 4.

Mistake:

Recognizing only a porting of recurring expense in income statement and treating the rest as capital expense and planning to recognize in the future years.

GAAP violation

Every recurring expense are revenue expense and every nonrecurring expense are capital-expense as per GAAP. Here they recognized Recurring expenses as a capital expense and violate the GAAP principle

Effect on income statement:

As less Revenue expense is recognized what it is exactly will cause an increase in the revenue profit more than what it is. And reorganization of a portion of capital expenditure which is not exactly in that nature in future accounting will reduce the net income future accounting periods.

Effect on financial position:

Will show a high long time liability and future accounting periods more than what it exactly.

Effect on cash flow:

Net cash inflow for the current period will increase. no effect on future because depreciation and amortization is noncash items.

Situation 5

Mistake:

Debt treated as SPE.

GAAP violation

Debt liability should treat separately as per GAAP

Effect on income statement:

No effect income statement because the adjustment is made in balance sheet.

Effect on financial position:

If debt shielded out from balance sheet it will show less long-term liability than what it exactly.

Effect on cash flow:

Nothing motioned about the payments so cant makes decision how might is effect cash flow.