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 business.

1. 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.