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13-1Acc-502week5assignment.docx

13-1 Accounting for Contingent Assets: The Case

of Cardinal Health

In a complaint dated 26 July 2007, and after a four-year investigation,

the US Securities and Exchange Commission (SEC)

accused Cardinal Health, the world’s second largest distributor

of pharmaceutical products, of violating generally accepted

accounting principles (GAAP) by prematurely recognizing

gains from a provisional settlement of a lawsuit filed against

several vitamin manufacturers. Weeks earlier, the company

agreed to pay $600 million to settle a lawsuit filed by shareholders

who bought stock between 2000 and 2004, accusing

Cardinal of accounting irregularities and inflated earnings.*

The recovery from the vitamin companies should have been

an unqualified positive for Cardinal Health. What happened?

Case Study

*“Cardinal Health Settles Shareholders’ Suit,” The Associated Press,

1 June 2007.

(Continued)

Copyright ©

Background

The story begins in 1999 when Cardinal Health joined a class

action to recover overcharges from vitamin manufacturers.

The vitamin makers had just pled guilty to charges of pricefixing

from 1988 to 1998. In March 2000, the defendants in

that action reached a provisional settlement with the plaintiffs

under which Cardinal could have received $22 million. But

Cardinal opted out of the settlement, choosing instead to file its

own claims in the hopes of getting a bigger payout.

The accounting troubles started in October 2000 when

senior managers at Cardinal began to consider recording a

portion of the expected proceeds from a future settlement as

a litigation gain. The purpose was to close a gap in Cardinal’s

budgeted earnings for the second quarter of FY 2001, which

ended 31 December 2000. According to the SEC, in a November

2000 e-mail a senior executive at Cardinal Health explained

why Cardinal should use the vitamin gain, rather than other

earnings initiatives, to report the desired level of earnings: “We

do not need much to get over the hump, although the preference

would be the vitamin case so that we do not steal from Q3.”

On 31 December 2000, the last day of the second quarter

of FY 2001, Cardinal recorded a $10 million contingent vitamin

litigation gain as a reduction to cost of sales. In its complaint, the

SEC alleged that Cardinal’s classification of the gain as a reduction

to cost of sales violated GAAP. It is worth noting that had

the gain not been recognized, Cardinal would have missed analysts’

average consensus EPS estimate for the quarter by $.02.

Later in FY 2001, Cardinal considered recording a similar

gain, but its auditor at the time, PricewaterhouseCoopers

(hereafter PwC), was opposed to the idea. Accordingly, no litigation

gains were recorded in the third or fourth quarters of FY

2001. Moreover, PwC advised Cardinal that the $10 million

recognized in the second quarter of FY 2001 as a reduction

to cost of sales should be reclassified “below the line” as nonoperating

income. Cardinal management ignored the auditor’s

advice, and the $10 million gain was not reclassified.

The urge to report an additional gain resurfaced during

the first quarter of FY 2002, and for the same reason as in the

prior year: to cover an expected shortfall in earnings. On 30

September 2001, the last day of the first quarter of FY 2002,

Cardinal recorded a $12 million gain, bringing the total gains

from litigation to $22 million. As in the previous year, Cardinal

classified the gain as a reduction to cost of sales, allowing the

company to boost operating earnings. However, PwC disagreed

with Cardinal’s classification. The auditor advised Cardinal that

the amount should have been recorded as nonoperating income

on the grounds that the estimated vitamin recovery arose from

litigation, was nonrecurring, and stemmed from claims against

third parties that originated nearly 13 years earlier.

By May 2002, PwC had been replaced as Cardinal’s

auditor by Arthur Andersen.† Andersen was responsible for

auditing Cardinal’s financial statements for the whole of FY

2002, ended 30 June 2002, and thus, it reviewed Cardinal’s

classification of the $12 million vitamin gain. The Andersen

auditors agreed with PwC that Cardinal had misclassified the

gain. After Cardinal’s persistent refusal to reclassify the gains,

Andersen advised the company that it disagreed but would treat

the $12 million as a “passed adjustment” and include the issue

in its Summary of Audit Differences.‡

In spring 2002 Cardinal Health reached a $35.3 million

settlement with several vitamin manufacturers. The

$13.3 million not yet recognized was recorded as a gain in the

final quarter of FY 2002. But while management thought its

accounting policies had been vindicated by the settlement, the

issue wouldn’t go away.

On 2 April 2003, an article in the “Heard on the Street”

column in The Wall Street Journal sharply criticized Cardinal

Health for its handling of the litigation gains.§ “It’s a CARDINAL

rule of accounting:” the article begins, pun intended.

“Don’t count your chickens before they hatch. Yet new disclosures

in Cardinal Health Inc.’s latest annual report suggests that

is what the drug wholesaler has done not just once, but twice.”

Nevertheless, management continued to defend its accounting

practices, partly on the grounds that the amounts later received

from the vitamin companies exceeded the amount of the contingent

gains recognized in FY 2001 and FY 2002. Moreover,

after the initial settlement, Cardinal Health received an additional

$92.8 million in vitamin related litigation settlements,

bringing the total proceeds to over $128 million.

The Outcome

Cardinal management finally succumbed to reality in the following

year, and in the Form 10-K (annual report) filed with

the SEC for FY 2004, Cardinal restated its financial results to

reverse both gains, restating operating income from the two

† Arthur Andersen ceased operating months later in the aftermath of the

Enron scandal. The Cardinal Health audit was then taken over by Ernst &

Young.

‡ A Summary of Audit Differences is a nonpublic document that lists the

errors and adjustments identified by the auditor. It serves as the basis for the

audit opinion. If the net effect of the errors exceeds the materiality threshold

established for the client, the auditor will require an adjustment to the financial

statements. “Passed adjustment” means that the error in question was

waived; that is, no adjustment was demanded by the auditor.

§ “Cardinal Health’s Accounting Raises Some Questions,” by Jonathan Weil,

The Wall Street Journal, 2 April 2003, p. C1.

affected quarters. But the damage had already been done. The

article in The Wall Street Journal triggered the SEC investigation

alluded to earlier. A broad range of issues, going far

beyond the treatment of the litigation gains, were brought

under the agency’s scrutiny, culminating in the SEC complaint.

Two weeks after the complaint was filed, Cardinal Health settled

with the SEC, agreeing to pay a $35 million fine.

13

-

1 Accounting for Contingent Assets: The Case

of Cardinal Health

In a complaint dated 26 July 2007, and after a four

-

year investigation,

the US Securities and Exchange Commission (SEC)

accused Cardinal Health, the world

s second largest distributor

of pharmaceutical products, of violating generally accepted

accounting principles (GAAP) by prematurely recognizing

gains from a provisional settlement of a lawsuit filed against

several vitamin manufacturers. Weeks earlier, the company

agreed to pay $600

million to settle a lawsuit filed by shareholders

who bought stock between 2000 and 2004, accusing

Cardinal of accounting irregularities and inflated earnings.

*

The recovery from the vitamin companies should have been

an unqualified positive for Cardinal H

ealth. What happened?

Case Study

*

Cardinal Health Settles Shareholders

Suit,

The Associated Press,

1 June 2007.

(Continued)

Copyright ©

Background

The story begins in 1999 when Cardinal Health joined a class

action to recover overcharges from vitamin man

ufacturers.

The vitamin makers had just pled guilty to charges of pricefixing

from 1988 to 1998. In March 2000, the defendants in

that action reached a provisional settlement with the plaintiffs

under which Cardinal could have received $22 million. But

Car

dinal opted out of the settlement, choosing instead to file its

own claims in the hopes of getting a bigger payout.

The accounting troubles started in October 2000 when

senior managers at Cardinal began to consider recording a

portion of the expected proceeds from a future settlement as

a litigation gain. The purpose was to close a gap in Cardinal

s

budgeted earnings for the second quarter of FY 2001, which

ended 31 December 2000. According to the SEC, in a November

2000 e

-

mail

a senior executive at Cardinal Health explained

why Cardinal should use the vitamin gain, rather than other

earnings initiatives, to report the desired level of earnings:

We

do not need much to get over the hump, although the preference

would be the vitam

in case so that we do not steal from Q3.

On 31 December 2000, the last day of the second quarter

of FY 2001, Cardinal recorded a $10 million contingent vitamin

litigation gain as a reduction to cost of sales. In its complaint, the

SEC alleged that Cardina

l

s classification of the gain as a reduction

to cost of sales violated GAAP. It is worth noting that had

the gain not been recognized, Cardinal would have missed analysts

average consensus EPS estimate for the quarter by $.02.

Later in FY 2001, Cardinal

considered recording a similar

gain, but its auditor at the time, PricewaterhouseCoopers

(hereafter PwC), was opposed to the idea. Accordingly, no litigation

gains were recorded in the third or fourth quarters of FY

2001. Moreover, PwC advised Cardinal tha

t the $10 million

recognized in the second quarter of FY 2001 as a reduction

to cost of sales should be reclassified

below the line

as nonoperating

income. Cardinal management ignored the auditor

s

advice, and the $10 million gain was not reclassified.

T

he urge to report an additional gain resurfaced during

the first quarter of FY 2002, and for the same reason as in the

prior year: to cover an expected shortfall in earnings. On 30

September 2001, the last day of the first quarter of FY 2002,

Cardinal recorded a $12 million gain, bringing the total gains

from litigation to $22 million. As in the previous year, Cardinal

13-1 Accounting for Contingent Assets: The Case

of Cardinal Health

In a complaint dated 26 July 2007, and after a four-year investigation,

the US Securities and Exchange Commission (SEC)

accused Cardinal Health, the world’s second largest distributor

of pharmaceutical products, of violating generally accepted

accounting principles (GAAP) by prematurely recognizing

gains from a provisional settlement of a lawsuit filed against

several vitamin manufacturers. Weeks earlier, the company

agreed to pay $600 million to settle a lawsuit filed by shareholders

who bought stock between 2000 and 2004, accusing

Cardinal of accounting irregularities and inflated earnings.*

The recovery from the vitamin companies should have been

an unqualified positive for Cardinal Health. What happened?

Case Study

*“Cardinal Health Settles Shareholders’ Suit,” The Associated Press,

1 June 2007.

(Continued)

Copyright ©

Background

The story begins in 1999 when Cardinal Health joined a class

action to recover overcharges from vitamin manufacturers.

The vitamin makers had just pled guilty to charges of pricefixing

from 1988 to 1998. In March 2000, the defendants in

that action reached a provisional settlement with the plaintiffs

under which Cardinal could have received $22 million. But

Cardinal opted out of the settlement, choosing instead to file its

own claims in the hopes of getting a bigger payout.

The accounting troubles started in October 2000 when

senior managers at Cardinal began to consider recording a

portion of the expected proceeds from a future settlement as

a litigation gain. The purpose was to close a gap in Cardinal’s

budgeted earnings for the second quarter of FY 2001, which

ended 31 December 2000. According to the SEC, in a November

2000 e-mail a senior executive at Cardinal Health explained

why Cardinal should use the vitamin gain, rather than other

earnings initiatives, to report the desired level of earnings: “We

do not need much to get over the hump, although the preference

would be the vitamin case so that we do not steal from Q3.”

On 31 December 2000, the last day of the second quarter

of FY 2001, Cardinal recorded a $10 million contingent vitamin

litigation gain as a reduction to cost of sales. In its complaint, the

SEC alleged that Cardinal’s classification of the gain as a reduction

to cost of sales violated GAAP. It is worth noting that had

the gain not been recognized, Cardinal would have missed analysts’

average consensus EPS estimate for the quarter by $.02.

Later in FY 2001, Cardinal considered recording a similar

gain, but its auditor at the time, PricewaterhouseCoopers

(hereafter PwC), was opposed to the idea. Accordingly, no litigation

gains were recorded in the third or fourth quarters of FY

2001. Moreover, PwC advised Cardinal that the $10 million

recognized in the second quarter of FY 2001 as a reduction

to cost of sales should be reclassified “below the line” as nonoperating

income. Cardinal management ignored the auditor’s

advice, and the $10 million gain was not reclassified.

The urge to report an additional gain resurfaced during

the first quarter of FY 2002, and for the same reason as in the

prior year: to cover an expected shortfall in earnings. On 30

September 2001, the last day of the first quarter of FY 2002,

Cardinal recorded a $12 million gain, bringing the total gains

from litigation to $22 million. As in the previous year, Cardinal