Accounting of Contingent

Case studies

13.2 Analyzing and interpreting disclosures on the provision

for warranties

13.1 Accounting for contingent assets: the case of

Cardinal Health

13.1 Accounting for contingent assets: the case of

Cardinal Health

13.1 Accounting for contingent assests: 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?

Background

Background

The story begins in 1999 when Cardinal Health joined a class action to recover over-

charges from vitamin manufacturers. The vitamin makers had just pled guilty to charges

of price-fixing 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.

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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 mis-

classified 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.

¼

In spring 2002 Cardinal Health reached a $35.3 million settlement with several vita-

min 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.

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“It’sa

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

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 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.

Arthur Andersen ceased operating months later in the aftermath of the Enron scandal. The Cardinal Health audit was then taken over by Ernst & Young.

¼

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.

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“Cardinal Health’s Accounting Raises Some Questions,” by Jonathan Weil, The Wall Street Journal, 2 April

2003, p. C1.