The purpose of this assignment is to analyze liabilities when making business decisions.
Read Case Study 13-1 “Accounting for Contingent Assets: The Case of Cardinal Health,” from Chapter 13 in the textbook.
In a 250-500 word executive summary to the Cardinal Health CEO, address the following:
- Explain the justification that could be given for deducting the expected litigation gain from cost of good sold and explain why Cardinal Health chose this alternative rather than reporting it as a nonoperating item.
- Explain what the senior Cardinal Health executive meant when he said, “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.” Include specific clarification of the phrase “not steal from Q3.”
- Explain specifically what Cardinal Health did to get into trouble with the SEC.
- Justify the timing of the $10 million and $12 million gains, and explain how Cardinal Health’s senior managers defend these decisions.
- Cardinal Health received more than $22 million from the litigation settlement. Discuss whether the actions of Cardinal Health senior managers were so wrong that they justify the actions of the SEC. Classify Cardinal Health’s behavior on a scale from 1-10, with 1 being “relatively harmless” and 10 being “downright fraudulent.” Justify your rating.
Prepare this assignment according to the guidelines found in the APA Style Guide, located in the Student Success Center. An abstract is not required.
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
–
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
