Analyzing liabilities

Assessment Description

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- to 500-word executive summary to the Cardinal Health CEO, address the following:

1. Explain the potential justification for deducting the expected litigation gain from cost of goods sold, and explain why Cardinal Health chose this alternative rather than reporting it as a nonoperating item.
2. 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.”
3. Explain specifically what Cardinal Health did to get into trouble with the SEC.
4. Justify the timing of the $10 million and $12 million gains, and explain how Cardinal Health’s senior managers defend these decisions.
5. 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 justified 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

Case Study13‐1
Accounting for Contingent Assets: The Case of Cardinal HealthIn 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?BackgroundThe 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 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.† 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 OutcomeCardinal 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.