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

Assignment

13-1 Accounting for Contingent Assets: The Caseof 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 share-holders 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 © 2019 John Wiley & Sons, Inc. NTINGENCIES256 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 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 Novem-ber 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 non-operating 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 mil-lion 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 OutcomCardinal management finally succumbed to reality in the fol-lowing 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 theaudit 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.Copyright © 2019 John Wiley & Sons, Inc. been done. The article in The Wall Street Journal triggered the SEC investi-gation 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 set-tled with the SEC, agreeing to pay a $35 million fine.

Executive summary to the Cardinal Health CEO, address the following.

1.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.

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 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.

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