The following article raises questions about Cardinal Health's accounting for an expected legal settlement. Management responded to the accusations by sending a letter to all shareholders and to analysts who covered the firm.

CARDINAL HEALTH’S ACCOUNTING RAISES SOME QUESTIONS It’s a cardinal rule of accounting: Don’t count your chickens before they hatch. Yet new disclosures in Cardinal Health Inc:s latest annual report suggest that is what the drug wholesaler has done not just once, but twice, independent accounting specialists say.
As the disclosures show, Cardinal recorded $22 million of an expected legal settlement with certain vitamin manufacturers that it had accused of overcharging for products—in advance of an actual settlement. Specifically, Cardinal recorded a $10 million pre-tax gain, as well as a corresponding receivable on its balance sheet, during its December 2000 quarter. It recorded a further $12 million gain during the quarter ended Sept. 30, 2001, after concluding that its minimum future recovery would be that much bigger.
Cardinal, which says it has done nothing improper, did reach a $35.3 million settlement in the vitamin antitrust litigation last spring. The company recorded the remaining $13.3 million during the final quarter of its past fiscal year, ended June 30.
To those unfamiliar with accounting rules, the posting of the two initial sums might not raise obvious questions. Yet even first-year accounting students are taught this: Under generally accepted accounting principles, companies aren't supposed to record expected gains as current income until they are certain the gains will be realized. When it comes to litigation settlements, that means waiting until an actual settlement agreement has been reached with a party that is able to pay, independent accounting specialists say.
Now consider this twist: Had Cardinal not recorded the two initial gains when it did, it would have fallen short of Wall Street analysts’ earnings targets by two cents a share for both the December 2000 and September 2001 quarters; Cardinal's earnings met analysts’ targets for each of the quarters. Cardinal didn't disclose the size of the gains until September 2002, when it filed its latest annual report.
“That's abracadabra accounting,’ says Walter Schuetze, a former chief accountant for the Securities and Exchange Commission.
“Cardinal should not have recognized a receivable and a gain until June 2002.” Before then, “it was all a matter of speculation,’
he says, adding, “Cardinal's actions explain what is meant by the term earnings management. This is diddling the numbers.’ . . .
“Cardinal Health is absolutely confident in our accounting and report practices and our adherence to high ethical standards,’
Mr. Miller [Cardinal’s chief financial officer] says. “With regard to GAAP and SEC regulations, we are in full compliance in all material respects..

CARDINAL HEALTH A Note from Steve Fischbach, VP Investor Relations I wanted to make sure all of our investors and analysts received some information that responds to today’s Wall Street Journal Heard on the Street article titled “Cardinal Health's Accounting Raises a Number of Questions.’ ...
Here are the facts:
As we have explained to the reporter, this item was not a recording of a contingent gain under SFAS 5. The recoveries that Cardinal Health recorded related to vendor overcharges in our vitamin business were based on the virtual certainty of the recovery as supported by numerous external factors.
The reporter questioned the timing of two items recorded by the company ($10 million in the second quarter of fiscal year 2001 and $12 million in the first quarter of fiscal year 2002) related to the vitamin overcharge situation. This event was the recognition of an asset related to recoveries for vendor overcharges, based on the following five factors:

1. Vendors had admitted overcharging and plead guilty in a criminal proceeding. In prior periods Cardinal Health was in fact overcharged by those vendors and those charges were reflected in prior periods as higher cost of sales.
2. Vendors had settled with a number of plaintiffs, based on their admission of guilt.
3. Vendors were all major pharmaceutical companies with a clear ability to pay.
4. Issue was not “if” we would recover, but “how much.”
5. Quantification of the amount of recovery that was virtually certain was supported by written legal opinions from independent outside legal counsel that served as substantial audit evidence.
As it turned out, Cardinal Health received over $120 million from the defendants in the case which exceeded what was actually recorded by over $100 million. That is a very important point because it demonstrates the conservatism with which Cardinal Health dealt with the issue.

Required:
1. Vendors had admitted overcharging and plead guilty in a criminal proceeding. In prior periods Cardinal Health was in fact overcharged by those vendors and those charges were reflected in prior periods as higher cost of sales.
2. Vendors had settled with a number of plaintiffs, based on their admission of guilt.
3. Vendors were all major pharmaceutical companies with a clear ability to pay.
4. Issue was not “if” we would recover, but “how much.”
5. Quantification of the amount of recovery that was virtually certain was supported by written legal opinions from independent outside legal counsel that served as substantial audit evidence.
As it turned out, Cardinal Health received over $120 million from the defendants in the case which exceeded what was actually recorded by over $100 million. That is a very important point because it demonstrates the conservatism with which Cardinal Health dealt with the issue. ...
Source: Cardinal Health Letter to Shareholders (April 2, 2003).
1. Consult SEAS No. 5, “Accounting for Contingencies.” Are the GAAP rules for recognizing contingent gains (and a corresponding receivable) the same or different from those for recognizing contingent losses (and a corresponding liability)?
2. In view of the details outlined in Cardinal Health’s letter to analysts and investors, do you believe the company fully complied with SFAS No. 5 as it pertains to recognizing contingent gains? Why or why not?
3. If asked, how might management respond to questions about the timing of the gain recognition in 2001 and 2002?
4. Suppose that management was intent on informing analysts and investors about an expected litigation settlement amount. How might this be done in situations where SFAS No. 5 precluded recognizing the gain on the financial statements?