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.

Case Study 13-1 Accounting for Contingent Assets: The Case of Cardinal Health In a complaint dated 26 July 2007, and after a four-year inves- tigation, the US Securities and Exchange Commission (SEC) accused Cardinal Health, the world's second largest distribu- tor 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? *"Cardinal Health Settles Shareholders' Suit, The Associated Press, 1 June 2007. (Continued) Background litigation, was nonrecurring, and stemmed from claims against The story begins in 1999 when Cardinal Health joined a class third parties that originated nearly 13 years earlier. action to recover overcharges from vitamin manufacturers. By May 2002, PwC had been replaced as Cardinal's The vitamin makers had just pled guilty to charges of price- auditor by Arthur Andersen. Andersen was responsible for fixing from 1988 to 1998. In March 2000, the defendants in auditing Cardinal's financial statements for the whole of FY that action reached a provisional settlement with the plaintiffs 2002, ended 30 June 2002, and thus, it reviewed Cardinal's under which Cardinal could have received $22 million. But classification of the $12 million vitamin gain. The Andersen Cardinal opted out of the settlement, choosing instead to file its auditors agreed with PwC that Cardinal had misclassified the own claims in the hopes of getting a bigger payout. gain. After Cardinal's persistent refusal to reclassify the gains, The accounting troubles started in October 2000 when Andersen advised the company that it disagreed but would treat senior managers at Cardinal began to consider recording a the $12 million as a "passed adjustment" and include the issue portion of the expected proceeds from a future settlement as in its Summary of Audit Differences. a litigation gain. The purpose was to close a gap in Cardinal's In spring 2002 Cardinal Health reached a $35.3 mil- budgeted earnings for the second quarter of FY 2001, which lion settlement with several vitamin manufacturers. The ended 31 December 2000. According to the SEC, in a Novem- $8.5 million not yet recognized was recorded as a gain in the ber 2000 e-mail a senior executive at Cardinal Health explained final quarter of FY 2002. But while management thought its why Cardinal should use the vitamin gain, rather than other accounting policies had been vindicated by the settlement, the earnings initiatives, to report the desired level of earnings: "We issue wouldn't go away. do not need much to get over the hump, although the preference On 2 April 2003, an article in the "Heard on the Street" would be the vitamin case so that we do not steal from Q3." column in The Wall Street Journal sharply criticized Cardinal On 31 December 2000, the last day of the second quarter Health for its handling of the litigation gains. "It's a CAR- of FY 2001, Cardinal recorded a $10 million contingent vitamin DINAL rule of accounting the article begins, pun intended. litigation gain as a reduction to cost of sales. In its complaint, the "Don't count your chickens before they hatch. Yet new disclo- SEC alleged that Cardinal's classification of the gain as a reduc- sures in Cardinal Health Ines latest annual report suggests that tion to cost of sales violated GAAP. It is worth noting that had is what the drug wholesaler has done not just once, but twice." the gain not been recognized, Cardinal would have missed ana- Nevertheless, management continued to defend its accounting lysts' average consensus EPS estimate for the quarter by $.02. practices, partly on the grounds that the amounts later received Later in FY 2001, Cardinal considered recording a simi- from the vitamin companies exceeded the amount of the con- lar gain, but its auditor at the time, PricewaterhouseCooperstingent gains recognized in FY 2001 and FY 2002. Moreover, (hereafter PwC), was opposed to the idea. Accordingly, no liti- after the initial settlement, Cardinal Health received an addi- gation gains were recorded in the third or fourth quarters of FY tional $92.8 million in vitamin related litigation settlements, 2001. Moreover, PwC advised Cardinal that the $10 million bringing the total proceeds to over $128 million. recognized in the second quarter of FY 2001 as a reduction to cost of sales should be reclassified "below the line" as non- The Outcome operating income. Cardinal management ignored the auditor's Cardinal management finally succumbed to reality in the fol- advice, and the $10 million gain was not reclassified. lowing year, and in the Form 10-K (annual report) filed with The urge to report an additional gain resurfaced during the SEC for FY 2004, Cardinal restated its financial results to the first quarter of FY 2002, and for the same reason as in the reverse both gains, restating operating income from the two prior year: to cover an expected shortfall in earnings. On 30 September 2001, the last day of the first quarter of FY 2002, Arthur Andersen ceased operating months later in the aftermath of the Enron scandal. The Cardinal Health audit was then taken over by Ernst & Cardinal recorded a $12 million gain, bringing the total gains Young from litigation to $22 million. As in the previous year, Cardinal *A Summary of Audit Differences is a nonpublic document that lists the classified the gain as a reduction to cost of sales, allowing the audit opinion. If the net effect of the errors exceeds the materiality threshold company to boost operating earnings. However, PwC disagreed established for the client, the auditor will require an adjustment to the finan- with Cardinal's classification. The auditor advised Cardinal that cial statements. "Passed adjustment" means that the error in question was waived; that is, no adjustment was demanded by the auditor the amount should have been recorded as nonoperating income 3-Cardinal Health's Accounting Raises Some Questions," by Jonathan Weil, on the grounds that the estimated vitamin recovery arose from The Wall Street Journal, 2 April 2003, p. CI. affected quarters. But the damage had already 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. Required a. What justification could be given for deducting the expected litigation gain from cost of goods sold? Why did Cardinal Health choose this alternative instead of report- ing it as a nonoperating item? b. What did the senior Cardinal executive mean 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"? And more specifically, what is meant by the phrase, "not steal from Q3"? c. What specifically did Cardinal Health do wrong that got it into trouble with the SEC? d. What might Cardinal Health's senior managers say in their own defense? How might they justify the timing of the $10 million and the $12 million gains? e. Cardinal Health ended up receiving a lot more than $22 million from the litigation settlement. Were their actions so wrong as to justify the actions of the SEC? On a scale of 1 to 10, with 1 being relatively harmless and 10 being "downright fraudulent," where would you classify Cardinal's behavior, and why