ACC 502 Analyzing Liabilities

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 using effective business writing style. Refer to the resource, “Effective Business Writing,” located in the Class Resources, for specific guidelines and formatting requirements.

warranty service is deferred and amortized on a straight‐line basis over the term of
the extended warranty.
Required
Based on this note, answer the following:
a. How does Sony account for the product warranties? What would be the impact of
the estimated cost of product warranties on each of the three principal financial
statements?
b. If Sony underestimates product warranties expense, how would it correct the
error?
c. How does Sony treat the extended warranty program at (a) time of sale, and (b) in
subsequent periods? How would the accounting affect each of the three principal
financial statements?
13.2 Analyzing and Interpreting Disclosures on the Provision for Warranties
Creative Technology, Ltd., a Singapore‐based consumer electronics company,
disclosed the following information regarding warranty provisions in its 2011 Annual
Report.
The warranty period for the bulk of the products typically ranges between 1 to 2
years. The product warranty provision reflects management’s best estimate of
probable liability under its product warranties. Management determines the
warranty provision based on known product failures (if any), historical experience,
and other currently available evidence. Movements in provision for warranty are as
follows:
2011 2010
($000)
Beginning of financial year
2,784
2,899
Provision (written back) made (606)
1,915
Provision utilized
(711) (2,030)
End of financial year
1,467
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2,784
Required
a. Make the necessary journal entries to record the movements in the provisions for
warranties account for 2010 and 2011.
b. What is meant by “provision made” and “provision written back”?
c. What does “provision utilized” mean?
d. Describe what happened in 2011 regarding Creative’s provisions.
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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 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?
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 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.
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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
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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 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.
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 reporting 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?
* “Cardinal Health Settles Shareholders’ Suit,” The Associated Press, 1 June 2007.
† 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”
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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.
Case Study
13‐2 Firestone Tire and Rubber Company (A)
Throughout most of the twentieth century, Firestone Tire and Rubber Company
was one of the world’s leading manufacturers of tires for passenger cars and
trucks. In 1978 the company was forced to recall some of its radial tires for
alleged defects. The following pages provide excerpts from Firestone’s 1979
annual report, detailing the provisions and contingencies involved in the tire
recall and related issues. The report of the company’s auditors is also provided.
Required
a. Reconstruct summary journal entries for all of the activity in the “accrued
liability for tire recall” account since it was established in 1978 (see Note 15).
Assume that settlements with customers take the fo
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