Discussion Board

The principles regarding leases were recently updated by FASB, as discussed in the textbook. Explain two main differences between finance and operating leases under these new lease provisions.Select a publicly traded company and access its most recent financial statements, form 10-K. Include the name of the company in your subject line, and do not choose a company about which one of your classmates has already posted. Navigate to the notes to the financial statements and locate the company’s note on lease disclosures. Identify if the company has operating leases, financing leases, or both. Explain how you can tell which type of leases the company utilizes. Is the company properly reporting leases using the new standard? How can you tell?

13
Provisions and Contingencies
Introduction
The purpose of this chapter is to address the accounting treatment for provisions and
contingencies. The chapter draws on the examples of L’Oréal and Merck to illustrate the key
concepts. Sources of provisioning include corporate restructuring, warranties, environmental
clean‐up, litigation, and onerous contracts.1 Contingencies can arise for several reasons, but
litigation‐related costs are the most common.
To begin, let’s imagine a vacuum‐cleaner manufacturer offering a two‐year warranty for its
products. If something goes wrong within the warranty period, the company either repairs the
machine or replaces it. This means that every time a vacuum cleaner is sold, a potential
liability is assumed. For accounting purposes, the company could, in theory, report a
warranty‐related expense only when resources are paid out to service a warranty (e.g., when
a faulty machine is brought in by a customer for repair). But this approach would violate both
the matching principle and conservatism. The matching principle says that any costs incurred
to generate revenue must be “matched” against the revenue in the period in which the
revenue is recognized, even if cash payments will not be made until a future period, and the
amount is not known with certainty. Conservatism says that companies should not understate
liabilities or expenses. If we have reason to believe that the company has incurred obligations
as a result of past transactions (e.g., the sale of vacuum cleaners), the related liability and the
warranty expense that go with it should be recognized immediately.
Simply put, both matching and conservatism require the recognition of the liability and
expense in the period of sale, even if cash payments will not happen until later. Of course, this
requirement gives rise to a problem: how do we know what the warranty cost is likely to be?
In fact, we cannot know (at least not with precision), but estimates must be made anyway.
Because all provisions are estimates, and estimates are a function of a set of assumptions
made by management, companies have some latitude in the figures they report in the
financial statements. In short, they can underprovision or overprovision. The effect of the
former is to understate expenses or losses in the current period, thereby boosting profits. Of
course, underprovisioning must eventually be corrected, as actual expenditures related to the
provision will, at some point, exceed the recognized provision. This means that future
accounting periods will be burdened with higher expenses or losses, and thus lower profits.
Overprovisioning has the opposite effect, overstating expenses in the current period (and
understating profits), while understating expenses in future periods. Overprovisioning is
especially important for the financial statement reader to understand because of the
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tendency of some companies to use it as a means of creating “hidden” or “cookie‐jar”
reserves. The risk of overprovisioning is highest when companies enjoy highly profitable years
or, conversely, when they take huge write‐offs to acknowledge underperforming assets
bought in previous years. The temptation in such cases is to deliberately overstate the
amount of the write‐off, allowing reversals (and higher profits) in future years. This practice is
widely known as “big bath accounting.”
Defining Provisions
IFRS has one specific standard that deals generally with how companies should account for
provisions, while US GAAP has several standards addressing specific types of provisions – for
example, environmental liabilities or restructuring costs.2
According to IFRS, a company should recognize a provision only when:
the entity has a present obligation to transfer economic benefits as a result of past events;
it is probable that such a transfer will be required to settle the obligation; and
a reliable estimate of the amount of the obligation can be made.
A present obligation arises from an obligating event and may take the form of either a legal
obligation or a constructive obligation. A legal obligation may arise, for example, from
minimum payments a company must make to laid‐off employees. A constructive obligation
may arise from the same event if the company has a practice of paying workers above the
legal minimum. Even if the company is not legally obligated to make supplemental payments,
but corporate history and policy suggest that they will, a constructive obligation exists. The
key point is that without some obligation on the company’s part, whether legal or
constructive, a provision cannot be recognized. Also, if the company can avoid the
expenditure by its future actions, it has no present obligation, and a provision is not
recognized.
To illustrate, consider the case of restructuring events. According to IFRS, a present obligation
exists only when the entity is “demonstrably committed” to the restructuring. This criterion is
met when there is a binding agreement to sell or dispose of assets (legal obligation), or when
the company has a detailed plan for the restructuring and is unable to withdraw because
implementation has already started or the main features have been announced to those
affected by the plan (constructive obligation).
The term “past events” implies that provisions cannot be taken for events that might happen
in the future. In other words, a company is not permitted to recognize a provision as a sort of
contingency in case some loss is incurred.
Under IFRS, “probable” means “more likely than not” (i.e., any probability greater than 50%).
The meaning of probable under US GAAP normally conveys a higher probability threshold,
perhaps as high as 80%.3
Finally, a provision should not be recognized unless a reliable estimate can be made of it. In
cases where the other criteria are met but this one is not, disclosure is made in the form of a
note.
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Measuring the Provision
According to IFRS, the amount recognized as a provision must be the best estimate of the
minimum expenditure required to settle the present obligation at the balance sheet date. The
entity must discount the anticipated cash flows using a discount rate that reflects current
market assessments of the time value of money and those risks specific to the liability. If a
range of estimates is predicted and no amount in the range is more likely than any other, the
“midpoint” of the range must be used to measure the liability.
US GAAP is similar to IFRS, however, if a range of estimates is present and no amount in the
range is more likely than any other amount in the range, the “minimum” (rather than the
midpoint) must be used. Also, a provision is discounted only when the timing of the cash
flows is fixed.
Disclosure of Provisions: Interpreting the Notes
This section focuses on how to interpret corporate disclosures of provisions. The material in
Box 13.1 comes from the 2016 annual report of L’Oréal, the Paris‐based cosmetics giant.
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BOX 13.1 Example of Corporate Disclosures for Provisions
13.1.1 Closing Balances
€ millions
12.31.2016 12.31.2015 12.31.2014
Non‐current provisions for liabilities and
charges
333.3
195.9
193.6
Other non‐current provisions(1)
333.3
195.9
193.6
Current provisions for liabilities and charges
810.7
754.6
722.0
Provisions for restructuring
47.5
50.9
65.5
Provisions for product returns
323.4
309.3
244.4
Other current provisions(1)
439.8
394.4
412.1
1,144.0
950.4
915.6
TOTAL
(1) This item includes provisions for tax risks and litigation, industrial, environmental and commercial
risks relating to operations (breach of contract), personnel‐related costs and risks relating to
investigations carried out by competition authorities.
The provisions relating to investigations carried out by competition authorities amount to
€214.4 million at December 31st, 2016 compared with €212.5 million at December 31st, 2015
and €239.4 million at December 31st, 2014 (note 12.2.2.a and b).
The provisions relating to the dispute on IPI with the tax administration in Brazil amount to
€91.4 million and €20.8 million respectively at December 31st, 2016 and December 31st, 2015
(note 12.2.1.).
This caption also includes investments in associates when the Group’s share in net assets is
negative (note 8).
13.1.2 Changes in Provisions for Liabilities and Charges During the Period
€ millions
12.31.2014 12.31.2015 Charges(2) Reversals Reversals Other(1) 12.31.2016
(not
(used)(2)
used)(2)
Provisions
for
restructuring
65.5
50.9
48.5
−40.4
−6.1
−5.4
47.5
Provisions
for product
returns
244.4
309.3
303.1
−216.8
−79.3
7.2
323.4
Other
provisions
605.7
590.2
219.7
−115.2
−51.8
130.1
773.1
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€ millions
12.31.2014 12.31.2015 Charges(2) Reversals Reversals Other(1) 12.31.2016
(not
(used)(2)
used)(2)
for liabilities
and charges
TOTAL
915.6
950.4
571.3
−372.4
−137.2
131.9
1,144.0
1 Mainly resulting from translation differences and €58.4 million relating to the dispute on IPI with the
tax administration in Brazil (note 12.2.1.).
2 These figures can be analysed as follows:
€ millions
Charges Reversals (used) Reversals (not used)
♦ Other income and expenses
50.6
−40.5
−7.8
♦ Operating profit
480.2
−322.2
−107.1
♦ Income tax
40.5
−9.7
−22.3
The first panel in the note (part (a)) reports total provisions of €1,144.0 million as of the end of
2016 (2015 = €950.4 million), of which €810.7 million are current (i.e., payment of the liability
is expected within 12 months) and €333.3 million are noncurrent. Nearly all of these
provisions relate to tax risks (including, for example, disputes with fiscal authorities over the
amount of tax owed), litigation, restructuring costs, and a variety of commercial risks such as
potential losses from breaches of contract and product returns.
The second panel (part (b)) reports on variations in provisions from the end of the previous
year. In effect, it tells us the debits and credits made by L’Oréal in 2016 to the provisions
account and why those entries were made. For example, “charges” indicates the additional
provisions taken by the company during the year. Although numerous entries were probably
made as a result of the charges, they can be summarized as follows:
Expenses and losses 571.3
Provisions
571.3
For tax risks, litigation, breaches of contract, product returns, and restructuring.
“Reversals” indicate the reductions taken to the provisions account during the year. These
reductions, recorded as debits to provisions, occur for either of two reasons:
1. The company pays off at least a portion of the liabilities incorporated in the account (e.g.,
redundancy payments are actually made to laid‐off employees) or
2. The company is correcting an overestimation of provisions from previous years.
In L’Oréal’s case, €372.4 of reversals were “used,” which implies that they fall into the former
category. Assuming that all of the payments were made in cash, the summary entry looks like
this:
Provisions 372.4
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Cash
372.4
The reversals “not used” have a very different interpretation. In effect, L’Oréal is telling us that
€137.2 million of provisions recognized in previous years will not have to be paid and,
therefore, should be reversed. Put another way, provisions taken before 2016 were
overstated by €137.2 million. Based on the final section of panel (b), the summary entry to
record the unused provisions would be (in millions of €):
Provisions
137.2
Other income and expenses
7.8
Income tax expense
22.3
Operating profit
107.1
Readers of financial statements should be especially wary of such reversals because their
effect is to boost earnings. Note that all three credits are to income statement accounts,
which means that the reversal allowed L’Oréal to increase reported pretax income by €137.2
million. And none of that increase in profit had anything to do with L’Oréal’s activities in 2016.
It simply reflected accounting adjustments. In effect, pre‐2016 overprovisioning created a
“hidden reserve” of profits that L’Oréal could draw on in 2016 to report higher profits. Judging
whether the overprovisioning was deliberate or a good‐faith reflection of conservative
accounting policy is beyond the scope of this book.
Contingent Liabilities
IFRS defines a contingent liability as a possible obligation whose outcome will be confirmed
only on the occurrence or nonoccurrence of uncertain future events outside the entity’s
control. It can also be a present obligation that is not recognized because it is not probable
that an outflow of economic benefits (e.g., cash) is required, or the amount of the outflow
cannot be reliably measured. Contingent liabilities are disclosed in the notes unless the
probability of outflows is remote (in which case no disclosure is required). The most common
type of contingent liability arises from litigation, where payment by the entity will depend on a
future verdict or settlement.
When a contingency is both probable and the amount can be reasonably estimated, the
contingency is accounted for in the same manner as a provision. Accounting for contingencies
under US GAAP and IFRS is roughly the same, with the exception (noted earlier) that the bar
for determining whether or not a liability is probable is set higher under US GAAP. To
illustrate how contingencies work, and to contrast contingencies with provisions, we draw on
the example of Merck, the US‐based pharmaceutical company. The following example
focuses on Merck’s problems with Vioxx, an anti‐inflammatory pain medication that had to
be withdrawn after the drug was linked in scientific studies to heart disease.
Three basic issues arise. How does Merck account for (1) the drug’s withdrawal, (2) current
and future litigation costs (mainly the fees paid to legal counsel), and (3) any losses Merck
suffers because of adverse court decisions or out‐of‐court settlements?
The note in Box 13.2 addresses the first issue.4
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BOX 13.2 Merck’s Note on the Accounting for the Withdrawal of
Vioxx
On 30 September, 2004, the Company announced a voluntary worldwide withdrawal of
Vioxx, its arthritis and acute pain medication… . In connection with the withdrawal, in
2004 the Company recorded an unfavorable adjustment to net income of $552.6
million… . The adjustment to pre‐tax income was $726.2 million. Of this amount, $491.6
million related to estimated customer returns of product previously sold and was
recorded as a reduction of Sales, $93.2 million related to write‐offs of inventory held by
the Company and was recorded in Materials and production expense, and $141.4 million
related to estimated costs to undertake the withdrawal of the product and was recorded
in Marketing and administrative expense. The tax benefit of this adjustment was $173.6
million… . The adjustment did not include charges for future legal defense costs.
Ignoring tax effects, the summary entries to record these estimates include:
Sales
Payables
491.6
491.6
To record the return of Vioxx after the recall.
If the customer had not yet paid for the product, the balancing credit is to accounts
receivable. If the customer had already paid, the balancing credit is to a payable (i.e., a current
liability).
Materials and production expense 93.2
Inventories
93.2
To record the write‐off of Vioxx inventory.
Marketing and admin expense 141.4
Provision
141.4
To record the provision for the costs of the withdrawal.
This provision covers all of the costs of the product recall, apart from the write‐off of
inventories.
As for legal costs, those expected to be incurred before the end of 2007 were accrued, but
later costs were not, as the note shown in Box 13.3 explains.
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BOX 13.3 Merck’s Note on Legal Costs
Legal defense costs … are accrued when probable and reasonably estimable. As of
December 31, 2004, the Company had established a reserve of $675 million solely for its
future legal defense costs related to the Vioxx Litigation. During 2005, the Company spent
$285 million in the aggregate in legal defense costs worldwide related to Vioxx… . In the
fourth quarter, the Company recorded a charge of $295 million to increase the reserve …
to $685 million at December 21, 2005. This reserve is based on certain assumptions and
is the best estimate of the amount that the Company believes, at this time, it can
reasonably estimate will be spent through 2007… . Events such as scheduled trials, that
are expected to occur throughout 2006 and 2007, and the inherent inability to predict
the ultimate outcomes of such trials, limit the Company’s ability to reasonably estimate
its legal costs beyond the end of 2007.
In 2004, the following entry was made:
Litigation expense 675.0
Provisions
675.0
To record the establishment of the provision for litigation costs.
During 2005, the company disbursed $285 million to cover litigation needs:
Provisions 285.0
Cash
285.0
To record litigation‐related expenditures.
At the end of 2005, Merck management estimated that additional litigation costs, through the
end of 2007, are expected to be $685 million. To bring the liability account up to the required
amount, the following entry was needed:
Litigation expense 295.0
Provisions
295.0
To record the increase in provisions.
Note that because no reliable estimate can be made for litigation costs beyond 2007, no
liability is recognized.
Finally, the excerpt shown in Box 13.4 explains why the actual losses from adverse court
decisions have not yet been accrued.
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BOX 13.4 Merck’s Explanation of Their Treatment of Losses from
Adverse Court Decisions
… on August 19, 2005, in a trial in state court in Texas, the jury in Ernst vs. Merck reached
a verdict in favor of the plaintiff and purported to award her a total of $253 million in
compensatory and punitive damages. Under Texas law, the maximum amount that could
be awarded to the plaintiff is capped at approximately $26 million. The Company intends
to appeal this verdict after the completion of post‐trial proceedings in the trial court. The
Company believes that it has strong points to raise on appeal and is hopeful that the
appeals process will correct the verdict. Since the Company believes that the potential for
an unfavorable outcome is not probable, it has not established a reserve with respect to
the verdict.
Although an analyst would rightly assume that Merck is likely to incur significant liabilities
related to the thousands of cases pursued against it (losses may eventually run in the many
billions of dollars), no reliable estimate of the amount could be made by the time the 2005
annual report was published. In addition, Merck could claim that losses from specific lawsuits,
like the one cited above, might not result in any losses at all. As a result, no potential losses
from court judgments of settlements had been acknowledged as of the end of 2005. As
Merck’s losses come into sharper focus, provisioning for those losses can be expected.
Contingent Assets
A contingent asset is a possible asset arising from past events whose existence will only be
confirmed by future events not wholly within the entity’s control. Possible cash receipts from
the favorable settlement of a lawsuit is one common example. Contingent assets may require
disclosure but should not be recognized in the accounts. In practice, the recognition of
contingent assets is rare. However, such contingencies should be disclosed in the notes if an
inflow of economic benefits is probable. When the realization of benefits is virtually certain,
the related asset is no longer a contingency. At this point the asset should be recognized on
the balance sheet. The asymmetric treatment of contingent liabilities (which often are
recognized) and contingent assets (which almost never are) is a consequence of conservatism.
KEY LESSONS FROM THE CHAPTER
Contingencies can arise for several reasons, but litigation‐related costs are the most
common source. Contingent liabilities are accrued (i.e., lead to an accounting entry
affecting the income statement and balance sheet) only if the likelihood of the liability is
greater than 50% under IFRS, rising to 80% under US GAAP, and it can be reasonably
estimated. Otherwise, the contingency is disclosed in the notes (assuming it is material).
Contingent assets are almost never recognized, unless the receipt of economic benefits is
virtually certain. The asymmetric treatment between contingent liabilities and contingent
assets is driven by the conservatism doctrine.
20538391 – Wiley US ©
Because all provisions are estimates, and estimates are a function of a set of assumptions
made by management, companies have some latitude in the figures they report in the
financial statements.
Analysts should recognize that companies often create “cookie jar” (or “hidden”) reserves
in good years and reverse them in bad years. The effect is to smooth the time series of
earnings.
The creation of hidden reserves ranks among the most common forms of financial
statement manipulation.
A company should recognize a provision only when the entity has a present obligation to
transfer economic benefits as a result of a past event, it is probable that such a transfer
will be required, and a reliable estimate of the amount can be made.
The amount recognized as a provision must be the best estimate of the minimum
expenditure required to settle the present obligation as of the balance sheet date.
KEY TERMS AND CONCEPTS FROM THE CHAPTER
Provisions
Legal obligation
Constructive obligation
Contingent liabilities
Contingent assets
QUESTIONS
1. Why are contingent liabilities often recognized on the balance sheet, but contingent assets
are not?
2. What requirements must be met before a provision can be recognized?
3. How are provisions used to “smooth” earnings?
4. Companies should neither over‐ nor underprovision for losses and routine expenses such
as bad debts. And yet both forms of misstatement are common. Why?
5. True or false: The widespread adoption of IFRS has led to an increase in reported
provisions.
6. What criteria determine whether a contingent liability should be accrued?
7. What is meant by the term “provisions reversal,” and what effect does it have on the
balance sheet and income statement?
8. True or false: When companies recognize a provision, for whatever purpose, it is highly
unlikely that they will be able to deduct the loss or expense on their tax returns.
PROBLEMS
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13.1 Accounting for Warranties
The following note comes from a recent annual report for Sony Corporation:
Sony provides for the estimated cost of product warranties at the time revenue is recognized by
either product category group or individual product. The product warranty is calculated based
upon product sales, estimated probability of failure and estimated cost per claim. The variables
used in the calculation of the provision are reviewed on a periodic basis.
Certain subsidiaries in the Electronics business offer extended warranty programs. The
consideration received through extended 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
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”?
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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.
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.
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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 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.
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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” 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.
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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 form of both cash refunds and tire
replacements. Ignore tax effects.
b. Explain why the company has provided for potential losses on the tire recall, but not
for the lawsuits relating to the defective tires.
c. What key messages are the auditors trying to convey in their report?
15. Provision for tire recall and related costs
In October 1978, a provision for tire recall of $234.0 million ($147.4 million after income
taxes) was charged against income. The provision represented management’s estimate
of the cost of fulfilling the company’s obligations under the agreement with the National
Highway Traffic Safety Administration and the Company’s program of cash refunds to
those customers who had received an adjustment on tires that would otherwise have
been subject to recall and free replacement.
In October 1979, based on experience to date and anticipated future charges, the 1978
provision was reduced. Management also determined that the provision should be
broadened to include $30.8 million of other related costs which were not considered for
inclusion in the original provision. The net effect of the above was to reduce the provision
by $46.9 million, for which no provision for income taxes was required because of the
use of 1978 foreign tax credits of $20.8 million.
It should be recognized that the number of tires still to be returned and the other costs
yet to be incurred may vary from management’s estimates. Any additional adjustments
required by such variance will be reflected in income in the future.
The activity in the accrued liability for tire recall and related costs for 1979 and 1978
follows:
1979
1978
Accrued liability at beginning of year
$227.2
$—
Amount accrued (reversed) during the year
(46.9)
234.0
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1979
1978
Amounts charged thereto
(123.9)
(6.8)
Accrued liability at end of year
$ 56.4 $227.2
16. Contingent liabilities
Twelve purported consumer commercial class actions (one of which consolidates five
previous actions) are presently pending against the Company in various state and federal
courts … In the purported class actions, the named plaintiffs are requesting … various
forms of monetary relief, including punitive damages, as a result of the Company’s
having manufactured and sold allegedly defective Steel Belted Radial 500 and other steel
belted radial passenger tires.
… In addition to the class actions, there are several thousand individual claims pending
against the Company for damages allegedly connected with steel belted radial passenger
tires …
… The Company is a defendant in a purported class action which seeks, among other
things, recovery for losses by stockholders who purchased the Company’s common stock
between December 1975 and July 1978 by reason of the decline in market price for such
stock alleged to result from the Company’s alleged failure to make proper disclosure of,
among other things, the steel belted radial passenger tire situation.
In March 1979, the United States brought an action seeking recovery against the
Company in the amount of approximately $62 million by reason of alleged illegal gold
trading activity in Switzerland.
Following a federal grand jury investigation into the Company’s incomes taxes, the
Company entered into a plea agreement in July 1979 under which the Company pleaded
guilty to two counts charging the inclusion in its taxable income for 1972 and 1973
amounts that had been generated in prior years: the courts imposed a total fine of ten
thousand dollars on the Company by reason of its plea. A civil tax audit by the Internal
Revenue Service is currently in progress covering some of the same matters investigated
by the grand jury as well as other matters. The government may assess substantial tax,
interest and penalties in connection with the matters under investigation.
The Securities and Exchange Commission is conducting an investigation of the adequacy
of the Company’s disclosures in earlier years concerning the Steel Belted Radial 500 tire
…
… The Company has various other contingent liabilities, some of which are for substantial
amounts, arising out of suits, investigations and claims related to other aspects of the
conduct of its business …
… Increased uncertainties have developed during the past year with regard to some of
the contingencies identified in this note. Because of the existing uncertainties, the
eventual outcome of these contingencies cannot be predicted, and the ultimate liability
with respect to them cannot be reasonably estimated. Since the minimum potential
liability for a substantial portion of the claims and suits described in this note cannot be
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reasonably estimated, no liability for them has been recorded in the financial statements.
Management believes, however, that the disposition of these contingencies could well be
very costly. Although the Company’s management, including its General Counsel,
believes it is unlikely that the ultimate outcome of these contingencies will have a
material adverse effect on the Company’s consolidated financial position, such a
consequence is possible if substantial punitive or other damages are awarded in one or
more of the cases involved.
Report of independent certified public accountants
To the Stockholders and Board of Directors,
The Firestone Tire & Rubber Company:
We have examined the balance sheets of The Firestone Tire & Rubber Company and
consolidated subsidiaries at October 31, 1979 and 1978, and the related statements of
income, stockholders’ equity, and changes in financial position for the years then ended.
Our examinations were made in accordance with generally accepted auditing standards
and, accordingly, included such tests of the accounting records and such other auditing
procedures as we considered necessary in the circumstances.
As set forth in Note 16 to the financial statements, the Company is a party to various
legal and other actions. These actions claim substantial amounts as a result of alleged
tire defects and other matters. The ultimate liability resulting from these matters cannot
be reasonably estimated. In our report dated December 18, 1978, our opinion on the
financial statements for the year ended October 31, 1978, was unqualified. However, due
to the increased uncertainties that developed during the year ended October 31, 1979,
with respect to these matters, our present opinion on the financial statements for the
year ended October 31, 1978, as presented herein, is different from that expressed in
our previous report.
In our opinion, subject to the effects on the financial statements of adjustments that
might have been required had the outcome of the matters referred to in the preceding
paragraph been known, the financial statements referred to above present fairly the
financial position of The Firestone Tire & Rubber Company and consolidated subsidiaries
at October 31, 1979 and 1978, and the results of their operations and the changes in
their financial position for the years then ended, in conformity with generally accepted
accounting principles applied on a consistent basis.
Coopers & Lybrand
Cleveland, Ohio
December 12, 1979
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Case Study
13‐3 Firestone Tire and Rubber Company (B)
Late in 1979, to save the company from pending collapse, Firestone brought in John
Nevin as CEO. He closed several of the company’s manufacturing plants, and spun off
nontire‐related businesses, including the famous Firestone Country Club. In 1988, after
the company had been restored to some measure of profitability, Nevin negotiated the
sale of Firestone to the Japanese company Bridgestone. The North American division,
headquartered in Nashville, became known as Bridgestone‐Firestone (BFS).
It’s déjà vu All over Again
But just as memories were fading of the tire recall from the late 1970s, rumours began to
circulate regarding new quality concerns at BFS. The trouble started in 1996 as
customers began to allege that Firestone tires on their Ford Explorers were faulty. As the
complaints grew louder, BFS decided to conduct an internal investigation. The
conclusion: the tires had either been misused or underinflated.
But the problem wouldn’t go away. The tires were linked to several road deaths in
Venezuela, and a nasty argument ensued between BFS and Ford, with each blaming the
oth
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