The case issue is the accusation of Cardinal Health in premature recognizing of litigation gains. According to the US Securities and Exchange Commission (SEC), the company’s actions violated the generally accepted accounting principles (GAAP), which is unacceptable (Young, Cohen & Bens, 2019). Cardinal Health’s decision to deduct the expected litigation cost is dictated by the company’s need to close the gap of the estimated earnings per share (EPS) for the 2nd quarter of the fiscal year (FY) 2001. Choosing to report this amount as a nonoperating item would not help the company with this goal.
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The phrase of Cardinal Health’s senior executive can be interpreted as the desire to deliberately overstate the gain to create higher profit in the upcoming quarter. Since the company could not meet the EPS estimate otherwise, it could fix the situation on paper. Such actions are known as “big bath accounting” and are strongly discouraged in accounting (Young et al., 2019). Cardinal Health basically created a hidden reserve, which SEC viewed as financial statement manipulation.
The reason behind the negative reaction of the SEC was the fact that Cardinal Health violated International Financial Reporting Standards (IFRS). According to these principles, the provision cannot be recognized without the obligation on the defendant’s part, which Cardinal Health did not obtain. As a result, the company created a hidden reserve of profits, which effectively covered their gap and resulted in higher profits.
The senior management defended their decision by classifying the amount of potential litigation gain as a reasonable estimation, hence, accounting for it as a provision. On a scale from 1 to 10, the actions of Cardinal Health management can be classified as 6. Although they received the estimated amount of $22 million, the violation happened more than once, and the company ignored multiple warnings.
Young, S. D., Cohen, J., & Bens, D. A. (2019). Corporate financial reporting and analysis: A global perspective (4th ed.). Hoboken, NJ: Wiley.