Revenue Games at Cardinal Health

The distributor settles with the SEC after several investigations uncover too much tinkering with reserve accounting and revenue recognition.

Cardinal Health will pay the Securities and Exchange Commission $35 million to settle charges that it had used improper accounting methods and filed misleading financial reports from 2000 to 2004. The SEC’s complaint against the drug and equipment distribution company included allegations that Cardinal violated generally accepted accounting principles (GAAP) in its treatment of balance-sheet reserve accounts and prematurely recognized revenue from its equipment business.

The SEC charged that Cardinal employed several methods to overstate its operating revenue and meet earnings estimates in press releases and regulatory filings. For example, the company allegedly made adjustments to 60 reserve accounts that violated GAAP, resulting in an overstatement of about $65.2 million. The company adjusted the reserves to “meet its own earnings projections, earnings guidance, and analysts’ expectations, without regard for whether the reserve adjustments were in accordance with GAAP,” the SEC said, citing excerpts from e-mail exchanges between two corporate managers. An e-mail message from 2002, for instance, discussed the reversal of a $2 million reserve to “help make the quarter.” The e-mail exchange also noted: “We built it for a rainy day … and it looks like it is pouring!”

When the company later restated its financials to account for the adjustments made to reserves and other accruals, its net earnings were reduced by a total of $65.2 million, noted the SEC.

Since June 2004 – after Cardinal disclosed that its audit committee, the SEC, and the Department of Justice were investigating how the company classified revenue from one of its divisions – the company restated nearly four years’ worth of financial results. The restatements primarily related to bulk deliveries to customers, cash discounts earned from suppliers in exchange for prompt payment, and the reserve and accrual adjustments.

In a press release on Thursday, the company also acknowledged that it has made a “number of important changes” to its financial reporting and disclosure practices and has hired a new CFO, chief accounting officer, and controller, as well as created the position of chief ethics and compliance officer. In fact, Cardinal recently shuffled its finance department, following the resignation of Chief Accounting Officer and Controller Eric Slusser in June. Also as part of the settlement with the SEC, the company will hire an independent consultant to review some of its policies.

The settlement may not mean the issue is completely over for Cardinal, however. Earlier this year, the company said its founder and chairman, Robert Walter, along with four unnamed former officers had received a Wells Notice, which indicates that the SEC staff may recommend that the commission bring civil charges against the individuals. Former Cardinal CFO Richard Miller resigned a month after the company disclosed the federal investigations in 2004.

Cardinal officials also announced on Thursday that the DoJ closed its investigation of the company.

Thursday’s news from the SEC was not a surprise. The company had set aside a $35 million reserve in January 2006 after reaching a tentative agreement with the SEC staff on the basic terms of a settlement. The SEC will put the money into a Fair Fund for eventual distribution to Cardinal Health shareholders who were “deceived” by the misrepresentations of revenue and earnings, the regulator said. “As this case demonstrates, issuers cannot resort to accounting ploys and misleading disclosures to make their numbers,” said Linda Thomsen, director of the SEC’s Division of Enforcement.

Among its charges against Cardinal Health, the SEC alleged that the company:

• Created an undisclosed process of classifying its bulk-product revenue as operating revenue to inflate the numbers revealed to investors by approximately $2 billion over three years. “This initiative did not create any new revenue, but instead shifted revenue from the bulk revenue line to the operating revenue line,” the SEC explained.

• Misclassified $22 million of litigation recoveries resulting from overcharges from vitamin manufacturers. Cardinal recorded the amount as a reduction to the cost of sales during two different time periods, which violates GAAP, as one of its auditors later warned. Rather, the amount should have been recorded once as a non-recurring item the previous year and as non-operating income.

• Manipulated its LIFO (last in, first out) inventory-accounting method. On one occasion, the company switched its method without telling investors by using the first in, first out method and deliberately holding inventory at one of its business units past the end of the 2003 fiscal year. By doing so, the company realized a $23.1 million increase in its operating earnings and an earnings-per-share increase of 3 cents for one quarter.

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